Download Demand Curve AP Microeconomics II. Nature and Function of

Demand Curve
AP Microeconomics
II. Nature and Function of Product Markets
A. Supply and Demand
4. Elasticity
Substitution Effect. Change in the price of a good is the change in the quantity of that good
demanded as the consumer substitutes the good that has become relatively more expensive.
Substitution effect of a lower price creates an increase in QD.
Income Effect. Change in the price of a good is the change in the quantity of that good demanded
that results from a change in the consumer's purchasing power when the price of the good changes.
Combining substitution and income effects, lower prices create increased QD, thus explaining the
law of demand.
Note on inferior and normal goods. If the good is an inferior good then a lower price creates an
income effect to purchase less of such a good. In order for demand curves to be downward sloping,
the substitution effect must dominate the income effect for inferior goods.
Law of demand states that consumers will respond to a decrease in price by buying more of a
product (other things remaining constant), but it does not tell us how much more. That's where
elasticity comes in.
Price elasticity of demand. Ratio of the percent change in QD to percent change in P as we move
along demand curve. Sensitivity of consumers to a change in price is measured by price elasticity of
demand. The terms elastic or inelastic describe the degree of responsiveness.
1. If consumers are relatively responsive to price changes, demand is said to be elastic.
2. If consumers are relatively unresponsive to price changes, demand is said to be inelastic.
3. With both elastic and inelastic demand consumers behave according to the law of demand-they are responsive to price changes.
Elastic: ED > 1
Inelastic: ED < 1
Unit elastic: ED = 1
Calculating the Price Elasticity of Demand: ED = %ΔQD/%ΔP
Example. P of digital cameras increases by 1% and QD decreases by 2%.
ED = -2%/1% = -2
ED = 2
Ignore negative sign because downward sloping demand curves will insure a negative price elasticity,
what’s important is the magnitude of that elasticity. For the digital camera, the % decrease in QD (the
effect) was twice as large as the % increase in P (the cause). Consumers have exhibited an elastic
response to a higher price.
1
Demand Curve
AP Microeconomics
Example. P of milk increases by 10% and QD decreases by 5%.
ED = -5%/10%
ED = - 1⁄2 OR 0.50
For the milk, the % decrease in QD (the effect) was only half the size as the % increase in P (the
cause). Consumers have exhibited an inelastic response to a higher price.
% change equation--NOOO! (new number - old number/old number)
%ΔP = 100*(New Price – Old Price)/Old Price
%ΔQD = 100*(New Quantity – Old Quantity)/Old Quantity
Example. The price of a doughnut rises from $1.00 to $1.15 and Shane reduces his weekly
doughnut consumption from 20 to 19.
%ΔP = 100*(New Price – Old Price)/Old Price
%ΔP = 100*(1.15 – 1)/1 = 15% increase
%ΔQD = 100*(New Quantity – Old Quantity)/Old Quantity
%ΔQD = 100*(19 – 20)/20 = 5% decrease
Shane's ED for doughnuts is 5%/15% = 1/3 OR 0.33.
Midpoint Method. Elasticity computations change if the new and old prices (or quantities) are
reversed.
Example. If a variable goes from a value of 100 to a value of 110, it is a 10% increase. If
the variable were to go from a value of 110 to a value of 100, it is a 9.1% decrease.
Because of this, the value of the price elasticity will change, depending upon whether the price is
increasing or decreasing. In order to account for this, economists sometimes use the average price
and average quantity between two points on a demand curve.
%ΔP = 100*(New Price – Old Price)/Average Price
%ΔQD = 100*(New Quantity – Old Quantity)/Average Quantity
Example. Tuition at UF increases from $20,000 to $24,000 per year. UF discovers that the
entering class of first-year students declined from 500 to 450.
%ΔP = 100*(New Price – Old Price)/Average Price
%ΔP = 100*($4000)/$21,000 = 19%
%ΔQD = 100*(New Quantity – Old Quantity)/Average Quantity
%ΔQD = 100*(-50)/475
%ΔQD = - 10.5%
ED = 19%/10.5% = 1.8
Tuition at UF is elastic response between these two points on the demand curve.
2
Demand Curve
AP Microeconomics
Perfectly Inelastic and Perfectly Elastic Demand
Example. ED is equal to 0.25. ED
= %ΔQD/%ΔP = 0.25. Assume P
increases by 1%. Since,
ED = %ΔQD/1% = 0.25, it can be
predicted that QD will decrease by
only 0.25%, which is a small
response.
The smallest response to a price
increase is no response at all.
If P
increased 1%, and there was no
change to QD, %ΔQD = 0 so ED = 0.
As a matter of algebra, D is vertical,
or perfectly inelastic. Consumers
have no response to higher or lower prices.
Example. ED = 10. ED
= %ΔQD/%ΔP = 10. Assume P
increases by 1%. Since, ED
= %ΔQD/1% = 10, it can be predicted
that QD will decrease by a 10%, which
is a big response.
 The largest response to a price
increase would be that consumers
immediately decrease consumption to
zero.
 The largest response to a price
decrease would be that consumers
immediately increase consumption to
3
Demand Curve
AP Microeconomics
an infinitely large amount.
If P increased 1%, and there was an enormous change to QD, %ΔQD = ∞ so ED = ∞.
As a matter of algebra, D is horizontal, or perfectly elastic. Consumers have an infinitely large
response to higher or lower prices.
Quick read of elasticity graphs: If D is closer to
vertical (steeper), it will tend to be less elastic than D
that is closer to horizontal (flatter).
Total Revenue and Elasticity. When a firm sells
products to consumers, the firm earns revenue.
Total revenue (TR) earned by a firm is equal to P of
product multiplied by Q sold at P.
TR = (P)(QD)
Assume that a firm wants to increase TR by
increasing P. QD will decrease. Increasing P and
decreasing QD both influence TR, but in opposite
directions. It ultimately depends upon which effect,
higher P or lower Q, is stronger--price effect or
quantity effect.
 Price effect. After an increase in P, each unit
sold sells at a higher price, which tends to increase
revenue.
 Quantity effect. After an increase in P, fewer
units are sold, which tends to lower revenue.
Example. P increases 1%, QD decreases 5%,
elastic. TR will decrease, because downward
quantity effect is stronger than upward price effect.
Example. P increases 10%, QD decreases 5%,
inelastic. TR will increase, because downward
quantity effect is weaker than upward price effect.
Example. P increases 10%, QD decreases 10%,
unit elastic (ED = 1). TR will not change, because
downward quantity effect is equal to upward price
effect.
4
Demand Curve
AP Microeconomics
Example. Initial price of pizza slices is
equal to $2 and 50 slices are sold every
day. This is point A on D.
TR = (P)(QD) = ($2)(50) = $100
This is the area marked TR on the graph,
the rectangle below D.
Pizzeria wishes to increase P of a slice to
$3 and estimates that 40 slices will be
sold each day. This is point B on D.
TR = (P)(QD) = ($3)(40) = $120
The $20 gain can be seen through both P and Q effects. Area L is revenue lost due to decreased Q.
Ten slices were lost, at $2 each, so area L represents $20 of lost revenue.
Area G is revenue gained due to increased P. Forty slices were sold, at a price $1 higher than before,
so area G represents $40 of gained revenue.
Area G – Area L = $40 - $20 = $20, which is the total increase from the higher price.
If upward price effect is stronger than downward quantity effect, demand must be inelastic.
If upward price effect is weaker than downward quantity effect, demand must be elastic.
5
Demand Curve
AP Microeconomics
Elasticity Along Demand Curve
As P increases, initially TR increases because of inelastic response in QD. However, further price
increases eventually cause TR to decrease because of a larger elastic response. Along the same D
curve, ED is inelastic at low prices and grows more elastic at higher prices.
Factors Determining ED
1. Substitutes for the product. More substitutes, more elastic the demand. If a product has
many substitutes, and P increases, consumers will have an elastic response because they can
easily find alternatives.
2. Luxury or a necessity. Less necessary the item, more elastic the demand. n the case of a
luxury, if P increases, consumers will not buy the product and have an elastic response.
3. Percentage of income spent on good. Larger the expenditure relative to a budget, more
elastic the demand, because buyers notice the change in price more.
4. Amount of time. Longer the time period involved, more elastic the demand becomes.
6
Demand Curve
AP Microeconomics
Cross-Price Elasticity of Demand. Between two goods, this measures the effect of change in one
good's P on the QD of other good. It is equal to percent change in QD of one good divided by
percent change in other good's P. Another way, the effect of a change in a product's P on QD for
another product. In other words, complements and substitutes.
Exy = (%ΔQD of product X)/(%ΔP of product Y)



Substitutes --> cross-elasticity is positive. P of Nikes increase by 2% and QD for Converse
increases by 4%. Exy = 4%/2% = 2. Nikes and Converse are substitutes.
Complements --> cross-elasticity is negative. P of gas increases 20% and QD for large SUVs
decreases by 5%. Exy = -5%/20% = -0.25. Gas and SUVs are complements.
Unrelated --> cross-elasticity is zero. P of Cinnamon Toast Crunch increases. Hollister tshirts are unaffected.
Income Elasticity of Demand. Percent change in QD of good when a consumer's income changes
divided by the percent change in consumer's income. In other words, normal and inferior goods.
EI = (%ΔQD of good X)/(%ΔI)


Normal good --> income elasticity is positive. American consumer income decreases by 2%
and quantity of flights to Europe declines by 8%. EI = 8%/2% = 4. Normal good. Incomeelastic response. Luxury.
o Consumer income rises by 4% and quantity of fresh vegetables purchased increases by 1%.
EI = 1%/4% = 0.25. Normal good. Income-inelastic response. Necessity.
Inferior good --> income elasticity is negative. Consumer income decreases by 5% and
consumers increase consumption of Blech, a meat substitute, by 4%. EI = 4%/-5% = -0.80.
Inferior good.
o For inferior goods, there is no distinction between luxuries and necessities.
Income-elastic. Demand for good is income-elastic if EI for that good is greater than 1.
Income-inelastic. Demand for good is income-inelastic if EI for that good positive but less than 1.
Price Elasticity of Supply. Measure of the responsiveness of the QS of a good to P of that good.
It is the ratio of the percent change in QS to percent change in price as it moves along the S curve.
ES = %ΔQS/%ΔP
Elastic: ES > 1
Inelastic: ES < 1
Unit elastic: ES = 1
7
Demand Curve
AP Microeconomics
Perfectly Inelastic and Elastic Supply. Same analysis as in elasticity of demand.
This graph shows an upward sloping
supply curve, a perfectly elastic supply
curve, and a perfectly inelastic supply
curve.
A vertical S curve like S3 implies that
even at the highest of prices, there is
something that prevents firms from
increasing QS. (e.g., technological
problem or seasonal issue).
A horizontal S curve like S2 implies
that even smallest increase in P would
dramatically increase QS. A small
decrease in P would decrease Qs to zero.
Factors Determining ES
1. Availability of inputs. If a firm can get inputs (labor, capital, raw materials) into and out of
production quickly, ES will be more elastic.
2. Time period
 Market period. Market period is so short that ES is inelastic, possibly
perfectly
inelastic.
 Short-run ES is more elastic than market period and will depend on ability of producers
to respond to P changes as to how elastic it is.
 Long-run ES is most elastic, because more adjustments can be made over time and Q can
be changed more relative to a small change in P (e.g., agriculture).
Example. July 2010, and P of soybeans is increasing. Farmers would love to supply more soybeans
at a higher price, but soybean crops have already been planted. QS of soybeans at harvest 2010 was
basically determined months previously during the spring planting season. The immediate soybean
S curve is very inelastic or nearly vertical and farmers are incapable of responding to higher
But, if high P continue in early 2011, farmers will plant more acres of soybeans next year and will
supply more soybeans. Increase in QS is greater as more time passes and farmers are able to respond.
8
Demand Curve
AP Microeconomics
5. Consumer surplus, producer surplus, and market efficiency.
Consumer surplus. Net gain to an individual
buyer from the purchase of a good. It is equal to
the difference between the buyer's willingness to
pay and the price paid. Total consumer surplus is
sum of the individual consumer surpluses of all
the buyers of a good in a market.
Willingness to pay. Consumer's willingness to
pay for a good is the maximum price at which he
or would buy that good.
Total CS generated by purchase of a good at a
given P equals the area below the D curve but
above P.
Example. Demand curve for a product is
given by the equation P = -2QD + 40. Current
price for the product is $20. The formula for
CS is the formula for the area of a triangle.
CS = (1/2)bh
CS = (1/2)(20)(10)
CS = $100.
If P is lowered, this would expand CS, and
make a bigger triangle. If P is raised, this would
contract CS, and make a smaller triangle.
On past AP Micro exams, some problems
regarding CS have been based on calculating
individual CS. To do this, you simply do basic
arithmetic for each individual above price.
In the graph here, $29 + $15 + $5 = $59 for
total CS. Darren and Edwina are not included
because they are unwilling to pay the price of
$30.
9
Demand Curve
AP Microeconomics
Other AP problem that typically shows up will
ask about the difference between one CS vs.
another after a price change. Or what the gain or
loss in CS would be if it changed. To solve these
problems, use basic geometry after identifying the
change in CS.
Producer Surplus. Net gain to an individual seller
from selling a good. It is equal to the difference
between the price received and the seller's cost.
Total producer surplus in a market is the sum of the
individual producer surpluses of all the sellers of a
good in a market.
Cost. Seller's cost is the lowest P at which he is
willing to sell a good.
Total PS generated from sales of a good at a
given P equals the area above S curve but below
P.
Example. Supply curve for a particular product is
P = 2QS. If current price equals $60, what is the
PS? PS can be found by the area of the triangle.
PS = (1/2)bh
PS = (1/2)(60)(30)
PS = $900
If P is lowered, this would contract PS, and make a
smaller triangle. If P is raised, this would expand
PS, and make a larger triangle.
10
Demand Curve
AP Microeconomics
On past AP Micro exams, some problems
regarding PS have been based on calculating
individual PS. To do this, you simply do basic
arithmetic for each individual above price.
In the graph here, $25 + $15 + $5 = $45 for
total PS. Donna and Engelbert are not included
because they are unwilling to supply the good at
at P of $30.
Gains from trade. Any time a consumer
makes a purchase from a producer, a trade has
been made and both parties expect to gain.
These gains are the concepts of CS and PS.
Economists state that markets provide the most
efficient outcome. A market is efficient if,
once the market has produced its gains from
trade, there is no way to make some people
better off without making other people worse
off.
Efficient markets perform four functions:
1. It allocates consumption of good to
potential buyers who most value it, indicated
by fact that they have highest willingness to pay.
2. It allocates sales to potential sellers who
most value right to sell good, indicated by
fact that they have lowest cost.
3. It ensures that every consumer who makes a purchase values good more than every seller
who makes a sale, so that all transactions are mutually beneficial.
4. It ensures that every potential buyer who doesn’t make a purchase values the good less
than every potential seller who doesn’t make a sale, so that no mutually beneficial
transactions are missed.
AP Note. Efficiency is just one outcome. Not all markets are efficient, and not all market
outcomes are fair. AP Micro test will give scenarios where solution is not necessarily fair.
6. Tax Incidence and Deadweight Loss
Types of taxes
 Progressive tax. A tax that rises more than in proportion to income, so that high-income
taxpayers pay a larger percentage of their income than low-income taxpayers.
 Regressive tax. A tax that rises less than in proportion to income, so that high-income
taxpayers pay a smaller percentage of their income than low-income taxpayers.
 Proportional tax. A taxes that rises in proportion to income, so that all taxpayers pay the same
percentage of their income.
11
Demand Curve
AP Microeconomics
12
Demand Curve
AP Microeconomics
Taxes and Total Surplus. Excise taxes are taxes levied on each unit of gold sold. In the U.S., and
on the AP exam, typically the examples are gasoline, tobacco, alcohol and hotel rooms.
Example. Suppose the market for gasoline in
Orlando is free of any taxes.
PE is $2 per
gallon, and 1 million gallons are sold every day.
CS = (1/2)($3)(1 million) = $1.5 million
PS = (1/2)($2)(1 million) = $1 million
TS = $2.5 million
Now, politicians in Orlando decide to impose
on gasoline sellers a $1 tax on every gallon of
gasoline sold.
For sellers, this means that to continue to sell 1
million gallons per day, they must receive $3 per
gallon because $1 must be sent to the
government. In other words, S curve shifts
upward by $1, the amount of the tax.
After the tax, only 0.8 million (or 800,000)
gallons of gasoline are exchanged and the price
paid by consumers at the pump has risen to
$2.60.
The price sellers actually receive is equal to
$2.60 - $1.00 = $1.60 because they send $1 to
the government for every gallon that they sell.
The tax creates a wedge between P buyers pay ($2.60) and P sellers actually receive ($1.60).
Who is really paying the tax? Consumers see a price that is $.60 higher than before. Sellers receive,
after tax, a price that is $.40 lower than before. We can determine that consumers are paying $.60 of
a $1 tax (60%) and sellers are paying $.40 (40%)
of the $1 tax. As such, the tax incidence falls
on the consumers. Tax incidence is the
distribution of the tax burden.
Now, politicians in Orlando decide to impose
the $1 tax on gasoline buyers, rather than sellers.
Buyers must pay $1 to government for every
gallon of gasoline that they purchase. This
would lower consumer willingness to pay by $1
for each gallon purchased, which serves to shift
D curve downward by the amount of the tax.
13
Demand Curve
AP Microeconomics
After the tax, 800,000 gallons are exchanged. Sellers receive $1.60 for each gallon of gasoline sold,
and buyers pay a total of $1.60 + $1 = $2.60 for each gallon purchased. Tax has created a wedge
between P received by sellers and P paid by buyers.
Who is really paying the tax? Buyers are still paying 60% and sellers are still paying 40% of a $1 tax.
Tax incidence falls on the consumers.
Note: This result in both taxes is due to elasticity of demand and supply here.
Price Elasticities and Tax Incidence. Tax incidence really depends upon the shape of D and S
curves. This shape, steep vs. flat, depends upon ED and ES.
Excise Tax Paid Mainly by Consumers. If
tax of $T is imposed on the sellers, S curve will
shift upward by $T and the new price P2 is the
entire amount of $T higher than the original
price P1. If D curve is relatively inelastic and
the supply curve is relatively elastic,
consumers will pay larger share of excise
tax.
In the second graph here, the steep D curve has
a low ED for gasoline. The flat S curve has a
high ES. Pre-tax price of a gallon of gas is $2.00,
and a tax of $1.00 per gallon is imposed. Price
paid by consumers increases by $0.95 to $2.95.
Tax incidence falls on consumers. Only a small
portion of the tax is paid by the producers.
14
Demand Curve
AP Microeconomics
Excise Tax Paid Mainly by Producers. P
increases slightly to P2. Sellers must then pay
$T of tax so the after-tax price sellers receive is
nearly $T lower than the original price P1. If D
curve is relatively elastic and S curve is
relatively inelastic, sellers will pay larger
share of the excise tax.
In this graph, the relatively flat D curve has a
high ED, and the relatively steep S curve has a
low ES. Pre-tax price is $6 and a tax of $5 is
imposed. P received by producers falls to $1.50.
Producers have tax incidence. Price paid by
consumers increases a small amount, but they
have little of the burden.
Tax Revenue. After the gasoline tax in
Orlando, buyers are paying higher prices and
sellers are receiving lower prices, for the
gasoline they exchange. However, Orlando city
government is collecting TR. This can be
figured out by finding the area of the rectangle
created by the wedge.
TR = (#gallons sold)(tax)
TR = (800,000)($1)
TR = $800,000
This graph just gives you a general idea of
where TR is in a graph. Finding the area of the
rectangle will give you the TR created by the
excise tax. It's the wedge.
15
Demand Curve
AP Microeconomics
Costs of Taxation. Notice in this graph that the
excise tax creates a loss in both CS and PS. You
can calculate the individual losses in CS and PS by
the area of the rectangles and triangles. Triangles B
and F represent deadweight loss. Deadweight
loss is the decrease in total surplus resulting from
the tax, minus the tax revenues generated.
Example. From the example above, TS was
CS = (1/2)($3)(1 million) = $1.5 million
PS = (1/2)($2)(1 million) = $1 million
TS = $2.5 million
After the $1 tax was imposed, consumers are now
paying $2.60 for only 800,000 gallons of gasoline.
New CS = (1⁄2)($2.40)(800,000) = $960,000
Sellers are now receiving $1.60 for those 800,000
gallons.
New PS = (1⁄2)($1.60)(800,000) = $640,000
Now, add the area of government TR, $800,000.
CS + PS + Revenue = $2.4 million.
Um, what happened to the other $100,000? This is
the DWL, labeled in the graph. It exists because
there are 200,000 gallons of gasoline that go unsold
because tax moved the after-tax quantity away from
the market equilibrium quantity.
For example, there is a consumer out there who is
willing to pay $2.50 for a gallon of gas, but no seller
can afford to offer that gallon for sale. This is a
transaction that goes unmade and thus efficiency is lost. If the tax had NOT reduced the quantity of
gasoline exchanged, there would have been no DWL.
B. Theory of Consumer Choice
Utility and Consumption. Assumption: Individuals try to maximize some personal measure of
satisfaction gained from consumption.
• Utility. Measure of satisfaction.
• Utils. Unit of utility.
• Utility function. Shows relationship between consumer’s utility and combination of goods and
services (consumption bundle) he consumes.
16
Demand Curve
AP Microeconomics
Example. Cassie likes to eat clams at an all-you-can-eat buffet. Her utility function slopes upward,
but gets flatter as the number of clams increases, eventually turning downward because of
diminishing marginal utility.
Adding each additional clam makes Cassie worse off—it lowers her total utility. Acting rationally,
Cassie will stop at 8. To make this decision, she must consider the change in her total utility from
consuming one more clam.
17
Demand Curve
AP Microeconomics
Key point: To maximize total utility, consumers most focus on marginal utility.
Marginal utility. Change in total utility generated by consuming one additional unit of a good or
service.
Marginal utility curve. Shows how marginal utility depends on quantity of a good or service
consumed.
Looking at the table, marginal utility per clam changes with the consumption of each additional clam.
According to this table, Cassie should stop consuming clams at 8. With each clam consumed, her
marginal utility decreases more and more. After her 8th clam, she actually sees a negative marginal
utility in clam consumption.
The marginal utility schedule can be graphed as the marginal utility curve. The curve slopes
downward because each clam decreases the total utility than the previous one. Consumption of
most goods and services is subject to diminishing marginal utility.
Principle of Diminishing Marginal Utility. The additional satisfaction a consumer gets from one
more unit of a good or service declines as the amount of that good or service consumed rises.
Optimal Consumption. It costs some additional resources to consume more of a good, and
consumers must take that cost into account when making choices. The fundamental measure of
cost is opportunity cost. Because the amount of money a consumer can spend is limited, a decision to
consume more of one good is also a decision to consume less of another good.
Example. Sammy likes both clams and potatoes. Whatever he chooses, the cost of his
consumption bundle can not exceed the amount of money he has to spend.
Budget constraint. Limits cost of a consumer’s consumption bundle to no more than the
consumer’s income.
Expenditure on clams + Expenditure on potatoes ≤ Total Income
Consumption possibilities. Set of all consumption bundles that affordable given the consumer’s
income and prevailing prices. Possibilities depend on consumer’s income and prices of g/s.
18
Demand Curve
AP Microeconomics
Budget line. Shows
consumption bundles available
to a consumer who spends all of
his income.
We assume that consumption
bundles are made along the
budget line so long as his
marginal utility from consuming
either good is still positive.
Note. Analyze this in the same
way you would analyze a PPC.
Optimal Consumption
Bundle. Consumption bundle
that maximizes consumer’s total
utility given his budget
constraint.
Examining the first table here,
there are 6 possible
combinations. The more of
either good he consumes, the
higher Sammy’s utility.
However, Sammy’s got a limited
budget, so he’s got to make a
trade off between clam and
potato consumption.
Notice that the utils are inverse for clams and potatoes. This is due to the opportunity cost--the
budget constraints force Sammy to make a choice. At bundle C, we see total utility maximized.
19
Demand Curve
AP Microeconomics
Graphing out the budget line and utility function together, we see that the more clams Sammy
consumes, the less potatoes, and vice versa. It's an inverse relationship. C is the optimal
consumption bundle because this is where total utility is maximized given Sammy's budget.
Marginal Utility per Dollar. Dollar spent on a g/s is the additional utility from spending one
more dollar on that g/s. This is how to allocate an additional dollar between g/s in a way that
maximizes utility.
20
Demand Curve
AP Microeconomics
Marginal utility per dollar for each good is found by dividing the marginal utility of the good by its
price in dollars. Marginal utility of clams is decreasing because of diminishing marginal returns.
MU per dollar = MUgood/Pgood
This graph sets out the two tables on marginal
utility per dollar above. Notice that the two
curves, MUc/Pc and MUp/Pp intersect at the
optimal consumption bundle, point C,
consisting of 2 pounds of clams and 6 pounds
of potatoes.
When Sammy consumes 2 pounds of clams
and 6 pounds of potatoes, his marginal utility
per dollar spent is the same for both goods: 2.
At the optimal consumption bundle, MUc/Pc
= MUp/Pp = 2.
Now, assume Sammy’s marginal utility per
dollar for clams is higher than potatoes. He
can fix this by spending $1 less on potatoes and $1 more on clams. He becomes better off and stays
within his budget. If Sammy has chosen the optimal consumption bundle, his marginal utility per
dollar spent on clams and potatoes must be equal.
21
Demand Curve
AP Microeconomics
Optimal Consumption Rule. When a consumer maximizes utility in the face of a budget
constraint, the marginal utility per dollar spent on each good or service in the consumption bundle is
the same. That is, for any two goods C and P, at the optimal consumption bundle
MUC MU P
=
PC
PP
This rule applies no matter how many g/s a consumer buys. The marginal utilities per dollar spent
for each and every good or service in the optimal consumption bundle are equal.
22