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Terms and Definitions
• Utility: Number representing satisfaction gained from the cost of
goods and services. Measured in utils (one unit of utility)
• Total Utility: Total satisfaction gained from a given activity
• Marginal Utility: The change in total utility from one additional unit
of consumption
Terms and Definitions
• Budget Constraint: How much you can consume of two goods fully
utilizing your income
• Income = $100
• Pizza = $10
• Wings = $5
Terms and Definitions
• Indifference Curve: Curve showing combination of two goods and/ or
services that generates the same level of utility.
- Any place on that curve you are equally satisfied
- Indifference curves never intersect
- Indifference curves are negatively sloped
- The further from the origin, the higher the satisfaction
- Convex to the origin
Terms and Definitions
• Marginal Rate of Substitution (MRS)
- Rate at which consumers are willing to substitute 1 good/
service for another
- MRS is larger at the top and smaller at the bottom
Circular flow model
Demand
• Law of demand—the quantity of a good demanded in a given time
period increases as its price falls, ceteris paribus.
• Ceteris paribus—assumption that nothing else changes.
• So when price changes, the ceteris paribus assumption means that
everything else stays the same and we measure the change in quantity
demanded
• Demand curve—describes the quantities of a good a consumer is
willing and able to buy at alternative prices in a given time period,
ceteris paribus.
Examples of positive and normative
economics
• Positive: A study to determine the impact of gasoline taxes on
distances driven (and/or car fleets manufactured)
• Positive: A study to determine the impact of non-point source
pollution of the Chesapeake Bay Watershed and its impact on
pfisteria
• Normative: A study to determine the appropriate regulatory device to
implement to lower the number of automobile miles driven
• Normative: A study to determine the appropriate regulatory device to
decrease the occurrence of pfisteria in the Chesapeake Bay
Benefits
• Economic agents derive benefits from something once there is a value
associated with it.
• Benefits—the benefits that people receive from a good or service must be
equal to the amount they are willing to pay for it.
• We use WTP to determine benefits since value is associated with WTP.
• This permits us to use ordinary demand curves to determine the benefits
that accrue to people.
• The demand curve can also be described as:
• MWTP (marginal willingness to pay)
• MB (marginal benefit) curve
Is WTP the only (best) way to determine
value?
• What may be wrong with using WTP to determine value?
• Endowment effect—people often demand more to give up an object than
they would be willing to pay to acquire it.
• Status quo effect—a preference for the current state.
• Loss aversion—the disutility of giving up an object is greater than the utility
associated with acquiring it.
Cost
• Choice and opportunity costs: Every time you make a choice, you
incur an opportunity cost
• Opportunity cost—the value of the most desired goods or services
that are forgone in order to obtain something else.
• Opportunity cost applies to society as a whole: To produce more of
one thing means we must shift resources away from something else.
• PPF is simply a graphical illustration of opportunity cost.
Opportunity Cost
• Increasing opportunity cost—the more of something that is
produced, the greater the opportunity cost of producing one more
unit
• In order to produce more environmental quality at point a, we take
away resources that were used in a relatively efficient manner to
produce market goods and use them in a relatively inefficient manner
to produce environmental quality.
• The PPF is concave because of the Law of increasing opportunity cost.
Deriving Cost Curves
• Stems from the notion of supply
• Supply—the quantities of a good the producer is willing and able to
bring to market at a given set of prices during some discrete period of
time, ceteris paribus.
• Law of Supply—there is a positive relationship between price and
quantity supplied of a good, ceteris paribus.
The MC curve is also the Supply Curve
Why is the MC curve also the Supply Curve?
• In the previous graph, assume we have a competitive industry.
• P* is given and the firm acts as a price-taker.
• This firm maximizes profit by producing where MC = P*; this level of
production is Q*
• This firm does not produce at Q<Q* because it could INCREASE profits
by moving toward Q*. When MC<P*, the firm should INCREASE
production.
• This firm does not produce at Q>Q* because it could INCREASE profits
by moving toward Q*. When MC>P*, the firm should DECREASE
production.
Externalities
• Externality—a spillover effect associated with production or consumption
that extends to a third party outside the market
• Negative externality—an external effect that generates costs to a third party
• Positive externality—an external effect that generates benefits to a third party
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Solution to Externalities
Government Intervention
• Set policy prescription, such as:
•
•
•
•
Set standards on pollution allowed
Tax polluter equal to MEC at QE
Establish a market and price for pollution
Assigning property rights
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Utility Curve
Utility Maximization
Production Possibility Frontier (PPF)
Economic Growth using PPF Diagram
Opportunity Cost
The PPF and Opportunity Cost
PPF, Diminishing Returns and Opportunity Cost