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

5

Diminishing Marginal Utility

As consumption increases beyond some point , the

marginal utility gained from consuming additional

unit of a good tends to decrease.

6

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

7

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

8

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?

9

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

10

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

12

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

13

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

15

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

16

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