Demand: The Benefit Side of

the Market

Law of Demand
Law of Demand
People do less of what they want to do as
the cost of doing it rises

Recall the Cost-Benefit Principle

Pursue an action if and only if its benefits
are at least as great as its costs

Recall the Reservation Price

The highest price wed be willing to pay
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Utility
Utility represents the satisfaction people
derive from consumption activities
Utility Maximization refers to people trying
and allocate their incomes to maximize their
satisfaction
Normally, the more we consume, the more
total utility we have (assumes goods are good)
At the margin however, incremental utility
decreases in quantity law of diminishing
marginal utility
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Marginal Utility
The additional utility gained from consuming
an additional unit of the good
The movement from one quantity to the next

The Law of Diminishing Marginal Utility

As consumption of a good increases beyond some
point, the additional utility gained from an
additional unit of the good tends to decline
I.E., when the second good does not double our
utility
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Fig. 5.2
Total Utility from
Ice Cream Consumption

Optimal Combination
When buying a variety of goods, how
do we maximize total utility?
The optimal combination of goods to
purchase is the affordable combination
that yields the highest total utility

Rational Spending Rule

Suppose we are purchasing 2 goods: C and S
Spending should be allocated across goods so that
the marginal utility per dollar (bang-for-thebuck) is the same for each good

MUC
MU S

PC
PS
the marginal utility per dollar =

MU
P

The ratio of marginal utility to price must

be the same for each good the consumer
buys
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Rational Spending Rule

What should you do if: MUc/Pc > MUs/Ps ?
E.g. you get 20 units of utility per dollar
spent on C and only 16 units of utility per
dollar spent on S.
You should buy more C and less S to
increase total utility without spending any
more money.
But, what happens when you do this??
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Rational Spending Rule

As you buy more of the higher MU/P
good its MU decreases (law of DMU).
As you buy less of the lower MU/P
good its MU increases (law of DMU in
reverse).
Eventually, the MU/P will be equal,
and you cannot increase utility further
by moving your dollars around.
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Exercise #4 p 138
Tobys current marginal utility from
consuming peanuts is 100 units of utility per
once, and his marginal utility from cashews is
200 units of utility per once. The price of
peanuts is 10 cents per once, and the price of
cashews is 25 cents per once.
Is Toby maximizing his total utility from the
consumption of these 2 goods?
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Exercise #4 p 138
Peanuts:
MU/$ = 100/.10 = 1000
Cashews:
MU/$ = 200/.25 = 800
Peanuts yield higher marginal utility per dollar
and are therefore a better deal. He should
consumer more peanuts and less cashews to
increase total utility.
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Individual vs. Market Demand

How do we add-up the individual
demands for all consumers in a market
to form the market demand curve?
Option 1: add all prices and quantities
Option 2: add all prices at each
quantity demanded
Option 3: add quantities demanded at
each price
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Individual vs. Market Demand

Option 3 is correct: to find the market
quantity demanded at each price, simply add
the individual quantities demanded
This should make sense, because consumers
face the same set of prices, but have different
quantities demanded.
This is called horizontal summation
because we are adding along the horizontal
(quantity) axis
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Fig. 5.4
Individual and Market Demand Curves for
Canned Tuna

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Consumer Surplus
What happens when you purchase
something for a price that is less than
your maximum willingness to pay?
E.g. you are willing to pay $20,000 for
a new car and you buy it for 18,000
You receive a surplus of benefit over
cost = $2,000
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Consumer Surplus and

Demand
Consumer surplus for a given quantity
is therefore the difference between your
maximum willingness to pay
(reservation price) and what you
actually paid (actual price).
CS = the sum of the difference between
MB and MC (price) for all units
consumed
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Consumer Surplus and

Demand
Graphically then, CS is the area above
the price line and below the demand
curve, up to Q*
P

Here, CS = $200

40

=(base)(height)
= (20)(20)

20
D
20

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Consumer Surplus
What is the optimal quantity to consume, and how
much is consumer surplus?
Q

MB (demand)

MC (P)

100

40

80

40

60

40

40

40

20

40

Q* = 4 units (MC =MC) and CS = $120

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