The framework of an economy
Demand and Utility
Households
Demand
Supply
Markets for
Outputs
(products)
Markets
for Inputs
(factors)
Demand
Supply
Business Firms
Demand curve
What determines the demand?
Why is the demand curve downward
sloping?
What determines the shape of the
demand curve?
In responding to the demand shifters
(determinants), to what extent does
the demand shift?
Utility
The water versus diamond puzzle
Should
water be worth more than
diamond?
Yet water
water is so essential for human’
human’s
life so it should have enormous value
to a consumer, but its price is so low.
On the other hand, diamonds’
diamonds’ uses
are very limited but their prices are
so high. How can we explain the
paradox?
Utility
is the level of satisfaction that a
consumer derives from his
consumption.
Util
the unit of utility used in the old
days
1
Utility measured in $
But later economists found it was so
difficult to measure utility by utils.
utils. We
need to use something that is more visible
to measure the satisfactions level.
How about the unit of money, say,
dollars?
For instance, how many dollars is this
consumer willing to give up for this
hamburger? How many dollars is this
consumer willing to give up for five
hamburgers?
Total Utility
Total
Utility
The total utility of a quantity of a
good to a consumer (measured in
dollars) is the maximum amount of
dollars he is willing to give in
exchange for the quantity of the
good.
Robinson Crusoe’
Crusoe’s Total and
Marginal Utility for bananas
Robinson Crusoe economy
Robinson Crusoe is a novel by Daniel Defoe, first
published in 1719 and sometimes regarded as
the first novel in English. The book is a fictional
autobiography of the title character, an English
castaway who spends 28 years on a remote
island, encountering savages, captives, and
mutineers before being rescued.
The full title of the novel is
Number of
bananas
0
– The Life and Strange Surprising Adventures of Robinson
Crusoe of York, Mariner: who lived Eight and Twenty
Years, all alone in an uninhabited Island on the coast of
America, near the Mouth of the Great River of
Oroonoque;
Oroonoque; Having been cast on Shore by Shipwreck,
wherein all the Men perished but himself. With An
Account how he was at last as strangely deliver'd by
Pirates. Written by Himself.
Marginal utility
Marginal
Utility
The marginal utility is the
additional utility that an individual
derives by consuming one more unit
of the good.
The marginal utility is the difference
between any two successive total
utility figures.
.
Total utility
($)
0
Marginal
utility ($)
1
2.00
2.00
2
3.40
1.40
3
4.40
1.00
4
5.10
0.70
5
5.40
0.30
Diminishing marginal utility
The marginal utility is the difference
between any two successive total utility
figures.
The “law”
law” of diminishing marginal utility:
As the individual consumes more and
more of that good, the marginal utility of
each additional unit declines.
.
2
Total Utility and Marginal utility from
different amounts of bananas
Quantity demanded at each price
2.5
P ($)
MU for bananas
Dollars
2
1.5
1
1
0.5
0
1
2
3
4
5
0
6
3
Q
Bananas consumed
Total Utility
is the area below the MU curve
Suppose
all the bananas in the island
is supplied by a monopolist whose
name is Fred
Fred sets the price
Robinson is the consumer
P ($)
2.00
MU for bananas
1.40
1.00
0
How many bananas should
Robinson buy?
1
2
3
Q
Robinson Crusoe’
Crusoe’s Total and
Marginal Utility for bananas
Number of
bananas
Marginal utility ($)
dollars Robinson is
willing to pay
0
Price set by
Fred
0.60
1
2.00
0.60
2
1.40
0.60
3
1.00
0.60
4
0.70
0.60
5
0.30
0.60
Optimal purchasing rule
If
MU > P, Robinson will buy that
banana
If MU < P, Robinson will NOT buy
that banana
Optimal purchasing rule
To maximize total utility, a
consumer should buy the amount of
a good at the point where
MU = P.
3
Demand Curve
Marginal utility curve
The
demand curve of an individual
for a good is his marginal utility
curve for that good.
P ($)
MU for bananas
P
1
Qd
0
3
Q
Resolving the waterwater-diamond
paradox: total vs. marginal utility
Water is essential to us and the total
utility we derive from water is enormous,
but the supply of water is so plentiful.
Hence the marginal utility from water is
low.
On the other hand, diamond uses are very
limited, so the total utility is low
but because it is so scarce, the
marginal utility of diamond is so high.
Price is determined by marginal utility
Demand for diamond
MU
or
P ($)
D
S
P
0
Q
Market Demand versus
Individual Demand
Market
MU
or
P ($)
S
D
P
0
Demand for water
demand refers to the sum of
all individual demands for a
particular good or service.
Graphically, individual demand
curves are summed horizontally to
obtain the market demand curve.
Q
4
The market demand curve is the horizontal sum
of the individual demand curves!
When the price is $2.00,
Catherine will demand 4
ice-cream cones.
Catherine’s Demand
Price of IceCream Cone
When the price is $2.00,
Nicholas will demand 3
ice-cream cones.
+
2.00
2.00
1.00
1.00
4
8
Quantity of Ice-Cream Cones
When the price is $1.00,
Catherine will demand 8
ice-cream cones.
=
Nicholas’s Demand
Price of IceCream Cone
The market demand at
$2.00 will be 7 ice-cream
cones.
Market Demand
Price of IceCream Cone
2.00
1.00
3
5
Quantity of Ice-Cream Cones
When the price is $1.00,
Nicholas will demand 5
ice-cream cones.
7
13
Quantity of Ice-Cream Cones
The market demand at
$1.00, will be 13 icecream cones.
5