Preview of 4 Coming Attractions

Today: Derivation of the Demand Curve

Consumers (Buyers)

Next: Derivation of the Supply Curve

Firms (Sellers)

Later: Double Auction Market

Buyers and and sellers come together

Still later: Competitive Equilibrium Model

05_01

PRICE

Demand curve

QUANTITY DEMANDED

Why study the derivation of the demand curve?

Helps explain why a competitive market works well. Helps determine the position of the demand curve and the sensitivity of quantity demanded to price.

A brief digression on elasticity

Elasticity is a measure of how sensitive one variable (e.g. quantity demanded) is to another variable (e.g. price). Definition: the price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price

e = (% Q)/(%P)

Where we are going

Start with an individual consumer
maybe you, maybe me, but could be anyone

Derive demand curve for that individual

focus on marginal utility or marginal benefit

Add up demand curves for many such individuals to get market demand curve

Assumption about consumer behavior

General economic principle
People make purposeful choices with limited resources

When applied to the behavior of consumers

People maximize utility subject to a budget constraint

Utility: a numerical indicator of preferences

Marginal Utility Diminishing Marginal Utility

05_03T

Quantity
Pounds of Grapes 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 Pounds of Bananas 1 1 1 1 1 2 2 2 2 2 3 3 3 3 3 4 4 4 4 4 5 5 5 5 5 From Grapes and Bananas 16 20 23 25 26 24 28 31 33 34 28 32 35 37 38 30 34 37 39 40 31 35 38 40 41

Utility
From Grapes 6 10 13 15 16 6 10 13 15 16 6 10 13 15 16 6 10 13 15 16 6 10 13 15 16 From Bananas 10 10 10 10 10 18 18 18 18 18 22 22 22 22 22 24 24 24 24 24 25 25 25 25 25

The consumer prefers this combination to this combination because the utility is higher for the former.

The consumer is indifferent between these combinations because utility is equal.

05_04T

Pounds of Grapes 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Pounds of Bananas 1 1 1 1 1 2 2 2 2 2 3 3 3 3 3 4 4 4 4 4 5 5 5 5 5

Expenditures: Price of Grapes = $1 Price of Bananas = $1 2 3 4 5 6 3 4 5 6 7 4 5 6 7 8 5 6 7 8 9 6 7 8 9 10

Expenditures: Price of Grapes = $2 Price of Bananas = $1 3 5 7 9 11 4 6 8 10 12 5 7 9 11 13 6 8 10 12 14 7 9 11 13 15

Note: The red numbers are outside the budget constraint (the sum is greater than $8). The black numbers are within the budget constraint (the sum is less than or equal to $8).

05_05T

Pounds of Grapes 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 1 2 3 4 5

Pounds of Bananas 1 1 1 1 1 2 2 2 2 2 3 3 3 3 3 4 4 4 4 4 5 5 5 5 5

Utility from Grapes and Bananas 16 20 23 25 26 24 28 31 33 34 28 32 35 37 38 30 34 37 39 40 31 35 38 40 41

Expenditures: Expenditures: Price of Price of Grapes = $1 Grapes = $2 Price of Price of Bananas = $1 Bananas = $1 2 3 4 5 6 3 4 5 6 7 4 5 6 7 8 5 6 7 8 9 6 7 8 9 10 3 5 7 9 11 4 6 8 10 12 5 7 9 11 13 6 8 10 12 14 7 9 11 13 15

A maximum utility of 39 can be obtained with an $8 budget at these prices.

A maximum utility of 34 can be obtained with an $8 budget at these prices.

Marginal conditions for utility maximization

Ratio of marginal utilities equals ratio of prices for any two goods
(MUG/MUB) = (PG/PB) Explanation of Diamond Water Paradox
First pointed out by Adam Smith

The willingness to pay approach

Amount of X 0 1 2 3 4 Willingness to pay $0 $4 $7 $9 $10 Marginal Beneift --$4 $3 $2 $1

05_05

DOLLARS

5 4 3 2 1

QUANTITY DEMANDED (POUNDS)

An Important Conclusion: MB = P
The consumer chooses an amount such that the marginal benefit (MB) equals price (P) When I see a demand curve, I think of the marginal benefit to consumers WGAD: Why do economists put the quantity on the horizontal axis?

Consumer Surplus
Willingness to pay is usually greater than the price
for example my willingness to pay for a pair of eyeglasses is much more than the price

Consumer surplus is the area under the demand curve and above the price

Market Demand Curve

Consider all consumers in the market Add up quantity demanded by all individuals at each price to get market demand Add horizontally

05_06

PRICE (DOLLARS) 5 4 3 2 1 0 1 2 3 4 5 Pete's demand curve

PRICE (DOLLARS) 5 4 3 2 1 0 1 2 3 4 5 Ann's demand curve

QUANTITY DEMANDED BY PETE (POUNDS) PRICE (DOLLARS) 5 4 3 2 1 0 1 2 3 4 5 6

QUANTITY DEMANDED BY ANN (POUNDS)

Market demand curve

10

QUANTITY DEMANDED IN MARKET (POUNDS)