CHAPTER 5: DEMAND AND CONSUMER BEHAVIOUR O, reason not the need: our basest beggars Are in the poorest

thing superfluous King Lear SUMMARY 1. Market demands or demand curves are explained as stemming from the process of individuals choosing their most preferred bundle of consumption goods and services. 2. Economists explain consumer demand by the concept of utility, which denotes the relative satisfaction that a consumer obtains from using different commodities. The additional satisfaction obtained from consuming an additional unit of a good is given the name marginal utility, where marginal means the extra or incremental utility. The law of diminishing marginal utility states that as the amount of a commodity consumed increases, the marginal utility of the last unit consumed tends to decrease. 3. Economists assume that consumers allocate their limited incomes so as to obtain the greatest satisfaction or utility. To maximize utility, a consumer must satisfy the equimarginal principle that the marginal utilities of the last dollar spent on each and every good must be equal. Only when the marginal utility per dollar is equal for apples, bacon, coffee, and everything else will the consumer attain the greatest satisfaction from a limited dollar income. But be careful to note that the marginal utility of a $50-per-ounce bottle of perfume is not equal to the marginal utility of a 50-cent glass of cola. Rather, their marginal utilities divided by price per unit are all equal in the consumers optimal allocation. That is, their marginal utilities per last dollar, MU/P, are equalized. 4. Equal marginal utility or benefit per unit of resource is a fundamental rule of choice. Take any scarce resource, such as time. If you want to maximize the value or utility of that resource, make sure that the marginal benefit per unit of resource is equalized in all uses. 5. The market demand curve for all consumers is derived by adding horizontally the separate demand curves of each consumer. A demand curve can shift for many reasons. For example, a rise in income will normally shift DD rightward, thus increasing demand; a rise in the price of a substitute good (e.g., chicken for beef) will also create a similar upward shift in demand; a rise in the price of a complementary good (e.g., hamburger buns for beef) will in turn cause the DD curve to shift downward and leftward. Still other factors changing tastes, population, or expectations can affect demand. 6. We can gain added insight into the factors that cause downward-sloping demand by separating the effect of a price rise into substitution and income effects. (a) The substitution effect occurs when a higher price leads to substitution of other goods to meet satisfactions; (b) the income effect means that a price increase lowers real income and thereby reduces the desired consumption of most commodities. For most goods, substitution and income effects of a price increase reinforce one another and lead to the law of downward-sloping demand. We measure the quantitative

responsiveness of demand to income by the income elasticity, which is the percentage change in quantity demanded divided by the percentage change in income. 7. Remember that it is the tail of marginal utility that wags the market dog of prices and quantities. This point is emphasised by the concept of consumer surplus. We pay the same price for the last quart of milk as for the first. But, because of the law of diminishing marginal utility, marginal utilities of earlier units are greater than that of the last unit. This means that we would have been willing to pay more than the market price for each of the earlier units. The excess of total value over market value is called consumer surplus. Consumer surplus reflects the benefit we gain from being able to buy all units at the same low price. In simplified cases, we can measure consumer surplus as the area between the demand curve and the price line. It is a concept relevant for many public decisions such as deciding when the community should incur the heavy expenses of a road or bridge or set aside land for a wilderness area.

CONCEPTS FOR REVIEW Utility, marginal utility, utilitarianism, law of diminishing marginal utility, demand shifts from income and other sources, ordinal utility, equimarginal principle of equal MU of last dollar spent on each good: MU1/P1 = MU2/P2==MU per $ of income, market demand vs. individual demand, income elasticity, substitutes, complements, independent goods, substitution effect and income effect, merit goods, demerit goods, paradox of value, consumer surplus FURTHER READING AND INTERNET WEBSITES Further Reading An advanced treatment of consumer theory can be found in intermediate textbooks; see the Further Reading section in Chapter 3 for some good sources. Consumers often need help in judging the utility of different products. Look at Consumer Reports for articles that attempt to rate products. They sometimes rank products as Best Buys, which might mean the most utility per dollar of expenditure. Jeffrey A. Miron and Jeffrey Zwiebel, The Economic Case against Drug Prohibition, Journal of Economic Perspectives, Fall 1995, pp. 175-192, is an excellent nontechnical survey of the economics of drug prohibition. Utilitarianism was introduced in Jeremy Bentham, An Introduction to the Principles of Morals (1789). Websites Data on personal consumption expenditures for the United States are provided at the website of the Bureau of Economic Analysis, www.bea.gov. Data on family budgets are contained in the Bureau of Labor Statistics, Consumer Expenditures, available at www.bls.gov. Practical guides for consumers are provided at a government site, www.consumer.gov. The organization Public Citizen lobbies in Washington for safer drugs and medical devices, cleaner and safer energy sources, a cleaner environment, fair trade, and a more open and democratic government. Its website at www.citizen.org contains articles on many consumer, labour, and environmental issues. There are a number of new sites on behavioural economics. You can read the Nobel lectures of laureates Akerlof, Kahneman, and Smith, with their views on behavioural economics, at www.nobel.se/economics/laureates/.

QUESTIONS FOR DISCUSSION 1. Explain the meaning of utility. What is the difference between total utility and marginal utility? Explain the law of diminishing marginal utility and give a numerical example. Utility is the relative satisfaction a consumer gets from consuming goods or services. Jeremy Bentham, the utilitarian philosopher, defined utility as the property in any object to produce pleasure, good, or happiness or to prevent pain, evil, or unhappiness. Today we use the word in laymans terms for something useful. In economics, it relates to the goods and services we buy. If we enjoy playing computer games, or eating chocolate, or driving cars, then we can say we gain utility from computer games, chocolate, and cars. If we prefer computer games, chocolate, and cars to fruit, films, and fast food, then we gain more utility from the former than the latter and would tend to spend our limited incomes on them. Total utility is the total satisfaction we get from consuming all goods. For instance, eating several chocolate bars will give us some total utility, which will be the sum of the utility we get from eating each chocolate bar. Marginal utility is the satisfaction we get from consuming an additional unit of a good. The expression marginal in economics means additional or extra. The utility of eating the next chocolate bar will be the marginal utility of a chocolate bar. The law of diminishing marginal utility states that, as the amount of a good consumed increases, the marginal utility of that good tends to diminish. The utility from consuming the next unit will be less than that of the last unit. For instance, the first chocolate bar will be hugely enjoyed, the next slightly less so, the third will be a little sickly, and the fourth will cause a longing to eat a healthy salad instead. For example:
Quantity of chocolate bars consumed Q 0 1 2 3 4 5 Total utility U 5 9 12 14 15 15 Marginal utility MU 5 4 3 2 1 0

Notice that the total utility is the sum of the marginal utilities up to that quantity, and that the marginal utilities are getting smaller as quantity increases, which shows the law of diminishing marginal utility.

2. Each week, Tom Wu buys two hamburgers at 2 each, eight cokes at $0.50 each, and eight slices of pizza at $1 each, but he buys no hot dogs at $1.50 each. What can you deduce about Toms marginal utility for each of the four goods? The equimarginal principle is the fundamental condition of maximum satisfaction or utility. It states that a consumer having a fixed income and facing given market prices of goods will achieve maximum satisfaction or utility when the marginal utility (MU) of the last dollar spent on each good is exactly the same as the MU of the last dollar spent on any other good. If Tom Wu used the equimarginal principle to maximize his utility from his purchases, then the MU he gained from buying the second hamburger at $2 was the same as the MU gained from the eighth coke at $0.50, which was the same as the MU gained from the eighth slice of pizza at $1. He could always gain more MU from an additional hamburger, coke, or pizza slice than from his first hot dog, before he ran out of money, which is why he didnt buy any. Writing the equimarginal principle as an equation: = = $2 $0.50 $1 From this, the MU of the second hamburger was four times that of the eighth coke and twice that of the eighth pizza slice. 3. Which pairs of the following goods would you classify as complementary, substitute, or independent goods: beef, ketchup, lamb, cigarettes, gum, pork, radio, television, air travel, bus travel, taxis, and paperbacks? Illustrate the resulting shift in the demand curve for one good when the price of another good goes up. How would a change in income affect the demand curve for air travel? The demand curve for bus travel? Complementary goods are goods people tend to consume together. Complements from the question could be: Beef and ketchup Air travel and paperbacks Air travel and taxis

If you eat more beef in hamburgers, you will have more ketchup as a flavouring. If you travel more by air, you will need more taxi rides to the airport, and will read more paperbacks while waiting in the Departure Lounge. If the price of beef rises, less hamburgers will be bought, and so less ketchup will be bought to put in them. That is, a price rise in one good causes the demand for complementary goods to fall:

D'

A'

D'

Q
Substitutes are goods people would consume one or the other of. Substitutes from the question could be: Beef and lamb Bus travel and taxis Television and paperbacks You would eat beef or lamb for dinner, but rarely both together. You would travel around town in a bus or get a taxi. You would relax in the evening by putting Coronation Street on the television or curling up with Dan Browns latest but it would be terribly confusing trying to follow both plots at the same time. If the price of beef rises, lamb becomes relatively cheaper, and so more people will buy it instead. That is, a price rise in one good causes the demand for substitute goods to rise:

D'

A'

D'

Independent goods are goods that people buy completely independently of each other. Independent goods from the question could be: Beef and paperbacks Ketchup and air travel Cigarettes and pork

You dont need to read a book to enjoy a steak. Youre unlikely even to be able to take ketchup onto an aeroplane. Pork doesnt satisfy a smokers cravings. If the price of beef were to rise, there would be no effect on the purchases of paperbacks. That is, a price rise in one good does not alter the demand for independent goods:

D, D'

D, D'

Q
A change in income would affect the demand curve for air travel as follows. A rise in incomes would mean people spent more money on air travel, as they could afford more holidays. The demand curve would shift to the right. A fall in incomes would have the opposite effect. The effect on the demand curve for bus travel may work in the opposite direction to air travel, as bus travel for many is an inferior good. As incomes rise, people will buy a car or take a taxi instead of the bus. The demand curve would shift to the left. The opposite would be true for a fall in incomes, as it would cause people to use the cheapest transport possible. 4. Why is it wrong to say, Utility is maximized when the marginal utilities of all goods are exactly equal? Correct the statement and explain. The statement, Utility is maximized when the marginal utilities of all goods are exactly equal, ignores the role of price. A second car will give more marginal utility than a second chocolate bar, but that doesnt mean that is the comparison people will make. The car is much more expensive than the chocolate bar, so the price of the items needs to be taken into account.

The correct statement is, Utility is maximized when the marginal utilities per dollar of all goods are exactly equal. This is the more plausible comparison, as people weigh up the costs of purchases as well as the benefits they hope to derive from them. 5. Here is a way to think about consumer surplus as it applies to movies: a. How many movies did you watch last year? Two, at the cinema. b. How much in total did you pay to watch movies last year? Just under 20. c. What is the maximum you would pay to see the movies you watched last year? I would have paid at maximum 15 a film, or 30 in total. d. Calculate c. minus b. That is your consumer surplus from movies. 30 20 = 10. My consumer surplus was 10. 6. Consider the following table showing the utility of different numbers of days skied each year:
Number of days skied 0 1 2 3 4 5 6 Total utility ($) 0 70 110 146 176 196 196

Construct a table showing the marginal utility for each day of skiing. Assuming that there are 1 million people with preferences shown in the table, draw the market demand curve for ski days. If lift tickets cost $40 per day, what are the equilibrium price and quantity of days skied? The marginal utilities of days skiing are:
Number of days skied 0 1 2 3 4 5 6 Total utility ($) 0 70 40 110 36 146 30 176 20 196 0 196 Marginal utility ($) 70

The demand curve from each consumer can be found by plotting the marginal utility (in $) against the number of days skied. The individual demand curve, which will be denoted dd to distinguish it from a market demand curve DD, is created by drawing a smoothed line joining the top of the blocks of marginal utility:

Individual Demand for Days Skied

80

Marginal utility ($)

70 60 50 40
30 20 10 0

Number of days skied

Given 1 million people with these preferences, the market demand is derived by adding up horizontally the demand from each individual consumer, where the individual consumers demand curve is their marginal utility (in $) plotted for each day skied:

Market Demand for Days Skied

80

Marginal utility ($)

70 60 50 40
30 20 10 0

Number of days skied (millions)

(N.B. The market demand curve will be an individuals demand curve, with each quantity times by a million.) If the price for each day skiing is $40, then it is clear that each individual will ski for 2 days, as their second day of skiing is worth $40 to them, as shown by the marginal utility of the

second day skiing. For the market as a whole, 1 million people will ski for 2 days, meaning 2 million days of skiing will take place.

Market Demand for Days Skied

Price per day or marginal utility ($)
80

70 60 50 40
30 20 10 0

Number of days skied (millions)

In summary, the equilibrium price of days skied is $40 per day, and the equilibrium quantity is 2 million days skied. 7. For each of the commodities in Table 5-2, calculate the impact of a doubling of price on quantity demanded. Similarly, for the goods in Table 5-3, what would be the impact of a 50 percent increase in consumer incomes? Table 5-2 shows the price elasticity of several commodities. Recall that: Price elasticity of demand =
percentage change in quantity demanded percentage change in price

A doubling in price is equivalent to a 100 percent change in price. So, Percentage change in quantity demanded = ED 100 (N.B. The percentage change in quantity demanded will actually be negative, a price rise will lead to lower quantity demanded. But the price elasticity of demand is taken as positive by definition) Adding a third column, the percentage change in quantity demanded (which will simply be the price elasticity in the second column times by 100), to Table 5-2 gives:

Commodity Tomatoes Green peas Legal gambling Taxi service Furniture Movies Shoes Legal services Medical insurance Bus travel Residential electricity

Price elasticity 4.60 2.80 1.90 1.24 1.00 0.87 0.70 0.61 0.31 0.20 0.13

Percentage change in quantity demanded 460 280 190 124 100 87 70 61 31 20 13

Table 5-3 shows the income elasticity of several commodities, which is defined as Income elasticity =
percentage change in quantity demanded percentage change in income

A 50 percent increase in consumer incomes means: Percentage change in quantity demanded = Income elasticity 50 Adding a third column, the percentage change in quantity demanded (which will simply be the income elasticity in the second column times by 50), to Table 5-3 gives:

Commodity Automobiles Owner-occupied housing Furniture Books Restaurant meals Clothing Physician's services Tobacco Eggs Margarine Pig products Flour

Income elasticity 2.46 1.49 1.48 1.44 1.40 1.02 0.75 0.64 0.37 -0.20 -0.20 -0.36

Percentage change in quantity demanded 123 74.5 74 72 70 51 37.5 32 18.5 -10 -10 -18

8. As you add together the identical demand curves of more and more people, the market demand curve becomes flatter and flatter on the same scale. Does this fact indicate that the elasticity of demand is becoming larger and larger? Explain your answer carefully.

The market demand curve is found by adding horizontally the individual demand curves. To illustrate this, imagine two people, Smith and Jones, who each have a separate demand curve for chocolate bars:
Smith's demand for chocolate bars Price ($) Quantity demanded P Q 5 2 4 3 3 5 2 8 1 12 Jones' demand for chocolate bars Price ($) Quantity demanded P Q 5 4 4 5 3 6 2 8 1 10

Smith's Demand Curve P

6

Jones' Demand Curve P

6

5 4 3 2 1 0 0

d1

5 4 3

d2

5
d1
5 10 15

2 1 0 0

6 d2
5 10 15

Assume, implausibly, that Smith and Jones make up the entire market for chocolate bars. If chocolate bars have a price of $3, then Smith will buy 5 bars, and Jones will buy 6 (see the bold red arrows above). The total quantity demanded will be 5 + 6 = 11. At each price, the quantities demanded by each individual in the market is added up. Since quantity demanded is on the horizontal axis, this is adding up the curves horizontally. The table and curve for the market is shown below:
Market demand for chocolate bars Price ($) Quantity demanded P Q 5 6 4 8 3 11 2 16 1 22

Market Demand Curve

6

P5
4

3 2
1 0 0

5 11 = 5 + 6

D
5 10 15 20 25

Q
(N.B. At a price of $3, the market quantity demanded is equal to the sum of the individual quantities demanded. The two bold red arrows add up to the bold dark red arrow) The question asks about adding identical demand curves. Assume each individual demand curve is as below, with price p1 corresponding to quantity q1, and price p2 corresponding to quantity q2:

Individual Demand Curve P p1 p2

q1
d

q2
d

Q
If another individual joins the market, then the market curve can be found by adding two such demand curves horizontally (as shown in the Smith and Jones example above):

Market of Two Demand Curve P p1 p2

q1
D

q1 Q1 q2

q2 Q2
D

Q
At p1, market demand Q1 = q1 + q1 = 2q1 At p2, market demand Q2 = q2 + q2 = 2q2 If a third individual joins the market, the new curve is:

Market of Three Demand Curve P p1 p2

q1
D

q1

q1

Q1 q2 q2 Q2
D

q2

Q
At p1, market demand Q1 = q1 + q1 + q1 = 3q1 At p2, market demand Q2 = q2 + q2 + q2 = 3q2 Clearly, for n individuals in the market, At p1, market demand Q1 = nq1 At p2, market demand Q2 = nq2

The graphs above show that the market demand curve gets flatter and flatter as more individual demand curves are added horizontally. Does this mean that the elasticity of demand is getting larger and larger? Since the prices and quantities are known in terms of the number of individuals in the market, the elasticity of demand can be found in terms of p1, p2, q1, q2, and n. Note that the market prices P1 and P2 are the same as the individual prices p1 and p2 the market demand curve results from adding the individual demand curves horizontally in the Q axis direction, not vertically in the P axis direction.
percentage change in quantity demanded percentage change in price 2 1 (1 +1 )/2

ED =

2 1 (1+2)/2

21 (1+1 )/2

Q1 = nq1 and Q2 = nq2

21

(1+2)/2 (2 1) (1+1)/2

21 (1+2 )/2 21 (1 +1 )/2

The ns on the top and bottom of the fraction cancel

ED =

21 (1 +1 )/2

21

(1 +2)/2

2 1 (1+2)/2

P1 = p1 and P2 = p2

Since the expression does not have an n term, it is clear that the price elasticity of demand for the market curve does not depend on the number of individuals in the market n, and is in fact the same as the price elasticity of demand of each individual demand curve. The same conclusion could have been reached without resorting to algebra. Adding more individuals to the market multiplies all quantities at each price by the same amount. The percentage change between any two quantities cannot change as long as both quantities are multiplied by the same factor. The elasticity of demand remains constant no matter how many individuals with identical demand curves join the market.

9. An interesting application of supply and demand to addictive substances compares alternative techniques for supply restriction. For this problem, assume that the demand for addictive substances is inelastic. a. One approach (used today for heroin and cocaine and for alcohol during Prohibition) is to reduce supply at the nations borders. Show how this raises prices and increases the total income of the suppliers in the drug industry. Using the familiar supply-and-demand curve analysis, restricting supply at the nations borders will shift the supply curve leftwards and upwards, from SS to SS. The equilibrium will move along the demand curve DD from E to E. Price will rise, and quantity demanded will fall, as shown by the bold red arrows. Total income of the suppliers is given by the area of the rectangles drawn from the origin to the equilibrium points (as total incomes = price quantity). The area of the rectangle drawn to E (in light pink) is smaller than the area of the rectangle drawn to E (in light blue). Total incomes of suppliers in the drug industry rises:

D E'

S'

Price

S S' E

D Quantity

b. An alternative approach (followed today for tobacco and alcohol) is to tax goods heavily. Using the tax apparatus developed in Chapter 4, show how this reduces the total income of the suppliers in the drug industry. If a tax of $275 were placed on each unit of drugs (Im happily unacquainted with real prices and quantities of drugs sold, so this example will use arbitrary figures), then the supply curve is shifted $275 upwards everywhere:

600

500 400

D E'

S' 275 S E 75

Price

300

S'

275

200

200
100 0 0

S
200 400 600

D
800 1000

Quantity

In raising the tax by $275, the price to the consumer has been raised from $200 to $400, a difference of $200 (as shown by the dark red double-ended arrow). The suppliers price has fallen by $75 (as shown by the other dark red double-ended arrow). The supplier sells a reduced quantity at a reduced price their total incomes have fallen. In fact, the total tax paid will be equivalent to the light yellow rectangle (see below), while the suppliers post-tax income will be equivalent to the light green rectangle (also below). Note that his has a smaller area than the light pink rectangle (see above), which was their pre-tax income. (N.B. The dotted orange line below traces out the area representing the pre-tax income, for easier, same-graph, comparison with the light green rectangle representing post-tax income.)
600

500 400

D E'

S'

275
S E

Price

300
200 100 0 0

S'

S
200 400 600

D
800 1000

Quantity

(Extra: To be slightly more precise, the tax incidence can be found. The total amount of tax (the light yellow rectangle above) can be split into that falling on consumers and that falling on suppliers:

600

500 400

D E'

S' 275 S E

Price

300

S'

200
100 0 0

S
200 400 600

D
800 1000

Quantity

The pink rectangle is the tax paid by consumers, $200 per unit bought. The blue rectangle is that paid by the suppliers, $75 per unit sold. Together they pay the $275 per unit tax.) c. Comment on the difference between the two approaches. In both approaches, the quantity of drugs demanded has been reduced, and the price has been increased. In fact, both examples yield the same equilibrium price and quantity after the intervention. In the first approach, that of restricting supply, this results in higher incomes for drugs suppliers. The lure of the high incomes, with the illegality of drugs supply, combines to turn drug supply into a lucrative criminal activity. In the second approach, the quantity reduction and price increase is achieved by a tax. The total increase in incomes from supplying drugs is the same as in the first approach, but the increase is now pocketed by the tax man at the expense of the consumer and supplier. However, the consumer is paying the same amount extra as they were under supply restrictions, so only the suppliers really suffer. In my opinion, the second approach is better. But this rests on the assumption that the demand for drugs is inelastic. There may (will?) be casual users for whom drug demand is elastic which would have to be considered in a change in drug policy. 10. Suppose you are very rich and very fat. Your doctor has advised you to limit your food intake to 2000 calories per day. What is your consumer equilibrium for food consumption? The approach taken so far to maximizing our utility in our consumption decisions given our limited incomes can also be used to maximize our utility given any limited resource. In this case, the limited resource is not money (by supposition I am very rich!) Rather, it is my calorie intake which, for health reasons, is the limited resource (again, only by supposition!).

By the equimarginal principle, I should allocate my food consumption so that the marginal utility I gain from the last calorie of each and every food consumed is equal. For example, when the last calorie of chocolate bar I consume gives me the same marginal utility as the last calorie of salad etc., then I have allocated my limited calories to give me the greatest utility: = = 500 15 11. Numerical problem on consumer surplus: Assume that the demand for travel over a bridge takes the form = , , , , where Y is the number of trips over the bridge and P is the bridge toll (in dollars). a. Calculate the consumer surplus if the bridge toll is $0, $1, and $20. The laws of diminishing marginal utility states that, as the amount of a good consumed increases, the marginal utility of that good tends to diminish. This is reflected in the downward-sloping Demand line. But consumers pay the price of the last unit for all units consumed, even though they enjoyed greater marginal utility from the earlier units consumed. This is shown below by the Price line. Because of this, consumers enjoy a surplus of utility over what they pay for a commodity this is the consumer surplus:

Price or Marginal Utility

Consumer Surplus Total Purchases Quantity

Price

The consumer surplus for users of the bridge is found from the area between the Demand line and the Price line. The Demand line for the bridge is given by the equation = 1,000,000 50,000 .

Rearranging to make P the subject of the equation: = 1,000,000 50,000 50,000 = 1,000,000 = 20
1 50,000

which can be plotted:

Bridge Toll vs. Number of Trips P

25 20 15 10 5 0

200000

350000

Y
If P = $0, then consumer surplus is the area under the graph. Noting that the y-intercept is 20, and the x-intercept is 1,000,000, the area of under the graph is given by the area of a triangle, which is base height: When P = $0, Consumer surplus = 1,000,000 20 = $10,000,000

If P = $1, then the Price line intersects the Demand line at E at = 1,000,000 50,000 = 950,000

Bridge Toll vs. Number of Trips P

25
20 15 10 5 0

E
0 1000000

200000

350000

100000

150000

250000

300000

400000

450000

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The consumer surplus is the area of the triangle made by the P axis, the Demand line and the Price line. The base of this triangle is the Y value of E, which is 950,000 (see above the graph). The height is the y-intercept of the Demand line minus the y-intercept of the Price line, which is 20 1 = 19. The area is base height: When P = $1, Consumer surplus = 950,000 19 = $9,025,000

If P = $20, then the Price line intersects the Demand line at E at = 1,000,000 (50,000 20) = 0:

Bridge Toll vs. Number of Trips P

25
20 15 10 5 0

Y
It can be seen by inspection that the Demand line is never above the Price line, and so the consumer surplus = 0. b. Assume that the cost of the bridge is $1,800,000. Calculate the toll at which the bridge owner breaks even. What is the consumer surplus at the break-even toll? Total revenues R from the bridge toll = price quantity = P Y, where Y itself varies with P according to = 1,000,000 50,000 : = = 1,000,000 50,0002 At the break-even point, total revenues = total cost R = $1,800,000: = = 1,000,000 50,0002 = 1,800,000 50,0002 1,000,000 + 1,800,000 = 0 2 20 + 36 = 0 ( 2)( 18) = 0 P = $2 or $18

1000000

200000

350000

100000

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50000

The bridge owner could set the toll between $2 and $18 to recoup costs. If P = $2, then the Price line intersects the Demand line at E at = 1,000,000 (50,000 2) = 900,000:

Bridge Toll vs. Number of Trips P

25 20 15 10 5 0

E
1000000 0

200000

350000

100000

150000

250000

300000

400000

450000

500000

550000

600000

650000

700000

750000

800000

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900000 900000

950000 950000

50000

Y
The consumer surplus is the area of the triangle made by the P axis, the Demand line and the Price line. The base of this triangle is the Y value of E, which is 900,000 (see above the graph). The height is the y-intercept of the Demand line minus the y-intercept of the Price line, which is 20 2 = 18. The area is base height: When P = $2, Consumer surplus = 900,000 18 = $8,100,000

If P = $18, then the Price line intersects the Demand line at E at = 1,000,000 (50,000 18) = 100,000:

Bridge Toll vs. Number of Trips P

25 20 15 10 5 0

1000000

200000

350000

100000

150000

250000

300000

400000

450000

500000

550000

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50000

The consumer surplus is the area of the triangle made by the P axis, the Demand line and the Price line. The base of this triangle is the Y value of E, which is 100,000 (see above the graph). The height is the y-intercept of the Demand line minus the y-intercept of the Price line, which is 20 18 = 2. The area is base height: When P = $18, Consumer surplus = 100,000 2 = $100,000

The consumer surplus is greatest at P = $2, though costs will be covered from P = $2 to $18. c. Assume that the cost of the bridge is $8 million. Explain why the bridge should be built even though there is no toll that will cover the cost. In question 11.a., it was found that the consumer surplus when the toll was $0 (the bridge was free to use) was $10 million. If the cost is $8 million, then the consumer still benefits from a consumer surplus of $2 million ($10 million $8 million). However, no toll can be set to cover the cost. If total revenue R is given by: = = 1,000,000 50,0002 Maximum revenue is found when

= 0. = 10

= 1,000,000 100,000 = 0

Substituting P = 10 into R: = = (1,000,000 10) (50,000 102 ) = 5,000,000 The maximum revenue from the bridge is $5 million, when the toll is $10. This is less than the $8 million cost. So, for a cost of $8 million, it does not make sense for the bridge owner to build the bridge, as they could never recoup the cost from toll revenues. But from the con sumers points of view, they will have a consumer surplus of $2 million from free use of the bridge, so they will gain from it. If it is a government decision to build the bridge for the welfare of its citizens, it should be built as those citizens gain a consumer surplus, even though the bridge does not make commercial sense.