1. Chapter 5 ELEMENTS OF DEMAND AND CONSUMER CHOICE

2. Learning objectives 2 Understand how consumers can optimize  Given that we have limited income, what is the best combination of goods to consume?  For a single good, how can we maximize consumer surplus? Understand how to sum individual demand curves to create a market demand curve

3. Law of Demand 3  People do less of what they want to do as the cost of doing it rises Recall the Cost-Benefit Principle  Pursue an action if and only if its benefits are at least as great as its costs Recall the consumer reservation price  The highest price you’d be willing to pay

4. “Utility” 4 Utility represents the satisfaction people derive from consumption activities Utility Maximization refers to people trying and allocate their incomes to maximize their satisfaction Normally, the more we consume, the more total utility we have (assumes goods are good) At the margin however, incremental utility decreases in quantity – law of diminishing marginal utility

5. Total Utility from Ice Cream Consumption 5

6. How does utility affect our purchase decisions? 6 1973 Pinto Squire Utility = 500 2011 Audi TT Utility = 50,000 (the Audi is 100 times more satisfying than the Pinto)

7. How does utility affect our purchase decisions? 7 Do we have enough information to decide which car to purchase? Is utility enough?

8. How does utility affect our purchase decisions? 8 We also need to know prices.  2011 Audi TT Price = $40,000  1973 Pinto Squire Price = $200 Which car is a “better deal”? Audi: 50,000 units of satisfaction for $40,000  = 1.25 units of utility per dollar spent Pinto: 500 units of satisfaction for $200  = 2.5 units of utility per dollar spent

9. Bang-for-the-buck 9 Utility per dollar (or marginal utility per dollar) gives us the value of the purchase per dollar spent. Utility per dollar = satisfaction / price

10. Optimal Combination 10 When buying a variety of goods, how do we maximize total utility? The optimal combination of goods to purchase is the affordable combination that yields the highest total utility.

11. Rational Spending Rule 11 o Suppose we purchase 2 goods: Candy (C) and Soda (S) o Spending should be allocated across goods so that the marginal utility per dollar (“bang-for-the- buck”) is the same for each good: o the marginal utility per dollar = o The ratio of marginal utility to price must be the same for each good the consumer buys

12. Rational Spending Rule What should you do if: MU c /P c > MU s /P s ? E.g. you get 20 units of utility per dollar spent on C and only 16 units of utility per dollar spent on S. You should buy more C and less S to increase total utility without spending any more money. But, what happens when you do this?? 12

13. Rational Spending Rule 13 As you buy more of the higher MU/P good its MU decreases (law of DMU). As you buy less of the lower MU/P good its MU increases (law of DMU in reverse). Eventually, the MU/P will be equal, and you cannot increase utility further by moving your dollars around.

14. Consumer equilibrium 14 Applying the rational spending rule leads to a stable purchases (sometimes called a “consumer equilibrium” ). Once you’ve found the optimal combination of goods, there’s no reason to purchase any other combination, unless…  Preferences change  Prices change  Income changes

15. Exercise 15 Toby’s current marginal utility from consuming peanuts is 100 units of utility per ounce, and his marginal utility from cashews is 200 units of utility per ounce. The price of peanuts is 10 cents per once, and the price of cashews is 25 cents per ounce. Is Toby maximizing his total utility from the consumption of these 2 goods?

16. Exercise 16 Peanuts: MU/$ = 100/.10 = 1000 Cashews: MU/$ = 200/.25 = 800 Peanuts yield higher marginal utility per dollar and are therefore a “better deal”. He should consumer more peanuts and less cashews to increase total utility.

17. Maximizing Consumer Surplus 17 What happens when you purchase something for a price that is less than your maximum willingness to pay? E.g. you are willing to pay $20,000 for a new car and you buy it for 18,000 You receive a “surplus” of benefit over cost = $2,000

18. Consumer Surplus and Demand 18 Consumer surplus for a given quantity is therefore the difference between your maximum willingness to pay (reservation price) and what you actually paid (actual price). CS = the sum of the difference between MB and MC (price) for all units consumed

19. Consumer Surplus and Demand 19 Graphically then, CS is the area above the price line and below the demand curve, up to Q* Here, CS = $200 =½(base)(height) = ½(20)(20) S D P 40 20 20 Q

20. Consumer Surplus QMB (demand)MC (P) 110040 28040 36040 4 52040 20 What is the optimal quantity to consume, and how much is consumer surplus? Q* = 4 units (MC =MC) and CS = $120

21. Individual vs. Market Demand 21 How do we “add-up” the individual demands for all consumers in a market to form the market demand curve? Option 1: add all prices and quantities Option 2: add all prices at each quantity demanded Option 3: add quantities demanded at each price

22. Individual vs. Market Demand 22 Option 3 is correct: to find the market quantity demanded at each price, simply add the individual quantities demanded This should make sense, because consumers face the same set of prices, but have different quantities demanded. This is called “horizontal summation” because we are adding along the horizontal (quantity) axis

23. Individual and Market Demand Curves for Canned Tuna 23

24. Exam 1 24 Exam 1 will be available on Blackboard Learn from Tuesday July 19 (6:00 am) through Wednesday July 20 (midnight). You will have 90 minutes to complete the exam once you begin. Be sure to have uninterrupted time available. As soon as you begin, the clock starts ticking. You may use lecture notes, textbook and Connect. Collaboration of any nature with anyone or discussion of the exam contents prior to Thursday July 21 is strictly prohibited and will result in an automatic failing grade for the course and potential disciplinary action by the University. Format: 25 short answer (m/c, t/f) and 2 essays (with options)  Short answer questions worth 80 points, essays worth 10 each