Download ECN 112 Chapter 11 Lecture Notes

ECN 112 Chapter 11 Lecture Notes
11.1 Consumption Possibilities
Our consumption choices are determined by our income and the prices of goods.
A. The Budget Line
The budget line is a line that describes the limits to consumption possibilities and that
depends on a consumer’s budget and the prices of goods and services. The budget line
shows which purchases are affordable and which are not.
1. The budget line is calculated by determining the different combinations of goods that
can be afforded given prices and a person’s income.
2. The budget line is downward sloping. With the quantity of water measured on the xaxis and the quantity of chewing gum measured on the y-axis, the horizontal intercept
reflects the quantity of water that can be purchased when no chewing gum is
purchased. Likewise, the vertical intercept reflects the quantity of chewing gum that
can be purchased when no water is purchased.
B. Changes in Prices
1. A Fall in the Price of Water
If the price of a bottle of water falls, the budget line rotates outward and consumption
possibilities increase.
2. A Rise in the Price of Water
If the price of a bottle of water rises, the budget line rotates inward and consumption
possibilities decrease.
C. Prices and the Slope of the Budget Line
1. The slope of the budget line equals the price of a bottle of water divided by the price of
a pack of chewing gum, or more generally, ratio of the price of the good measured on
the x-axis divided by the price of the good measured on the y-axis.
2. The slope of the budget line is an opportunity cost, which means that it is a relative
price. A relative price is the price of one good in terms of another good—an
opportunity cost. It equals the price of one good divided by the price of another good.
3. The slope of the budget line is negative because moving along the budget line, the
consumer faces a tradeoff. The consumer must give up some of one good to obtain
more of the other good.
D. A Change in the Budget
1. When the budget increases, the budget line shifts outward and the slope does not
change.
2. When the budget decreases, the budget line shifts inward and the slope does not
change.
11.2 Marginal Utility Theory
The budget line shows the choices that are available, but it doesn’t tell us which of those
choices the person makes. People make these choices based on preferences.
A. Utility is the benefit or satisfaction that a person gets from the consumption of a good or
service.
1. Temperature: An Analogy
Like temperature, we cannot observe utility, but nonetheless utility theory helps us
make predictions about people’s consumption choices.
B. Total utility is the total benefit a person gets from the consumption of a good or service.
Total utility generally increases as the quantity consumed of a good increases.
C. Marginal Utility
Marginal utility is the change in total utility that results from a one-unit increase in the
quantity of a good consumed. As more of a good is consumed, a person experiences
diminishing marginal utility, which is the general tendency for the marginal utility to
decrease as the quantity of a good consumed increases.
D. Maximizing Total Utility
Maximizing total utility is the goal of each consumer. A consumer uses a utilitymaximizing rule, which is the rule that leads to the greatest total utility from all the goods
and services consumed. The rule is:
1. Allocate the entire available budget.
2. Make the marginal utility per dollar spent the same for all goods. The marginal utility
per dollar spent is the increase in total utility that comes from the last dollar spent on
a good.
3. Units of Utility
The utility maximizing combination of goods and services does not change when the
units used to measure utility change.
E. Finding the Demand Curve
The demand curve for a good can be derived by varying the price of the good and using
marginal utility theory to determine how the quantity demanded changes. When the price
of a good rises, the marginal utility per dollar spent on the good falls, so to maximize
utility the consumer buys less of the good.
F. Marginal Utility and the Elasticity of Demand
1. When the marginal utility decreases quickly as more of a good is consumed, a fall in
the good’s price requires only a small change in consumption to equate the marginal
utility per dollar spent on it to the marginal utility per dollar spent on other goods. As a
result, the quantity demanded increases very little and so demand is inelastic.
2. When the marginal utility decreases slowly as more of a good is consumed, a fall in
the good’s price requires a large change in consumption to equate the marginal utility
per dollar spent on it to the marginal utility per dollar spent on other goods. As a result,
the quantity demanded increases significantly and so demand is elastic.
G. The Power of Marginal Analysis
Marginal analysis can be used to determine a consumer’s utility maximizing combination
of goods: if the marginal utility per dollar spent is greater for good x than for good y, the
person buys more of good x and less of good y because this change increases the
person’s total utility.
11.3 Efficiency, Price, and Value
A. Consumer Efficiency
A demand curve describes the quantity demanded at each price when total utility is
maximized. A demand curve tells us a consumer’s marginal benefit. Marginal benefit is
the maximum price a consumer is willing to pay for an extra unit of a good or service
when total utility is maximized.
B. The Paradox of Value
The paradox of value asks why we are willing to pay only a low price for water, which has
high total utility and low marginal utility, but willing to pay a much higher price for
diamonds, which have low total utility and high marginal utility. The paradox is explained
using the concepts of total utility and marginal utility: the price of a good reflects its
marginal utility, while the value of a good reflects its total utility.
1. Consumer surplus also explains the paradox of value because water has a huge
consumer surplus and diamonds a much smaller consumer surplus.