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Consumers, Producers, and
the Efficiency of Markets
 What is utility and how is it measured?
 What is the Law of Diminishing Marginal
Utility?
 How do consumers maximize utility?
 How is utility related to the demand curve?
 What is consumer surplus?
• How is it related to the demand curve?
Measuring Utility
 How much utility do you receive from eating
donuts?
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Law of Diminishing Marginal Utility
 The more of a good a person consumes, the
smaller the increase in total utility from
consuming the good, all else equal
 In other words, marginal utility falls as we
consume more and more donuts
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Finding the Optimal Bundle: An Example
 Assume:
• Isaac has $10 per week to spend on donuts and
•
•
cookies
Price of a donut = $1.00
Price of a cookie = $2.00
 How many of each should Isaac buy?
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Finding the Optimal Bundle: An Example
Cookies
Donuts
Q
TU
MU
MU per $
Q
TU
MU
MU per $
0
0
----
----
0
0
----
----
1
10
1
25
2
19
2
45
3
27
3
60
4
34
4
70
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The Consumer Optimum
 Occurs where the marginal utility per dollar
spent on each good is equal
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The Law of Demand
 What happens if the price of a cookie rises to
$3.00?
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Finding the Optimal Bundle: An Example
Cookies
Donuts
Q
TU
MU
MU per $
Q
TU
MU
MU per $
0
0
----
----
0
0
----
----
1
10
10
10
1
25
25
2
19
9
9
2
45
20
3
27
8
8
3
60
15
4
34
7
7
4
70
10
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The Law of Demand
 What happens if the price of a cookie rises to
$3.00?
 Quantity of cookies demanded falls
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A C T I V E L E A R N I N G 1:
Optimal bundle
Find the optimal quantity of both goods if the individual
has $5 per week to spend on apples and oranges and
they each are priced at $1:
Apples
Oranges
Q
TU
Q
TU
1
20
1
19
2
35
2
32
3
48
3
40
4
58
4
45
5
66
5
49
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Willingness to Pay (WTP)
A buyer’s willingness to pay for a good is the
maximum amount the buyer will pay for that good.
WTP measures how much the buyer values the
good.
Name
WTP
Anthony $250
Chad
175
Flea
300
John
125
Example:
4 buyers’ WTP for an iPod
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WTP and the Demand Curve
Q: If price of iPod is $200, who will buy an iPod,
and what is quantity demanded?
Name
WTP
Anthony $250
Chad
175
Flea
300
John
125
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WTP and the Demand Curve
Derive the
demand
schedule:
P (price
of iPod)
Who Buys?
Qd
$301 & up Nobody
Name
WTP
251 – 300 Flea
Anthony $250
176 – 250 Anthony, Flea
Chad
175
Flea
300
Chad, Anthony,
126 – 175
Flea
125
John, Chad,
0 – 125
Anthony, Flea
John
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Consumer Surplus (CS)
Consumer surplus is the amount a buyer is willing
to pay minus the buyer actually pays:
CS = WTP – P
Name
WTP
Anthony $250
Suppose P = $260.
Flea’s CS = $300 – 260 = $40.
Chad
175
Flea
300
The others get no CS because
they do not buy an iPod at this
price.
John
125
Total CS = $40.
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A C T I V E L E A R N I N G 2:
Consumer surplus 50
P
A. Find marginal
buyer’s WTP at
Q = 10.
demand curve
$ 45
40
35
B. Find CS for
30
P = $30.
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Suppose P falls to $20. 20
How much will CS
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increase due to…
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C. buyers entering
5
the market
0
D. existing buyers
0
paying lower price
5
10
15
20
Q
25
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A More Formal Utility Analysis
 Economists can be more specific about the ways
in which consumers maximize utility
 This material is from the Appendix to Chapter 6
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The Budget Constraint:
What the Consumer Can Afford
 Two goods: pizza and Pepsi
 A “consumption bundle” is a particular combination
of the goods, e.g., 40 pizzas & 300 pints of Pepsi.
 Budget constraint: the limit on the consumption
bundles that a consumer can afford
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A C T I V E L E A R N I N G 3:
Budget constraint
The consumer’s income: $1,000
Prices: $10 per pizza, $2 per pint of Pepsi
A. If the consumer spends all his income on pizza,
how many pizzas does he buy?
B. If the consumer spends all his income on Pepsi,
how many pints of Pepsi does he buy?
C. If the consumer spends $400 on pizza,
how many pizzas and Pepsis does he buy?
D. Plot each of the bundles from parts A-C on a
diagram that measures the quantity of pizza on
the horizontal axis and quantity of Pepsi on the
vertical axis, then connect the dots.
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The Slope of the Budget Constraint
From C to D,
Y (“rise”) = –100
Pepsis
X (“run”) = +20
pizzas
Pepsis
500
400
C
300
Slope = –5
Consumer must
give up 5 Pepsis to
get another pizza.
D
200
100
0
0
20 40 60 80 100 Pizzas
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The Slope of the Budget Constraint
 The slope of the budget constraint equals
• the rate at which the consumer
•
•
can trade Pepsi for pizza
the opportunity cost of pizza in terms of Pepsi
the relative price of pizza
price of pizza
$10

 5 Pepsis per pizza
price of Pepsi
$2
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A C T I V E L E A R N I N G 4:
Exercise
Show what
happens to the
budget constraint
if:
A. Income falls to
$800
B. The price of
Pepsi rises to
$4/pint.
Pepsis
500
400
300
200
100
0
0
20 40 60 80 100 Pizzas
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A C T I V E L E A R N I N G 5:
Inferior vs. normal goods
 An increase in income increases the quantity
demanded of normal goods and reduces the
quantity demanded of inferior goods.
 Suppose pizza is a normal good
but Pepsi is an inferior good.
 Use a diagram to show the effects of
an increase in income on the consumer’s
optimal bundle of pizza and Pepsi.
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Income and Substitution Effects
A fall in the price of Pepsi has two effects on the
optimal consumption of both goods.
• Income effect
•
A fall in the price of Pepsi boosts the purchasing
power of the consumer’s income, allowing him to
reach a higher indifference curve.
Substitution effect
A fall in the price of Pepsi makes pizza more
expensive relative to Pepsi, causes consumer to
buy less pizza & more Pepsi.
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The Substitution Effect for
Substitutes and Complements
 The substitution effect is huge when the goods are
very close substitutes.
• If Pepsi goes on sale, people who are nearly
indifferent between Coke and Pepsi will buy
mostly Pepsi.
 The substitution effect is tiny when goods are
nearly perfect complements.
• If software becomes more expensive relative to
computers, people are not likely to buy less
software and use the savings to buy more
computers.
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A C T I V E L E A R N I N G 6:
Income & substitution effects
 The two goods are skis and ski bindings.
 Suppose the price of skis falls.
Determine the effects on the consumer’s
demand for both goods if
• income effect > substitution effect
• income effect < substitution effect
 Which case do you think is more likely?
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One Last Issue
 Since an individual knows his or her own
preferences better than anyone else, is cash the
best gift for someone?
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