Chapter 5

Demand: the benefit side of the market

5.1 The law of demand

- Law of demand – the quantity demanded of a good or service in a given time period
declines as its price rises and increases as its price falls, ceteris paribus.
- A consequence of the cost-benefit principal, which says an activity should be pursued if
and only if its benefits are at least as great as its cost.
- Cost is the sum of all sacrifices – monetary and non-monetary, implicit and explicit.

The origins of demand

- Wants, also called preferences or tastes, can be
Ø Biological in origin
Ø Influenced by peers
Ø Influenced by other users

Needs vs Wants

5.2 Translating wants into demand

Measuring wants: the concept of utility
- Utility – a measure of relative satisfaction from consumption of various goods and
services.
- The assumption is that people try to allocate their incomes so as to maximize their
satisfaction, a goal referred to as utility maximization.

How much of a free good should we use?

- Marginal utility – the additional utility gained from consuming an additional unit of
good in a given period of time.
- Marginal utility= change in utility/change in consumption
- Law of diminishing marginal utility – the tendency for the additional tendency for the
additional utility gained from consuming an additional unit of a good in a given period of
time to diminish as consumption increases beyond some point.
- Opportunity cost of the time spent waiting is a sunk cost.

How should we allocate a fixed income between two goods?

- Optimal combination of goods – the affordable combination of goods and services that
yields the highest total utility.
- The scarcity principal challenges us to allocate our incomes among the various goods
that are available so fulfill our desires to the greatest possible degree.
The rational spending rule
- Rational spending rule – spending should be allocated across goods and services so that
the marginal utility per dollar is the same for each good.
- Equation: MUa/Pa=MUb/Pb
- If the condition were not satisfied, the consumer could increase her utility by spending
less on goods for which the marginal utility per dollar was lower, and more on goods for
which her marginal utility was higher.

Income and substitution effects revisited

- When the price of a good changes, the quantity of it demanded changes for two reasons
– the substitution effect and the income effect.
- Real income=income/price of good
Ø Hence price up, real income down.
- An increase in the price of a good reduces real income and shifts the demand curve for a
normal good to the left.

5.3 Applying the rational spending rule

Substitution at work
- Real price – the dollar price of a good relative to the average dollar price of all other
goods.
- Nominal price – the absolute price of a good in dollar terms.
- Application of the rational spending rule highlights the important roles of income and
substitution in explaining differences in consumption patterns – among individuals,
among communities and across time.
- The rule also highlights the fact that real, as opposed to nominal, prices and income are
what matter.
- The demand for a good falls when the real price of a substitute falls or the real price of a
complement rises.

Income differences at work

- Total utility increases with the amount that one consumes.

5.4 Individual and market demand curves

- To find the market demand curve for a good, we must add the individual demand curves
together.
- The quantity demanded at any price on the market demand curve is the sum of the
individual quantities demanded at that price.
- The process of adding individual demand curves to get the market demand curve is
known as horizontal addition, because we are adding quantities.
- When individual demand curves are identical, we get the market demand curve by
 multiplying each quantity on the individual demand curve by the number of consumers
in the market.
- An increase in the number of buyers will shift the demand curve to the right.

5.5 Demand and consumer surplus

- Consumer surplus / buyer’s surplus – the difference between a buyer’s reservation price
for a good and the price actually paid.
- It is a quantitative measure of the amount by which buyers benefit as a result of their
ability to purchase goods and services at the market price.
- Economists use it to measure the effect of changes in markets on consumer welfare.
- Used to denote the total surplus received by all buyers in a market or collection of
markets.

Calculating consumer surplus

- When a product can be sold only in whole-number amounts, its demand curve has the
staircase shape.
- Consumer surplus is the region bounded above by the demand curve and bounded
below by the market price.
- For the purpose of computing consumer surplus, we reply on the vertical interpretation
of the demand curve.
- The loss of CS is a measure of the harm caused to consumers by a price rise.

- At any quantity along a demand curve, the corresponding price represents the amount
by which the consumer would benefit from having one additional unit of the product.
Ø Hence the demand curve is sometimes described as a summary of the benefit side
of the market.