MARGINAL ANALYSIS AND DEMAND

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MARGINAL ANALYSIS AND DEMAND

• REFRESHER OF BASIC MICROECONOMICS CONCEPTS (1)

Dr. Fidel Gonzalez Department of Economics and
Intl. Business Sam Houston State University
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ECONOMIC CHOICE
Economics is all about costs and benefits. As
long you have a choice and this one has costs and
benefits economics is here to help. Economics
have elaborated complicated (and not so
complicated) models to deal with choices when
there are benefits and cost associated with the
decision. In these cases, you will find plenty of
trade offs you sacrifice something to get
something else instead. Trade offs are the core
of economic theory and practice. A common trade
off is when you buy any good. You give up money
(sacrifice) in order to get food (benefit). There
are more complicated and not so clear trade offs
in the real world. For example, going to college
implies a sacrifice in terms of time, tuition,
and money you could have been earning in you were
working. The latter is called opportunity cost
and we will come back to this later on. When
deciding if an activity it is useful to compare
the benefits and costs. If Benefits Cost then
the activity provides an overall gain and it
makes sense to do it. If Cost Benefit then the
activity is very costly and it does not make
sense to do it. In economics we introduce and
extra refinement to this cost-benefit analysis. I
will show you that what matters when making a
decision are not the total costs and benefits but
rather the marginal costs and benefits. Marginal
Cost the cost of an extra unit. Marginal
Benefit the benefit of an extra unit For
instance, when considering whether to watch
another hour of TV you consider the marginal
benefit and cost. Marginal Benefit of an extra
hour of TV enjoyment from the show, leisure and
relaxed time. Marginal Cost you could be doing
something else like walking your dog, work,
studying, talking to your family and friends.
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COST-BENEFIT ANALYSIS
When deciding if an activity it is useful to
compare the benefits and costs. If Benefits
Cost then the activity provides an overall gain
and it makes sense to do it. If Cost Benefit
then the activity is very costly and it does not
make sense to do it. In economics we introduce
and extra refinement to this cost-benefit
analysis. I will show you that what matters when
making a decision are not the total costs and
benefits but rather the marginal costs and
benefits. Marginal Cost the cost of an extra
unit. Marginal Benefit the benefit of an extra
unit For instance, when considering whether to
watch another hour of TV you consider the
marginal benefit and cost. Marginal Benefit of an
extra hour of TV enjoyment from the show,
leisure and relaxed time. Marginal Cost you
could be doing something else like walking your
dog, work, studying, talking to your family and
friends.
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COST-BENEFIT ANALYSIS
If Marginal Cost of watching TV for another hour
Marginal Benefit of watching TV of another
hour then you should watch TV for another
hour Note that in this rule, it does not matte
how long have you watched TV before. What
matters is the extra benefit and the extra cost
of the activity. If it did, then you will never
stop watching TV because the benefits from the
past will make the total benefit always bigger
than the total costs. If Marginal Cost of
watching TV for another hour Marginal Benefit
of watching TV of another hour then you should
NOT watch TV for another hour
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APPLICATION OF MARGINAL COST AND BENEFIT
A year ago my sister in-law talked to me about a
decision she was facing.
She had been together with her boyfriend for
about four years.
However, she was not sure if she was in love
anymore. Her feeling for him were not as strong
as they used to be.
Her problem is that she did not know if she
wanted to break up with him or not.
We can use marginal benefits and cost to solve
her problem.
From the conversation with her, it was clear that
the benefit of spending another day with her
boyfriend was very low.
Her marginal benefit of staying with him was low
What about the costs? The cost of staying with
him were also low, at that point she had not met
anyone else she would have liked to date.
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Why is it important the fact the she had not met
anyone else?
Because as soon as you find someone you like the
opportunity cost of staying together with you
significant other increases..
What was my recommendation?
1) It does not matter that you have been together
with your boyfriend for more than four years.
What matters is the marginal benefit and cost.
2) If the benefit of staying with him another day
is higher than the cost, then you should stay
together. Overall, the enjoyment from time spent
with him is higher than the boredom of staying
with him
She stayed with him for another six months, when
something happened.
She met someone else. At that point she did not
hesitate to break up with him. The cost of
staying with the old boyfriend another day
increased by a lot.
Everyday she stayed together meant to sacrifice
time with the other person.
At that point the marginal cost of staying with
the boyfriend was higher than the marginal
benefit of staying with him.
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This is a very common story in other couples,
because usually the marginal cost of staying with
the current boyfriend/girlfriend is very low and
the marginal benefit is hardly ever negative (you
still get some enjoyment from that person).
Why do you think cheating is so common? Why
usually people break up once they already found
another partner?
Why did I tell her that the time spent with him
did not matter when making the decision of
breaking up with him or not?
If it did matter then you will marry the first
person you have ever dated!!!!!!! What matters is
how you feel about spending an extra day with
that person. It is likely that if you have spent
some years with somebody you have developed some
kind of relationship that increase your enjoyment
each extra day you stay together
However, the reason to stay with someone is based
on the marginal benefit and cost. If past time
affects the marginal benefit or cost does not
change the marginal rule.
What do you think now about the people that leave
their spouse after 20 or 40 years or
marriage? Some people would say How can she/he
sacrifice so many years of marriage? You can now
answer that question.
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Marginal benefits and cost of dating the old
boyfriend
costs
Breaks up with old boyfriend. The marginal cost
is higher than the marginal benefit of another
day.
MC of dating the old boyfriend goes up
significantly when she meets someone else (the
new friend)
Marginal Benefit
When there is nobody else the MC of dating the
old boyfriend is zero
Marginal Cost (MC)
Days continuing with the old boyfriend
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Willingness to pay
Now, we are going to use marginal analysis to
derive the demand and supply curve. We start
first with the demand.
I like beer, so this is how much I am willing to
pay for different amounts of beer
for one beer I am willing to pay 10
for two beers I am willing to pay 18
for three beers I am willing to pay 25
for four beers I am willing to pay 31
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Marginal willingness to pay
Now, lets figure out how much I am willing to pay
for the first, second, third and fourth beer.
for the first beer I am willing to pay 10
For two beers I am willing to pay 18
If am willing to pay 10 for the first beer, and
18 dollars for two beers, that means that I am
willing to pay 8 for the second beer.
10
8


18
For three beers I am willing to pay 25
If am willing to pay 10 for the first beer, 8
for the second beer and 25 for three beers, that
means I am willing to pay 7 for the third beer.
10

8

7

25
For four beers I am willing to pay 31
If am willing to pay 10 for the first beer, 8
for the second beer, 7 for the third beer and 31
for four beers, that means I am willing to pay 6
for the fourth beer.
10

8

7

6

31
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Marginal willingness to pay
What I am willing to pay for the first, second,
third and fourth beer has a fancy name, it is
called Marginal Willingness to Pay.
Marginal Willingness to Pay the amount a
consumer is willing to pay for an extra unit.
These are my marginal willingness to pay for each
beer
8
7
6
10
10 is my marginal willingness to pay for the
first beer
8 is my marginal willingness to pay for the
second beer
7 is my marginal willingness to pay for the
third beer
6 is my marginal willingness to pay for the
fourth beer
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Marginal willingness to pay
The marginal willingness to pay is an important
concept in economics because it is an
approximation of how much the consumer values a
good in monetary terms.
For instance, in the beer example
If my marginal willingness to pay for the first
beer is 10
that means that I value my first beer in at least
10, otherwise I would not be willing to pay
10.
10
For the second beer my marginal willingness to
pay is 8, so the value that I put on a second
beer is lower than the value of the first beer.
The value I place on the third beer is 7 which
is lower than the value of the second beer, and
so on.
Q Why is the marginal willingness to pay
decreasing?
A The more we have of a good, the smaller is its
marginal benefit and the less we are willing to
pay for an additional unit.
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Marginal willingness to pay
A redundant clarifying issue what you actually
have to pay to get an extra unit of a good may be
different than what you are willing to pay for
it. How much you paid for an extra unit of a good
is the price per unit of the good. How much you
are willing to pay does NOT depend on the price
depends on how much you like the good.
Remember Willingness to pay does NOT depend of
the price. Willingness to pay depends on how much
you like the good (on your preferences).
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Bribes and MWTP
The MWTP is important because it tells us how
much we have to pay the consumer to prevent him
for consuming the good and keep him at the same
level of happiness. It is the amount of the bribe
to keep him away from the good. In the beer
example. If my wife does not want me to drink
but desires to keep me at the same level of
happiness as if I was drinking then all se has to
do is to pay me my marginal willingness to pay
for that beer. For instance, if she does not
want me to drink a second beer she would have to
pay me 8, for the third beer 7, and so
on. Next time you significant other asks you to
take him/her out find out the MWTP for each hour
of dating and pay them accordingly if you do not
want to go out. If they told you the truth they
should be in the same level of happiness.
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Marginal willingness to pay and demand
The information from the previous slides is now
presented in a table
Below the table you can see the graph of the
marginal willingness to pay for the first,
second, third and fourth beer.

The marginal willingness to pay for the first
unit is 10
10
The marginal willingness to pay for the second
unit is 8
8
The marginal willingness to pay for the third
unit is 7
7
6
The marginal willingness to pay for the fourth
unit is 6
Beers
4
3
2
1
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Marginal willingness to pay and demand

We can fit a straight line in our previous
graph. The straight line is my Demand Curve for
beer and it represent the marginal willingness to
pay for beer.
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Demand measures the benefit from consuming an
additional beer (benefit measured as the
willingness to pay, MWTP, for the extra
beer). Demand measures the marginal benefit (MB).
8
7
6
DMWTPMB
Beers
4
3
2
1
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ALTERNATIVE VIEW TO DEMAND
Suppose that we have the following information
about the price and the quantity demanded of ice
cream of a SHSU student
Quantity Demanded the amount of a good or
service that the buyer is willing and able to
purchase at a given price. For instance, when the
price per ice cream ball is 2 the student will
purchase 9 balls. Clearly, as the price per unit
goes up the quantity demanded will go down. This
is known as the Law of Demand price and quantity
demanded moves in the opposite direction.
The table above is called the demand schedule
because it shows the prices and their respective
quantity demanded.
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Marginal willingness to pay and demand
The graph below is the graphic representation of
the demand schedule. The line with the negative
slope is the Demand Curve.
P
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The negative slope of the demand curve represents
the Law of Demand ( negative relationship between
price and quantity demanded)
Demand Curve
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Ice Cream Balls
The negative slope of the demand curve and the
law of demand are based on the marginal analysis
we did before. Because the consumers marginal
willingness to pay is decreasing as the quantity
of ice cream increases the slope of the demand
curve is decreasing. Hence, as you can see the
Law of Demand is based on the decreasing marginal
willingness to pay.
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Marginal willingness to pay and demand
P
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Slope -1
Demand Curve
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Ice Cream Balls, (Q)
The equation of the demand curve is P - QD 11
, where P is the price and QD is the quantity
demanded of ice cream The previous equation is
called the inverse demand equation. Q Why it is
not called the demand equation if it is the
equation of the demand curve?
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Marginal willingness to pay and demand
A We have implicitly assumed that we are in a
competitive market. Competitive Market is
characterized by three things 1) many buyers, 2)
many sellers and 3) each seller produces a
homogenous good. As a result buyers and sellers
are price-takers. This means that none of them
have market power and can affect the market
price. Because in a competitive market the price
is given to the buyers and sellers, each of them
decides how much to buy or sell at the given
price, the price is the independent variable. The
demand equation is obtained by solving the
inverse demand equation with respect to the
quantity demanded P - QD 11, P -11 -QD QD
-P 11 (THIS IS THE DEMAND EQUATION)