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    Applications and Extensions of the Theory of Consumer Demand

  • A. The compact disc (CD) takeover:
  • 1. CDs have revolutionized the music industry since 1983, when fewer than 1 million were sold as compared to 210 million LPs. In 1999, 939 million CDs were sold, while only 2.9 million LPs were sold.
  • a. Preferences changed due to improved quality and the amount of music available on one CD.

    b. CD player prices fell from over $1,000 or more to under $200.

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    2. CD players and CDs have a higher ratio of marginal utility to price than do LP players and LPs. To maximize their utility, consumers will switch from LPs to CDs.

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    B. The diamond-water paradox:

  • 1. Before marginal analysis, economists were puzzled by the fact that some essential goods like water had lower prices than luxuries like diamonds.

    2. The paradox is resolved when we look at the abundance of water relative to diamonds.

    3. Theory tells us that consumers should purchase any good until the ratio of its marginal utility to price is the same as that ratio for all other goods.

  • a. The marginal utility of an extra unit of water may be low as is its price, but the total utility derived from water is very large.

    b. The total utility of all water consumed is much larger than the total utility of all diamonds purchased.

    c. However, society prefers an additional diamond to an additional drop of water, because of the abundant stock of water available.

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    • C. Time also has a value, so this must be considered in decision-making and utility maximization. The total price of an item must include the value of the time spent in consuming the product, i.e., the wage value of an hour of time. When time is considered, consumer behavior appears to be much more rational.

  • 1. Highly paid doctors may not spend hours hunting for bargains because their time is more valuable than the money to be saved from finding the best buy.

    2. Foreigners observe that Americans waste material goods but conserve time. This could be because our high productivity makes our time more valuable than many of the goods we waste.

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    D. Buying medical care or eating at a buffet:

  • 1. Most Americans have health insurance for which they pay a fixed monthly premium, which covers, say, 80 percent of their health care costs. Therefore, the cost of obtaining care is only 20 percent of its stated price for the insured patient.

    2. Following the law of demand, people purchase a larger quantity of medical care than if they had to pay the full price for each visit.

    3. If you buy a meal at an "all-you-can-eat" buffet, you eat more than if you paid separately for each item.

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    E. Cash and noncash gifts:

  • 1. Noncash gifts may yield less utility to the receiver than a cash gift of equal monetary value because the noncash gift may not match the receiver’s preferences.

    2. Individuals know their own preferences better than the gift giver.

    3. Look back at Table 21.1. If Holly had no income and was given $2 worth, she would rather have the cash transfer to spend on B than to be given 2 units of A. (She gets more utility or satisfaction by spending her $2 on B.)

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