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

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.

Quantity

Utility

Pounds
of
Grapes

Pounds
of
Bananas

From
Grapes and
Bananas

From
Grapes

From
Bananas

1
2
3
4
5

1
1
1
1
1

16
20
23
25
26

6
10
13
15
16

10
10
10
10
10

1
2
3
4
5

2
2
2
2
2

24
28
31
33
34

6
10
13
15
16

18
18
18
18
18

1
2
3
4
5

3
3
3
3
3

28
32
35
37
38

6
10
13
15
16

22
22
22
22
22

1
2
3
4
5

4
4
4
4
4

30
34
37
39
40

6
10
13
15
16

24
24
24
24
24

1
2
3
4
5

5
5
5
5
5

31
35
38
40
41

6
10
13
15
16

25
25
25
25
25

05_04T

Pounds
of
Bananas

Expenditures:
Price of
Grapes = $1
Price of
Bananas = $1

Expenditures:
Price of
Grapes = $2
Price of
Bananas = $1

1
2
3
4
5

1
1
1
1
1

2
3
4
5
6

3
5
7
9
11

1
2
3
4
5

2
2
2
2
2

3
4
5
6
7

4
6
8
10
12

1
2
3
4
5

3
3
3
3
3

4
5
6
7
8

5
7
9
11
13

1
2
3
4
5

4
4
4
4
4

5
6
7
8
9

6
8
10
12
14

1
2
3
4
5

5
5
5
5
5

6
7
8
9
10

7
9
11
13
15

Pounds
of
Grapes

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

Pounds
of
Bananas

Utility
from
Grapes
and
Bananas

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

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

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

Willingness
to pay
$0

Marginal
Beneift
---

$4

$4

$7

$3

$9

$2

$10

$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)

PRICE
(DOLLARS)

3
Pete's
demand
curve

3
2

1
0

Ann's
demand
curve

1
1

QUANTITY DEMANDED
BY PETE (POUNDS)

QUANTITY DEMANDED
BY ANN (POUNDS)

PRICE
(DOLLARS)
5
4
3
Market
demand
curve

2
1
0

10

QUANTITY DEMANDED
IN MARKET (POUNDS)