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From Individual Demand to Consumer Surplus Today: Deriving market demand from individual demand; using reservation prices to derive consumer surplus

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Previously… 7 core principles Thinking like economists Introduction to supply and demand Equilibrium A route choice experiment and its equilibrium Deriving individual demand

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Today Using individual demands to derive market demand Reservation price Consumer surplus

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Recall individual demand Last time, we went through the assumptions that gave us a downward- sloping individual demand curve We will use “horizontal addition” to derive market demand from all individual demands

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Example: Individual demand to market demand Suppose Pat and Shannon have the following demand schedules for apples PriceShannon’s quantity demanded Pat’s quantity demanded $600 $520 $440 $360 $283 $1106 $0129

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Example: Individual demand to market demand How do we get the market demand from individual demands? We add them up PriceShannon’s quantity demanded Pat’s quantity demanded Total demand $6000 $5202 $4404 $3606 $28311 $110616 $012921

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Some graphing reminders Some reminders of graphs Label axes Label dollar amounts, quantities, etc. To save space, all quantity numbers here are apples

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Graphing demands: Shannon (left) & Pat (right)

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Total demand

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How can we graph demand with only the graphs? Another method of graphing total demand from individual demand is a method called horizontal addition We horizontally add quantities demanded from each person AT A GIVEN PRICE

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Price greater than $3 When price is greater than $3, Shannon is the only person demanding a positive quantity Thus, the top half of Shannon’s demand curve is the same as the market’s

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At $3, 6 + 0 units are demanded

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At $0, 12 + 9 units are demanded

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Bottom half of the demand curve At $3, 6 units are demanded At $0, 21 units are demanded Bottom half of demand curve connects (6, $3) and (21, $0)

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Reservation price and consumer surplus How “well off” are we when we buy something? Calculate consumer surplus by using demand curve and reservation price

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Reservation price Reservation price is the highest price a person is willing to pay for a good or service Note that reservation price for the n th unit corresponds to a particular point of a demand curve

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Let’s return to part of Shannon’s demand Shannon’s reservation price for 6 th apple is $3 PriceShannon’s quantity demanded $60 $52 $44 $36

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Core principle: Efficiency Today, we calculate consumer surplus to help on our quest to efficiency

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Calculating consumer surplus Consumer surplus (CS) for the n th unit is the vertical difference between the demand curve and the price paid We will calculate CS two ways Discretely Approximate using area under demand curve

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Back to Shannon PriceShannon’s quantity demanded $60 $52 $44 $36 QuantityReservation price 1 st unit$5.50 2 nd unit$5 3 rd unit$4.50 4 th unit$4 5 th unit$3.50 6 th unit$3

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If P = $3… At P = $3, Shannon demands 6 apples To calculate total consumer surplus for Shannon, we simply add CS for each unit purchased QuantityReservation price CS 1 st unit$5.50$2.50 2 nd unit$5.00$2.00 3 rd unit$4.50$1.50 4 th unit$4.00$1.00 5 th unit$3.50$0.50 6 th unit$3.00$0.00

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CS for 6 units purchased CS is the sum of the six dollar amounts in the right column, or $7.50 QuantityReservation price CS 1 st unit$5.50$2.50 2 nd unit$5.00$2.00 3 rd unit$4.50$1.50 4 th unit$4.00$1.00 5 th unit$3.50$0.50 6 th unit$3.00$0.00

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CS from demand curves CS can be approximated by calculating the area under the demand curve and above the price The area of this triangle is a good approximation of CS

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CS from demand curves Height of triangle is ($6 – $3), or $3. Length of triangle is (6 – 0), or 6 Area of triangle is one-half times length times height CS = $9 The area of this triangle is a good approximation of CS

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This concludes demand What have we learned? How individual demand is derived Utility The rational spending rule Deriving market demand from individual demand Consumer surplus

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