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Frank & Bernanke 3 rd edition, 2007. Ch. 5: Demand - The Benefit Side of The Market. Questions. 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 opportunity cost terms? - PowerPoint PPT Presentation
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Frank & BernankeFrank & Bernanke33rdrd edition, 2007 edition, 2007
Ch. 5: Ch. 5: Demand - The Benefit Side of The Market
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QuestionsQuestions If free ice cream is available between 2 If free ice cream is available between 2
PM and 4 PM, do every one who is PM and 4 PM, do every one who is attracted to the site get it?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 How is ice cream allocated among
consumers?consumers?
33
Law of DemandLaw of DemandThe costly one views an activity, the less The costly one views an activity, the less
likely one will do it.likely one will do it.The lower the cost of a good/service/activity, The lower the cost of a good/service/activity,
the more of it will be “consumed.”the more of it will be “consumed.”
44
Law of DemandLaw of DemandThe benefit of an activity equals the highest The benefit of an activity equals the highest
price we’d be willing to pay to pursue it (i.e., price we’d be willing to pay to pursue it (i.e., the reservation price).the reservation price).
As the cost of an activity rises and exceeds As the cost of an activity rises and exceeds the reservation price, less of the activity will the reservation price, less of the activity will be pursued.be pursued.
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Needs vs WantsNeeds vs Wants ““Californians don’t have as much water as Californians don’t have as much water as
they need!”they need!” ““Californians don’t have as much water as Californians don’t have as much water as
they want at the ongoing price of water!”they want at the ongoing price of water!”
66
Measuring Wants: The Measuring Wants: The Concept of UtilityConcept of Utility
UtilityUtilityThe satisfaction people derive from their The satisfaction people derive from their
consumption activitiesconsumption activitiesAssumptionAssumption
People allocate their income to maximize their People allocate their income to maximize their satisfaction or total utilitysatisfaction or total utility
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Sarah’s Total Utility Sarah’s Total Utility from Ice Cream Consumptionfrom Ice Cream ConsumptionCone quantity (cones/hour) Total utility (utils/hour)
0 01 502 903 1204 1405 1506 140
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?
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Sarah’s Total Utility Sarah’s Total Utility from Ice Cream Consumptionfrom Ice Cream Consumption
Cones/hour
Util
s/ho
ur
1 3 4 5 60 2
150140
120
90
50
99
Sarah’s Marginal Utility from Sarah’s Marginal Utility from Ice Cream ConsumptionIce Cream Consumption
Cone quantity Total utility Marginal utility(cones/hour) (utils/hour) (utils/cone)
0 01 502 903 1204 1405 1506 140
50 40 30 20 10-10
1010
Diminishing Marginal UtilityDiminishing Marginal Utility50
40
30
20
10
Sarah’smarginalutility
0
0.5 1 1.5 2 2.5 3.5 43 4.5
1111
The Law of Diminishing The Law of Diminishing Marginal UtilityMarginal Utility
The tendency for the additional utility gained The tendency for the additional utility gained from consuming an additional unit of a good from consuming an additional unit of a good to diminish as consumption increases beyond to diminish as consumption increases beyond some pointsome point
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Allocating A Fixed Income Allocating A Fixed Income Between Two GoodsBetween Two Goods
Two goods: Chocolate and vanilla ice Two goods: Chocolate and vanilla ice creamcream
Price of chocolate equals $2/pintPrice of chocolate equals $2/pintPrice of vanilla equals $1/pintPrice of vanilla equals $1/pintSarah’s budget = $400/yrSarah’s budget = $400/yrCurrently Sarah is consuming 200 pints of Currently Sarah is consuming 200 pints of
vanilla and 100 pints of chocolatevanilla and 100 pints of chocolate
1313
Marginal Utility Curves for Marginal Utility Curves for Two Flavors of Ice CreamTwo Flavors of Ice Cream
Mar
gina
l util
ity o
f van
illa
ice
crea
m(u
tils/
pin
t)
Mar
gina
l util
ity o
f cho
cola
te ic
e cr
eam
(util
s/ p
int)
12
200
16
100Pints/yr Pints/yr
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Is Sarah Maximizing Her Is Sarah Maximizing Her Total Utility?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.
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Is Sarah Maximizing Her Is Sarah Maximizing Her Total Utility?Total Utility?
But how much more vanilla and how much But how much more vanilla and how much less chocolate?less chocolate?
Until MUUntil MUvv/P/Pv v = MU= MUcc/P/Pcc
If MUIf MUvv/P/Pv v > MU> MUcc/P/Pc c then buy more vanilla then buy more vanilla and less chocolate.and less chocolate.
If MUIf MUvv/P/Pvv < MU < MUcc/P/Pc c then buy more then buy more chocolate and less vanilla.chocolate and less vanilla.
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Pints/yr
Mar
gina
l util
ity o
f van
illa
ice
crea
m
(util
s/ p
int)
12
200
8
300
Sarah increases vanillaspending by $100, andMUV/PV = 8/$1 = 8
VanillaVanilla
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ChocolateChocolate
Mar
gina
l util
ity o
f cho
cola
te ic
e cr
eam
(util
s/ p
int)
Pints/yr
16
100
24
50
Sarah decreases chocolatespending by $100, andMUC/PC = 24/$2 = 12 >MUV/pV = 8
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Is Sarah Maximizing Her Is Sarah Maximizing Her Total Utility?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 Is MU per $ of vanilla greater or less than
MU per $ of chocolate?MU per $ of chocolate?MU/P of vanilla was $8 and MU/P of MU/P of vanilla was $8 and MU/P of
chocolate was $12.chocolate was $12.So Sarah should buy more chocolate and So Sarah should buy more chocolate and
less vanilla.less vanilla.
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EquilibriumEquilibrium
Pints/yr
Mar
gina
l util
ity o
f van
illa
ice
crea
m
(util
s/ p
int)
10
250
110
VanillaPrice Vanilla
MU
2020
EquilibriumEquilibrium
Mar
gina
l util
ity o
f cho
cola
te ic
e cr
eam
(util
s/ p
int)
Pints/yr
20
75
220
Chocolate PriceChocolate
MU
2121
EquilibriumEquilibriumBudget = $400Budget = $400PPCC = = $2 & $2 & PPVV = $1 = $1QQCC = 75 & = 75 & QQVV = 250 = 250
110
PMU
220
PMU
V
V
C
C
2222
The Rational Spending RuleThe Rational Spending RuleSpending should be allocated across goods Spending should be allocated across goods
so that the marginal utility per dollar is the so that the marginal utility per dollar is the same for each good.same for each good.
V
V
C
C
PMU
PMU
2323
Price of chocolate falls to $1Price of chocolate falls to $1
110
PMU
120
PMU
V
V
C
C
2424
Applying theApplying theRational Spending RuleRational Spending Rule
Why do the wealthy in Manhattan live in smaller Why do the wealthy in Manhattan live in smaller houses than the wealthy in Seattle?houses than the wealthy in Seattle?
Why did people turn to four-cylinder cars in the Why did people turn to four-cylinder cars in the 1970s only to shift back to six- and eight-cylinder 1970s only to shift back to six- and eight-cylinder cars in the 1990s?cars in the 1990s?
Why are automobile engines smaller in England Why are automobile engines smaller in England than in the United States?than in the United States?
Why are waiting lines longer in poorer Why are waiting lines longer in poorer neighborhoods?neighborhoods?
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Individual and Market Individual and Market Demand Curves for Canned TunaDemand Curves for Canned Tuna
Pric
e ($
/can
)
Smith’s quantity
1.20
6
1.40
1.60
1.00
.80
.60
.40
.20
0
(cans/week)
2 4 8Pr
ice
($/c
an)
Jones’s quantity60
(cans/week)
2 4
Smith Jones+
Horizontal Addition
1.20
1.40
1.60
1.00
.80
.60
.40
.20
2626
Individual and Market Individual and Market Demand Curves for Canned TunaDemand Curves for Canned Tuna
Pric
e ($
/can
)
Total quantity60
(cans/week)
2 4 8 1210
=
MarketDemandcurve
1.20
1.40
1.60
1.00
.80
.60
.40
.20
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The Individual and Market Demand Curves The Individual and Market Demand Curves When All Buyers Have Identical Demand CurvesWhen All Buyers Have Identical Demand Curves
Pric
e ($
/can
)
Quantity
6
6
5
4
3
2
1
0
(cans/month)
2 4 8 1210
D
Quantity
6
6
5
4
3
2
1
0
(1000s of cans/month)
2 4 8 1210
D
Pric
e ($
/can
)
•Each of 1,000 consumers have the same demand•Market Demand = P x number of consumers (1,000)
2828
Consumer SurplusConsumer SurplusThe difference between a buyer’s The difference between a buyer’s
reservation price for a product and the reservation price for a product and the price actually paid.price actually paid.
P
2929
Supply and Demand Supply and Demand in the Market for Milkin the Market for Milk
Quantity (1,000s of gallons/day)
Pric
e ($
/gal
lon)
1
.50
1.00
1.50
2.00
2.50
3.00
2 3 4 5 6 7 8 9 10 11 120
S
D
3030
Consumer Surplus Consumer Surplus in the Market for Milkin the Market for Milk
Quantity (1,000s of gallons/day)
Pric
e ($
/gal
lon)
1
.50
1.00
1.50
2.00
2.50
3.00
2 3 4 5 6 7 8 9 10 11 120
S
D
Consumer surplus •h = $1/gallon•b = 4,000•Consumer surplus = (1/2)(4,000)(1) = $2,000/day