1 Frank & Bernanke 3 rd edition, 2007 Ch. 5: Ch. 5: Demand - The Benefit Side of The Market

2 Questions If free ice cream is available between 2 PM and 4 PM, do every one who is attracted to the site get it? If free ice cream is available between 2 PM and 4 PM, do every one who is attracted to the site get it? What is the MC in monetary terms? What is the MC in monetary terms? What is the MC in opportunity cost terms? What is the MC in opportunity cost terms? How is ice cream allocated among consumers? How is ice cream allocated among consumers?

3 Law of Demand The costly one views an activity, the less likely one will do it. The costly one views an activity, the less likely one will do it. The lower the cost of a good/service/activity, the more of it will be “consumed.” The lower the cost of a good/service/activity, the more of it will be “consumed.”

4 Law of Demand The benefit of an activity equals the highest price we’d be willing to pay to pursue it (i.e., the reservation price). The benefit of an activity equals the highest price we’d be willing to pay to pursue it (i.e., the reservation price). As the cost of an activity rises and exceeds the reservation price, less of the activity will be pursued. As the cost of an activity rises and exceeds the reservation price, less of the activity will be pursued.

5 Needs vs Wants “Californians don’t have as much water as they need!” “Californians don’t have as much water as they need!” “Californians don’t have as much water as they want at the ongoing price of water!” “Californians don’t have as much water as they want at the ongoing price of water!”

6 Measuring Wants: The Concept of Utility Utility Utility The satisfaction people derive from their consumption activities The satisfaction people derive from their consumption activities Assumption Assumption People allocate their income to maximize their satisfaction or total utility People allocate their income to maximize their satisfaction or total utility

7 Sarah’s Total Utility from Ice Cream Consumption Cone quantity (cones/hour) Total utility (utils/hour) How much ice cream should Sarah consume if the ice cream is “free”? How many cones should she order once she is at the counter? Is the time spent in the line relevant to how many cones to order?

8 Sarah’s Total Utility from Ice Cream Consumption Cones/hour Utils/hour

9 Sarah’s Marginal Utility from Ice Cream Consumption Cone quantity Total utilityMarginal utility (cones/hour) (utils/hour)(utils/cone)

10 Diminishing Marginal Utility Sarah’s marginal utility

11 The Law of Diminishing Marginal Utility The tendency for the additional utility gained from consuming an additional unit of a good to diminish as consumption increases beyond some point The tendency for the additional utility gained from consuming an additional unit of a good to diminish as consumption increases beyond some point

12 Allocating A Fixed Income Between Two Goods Two goods: Chocolate and vanilla ice cream Two goods: Chocolate and vanilla ice cream Price of chocolate equals $2/pint Price of chocolate equals $2/pint Price of vanilla equals $1/pint Price of vanilla equals $1/pint Sarah’s budget = $400/yr Sarah’s budget = $400/yr Currently Sarah is consuming 200 pints of vanilla and 100 pints of chocolate Currently Sarah is consuming 200 pints of vanilla and 100 pints of chocolate

13 Marginal Utility Curves for Two Flavors of Ice Cream Marginal utility of vanilla ice cream (utils/ pint) Marginal utility of chocolate ice cream (utils/ pint) Pints/yr

14 Is Sarah Maximizing Her Total Utility? Marginal utility vanilla/P: $12/1 = 12 utils/$ Marginal utility chocolate/P: 16/2 = 8 utils/$ If Sarah spends $2 less on chocolate, utils will decline by 16. If Sarah spends $2 more on vanilla, utils will increase by 24. So… Sarah should buy more vanilla and less chocolate.

15 Is Sarah Maximizing Her Total Utility? But how much more vanilla and how much less chocolate? But how much more vanilla and how much less chocolate? Until MU v /P v = MU c /P c Until MU v /P v = MU c /P c If MU v /P v > MU c /P c then buy more vanilla and less chocolate. If MU v /P v > MU c /P c then buy more vanilla and less chocolate. If MU v /P v < MU c /P c then buy more chocolate and less vanilla. If MU v /P v < MU c /P c then buy more chocolate and less vanilla.

16 Pints/yr Marginal utility of vanilla ice cream (utils/ pint) Sarah increases vanilla spending by $100, and MU V /P V = 8/$1 = 8 Vanilla

17 Chocolate Marginal utility of chocolate ice cream (utils/ pint) Pints/yr Sarah decreases chocolate spending by $100, and MU C /P C = 24/$2 = 12 > MU V /p V = 8

18 Is Sarah Maximizing Her Total Utility? Can she improve her position? Can she improve her position? Use the rational decision-making rule. Use the rational decision-making rule. Is MU per $ of vanilla greater or less than MU per $ of chocolate? Is MU per $ of vanilla greater or less than MU per $ of chocolate? MU/P of vanilla was $8 and MU/P of chocolate was $12. MU/P of vanilla was $8 and MU/P of chocolate was $12. So Sarah should buy more chocolate and less vanilla. So Sarah should buy more chocolate and less vanilla.

19 Equilibrium Pints/yr Marginal utility of vanilla ice cream (utils/ pint)

20 Equilibrium Marginal utility of chocolate ice cream (utils/ pint) Pints/yr 20 75

21 Equilibrium Budget = $400 Budget = $400 P C = $2 & P V = $1 P C = $2 & P V = $1 Q C = 75 & Q V = 250 Q C = 75 & Q V = 250

22 The Rational Spending Rule Spending should be allocated across goods so that the marginal utility per dollar is the same for each good. Spending should be allocated across goods so that the marginal utility per dollar is the same for each good.

23 Price of chocolate falls to $1

24 Applying the Rational Spending Rule Why do the wealthy in Manhattan live in smaller houses than the wealthy in Seattle? Why do the wealthy in Manhattan live in smaller houses than the wealthy in Seattle? Why did people turn to four-cylinder cars in the 1970s only to shift back to six- and eight-cylinder cars in the 1990s? Why did people turn to four-cylinder cars in the 1970s only to shift back to six- and eight-cylinder cars in the 1990s? Why are automobile engines smaller in England than in the United States? Why are automobile engines smaller in England than in the United States? Why are waiting lines longer in poorer neighborhoods? Why are waiting lines longer in poorer neighborhoods?

25 Individual and Market Demand Curves for Canned Tuna Price ($/can) Smith’s quantity (cans/week) 248 Price ($/can) Jones’s quantity 6 0 (cans/week) 24 Smith Jones + Horizontal Addition

26 Individual and Market Demand Curves for Canned Tuna Price ($/can) Total quantity 6 0 (cans/week) = Market Demand curve

27 The Individual and Market Demand Curves When All Buyers Have Identical Demand Curves Price ($/can) Quantity (cans/month) D Quantity (1000s of cans/month) D Price ($/can) Each of 1,000 consumers have the same demand Market Demand = P x number of consumers (1,000)

28 Consumer Surplus The difference between a buyer’s reservation price for a product and the price actually paid. The difference between a buyer’s reservation price for a product and the price actually paid. P

29 Supply and Demand in the Market for Milk Quantity (1,000s of gallons/day) Price ($/gallon) S D

30 Consumer Surplus in the Market for Milk Quantity (1,000s of gallons/day) Price ($/gallon) S D Consumer surplus h = $1/gallon b = 4,000 Consumer surplus = (1/2)(4,000)(1) = $2,000/day