Chapter 5 ELEMENTS OF DEMAND AND CONSUMER CHOICE.

Chapter 5

ELEMENTS OF DEMAND AND CONSUMER CHOICE

Learning objectives2

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

Law of Demand3

Law of Demand People do less of what they want to do as the cost of

doing it risesRecall 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

“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

Total Utility from Ice Cream Consumption5

How does utility affect our purchase decisions?

6

1973 Pinto SquireUtility = 500

2011 Audi TTUtility = 50,000

(the Audi is 100 times more satisfying than the Pinto)

How does utility affect our purchase decisions?

7

Do we have enough information to decide which car to purchase?

Is utility enough?

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

Bang-for-the-buck9

Utility per dollar (or marginal utility per dollar) gives us the value of the purchase per dollar spent.

Utility per dollar = satisfaction / price

Optimal Combination10

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.

Rational Spending Rule11

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:MU

P

MU

PC

C

S

S

o the marginal utility per dollar =MU

Po The ratio of marginal utility to price must be the same for each good the consumer buys

Rational Spending Rule

What should you do if: MUc/Pc > MUs/Ps ?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

Rational Spending Rule13

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.

Consumer equilibrium14

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

Exercise15

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?

Exercise16

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.

Maximizing Consumer Surplus17

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

Consumer Surplus and Demand18

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

Consumer Surplus and Demand19

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

Consumer Surplus

Q MB (demand) MC (P)

1 100 40

2 80 40

3 60 40

4 40 40

5 20 40

20

What is the optimal quantity to consume, and how much is consumer surplus?

Q* = 4 units (MC =MC) and CS = $120

Individual vs. Market Demand21

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 quantitiesOption 2: add all prices at each quantity

demandedOption 3: add quantities demanded at

each price

Individual vs. Market Demand22

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

Individual and Market Demand Curves for Canned Tuna

23

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