Transcript Chapter 5
Econ 2610: Principles of Microeconomics Yogesh Uppal Email: [email protected] LO 5 - 1 Chapter 5 LO 5 - 1 Demand Free Ice Cream – Or Is It? Costs of a good extend beyond the monetary costs "Free" ice cream attract so many consumers that the time spent waiting in line acts as the price of the good Demand curves relate the quantity demanded to ALL costs, not just monetary costs LO 5 - 1 Law of Demand Law of Demand People do less of what they want to do as the cost of doing it rises LO 5 - 1 Cost-Benefit Principle at work Do something if the marginal benefits are at least as great as the marginal costs If market price exceeds the reservation price, buy no more LO 5 - 1 Origins of Demand Determinants of reservation price Individual tastes and preferences differ Biological needs Peer behavior Perceived quality ■ ■ ■ Cultural influences Individual differences Expected benefits Tastes may change over time LO 5 - 1 Macaroni and cheese Spinach Bell-bottoms Wants and Utility Utility: the satisfaction people derive from consumption Well-being, happiness Measured indirectly Subjective Observable Cannot be compared between people Individual goal is to maximize utility Allocate resources accordingly LO 5 - 1 Sarah's Utility from Ice Cream Utils/hour Cones / Hour Total Utility 0 1 2 0 50 90 4 5 90 50 2 6 120 140 150 140 150 140 120 1 LO 5 - 1 3 3 4 Cones/hour 5 6 Sarah's Marginal Utility from Ice Cream Cones / Hour Total Utility Marginal Utility 0 1 2 3 4 0 50 90 120 140 150 140 50 40 30 20 5 10 6 -10 Marginal utility: the additional utility from consuming one more Change in utility Marginal utility = Change in consumption LO 5 - 1 Diminishing Marginal Utility Law of Diminishing Marginal Utility Tendency for additional utility gained from consuming an additional unit of a good to decrease as consumption increases beyond some point LO 5 - 1 Diminishing Marginal Utility Marginal utility can increase at low levels of consumption Eventually marginal utility declines Apply Cost-Benefit Principle Consume an additional unit as long as the marginal utility (benefit) is greater than the marginal cost LO 5 - 1 Given a fixed budget, law of Diminishing Marginal Returns applies As you buy more of a single good, its marginal utility decreases When you buy less of that good, its marginal utility increases LO 5 - 1 Marginal utility increases as quantity decreases Marginal Utility Marginal Utility Spending on Two Goods Marginal utility decreases as quantity increases Rational Spending Rule The Rational Spending Rule Spending should be allocated across goods so that the marginal utility per dollar is the same for each good LO 5 - 1 Rational Spending Rule Rational Spending Rule can be written algebraically Notation MUC is the marginal utility from chocolate MUV is the marginal utility from vanilla PC is the price of chocolate PV is the price of vanilla Rational Spending Rule MUC / PC = MUV / PV The marginal utility per dollar spent on chocolate equals the marginal utility per dollar spent on vanilla LO 5 - 1 Budget Allocation Given the budget, the utility is maximized when the marginal utility per dollar spent is the same for all goods Current spending has marginal utility of a dollar spent on one good higher than the marginal utility of a dollar spent on the other good Take a dollar away from the good with low marginal utility and spend it on the good with high marginal utility LO 5 - 1 Marginal utilities per dollar begin to equalize Sarah's Ice Cream Chocolate is $2 per pint Vanilla is $1 per pint Vanilla Ice Cream 12 200 Pints/yr LO 5 - 1 Buy 200 pints of vanilla and 100 pints of chocolate Marginal utility is 12 for vanilla, 16 for chocolate MU (utils/ pint) $400 budget MU (utils/ pint) Chocolate Ice Cream 16 100 Pints/yr Sarah's Choices Vanilla 100 150 200 250 300 MU 16 14 12 10 7 chocolate 150 125 100 75 50 LO 5 - 1 MU / $ 16 14 12 10 7 MU MU / $ 8 4 12 6 16 8 20 10 24 12 TU 1600 2100 2400 2500 2100 TU 1200 1500 1600 1500 1200 Sarah's Next Step Increase vanilla by 100 Reduce chocolate by 50 Vanilla Ice Cream 12 8 200 Pints/yr LO 5 - 1 MU (utils/ pint) MU (utils/ pint) Marginal utility of vanilla is 8 Marginal utility of chocolate is 24 300 24 Chocolate Ice Cream 16 50 100 Pints/yr Sarah's Equilibrium Vanilla Ice Cream 10 250 Pints/yr LO 5 - 1 Marginal utility / price is the same for all goods Marginal utility of vanilla 10, chocolate 20 MU (utils/ pint) Optimal combination: highest total utility 250 pints vanilla; 75 pints chocolate MU (utils/ pint) Chocolate Ice Cream 20 75 Pints/yr Substitution Effect When the price of a good goes up, substitutes for that good are relatively more attractive If the price of vanilla ice cream goes up, some buyers will buy less vanilla and more chocolate Income Effect Changes in price affect the buyers' purchasing power LO 5 - 1 Suppose price of vanilla increases from $1 to $2 At the original equilibrium MUC / PC = MUV / PV With the increase in PV, MUV / PV < MUC / PC If Sarah buys more chocolate, MUC will go down If Sarah buys less vanilla, MUV will go up To get to a new optimal spending point, Buy more chocolate. Buy less vanilla. Stop when the marginal utility per dollar is the same At new price for vanilla, she buys 100 vanilla and only 100 chocolate LO 5 - 1 Suppose Chocolate Ice Cream Price Goes Down from $2 to $1 With the decrease in Pc, MUV / PV < MUC / PC If Sarah buys more chocolate, MUC will go down If Sarah buys less vanilla, MUV will go up To get to a new optimal spending point, Buy more chocolate, Buy less vanilla, Stop when marginal utility per dollar is the same At new price for chocolate, she buys somewhere between 250 and 275 vanilla and somewhere between 125 and 150 chocolate. LO 5 - 1 Eric's Apples Total Expenditures Price Total Utility Quantity Apples Oranges $100 $50 $2 1,000 50 $1 400 50 Is Eric following the Rational Spending Rule? LO 5 - 1 Individual and Market Demand Curves The market demand is the horizontal sum of individual demand curves At each possible price, add up the number of units demanded by individuals to get the market demand LO 5 - 1 Consumer Surplus Consumer's surplus is the difference between the buyer's reservation price and the market price With multiple buyers Find the consumer surplus for each buyer Add up the individual surpluses LO 5 - 1 When a product is sold in whole units, the demand curve is a stair-step function Many goods are indivisible: movie tickets and TVs If the market supplied only one unit, the maximum price would be $11 For the second unit, the price is $10, and so on The last buyer gets no consumer surplus LO 5 - 1 Marginal utility (utils/ pint) Consumer Surplus on a Graph Vanilla Ice Cream 12 11 10 9 8 7 6 5 4 3 2 1 D 2 4 6 8 Units/day 10 12 Market price is $6 for all sales Total consumer surplus The first sale generates $5 of consumer surplus Reservation price of $11 minus the price of $6 Selling the second unit has $4 of consumer surplus, and so on Total consumer surplus is the area under the demand curve and above market price LO 5 - 1 Marginal utility (utils/ pint) Consumer Surplus on a Graph Vanilla Ice Cream 12 11 10 9 8 7 6 5 4 3 2 1 D 2 4 6 8 Units/day 10 12 Consumer Surplus for Milk Consider the market demand and supply of milk The equilibrium price is $2 per gallon The equilibrium quantity is 4,000 gallons per day Last customer pays his reservation price and gets no consumer surplus LO 5 - 1 Consumer Surplus 3.00 Price ($/gallon) S 2.00 D 1.00 1 2 3 4 5 6 Quantity (000s of gal/day)