Chapter 5 Demand: the benefit side of the market Answers to review questions

1 To say that someone needs a good is to suggest that they cannot choose to do without the good or buy a substitute for it. We are more likely to be mindful of the fact that almost all goods have substitutes if we speak of wants rather than needs. Even though we cannot actually measure utility directly, the marginal utility model helps us to gain a better understanding of how a rational consumer would allocate their income among different goods. The law of diminishing marginal utility says that the first units we consume of a good deliver the highest bang for our buck. This means that we can generally achieve higher total utility by spreading our incomes over many goods than by concentrating them on only a few. A scarce good must be rationed in one way or another. If its monetary price is zero, people will either have to wait in line for it, as in the free sausage example, or pay a bribe, or incur some other cost to gain access to it. Many people report that they didnt like spicy food the first time they ate it, or didnt like a certain comedian the first time they heard them. However, after repeated exposures they often find that they like these experiences more and more. Also, depending on the nature of their condition, some people might derive greater benefit from their second visit within a month to an osteopath than they do from their first. When people are charged for water on the basis of how much they use, they will respond to an increase in its price in the same way that they would to an increase in the price of any other good. In particular, they will find ways of conserving water, by reusing and recycling and by adopting water-saving devices and production methods. When supply increases the price of a good falls and consumer surplus increases for two reasons. The first reason is that buyers who were previously purchasing the good at a higher price now enjoy a greater surplus. The second reason is that when the price of a good falls, more of it is sold; the additional units sold (except for the last one, for which price exactly equals the buyers reservation price) have a positive consumer surplus.

Answers to problems
1 Because willingness to pay for food quality is likely to be an increasing function of income, we expect the patrons of the gourmet restaurant to have higher incomes, on average, than the patron of the inexpensive cafe. And since willingness to pay for service is also likely to be an increasing function of income, we expect the service in the gourmet restaurant to be of a higher quality as well. Since restaurant patrons tend to leave tips of about 15 per cent of the price of their meals, they do, in fact, pay for and receive higher quality of service. Since the marginal cost of an additional morsel of food is zero, a rational person will continue eating until the marginal benefit of the last morsel (its marginal utility) falls to zero. Maryanne is currently receiving (75 utils/glass)/($2.50/glass) = 30 utils per dollar from her last dollar spent on orange juice, but only (50 utils/cup)/($2.00 /cup) = 25 utils per dollar from her last dollar spent on coffee. Since the two are not equal, she is not maximising her utility. She should spend more on orange juice and less on coffee. Toby is currently receiving (100 utils/gram)/($0.10/gram) = 1000 utils per dollar from his last dollar spent on peanuts, and (200 utils/gram)/($0.25/gram) = 800 utils per dollar from his last dollar spent on cashews. Since the two are not equal, he is not maximising his utility. He should spend more on cashews and less on peanuts. The information given enables us to conclude that Sues average utility per dollar is the same for both pizza and yoghurt. However, this information does not enable us to say whether her current combination of the two goods is optimal. To do that, we must be able to compare the values of marginal utility per dollar for the two goods. a Even at twice the original price, the marginal utility per dollar of the 20th train trip may be higher than the corresponding ratio for any other good that Ann might consume, in which case she would be perfectly rational not to alter the number of trips she takes. After all, missing a trip would mean missing a whole days work. b 7 The higher price of train tickets makes Ann poorer. The income effect of the price increase is what leads to the reduction in the number of restaurant meals she eats.

Consumer surplus is the area of the shaded triangle: (1/2)bh = (1/2) (80 000 litres/year) ($8/litre)= $320 000/year.

When the price of a slice of pizza is $6 and the price of a DVD rental is $3, the affordable combinations and their corresponding utilities are as listed in the table, which shows that the optimal combination is three pizza slices per week and two movie rentals.

Combinations of pizza and DVD rentals that cost $24 per week 8 rentals, 0 pizza slices 6 rentals, 1 pizza slices 4 rentals, 2 pizza slices 2 rentals, 3 pizza slices 0 rentals, 4 pizza slices

Total utility 57 + 0 = 57 57 + 20 = 77 54 + 38 = 92 46 + 54 = 100 0 + 68 = 68

The market demand curve (right panel) is the horizontal summation of the two individual demand curves (left and centre panels). For example, when the price of a ticket is $24, the first consumer will not want to buy any tickets while the second consumer wants to buy 16 tickets.

Price ($/ticket)

Price ($/ticket) 36 24

Price ($/ticket) 36 24

24

12

12

12

96

tickets/yr

16

48

tickets/yr

16

80

tickets/yr 144

Total consumer surplus is the sum of the three shaded areas: Area of small triangle:
(1/2)bh = (1/2) (16 tickets/yr) ($12/ticket) = $96/yr

Area of rectangle:
bh = (16 tickets/yr) ($12/ticket) = $192/yr

Area of large triangle:

(1/2)bh = (64 tickets/yr) ($12/ticket) = $768/yr

Total consumer surplus: $96/yr + $192/yr + $768/yr = $1056/yr