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Hi, I'm Richard McKenzie. In the previous lecture, I stressed that scarcity is a core concern on microeconomics.

The scarcity I had in mind, however, is not the scarcity out there in the external world. That scarcity is very important to economics, because it brin s to li ht the ever!present cost o" doin any and everythin , and draws attention to the need to ma#e cost bene"it calculations in situations involvin choices, and choices are everywhere in the human predicament. However, the core concern o" economics in my way o" thin#in is the scarcity in, in here that is in our, our brains. $e economists and students o" economics are "aced with a truly dauntin problem, a limited brain with constrained computin powers in a truly complex world that we want to understand throu h the limited brains that we have. I would love to ta#e the world as it is into this course, in its "ull complexity, but that is hardly an option. Tryin to cope with the buzzin con"usion o" in"ormation that comes "rom the world around us as it is would %uic#ly cause brain overload. &o, to put it bluntly, dealin with the "ull complexity o" the world is an impossibility. $e must deal with the world out there in reduced "orm that is in the simpli"ied "orm, so that we can have any hope o" ainin insi hts about the world out there. Remember Kenneth 'ouldin 's #ey insi ht, #nowled e is always ained by the orderly loss o" in"ormation. I #now I repeat mysel" in ivin you that %uote a ain, but 'ouldin 's observation is so pro"ound that I must repeat it time and a ain, and a ain, and a ain so that you can understand, the method o" the madness o", o" economists. (ven i" we were experimentalists, as many psycholo ists are, our "irst tas# in our laboratory would be to simpli"y in a ross way the complexity o" the real world environment, to "ocus on a relatively "ew "orces that can be controlled in the laboratory. )ust thin# o" the sterility o" most laboratory environments. In economics, we "ocus on a "ew relationships, with the domain curve bein t he most prominent one o" all. In tal#in about the demand, as we have here, we o"tentimes tal# o", as i" the inverse relationship that we have in mind is a relationship between the prices o" ood, that is the price ta or the stic#er

price. *nd at this price, we have a %uantity o", o" +,. you lower the price to -. and you et a lar er %uantity. *nd we, we o"tentimes su est that the only price that's involved is that which is on, on the stic#er or on the ta o" the arment or whatever, but really what we have in mind is the price the "ull price o" the ood includin all costs consumers must bear in various "orms assumin everythin else remains constant. /o when I tal# about a price oin down, I'm not 0ust tal#in about the price ta oin down, althou h, that maybe the case, and maybe the only price that people have to pay "or many oods. 'ut I'm really ma#in a more eneral statement, that the price, the "ull price oes down, the %uantity oes up. I will rant you that everythin else mi ht not remain constant when there is a price chan e. Indeed, I will rant you that lots o" thin s chan e out there in the real world when the prices chan e, but my point still holds but with a twist. I" some other "orce chan es, "or example, tastes or the number o" buyers, and the price oes down at the same time consumption will o up by more than otherwise and vice versa. * ain, let's return to the raph. here, we have the price oin "rom -, to -., the %uantity oin "rom +, to +., assumin everythin else remains constant, but it's %uite possible that at the same time the price oes down, the demand "or the ood oes down "rom +,, I mean, 1, to 1., as I have illustrated in this raph. $ell, that o" course, the decrease in demand means that less is oin to be bou ht because o" the chan e in taste or the, or the chan e in the number o", o" consumers. 'ut still, what I can say here is that iven the price chan e "rom -, to -., the %uantity demanded oes "rom zero, here to here and, or "rom zero to +2. The %uantity has, has not one down by as much as it would have had, had the price not one down. In the last lecture, we consider, considered several price chan e. The decline in the price o" wine and drun# drivin . lower the price o" wine and you et more wine consumed and reater drun# drivin . $e also considered the increase in the ris# cost costs, o", o" "lyin . * reater ris# cost in "lyin is onna lead to less "lyin and more car travel. Here, I add two more applications. 3or example, the advent o", o" 4ipitor, which is an

anti!cholesterol dru and it's very e""ective. I, I ta#e it and I hi hly recommend or it's eneric version because it can allow you to eat more red meat. now, when, with the advent o" 4ipitor what that did is it reduced the cost o" eatin stea#s and other red meats, as a result, it simulated the consumption o", o" stea#s. *nd indeed, I've told my doctor when he prescribed 4ipitor "or me that he had 0ust iven me a new lease on outbac#. This means that 4ipitor can increase the amount o" stea# o" bein consumed over what would otherwise be the case. It also means that 4ipitor won't len then people's lives by as much as it could. I" people didn't increase their consumption o" red meat in response to the "act that 4ipitor reduces the conse%uences, the cost o" eatin red meat. *nother example is an increase in the "uel e""iciency o" automobiles. Many people see such a technolo ical advancement as reducin "uel use, which could be the case. Here, I simply point out that reater "uel e""iciency can lead to a reduction in the cost o" travel per mile, which can lead to a reater %uantity demanded o" miles driven, which means that a reater "uel e""iciency at the technical level will not be realized as people drive. They et more miles per allon, but very li#ely they will increase the miles driven, because the price o" the miles driven, has one down. I also point you to the "act that laser tattoo removal has reduced the cost o" tattoos. it used to be that i" you ot a tattoo you went to the rave with a tattoo, and th at, you #now, a, a sailor on leave mi ht o et a tattoo a"ter a "ew drin#s but then could not remove it. $hat you mi ht "ind now are completely sober people ettin tattoos because they can reason that the cost o" those tattoos has one down, because in saner moments they may be able to remove the tattoos with laser technolo y. &ow that we've iven you a number o" examples about downward slopin demand curve, the %uestion is, why does the demand curve slope downward5 I su est that there are two preliminary, and I must admit super"icial reasons o"ten iven "or the downward slopin o" the demand curve. Here, I cleaned up my, the demand curve and the ar ument "or the downward slopin demand curve is this, that is, i" you lower the price o" the ood "rom -, to -., then the %uantity

consume is oin to o up "rom +, to +.. -rice oes down, %uantity oes up. 'ut one reason "or this increase in, in %uantity here could be that people are substitutin whatever ood is here, call that * "or other oods that could be used in its place, so there is a substitution e""ect. It could also be that as the price oes down, people's real income in, real incomes increase and as a conse%uence, they can buy more o" the ood. I consider this, these explanations as preliminary and perhaps a bit wea#, because one, the substitution e""ect doesn't explain why people actually substitute, * "or other oods, when in "act its price oes down. *lso, there may be a real income e""ect here, but the real income e""ect can be %uite wea#, especially, i" you're tal#in about toothpic#s. 4ower the price o" toothpic#s, and my uess is most people's real income doesn't rise by very much. 'ut also, you mi ht have a perverse e""ect "rom the income e""ect. That is, as people's real incomes o up they, they may "or some oods decide to reduce the consumption o" the other oods. 3or example, i" we're tal#in about the demand "or beans and there is a real income increase "or the demand "or real increase o" people who buy beans, they may switch "rom beans in to other, other oods. There's another more basic reason "or the down slopin demand curve that emer es "rom economist's "unction o" rational behavior, which is to say, that at the core o" economics is the assumption that people behave rationally and purposely, and they behave even more rationally than we #now them to be. The concept o" ratio, rational behavior has three components. It simply means that consumers #now what they want, they can order their wants, and they can choose consistently amon their all, their orderin . That is, consumers when "aced with three oods, a, b, and c, can ran# them a "irst, b second, and c third. they can also choose consistently or will be expected to choose consistently. I" a is ran#ed "irst, then a should be pre"erred and chosen over b, and b should be chosen over c. It's inconsistent o", there"ore, "or a consumer to buy c when "aced with the choice between a and c. There are implications "rom the rule o" rational behavior. That is, people act purposely with the idea o" maximizin their wel"are. "irst o"", we can conclude

that people will "ully allocate their income, say 6,77. I" they have 6,77 to spend and they have oods a and b, then they will allocate that 6,77 to the purchase o" a and, a and b. i" they leave 6"ive unspent, and then they have lost out on some en0oyment o" buyin either a or b. &ow I #now people save, but savin is nothin more than another ood "or economists. -eople are savin today with the idea o" buyin oods in the "uture. /o, a person can "ully allocate his income or her income by buyin a and b today, and then settin aside some income "or buyin c in the "uture. I" a person is behavin rationally, that individual will e%uate at the mar in. I understand that people consume hundreds, i" not thousands o" oods in rare cases, but let's lose a lot o" extraneous in"ormation to reduce the analysis to mana eable proportions or, and ma#e it comprehensible within the limits o" our three!pound brain. 4et's assume only two oods in the mar#et. That is, ood *, a nd ood '. 4et's also assume that both o" these oods cost 6one. I" each costs 6one, then the individual behavin rational, will evaluate the additional value o" * versus the additional value o" '. *nd i" the additional value o" the "irst unit o" * is reater than that or the "irst unit o" ', then the individual will buy *. The individual will continue to allocate his or her limited income to *, so lon as the additional value o" * exceeds the value o" the "irst unit o" '. *nd indeed, what we're sayin here is that the person will consume *, so lon as the additional value o" * exceeds the, the additional cost incurred by "ore oin '. The person won't move to ' until the value, the additional value o" * is lower then the additional value o" '. The person will continue to allocate between * and ' based on their mar inal values, that is their additional value. In the end, when the prices "or both is 6one, the individual is oin to e%uate at the mar in or e%uate mar inal value o" a e%ual the mar inal value o" b. &ow, i" in "act this were not the case, that is, the mar inal value o" a is reater than the mar inal value o" b, then an individual could ive up a unit o", o" b and trans"er it over to a and et more value. It's li#e sayin * has "i"teen utils o" satis"action and b has ten utils o" satis"action. &ow, what's a util5 It's

0ust an economists measure o" satis"action and it's "ictitious, but it ma#es "or an illustration. I" mar inal value o" a is reater than the mar inal value o" b, then the individual can ive up one unit o" b and "ore o ten utils o" satis"action, consume more, one more unit o" a and ain "i"teen utils o" satis"action "or a increase o", o", o" "ive utils, utils o" satis"action. /o we #now that the, i" this is the case, then we #now that the person is oin to allocate "rom b to a. *nd as they, as more units o" * is are consumed, the value is onna o down there and as "ewer units o" ' are consumed, the mar inal value o" b is onna o up, as a result, we should expect these, these mar inal values to e%uate at the mar in. &ow we've made a simpli"yin assumption. $e've assumed that the prices o" both * and ' is the same, 6one. 4et's suppose they di""er in price. The price o" * can be reater than ' or vice versa. $e don't care. I" that is the case, then what the individual is oin to do is oin to e%uate these ratios. That is, the mar inal value o" a over the price o" a is oin to be e%ual to the mar inal value o" b over the price o", o" b. *nd, the reason here is that i" this e%uality were not true, then you et more value per penny o" a than you et b. * ain, it's li#e sayin you've et "i"teen utils o" satis"action per penny "or a and ten utils o" satis"action per penny o" b. *s a result, the individual is oin to move "rom a I mean "rom b into a. * ain, the individual, is oin to e%uate these ratios. The important point here is i" a person e%uates at the mar in, then i" the price o" a oes down, it means that this ratio, the a ratio, is now reater than the b ratio. *s a conse%uence, the individual can et more utility out o" the last unit o" a per penny, then the last unit o" b per penny. $e should expect the individual who is e%uatin at the mar ins "rom the consumption o" b into the consumption o", o" a. notice what we have said here, as the price o" a oes down, the consumption o" a oes, oes up. $hat this means is that we have 0ust deduced the law o" demand. $e've deduced that the individual's demand curve is downward slopin . i" individual's demand curve is downward slopin , it's no bi leap to conclude that when you add all consumers individual demand curves to develop the

mar#et demand curve, that is the demand "rom all consumers, then that mar#et demand curve is, is oin to be downward slopin and I have a, a downward slopin mar#et demand curve here. I 0ust add the word Mar#et, and it should be downward slopin 0ust li#e individual demand curve. &ow the issue is, what can cause this demand curve to move5 $ell you can have an increase in the number o", o" buyers. I" you have an increase in the number o" buyers, the result can be that the demand curve oes "rom 1, to 1.. This means that at a price o" -,, the %uantity demanded oes "rom +, to +.. *nd the %uantity demanded will o up with, with, other with any increase in demand and will o up at each and every price. the increase in demand here can also be caused by an increase in the taste o", o" consumers. it can also be an improvement in, in the weather, at least, "or some oods, "or example ice cream cones. I" the weather ets hotter, you can expect the demand "or ice cream cones to, to o up. it may also be that the number o" conusumers declines. *nd as a result, you et a, reduction in the demand. This is an increase in, in the demand and this is a decrease in the demand. The decrease in demand means, two thin s. 8ne is, you et a reduction in the %uantity demanded, "rom -, to zero at a price -, now, but it also means that at, at any iven %uantity, the consumers are willin to pay a lower, lower price. 8" course, when, when you have an increase in demand consumers are willin to pay a hi her price with the increase in demand. with the demand startin here at 1, and the demand oin to 1., consumers not only want to buy more o" the ood at that price, but they also are willin to pay a hi her price "or that ood. $e could also consider the impact o" the chan e in, in income. but we have to be care"ul a ain because the demand curve here, mi ht in "act be "or, "or beans. I" in "act there's a real income increase "or consumers o" beans, they mi ht in "act cause they mi ht in "act reduce their demand "or beans, as they move "or meat. 'ut i" we're tal#in about the demand "or meat, an increase in the real income o" consumers indeed could in "act increase the demand "or meat. The prices o" substitute oods could, could also a""ect the demand curve. we earlier noted an, an a tie between airline trave and, and hi hway travel. These are two

substitutes. I" the price o", o" airline travel oes up, the ris# cost oes up. $e, we mi ht expect the demand "or, car travel, t o increase as we su ested earlier. The prices o" complement oods can also a""ect one another. their, their, tablet computers, say, i-ads, are, are, and applications "or tablet computers are, are complementary oods, they o to ether, they tend to be consumed to ether. I" the price o" tablet computers oes, oes up, spi#es "or some reason, we mi ht anticipate the demand "or applications to o down. I" the price o", o" tablet computers oes, oes down as we mi ht expect with the rowth in the number o" tablet computers, we mi ht anticipate the, the number o" application bou ht improvin . The demand "or the ood can, can also be related to the "unctions o", o" the ood. That is, here we have a demand "or a, a basic ood and it could be a cell phone or the demand "or cell phones. I" the, the producers o" cell could in "act add a music player to the cell phone. *nd the, result can be, an increase in demand "or these cell phones, 1, to 1.. The result can be that consumers can be willin to pay a hi her price "or any iven "eature that is added or in this case, the music player. That is, at one point, they were only willin to pay -, "or the basic cell phone. &ow, they're willin to pay a much hi her price, -., because the cell phone combines, combines the cell phone with a music player. *ddin a 9-/ system to an automobile can in "act ive the automobile more value and can increase the demand "or the car. *ddin ranite countertops to the #itchens o" new houses can also add new value to those houses and can increase their demand. 8" course, we've ot to assume that ranite countertops are, are valuable. ma#in laptop computers in colors other than blac#, white, and silver can have the e""ect o" addin a "eature. that is, we can ma#e the laptop computers in hot pin# or, or lime reen, and it seems as thou h I have seen such laptops out there in, in co""ee shops. The variety o" "eatures to be added to various products is indeed endless. The basic rule that we can deduce is that you should only add the "eatures to a pr oduct, so lon as the value o" the "eature to the consumer increases consumer demand and the value o" the "eature is in "act reater than cost o" the "eature.

There are two reasons "or addin "eatures to products, one is the obvious. you want to sell more units, but also note that the, that there's another bene"it. you add a "eature and you can also sell the oods at a hi her price. Here, we have, %uantity +, at a basic cell phone, price is -,, but now, with the added "eature, we can add increase the price to - to -.. In summary, rational people will see# to maximize their wel"are by optimizin that is by e%uatin at the mar in, their optimizin behavior ives rise to the law o" demand. The law o" demand is everywhere, can be seen in people's actions everywhere. The law o" demand may not be an absolute rule o", o" human behavior. There, there may be exceptions, but they are li#ely to be rare. The law o" demand is probably the stron est statement economists can ma#e about human behaviour, which is why I've spent so much time on, the law o" demand and its predictive power to the economic way o" thin#in . I" the price oes down, more will be bou ht and vice!versa, everythin else held constant. The late 3ran# Kni ht used to muse that there are no absolutes in this world, aside "or that statement. 'ut there can be relatively absolute absolutes or rules o" behavior that are so solid, that we can treat them as i" they are absolute, and we can do so until stron convincin counter evidence proves them wron . That is how economists tend to treat the law o" demand as a relatively absolute, absolute. we, we view it that way, because there have been so many statistical studies that demonstrate, that it i" you low, lower the price, you're onna increase the %uantity o" sales. There is also casual observations o" stores puttin oods on sale and consumers "loc#in to those stores. In a "ollowin lecture, I will add clarity to the economic way o" thin#in by ta#in up a di""erent way o" thin#in , employed many business course s. Most prominently mar#etin Maslow's hierarchy o" needs. 3or now, I'I am pleased that you have been with me. Than# you.