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Chapter 5: Demand. Food. Question: Given that a person can consume a combination of food and clothes at any point on the budget line, which point would satisfy the person the most? A or B or any other point?. A. B. Budget line. Clothes. Demand. - PowerPoint PPT Presentation
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1
Chapter 5: Demand
Question: Given that a person can consume a combination of food and clothes at any point on the budget line, which point would satisfy the person the most? A or B or any other point?
Food
Clothes
A
BBudget line
2
Demand
• People allocate their limited income among different goods and services to maximize their satisfaction.
– Utility: the satisfaction people derive from consumption• Subjective• Not comparable between people• Individuals’ goal is to maximize their utility
– Revisit the cost-benefit principle• People would consume one more unit of food only if the
marginal utility of doing so is at least as large as its cost, which is the utility lost from the reduction in the consumption of clothes.
3
Utility – An Example
Sarah's Utility from Ice Cream
Cones / Hour 0 1 2 3 4 5 6
Total Utility 0 50 90 120 140 150 140
Cones/hour
Util
s/ho
ur
1 3 4 5 62
150140
120
90
50
4
Utility – An Example (Cont.)
Sarah's Marginal Utility from Ice Cream
Cones / Hour 0 1 2 3 4 5 6
Total Utility 0 50 90 120 140 150 140
Marginal Utility 50 40 30 20 10 -10
Marginal utility: the additional utility from consuming one more
Marginal utility = Change in utility
Change in consumption
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Diminishing Marginal Utility
As consumption increases beyond some point , the
marginal utility gained from consuming additional
unit of a good tends to decrease.
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Marginal Utility
ε = P
Q
1
slopex
• Given a fixed income, how would a person choose between two goods in order to maximize his/her utility from consumption?
- Compare the marginal utility gained from choosing one good with the marginal utility lost from giving up another good;
- Law of Diminishing Marginal Utility applies
– As you buy more of a single good, its marginal utility decreases
– When you buy less of that good, its marginal utility increases
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Utility Maximization – An Example
ε = P
Q
1
slopex
Pints/yr
Vanilla Ice Cream
12
200
MU
(u
tils/
pin
t) Chocolate Ice Cream
Pints/yr
16
100
MU
(u
tils/
pin
t)
• $400 budget• Chocolate is $2 per pint• Vanilla is $1 per pint
• Buy 200 pints of vanilla and 100 pints of chocolate• Marginal utility is 12 for
vanilla, 16 for chocolate
Sarah's Ice Cream
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Utility Maximization – An Example
• Susan can increase her utility by consuming less Chocolate and more Vanilla
– Reduce one pint of chocolate saves her $2, with which Susan can buy two more pints of vanilla ($1 per pint);
– Marginal utility lost from giving up one pint of chocolate = 16 utils;– Marginal utility gained from two more pints of vanilla = 2x12=24
utils;– Gain > Loss, Susan should buy more vanilla and less chocolate;– So, under what conditions would Susan maximizes her total utility?
In other words, what is the optimal combination of chocolate and vanilla that gratifies Susan the most?
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Utility Maximization – An Example
Pints/yr
Vanilla Ice Cream
200
MU
(u
tils/
pin
t)
300
812
Chocolate Ice Cream
Pints/yr
16
100
MU
(u
tils/
pin
t)
50
24
Increase vanilla by 100 Reduce chocolate by 50
Marginal utility of vanilla is 8 Marginal utility of chocolate is
24
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Utility Maximization – An ExampleM
U
(util
s/ p
int)
Pints/yr
Vanilla Ice Cream
250
10M
U
(util
s/ p
int)
Chocolate Ice Cream
Pints/yr
20
75
• Optimal combination: highest total utility
• 250 pints vanilla; 75 pints chocolate
• Marginal utility / price is the same for all goods• Marginal utility of vanilla
10, chocolate 20
11
Utility Maximization – An Example
Scenario 1 Price Quantity Marginal Utility MU / $
Vanilla $1 200 12 12
Chocolate $2 100 16 8
Scenario 2 Price Quantity Marginal Utility MU / $
Vanilla $1 300 8 8
Chocolate $2 50 24 12
Scenario 3 Price Quantity Marginal Utility MU / $
Vanilla $1 250 10 10
Chocolate $2 75 20 10
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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
MU1 / P1 = MU2 / P2
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Rational Spending Rule
• Substitution effect– Suppose, one starts with MU1/P1=MU2/ P2;
– When P1 increases, MU1/P1<MU2/ P2;
– According to the rational spending rule, one should increase spending on good 2 and reduce spending on good 1 until MU1/P1=MU2/ P2 again;
– So explained is the substitution effect.
14
Rational Spending Rule
Is Eric following the Rational Spending Rule? What matters is the marginal utility in the rational
spending rule.
Eric's Apples
Apples Oranges
Total Expenditures $100 $50
Price $2 $1
Total Utility 1,000 400
Quantity 50 50
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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
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Consumer Surplus
• Consumer's surplus is the difference between the buyer's reservation price and the market price
• 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
D
Units/day
12
34
5
6789
1011
12
2 4 6 8 10 12
Vanilla Ice Cream
Mar
gina
l util
ity
(util
s/ p
int)
17
Consumer Surplus
• 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
D12
345
67
89
1011
12
2 4 6 8 10 12
Vanilla Ice Cream
Units/day
Mar
gina
l util
ity
(util
s/ p
int)
18
Consumer Surplus: An Example
• Price is $2 and quantity is 4,000 gallons per day
• Consumer surplus is the area of the triangle formed by– Demand curve– Vertical axis– Horizontal intercept of
demand curve– Remember: area of a right
triangle is ½ width times height
• The area is ½ ($1)(4,000 gal) = $2,000
Quantity (000s of gal/day)
Pric
e ($
/gal
lon)
1
1.00
2.00
3.00
2 3 4 5 6
S
D
Consumer Surplus