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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. 2 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. 3 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. 4 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. 6 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 7 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 8 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 9 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 11 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. 12 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) 13 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 14 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. 15 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! 16 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 17 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. 18 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) 19 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. 20 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: 21 Deriving the Market Demand Curve for Pizza By adding the individual demand at each price, we obtain the market demand for pizza. 22 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! 23