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.

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

Total utility

8 rentals, 0 pizza slices

57 + 0 = 57

6 rentals, 1 pizza slices

57 + 20 = 77

4 rentals, 2 pizza slices

54 + 38 = 92

2 rentals, 3 pizza slices

46 + 54 = 100

0 rentals, 4 pizza slices

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

24

24

12

12

12

96

tickets/yr

16

Price
($/ticket)
36

48

tickets/yr

16

80

144

tickets/yr

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

Chapter 6 Perfectly Competitive Supply: the cost side of

the market
Answers to review questions
1

The principle of increasing opportunity cost, also known as the low-hanging-fruit

principle, says that the least costly options should be exploited first, with more costly
options taken up only after the least costly ones have been exhausted. At low prices,
only those with low opportunity costs of producing a product would find it worthwhile
to offer it for sale. As prices rise, others with higher opportunity cost could profitably
enter the market. This positive relationship between a products price and the quantity
supplied is shown by an upward-sloping supply curve.

Bus fares are determined by the interaction of the market demand for bus rides and the
market supply of bus rides. In a perfectly competitive market, each individual
travellers demand is so small compared to the size of the market that no single

individuals decision has an effect on market demand or on the equilibrium price of a

bus ride. Individual bus travellers are price-takers. Similarly, an individual apple
growers decision about how much to supply at each price has no effect on total market
supply or on the price of a kilo of apples. Individual apple growers are also price-takers
in the market for apples.

Answers to problems
1

If the price of a fossil is less than $6, Jo should devote all her time to photography because when the price is, say, $5 per fossil, an hour spent looking for
fossils will give her 5($5) = $25, or $2 less than shed earn doing photography. If
the price of fossils is $6, Jo should spend one hour searching, which will supply
five fossils and earn Jo revenue of $30; that is, $3 more than she would earn from
photography. However, an additional hour would yield only four additional
fossils or $24 additional revenue, so Jo should not spend any further time looking
for fossils. If the price of fossils rises to $7, however, the additional hour
gathering fossils would yield an additional $28; gathering fossils during that hour
would then be the best choice, and Jo would therefore supply nine fossils per day.
Using this reasoning, we can derive Jos pricequantity supplied relationship for
fossils as follows:

Price of fossils ($)

Number of fossils supplied per day

05

7, 8

913

12

1426

14

27+

15

If we plot these points, we get Jos daily supply curve for fossils:

Price($/fossil)
27

14
9
7
6
5

9 12 15
14

Numberoffossils

The market supply curve (right) is the horizontal summation of the supply curves of the
individual market participants (left and centre).

P=2Q1

P=2+Q
2

Q
1

Q
2

Horizontal summation means holding price fixed and adding the corresponding
quantities. For example, at a price of $4 per unit, a total of 2 + 2 = 4 units will be
supplied. If you want to derive the market supply curve algebraically, rewrite each
individual supply curve with quantity as the dependent variable and add. Pay careful
attention to the region for which the supply curves dont overlap (here, the region P<2).
From P = 2Q1, get Q1 = P/2; from P = 2 + Q2, get Q2 = P 2.
For the region P<2, the market supply is the same as Firm 1s supply:
Q = P/2, or P = 2Q

For P>2 we add Q1 + Q2 to get Q = P/2 + (P 2), which reduces to Q = (3P/2) 2.

Rewriting this, we have P = (4/3) + (2/3)Q for P>2.
Expressed algebraically, the market supply curve is thus:
P = 2Q for P<2
and P = (4/3) + (2/3)Q for P>2