Download Lecture 12 02_14

Econ 200: Lecture 12
February 14, 2017
0. Learning Catalytics Session:
1. Consumer Utility and Choice Under Constraint
2. Income and Substitution Effects
3. Deriving the Demand Curve for a Consumer
Consumer Decision Making
In our study of consumers so far, we have looked at what they do, but
not why they do what they do.
Economics is all about the choices that people make; a better
understanding of those choices furthers our understanding of
economic behavior.
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Rationality and Its Implications
As a starting point, economists assume that consumers are rational:
making choices intended to make themselves as well-off as possible.
We examine these choices when consumers make their decisions
about how much of various items to buy, given their scarce resources
(income).
Facing this budget constraint, how do people choose?
Budget constraint: The limited amount of income available to
consumers to spend on goods and services.
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Measuring Happiness
Economists refer to the enjoyment or satisfaction that people obtain
from consuming goods and services as utility.
• The amount by which utility would change when consuming an
extra unit of a good or service is called the marginal utility.
Law of diminishing marginal utility: The principle that consumers
experience diminishing additional satisfaction as they consume more
of a good or service during a given period of time.
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Pizza on Super Bowl Sunday
-Total utility (in utils) increases at a
decreasing rate until it reaches its
maximum.
-Marginal utility is decreasing,
showing the Law of Diminishing
Marginal Utility directly.
5
Allocating Your Resources
Assumption: Given unlimited resources, a consumer would consume
every good and service up until the maximum total utility. (so, not like
the pizza example – why?)
But resources are scarce; consumers have a budget constraint.
The concept of utility can help us figure out how much of each item to
purchase.
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Utility from Pizza and Coke
Suppose you can now obtain utility by eating pizza and drinking
Coke.
The table gives the total and marginal utility derived from each
activity.
Number
of Slices
of Pizza
Total Utility
from Eating
Pizza
Marginal
Utility from
the Last Slice
Number
of Cups
of Coke
Total
Utility from
Drinking Coke
Marginal
Utility from
the Last Cup
0
0
—
0
0
—
1
20
20
1
20
20
2
36
16
2
35
15
3
46
10
3
45
10
4
52
6
4
50
5
5
54
2
5
53
3
6
51
−3
6
52
−1
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Marginal Utility from Pizza and Coke
Suppose that pizza costs $2 per slice, and Coke $1 per cup.
Marginal utility of pizza per dollar is just marginal utility of pizza
divided by the price, $2.
Similarly for Coke: divide by $1.
(1)
Slices
of Pizza
(2)
Marginal
Utility
(MUPizza)
(4)
Cups
of Coke
(5)
Marginal
Utility
(MUCoke)
1
20
10
1
20
20
2
16
8
2
15
15
3
10
5
3
10
10
4
6
3
4
5
5
5
2
1
5
3
3
6
−3
−1.5
6
−1
−1
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Rule of Equal Marginal Utility per Dollar Spent
Rule of Equal Marginal Utility per Dollar Spent: the rate at which
that item allows the consumer to transform money into utility
(bang for their buck).
Some combinations satisfying this rule are given below:
Combinations of Pizza
and Coke with Equal
Marginal Utilities per Dollar
Marginal Utility
Per Dollar
(MU/P)
Total
Spending
Total Utility
1 slice of pizza and 3 cups of Coke
10
$2 + $3 = $5
20 + 45 = 65
3 slices of pizza and 4 cups of Coke
5
$6 + $4 = $10
46 + 50 = 96
4 slices of pizza and 5 cups of Coke
3
$8 + $5 = $13
52 + 53 = 105
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Optimizing Your Consumption of Pizza and Coke
• With $5 to spend, you would purchase 1 slice of pizza and 3
cups of Coke.
• With $10 to spend, you would purchase 3 slices of pizza and 4
cups of Coke.
 Always exhaust your budget!
Combinations of Pizza
and Coke with Equal
Marginal Utilities per Dollar
Marginal Utility
Per Dollar
(MU/P)
Total
Spending
Total Utility
1 slice of pizza and 3 cups of Coke
10
$2 + $3 = $5
20 + 45 = 65
3 slices of pizza and 4 cups of Coke
5
$6 + $4 = $10
46 + 50 = 96
4 slices of pizza and 5 cups of Coke
3
$8 + $5 = $13
52 + 53 = 105
10
Conditions for Maximizing Utility
This gives us two conditions for maximizing utility:
1. Satisfy the Rule of Equal Marginal Utility per Dollar Spent:
MU Pizza MU Coke

PPizza
PCoke
2. Exhaust your budget:
Spending on pizza + Spending on Coke = Amount available
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What If We “Disobey” the Rule?
But what if you buy a combination which doesn’t satisfy the Rule of
Equal Marginal Utility per Dollar?
What if you bought 4 slices and 2 cups of coke?
Price = $10, but what is utility?
Utility = 52 + 35 = 87 (less than 96)
Marginal utility per dollar from 4th slice: 3 utils per dollar
Marginal utility per dollar from 2nd cup: 15 utils per dollar
Since you get so much more marginal utility per dollar from Coke, you
ought to drink more Coke—and indeed, that would increase utility.
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What If Prices Change?
If the price of pizza changes from $2 to $1.50, then the Rule of Equal
Marginal Utility per Dollar Spent will no longer be satisfied.
You must adjust your purchasing decision:
1. You can afford more than before; this is like having a higher
income. (income effect of price change)
2. Pizza has become cheaper relative to Coke (and MU/$ goes up).
(substitution effect)
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1. Income Effect
The income effect of a price change refers to the change in the
quantity demanded of a good that results from:
• The effect of the change in price on consumer purchasing power,
holding all other factors constant.
Reminder:
- Normal Goods: We consume more as our income rises
- Inferior Goods: We consume less as our income rises
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2. Substitution Effect
The substitution effect of a price change refers to the change in the
quantity demanded of a good that results from:
• A change in price making the good more or less expensive relative
to other goods, and
To isolate the substitution effect, we can think of your income
decreasing so you can just afford your previous combination (when
price goes down). The change in the quantity purchased (relative to
before the price change) is the substitution effect.
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2. Substitution Effect
Um, what?
If you had $10 before, you bought 3 slices of pizza (3 x $2.00) and 4
cups of Coke (4 x $1.00).
If pizza cost $1.50, $8.50 would allow you to purchase the same
combination of items: 3 x $1.50 + 4 x $1.00.
But MU per dollar spent would change!
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2. Substitution Effect—continued
This combination would no longer maximize utility, because :
But…
In other
words…
𝑴𝑼𝑷𝒊𝒛𝒛𝒂
𝑶𝒍𝒅 𝑷𝒓𝒊𝒄𝒆𝑷𝒊𝒛𝒛𝒂
𝟏𝟎
𝟐
𝟏𝟎
𝟏. 𝟓𝟎
𝑴𝑼𝑪𝒐𝒌𝒆
=
𝑶𝒍𝒅 𝑷𝒓𝒊𝒄𝒆𝑪𝒐𝒌𝒆
𝟓
=
𝟏
𝟓
>
𝟏
𝑴𝑼𝑷𝒊𝒛𝒛𝒂
𝑴𝑼𝑪𝒐𝒌𝒆
>
𝑵𝒆𝒘 𝑷𝒓𝒊𝒄𝒆𝑷𝒊𝒛𝒛𝒂 𝑶𝒍𝒅 𝑷𝒓𝒊𝒄𝒆𝑪𝒐𝒌𝒆
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2. Substitution Effect—continued
Consumption of pizza should rise (decreasing the marginal utility of
pizza), and/or consumption of Coke should fall (increasing the
marginal utility of pizza)
Consuming more pizza and less Coke is the substitution effect.
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New Optimal Consumption
A possible new combination of items is 4 slices of pizza and 4 cups
of Coke, costing 4 x $1.50 + 4 x $1.00 = $10.00.
The marginal utility per dollar is not quite equal, but it is as close as
we can get without allowing fractional goods.
Number
of Slices
of Pizza
Marginal
Utility from
Last Slice
(Mupizza)
1
20
13.33
1
20
20
2
16
10.67
2
15
15
3
10
6.67
3
10
10
4
6
4
4
5
5
5
2
1.33
5
3
3
6
−3
—
6
−1
—
Number
of Cups
of Coke
Marginal
Utility from
Last Cup
(Mucoke)
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Summarizing the Income and Substitution Effects
When price . . .
consumer
purchasing
power . . .
The income effect
causes quantity
demanded to . . .
The substitution effect
causes the opportunity cost
of consuming a good to . . .
decreases,
increases.
increase, if a normal
good, and decrease,
if an inferior good.
decrease when the price
decreases, which causes the
quantity of the good
demanded to increase.
increases,
decreases.
decrease, if a normal
good, and increase, if
an inferior good.
increase when the price
increases, which causes the
quantity of the good
demanded to decrease.
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Deriving Your Demand Curve for Pizza
We can use our two observations of consumer behavior (with pizza
prices of $2.00 and $1.50) to trace out your demand curve for pizza:
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Deriving the Market Demand Curve for Pizza
By adding the individual
demand at each price, we
obtain the market demand for
pizza.
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Could a Demand Curve Slope Upward?
A good with an upward-sloping demand curve is known as a Giffen
good.
For a demand curve to be upward sloping, the good would have to
be an inferior good with a greater income effect than substitution
effect (spending on the good must be a large share of the budget).
Decrease in price  More consumption (sub eff) + less
consumption (inferior inc. effect)
 Only less consumption if inc. effect very large!
 Giffen goods are very rare – only one confirmed example!
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