L11 Econ 1011 Chapter Notes - Chapter 5: Reservation Price, Demand Curve, Economic Surplus
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Chapter 5 Demand
• The demand curve is a relationship between the quantity demanded and all costs –
monetary and nonmonetary – associated with acquiring a good
Law of Demand
• Law of demand – People will do less of what they want to do as the cost of doing it rises
o A direct consequence of the Cost-Benefit Principle
o We measure the benefit of an activity by the highest price we’d be willing to pay
to pursue it – the reservation price
o Stresses that the “cost” is the sum of all the sacrifices we must make to engage in
an activity
• Needs vs. Wants
Translating Wants into Demand
• Utility – the satisfaction people derive from their consumption activities
• Utility maximization – people try to allocate their incomes so as to maximize their
satisfaction
• Marginal utility – the additional utility gained from consuming an additional unit of a
good
o =
Ex:
= 40 utils/cone
• Law of diminishing utility – the tendency for the additional utility gained from
consuming an additional unit of a good to diminish as consumption increases beyond
some point
o Ex: the more cones Sarah consumes each hour, the smaller her marginal utility
will be
o Suggests that spending all of your money on a single good isn’t a good strategy
o Rather than devote more and more money to the purchases of a good we already
consume in large quantities, we generally do better to spend that money on other
goods we don't have much of, whose marginal utility will likely be higher
o Some consumption activities exhibit an increasing marginal utility
• Ex: Sarah has $400/year to spend on ice cream
o Chocolate - $2/pint and marginal utility is 16 utils/pint → 8 utils/$
o Vanilla - $1/pint and marginal utility is 12 utils/pint → 12 utils/$
o If she spends $200 a year on vanilla and $200 on chocolate, is she maximizing her
utility?
▪ No, vanilla yields a higher marginal utility than chocolate
▪ If she spends $100 less on chocolate, that would boost her utility by 24
utils, for a net gain of 8 utils
▪ She is spending too little on vanilla and too much on chocolate
o If she is buying 300 pints of vanilla, and 50 pints of chocolate, is she maximizing
her utility?
▪ She is spending too much on vanilla now and too little on chocolate
• Optimal combination – the affordable combination that yields the highest total utility
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