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Lecture 3

# MGEA02H3 Lecture Notes - Lecture 3: Demand Curve, Economic Surplus, Utility

Department
Economics for Management Studies
Course Code
MGEA02H3
Professor
Gordon Cleveland
Lecture
3

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Week #3 – Demand and Utility
Explaining/Exploring Demand Curves
(Parts of Chapter 10 and Chapter 4 in Krugman, 2nd Canadian edition)
Why are demand curves negatively sloped?
How do we interpret a point on the demand curve?
How do we interpret an area under the demand curve?
How do demand curves relate to behaviour of consumers and well-being of
consumers?
Demand curves reflect the “utility” (or well-being, or satisfaction, or happiness) of
consumers – measured in dollars. Another way of putting it: The height of a
demand curve and the area under the demand curve both reflect the willingness-to-
pay for a good by consumers. Individuals who consume are making decisions
designed to maximize their own well-being (utility), with the income they have
available.
Fred seeks to maximize CS.
Maximize by: dCS/dQ = 0
CS = U(Q) – (P x Q),
so dCS/dQ = dU/dQ – P = 0 (for a maximum)
The price (P) is the constant
Therefore, when dU/dQ = P (sometimes called the Optimal Purchase Rule), CS is
maximized. When marginal utility = price, CS is maximized.
Rational consumers follow the Optimal Purchase Rule, and the demand curve is the
result. The demand curve and MU curve are the same.
In words… consumers choose to consume hamburgers up until the point where the
(diminishing) marginal utility of consuming those hamburgers is equal to the price of
hamburgers.
If we take all possible points for Fred where dU/dQ = P, this will give us Fred’s
monthly demand curve for hamburgers.
For Fred, this gives us P = dU/dQ = 20 – 2Q
Then if P = \$2, 2Q = 18 or Q = 9
If P = \$4, 2Q = 16 or Q = 8
If P = \$6, 2Q = 14 or Q = 7
If P = \$20, 2Q = 0 or Q = 0
We can interpret areas under the Demand curve as
Total Utility or willingness-to-pay (measured in dollars)
Expenditure = (P x Q)
Consumer Surplus = U(Q) – [P x Q]

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Fred maximizes CS by choosing Q, such that P = 20 – 2Q
We can interpret the height of the curve as:
Marginal Utility (dU/dQ)
Willingness to pay for this unit (= marginal value or marginal benefit)
Our utility explanation helps us think about the two ways of interpreting any point on
the demand curve:
1. At point A, QA is the maximum quantity that consumers are willing to purchase at
price PA. Why? Because this quantity maximizes consumer surplus at that price.
2. At point A, PA is the maximum price that consumers are willing to pay for the last
unit of the good, which is unit QA. Why? Because consumers are not willing to pay
more than the marginal utility of the last unit, which is PA.
What have we learned about Demand for a good?
1. Individuals consume because they gain utility
2. Consumers seek to maximize consumer surplus by choosing amount to
consume
3. Consumer surplus is dollar value of utility received by consumers above cost
of purchase
4. Consumers max CS by following OPR and choosing amount of good such that
MU = P or dU/dQ = P. This is the individual demand curve.
5. Height of curve and areas under curve can be interpreted usefully.
Review: Why are demand curves negatively sloped? Two complementary
explanations…
It's because of diminishing marginal utility.
2nd year answer: income and subsition effects. Less income = consume less. All
goods are substitutes for each other.
Slutsky equation.