Oemandi

goods own price. If no shift has occurred, no change in demand has taken place. Consequendy, a decreased price of root beer will cause an increase in the quantity demanded and not an increase in demand. Failure to make this key distincdon has lead to much muddled reasoning.

Goods whose demand increases as income rises are termed normal or superior goods. Goods whose demand decreases as income rises are inferior goods. Few clear examples of inferior goods exist, but potatoes, hamburger helper, and bus tiansportation are probably examples. Figure III shows the effect of an increase in income for a normal good and Figure IV for an inferior good. Figure IV also portrays the effect of a decrease in income for a normal good and Figure III the effect of a decrease in income for an inferior good.

Changes in the prices of other goods also shift the demand curve according to whether these other goods are substitutes or complements. Substitutes are goods which have similar characteristics, such as oranges and grapefruits, coffee and tea, margarine and butter, and even gasoline and fuel efficient carburetor. In short, a substitute for a certain good is any other good which can be used instead of it. Complements are goods which are consumed togedier in order to get the desired effect. Examples are gin and tonic, tennis balls and rackets, and bread and butter.

If two goods are substitutes, a decrease in the price of one will decrease the demand for the othen For example, if the price of tea falls, people will switch out of coffee and into tea. This means that the demand curve for coffee in Figure FV will decrease firom Di to Dg. On the other hand, if the price of a substitute increases, consumers will switch out of the

good with the increased price and into the other. For example, if the price of margarine rises, the demand for butter will increase as in Figure III. In summary, : the demand for a particular good increases or; decreases -mih the price of its substitute.

If two goods are complements, on the other < hand, a decrease in the price of one will increase the demand for the other. For example, if the price often-] nis balls decreases, some people will play tennis morc.i causing their demand for tennis rackets, a complcJ ment to tennis balls, to increase. Such a shift is por- trayed in Figure III. The opposite would, of course,! occur if the price of tennis balls increased instead ofl decrezised, i.e.. Figure IV. In working problems withj substitutes and complements, always remember tha the initial price change in the substitute or comple ment good is taken as a given: in other words, cause of the price change is considered complet outside the analysis. Hence, if the price of tennis 1 were to increase, we consider the impact on racl ceteris paribus.

Finally, changes in tastes shift the der ciurve. For example, over the past ten years, tastes 1 changed in favor of diet soft drinks, sushi, aerobic < ing, and health clubs. As such, the demand for goods and services has increased as in Figure III. On I other hand, the taste for coffee and disco music declined, leading to the demand decrease in Figure 1

CONSUMER SURPLUS

In Section I we noted that trade transp because it makes the pardes better off With the i cept of consumer surplus, we measure the gains from trade. Consider your electiic bill. You

Fig. Ill

Fig IV

FigV

P (per unit)

Demand Increase

An 1

Increase in ttie J Quantity DemandM

Qi 02

Q2 Qi

Q1 Qa

Table III

of X kilowatt-hours (kwh) and you pay, say, $10 imonth for those X kwh. What is that amount of idty worth to you? Clearly its not $10; after all, ►uld hardly be indifferent between the choice of id your electricity; youd pick the electricity time. The electricity must therefore be worth than $10 to you. Svuely the only reasonable mea-what the electricity is worth to you is what youd [ling to pay for it, not what you have to pay for it. lendy, if you would willingly pay more than could only 1 t)ecause subjecdvely those X kwh lyrorth more to you than what you do in fact pay. difference between what you i)ersonaIly consider .X kwh to be worth and what you actually pay for is consumer surplus. To get a closer look at this concept, consider d for electricity given in columns 1 and 2 of HI. At a price of $15 f>er kwh, we know from col-2 that the consumer would buy only 1 unit. What «1 of that unit to him? It must be $15 since he ig to forego $15 worth of other goods, but not a more, in order to buy it Therefore, the cons subjective value of the first unit, which we also his marginal benefit (MB), is $15 and that is die entry in column 3. Since he buys only one unit, tal value of everything bought 1 kwh, is also $15. total expenditure (Pq) in the next column is $15. can ignore the last column for now.

Next consider the 2nd kwh. The consumer have stopped purchases at 1 kwh, paying $15 for .Instead, he is willing to buy a 2nd imit, but only if price falls to $14. Clearly, this 2nd kwh must then subjectively worth $14 since the consumer would Uingly forego that amount but not more for it This is that the marginal or added l)enefit of the sec-unit is $14, and that is the entry in column three, his total subjective value in being able to consume

a total of 2 kwh is the subjective value (marginal t>ene-fit) of the first kwh plus that of the second ($15 + $14 = $29). But the consumers total expenditure (Pq) is only $28 ($14 x 2). Here comes consumer surplus. Consumer surplus is the difference between the total subjective benefits and the total expenditure. In this case it is $29 - $28 = $1. Do you see why consumer surplus must t>e zero if only one unit is consumed?

Continuing to the third unit, again the marginal benefit ofthis unit must be $13. After all, thats the value of other goods that the consumer would be willing to give up to acquire the third unit Therefore, the total subjective t)enefit from the consumption of three units is the sum of the marginal benefits, $42 ($15 + $14 + $13). However, the consumers ouday for three units is only $13x3 = $39. Therefore, the con-siuner smrplus associated with the purchase of three units is $42 - $39 = $3. You should now verify the results for the other entries in the table.

The whole concept is illustrated graphically in

Fig. VI

Consumer Surplus Discrete Case

1 2 3 4 5

Demand -

Fig. VII

Fig. VIII

1/21

600 800

Figure VI. Here we assume the price is $11, so the consumer buys 5 units. Geometrically, his total expenditure (Pq) is the shaded area. Consiuner surplus is the white step-Uke area above the shaded portion. This sums to $10. As the figure illustrates, this number can be calculated as the sum of $4, $3, $2, $1, and $0. These numbers are the difference between the consumers subjective value for each of the five units, i.e., his marginal benefit, and the $11 price he actually pays for each of them.

In Figure VI weve assumed that electricity is available only in whole kwhs, which causes the step-like, i.e., discrete, consumer surplus. As you can see, it is approximately the area of a triangle. In Figure VII, where electricity can be bought in half kwh units, consumer siuplus more closely approaches a triangle. In Figure VIII we calculate the consumer surplus of a straight line "continuous* demand curve by exploiting this fact

From Figure VIII, Pauls consumer surplus at a price of $5 per unit is the triangle above the $5 price. Its area is one-half base times height Here the base is 600 units, and the height is $3 ($8 - $5). Therefore, consumer surplus is $900. At the lower price of $4, consumer surplus will be $1,600 (Verify). It is geometrically apparent that as price declines, consumer surplus increases.

We also often work with the market consumer surplus. For example, if in Figure IX we know that no peanuts will be sold at a market price of $15 per bag and that 2 billion bags will be sold at $1 per bag, then we can approximate the consumer surplus at a price of $1 as $14 billion 1/2(2 bilUon)($15 - $1) through the triangle formula. However, unless the demand curve

really is a straight line, the triangle formula is only anJ approximation. In problems, the appropriate method,;! discrete or tiiangular, must be read from the context,] since they will not always generate the same answer, j Like Table III, discrete problems display the price at ] whole unit quantities.

The consumer surplus concept allows us tol solve a paradox that stumped the early economists for ] years. Consider the price of diamonds and the price ofl water. Diamonds are tremendously expensive, yet arc quite inessential ornaments. Water, on the other hand,! is vital, but very cheap. If prices reflect human values, then how could an essential good such as water sell for] so much less than an inessential good such as diamonds? ]

The confusion of the early economists arose i from their failure to distinguish between the total value of ail units consumed of a good and the value