Download Diminishing Marginal Utility

Consumer Choices and
Economic Behavior
Key Topics
1.
The budget constraint
a.
b.
2.
Definition, equation, graph, opportunity cost
Impact of ΔI, ΔPx, ΔPy
Utility
a.
b.
c.
Total and marginal
Indifference curve: definition, slope
Utility maximization
Key Topics
3. Downward-sloping demand factors
a.
b.
c.
Diminishing marginal utility
Income effect
Substitution effect
4. Other consumer decisions
a.
b.
Work or leisure
Save or borrow
Questions
1.
What does it mean if you have a ‘budget
constraint’?
2.
How can your attainable consumption
choices be shown mathematically and
graphically?
Budget Constraint

The maximum Q
combinations of goods
that can be purchased
given one’s income and
the prices of the goods.
Budget Constraint Variables
I (or M) =
the amount of income or money
that a consumer has to spend on
specified goods and services.
X =
the quantity of one specific good or one specific bundle of
goods
Y =
the quantity of a second specific good or
second specific bundle of goods
Px =
the price or per unit cost of X
PY =
the price or per unit cost of Y
Budget Line Equation
Income = expenses
I = PxX+PYY
Y = l/PY – (Px/PY)X
 straight line equation
The Opportunity Set
Y
I/PY
Budget Line
PX
PY
I/PX
X
Budget Line: Axis Intercepts &
Slope



Vertical Axis Intercept
=
I/PY
=
max Y (X = 0)
Horizontal Axis Intercept
=
I/PX
=
max X (Y = 0)
- Slope
= PX/PY
= ‘inverse’ P ratio
= X axis good P/Y axis good P
= Y/X
Changes in the Budget Line

Changes in Income
Increases lead to a parallel,
outward shift in the budget line (I2 > I1).
Decreases lead to a parallel,
downward shift (I2 < I1).
Y
I1
PY
I1
PY
X
Changes in the Budget Line

Changes in Price
A decrease in the price of good X rotates the
budget line counter-clockwise.
An increase rotates the budget line clockwise.
Y
New budget line for
a price decrease
1
I / Px
I / Px2
X
Q. What Are Your Preferences?


Lunch
A: 1 drink, 1 pizza slice
B: 1 drink, 2 pizza slices
C: 2 drinks, 1 pizza slice
Entertainment
A: 1 movie, 1 dinner
B: 1 movie, 2 dinners
C: 2 movies, 1 dinner
For each, indicate which of the following you prefer:
A vs B, B vs C, or A vs C
Utility Concepts




Utility:
satisfaction received from consuming goods
Cardinal utility:
satisfaction levels that can be measured or specified
with numbers (units = ‘utils’)
Ordinal utility:
satisfaction levels that can be ordered or ranked
Marginal utility:
the additional utility received per unit of additional
unit of an item consumed (ΔU/ ΔX)
Utility Assumptions
1.
2.
3.
Complete (or continuous)  can rank
all bundles of goods
Consistent (or transitive) 
preference orderings are logical and
consistent
Consumptive (nonsatiation)  more
of a ‘normal’ good is preferred to less
More of a Good is Preferred to
Less
The shaded area represents those combinations of X and Y that are
unambiguously preferred to the combination X*, Y*. Ceteris paribus,
individuals prefer more of any good rather than less. Combinations
identified by “?” involve ambiguous changes in welfare since they contain
more of one good and less of the other.
Indifference Curve
Indifference Curve
 A curve that defines the
combinations of 2 or more
goods that give a consumer
the same level of
satisfaction.

Curves further from origin
represent higher utility levels
Assume Bob and Jan are students who actually ENJOY
going to their classes and learning new things. Each have
been asked to rank the following combinations of classes
in terms of their preferences:
Combination
A
B
# Econ
2
3
# Math
4
3
C
4
2
Preferences:
Bob: a > b > c
Jan: c > b > a
Show and explain graphically with economic concepts.
Econ (#)
6
5
c
4
b
3
2
a
1
Math (#)
1
2
3
4
5
6
What is a ‘Bad’ Good?

A ‘bad’ good, or an economic ‘bad’ is an item
that a consumer does not like or enjoy, which
means their total satisfaction level is lower
the more of the item they have. This also
means the marginal utility of the item is
negative.
MRS & MU
MRS = marginal rate of substitution
= - slope of indifference curve
= -Y/ X
= the rate at which a consumer is willing to
exchange Y for 1more (or less) unit of X
U =
0 along given indiff curve
=
MUx(X)+MUY(Y) = 0
=
- Y/ X = MUx/MUY
=
- slope = inverse MU ratio

Consumer Equilibrium
(U Max)

The equilibrium
consumption
bundle is the
affordable bundle
that yields the
highest level of
satisfaction.
Equal Slopes Condition
(for consumer equilibrium)
 MUX/MUY
 MUX/PX
= PX/PY
= MUY/PY
U Max for Cy?
Q. Suppose Cy will obtain 50 units of additional
satisfaction from watching another 2 hour
movie and 60 units of additional satisfaction
from watching another 3 hour basketball
game on TV.
What should Cy do?
Individual Demand Curve

An individual’s
demand curve is
derived from
each new
equilibrium point
found on the
indifference curve
as the price of
good X is varied.
Y
U 1* ( P1 )
U 0* ( P0 )
X
$
P0
P1
X0
X1
X
Diminishing Marginal Utility

The law of diminishing marginal
utility:
The more of one good consumed in a
given period, the less satisfaction
(utility) generated by consuming each
additional (marginal) unit of the same
good.
Diminishing Marginal Utility and
Downward-Sloping Demand

Price per meal ($)
40

25
15
D
0
5
10
Thai meals per month
25
Diminishing marginal
utility helps to
explain why demand
slopes down.
Marginal utility falls
with each additional
unit consumed, so
people are not willing
to pay as much.
Income and Substitution Effects of a
Price Change (for normal goods)
Price of a
good or
service
Household is
better off
(higher real income)
Income
effect
Household
buys more
Opportunity
cost of the
good falls
Substitution
effect
Household
buys more
Household is
worse off
(lower real income)
Income
effect
Household
buys less
Opportunity
cost of the
good rises.
Substitution
effect
Household
buys less
FALLS
RISES
Household Choices in Labor Markets
As in output markets, households face
constrained choices in input markets. They
must decide:
Whether to work
2. How much to work
3. What kind of a job to work at
These decisions are affected by:
1. The availability of jobs
2. Market wage rates
3. The skill possessed by the household
1.
The Price of Leisure
W
= wage rate
= the price (or the
opportunity cost or lost
benefits of either unpaid
work or leisure.
Work vs. Leisure Constraint
Income
24W
24
Leisure (hrs/day)
The Labor Supply Curve
 The
labor supply curve
is a diagram that shows
the quantity of labor
supplied at different wage
rates.
Saving and Borrowing: Present
Versus Future Consumption


Households can use present income to
finance future spending (i.e., save), or they
can use future funds to finance present
spending (i.e., borrow).
In deciding how much to save and how much
to spend today, interest rates define the
opportunity cost of present consumption in
terms of foregone future consumption.
Saving & Borrowing Impacts on
Consumption
If r = interest rate:
(1 + r) = $ amount for spending 1 year from now as a
result of saving $1 of this year’s income
1
(
) = $ amount for spending this year as a
1 r
result of borrowing $1 against next year’s income
Two-Year Budget Line
Q1
(next yr)
save
I1/P
borrow
Q0 (this yr)
I0/P