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Chapter 18
Delving Deeper Into
Microeconomics
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Objectives
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Consumer choice
Utility maximization
Price elasticity
Consumer surplus
Tax incidence
18-2
Consumer Choice
• The underlying explanation of the demand
curve is based on the utility function.
• The utility function also tells us how much
benefit a person gets from purchasing and
consuming more of the same thing.
• Marginal utility is the added utility from
consuming one more unit of a good.
• Diminishing marginal utility is the
concept that marginal utility declines as
consumption increases.
18-3
The Utility Function of a Coffee
Drinker
Cups of Coffee
per Day
0
Utility
(utils)
0
Marginal Utility
(utils)
0
1
4
4
2
7
3
3
9
2
4
10
1
18-4
Budget Constraint
• The utility function is not the only factor
that determines what you buy and how
much.
• Budget constraint is the combination of
goods and services you are able to buy,
given their prices and the amount of
money you have available to spend.
• The budget constraint changes when
prices and/or income changes.
18-5
Example of Budget Constraint
# of
meals
eaten
out in
month
# of
movies
seen in
month
Price
per
meal
Price
per
movie
Cost of
meals
Cost of
movies
Total
spending
3
0
$20
$10
$60
$0
$60
2
2
$20
$10
$40
$20
$60
1
4
$20
$10
$20
$40
$60
0
6
$20
$10
$0
$60
$60
18-6
Utility Maximization
• The rational individual will select goods
and services to maximize utility, when
subject to a budget constraint.
• Due to diminishing marginal utility, you are
more likely to choose a combination of
goods and services rather than one good.
• As a consumer, you are weighing the
marginal utility of spending an extra dollar
on one good or service, versus another.
18-7
Utility Maximization
• Consumers often make decisions that
affect their spending decisions in the
future.
• This kind of choice is called intertemporal
utility maximization.
– That is, decisions which involve a trade-off
between consumption today and consumption
in the future.
– For example, a decision to cut back spending
today to save for a home tomorrow.
18-8
Price Elasticity of Demand
• A utility-maximizing consumer will change his or
her purchases when prices changes.
• The price elasticity of demand will determine
how much the purchases will change.
• The price elasticity of demand is the
percentage change in quantity demanded that
results from a one percent change in price.
– A price elasticity of 1 means that a 10% increase in
price leads to a 10% decrease in quantity demanded.
18-9
Price Elasticity of Demand
– An elasticity of 2 means that a 10% increase
in price leads to a 20% decrease in quantity
demanded.
– An elasticity of 0.5 means that a 10%
increase in prices leads to a 5% decrease in
quantity demanded.
• Demand for a good or service is inelastic
if its price elasticity is less than 1, and it is
elastic if its price elasticity is greater than
1.
18-10
Price Elasticity of Gasoline
Price
Before: $3.00
Annual quantity of gasoline
demanded (gallons)
800
After: $3.30
780
Percentage change:
Percentage change:
(3.30-3.00)/3.00 =
(780-800)/800= -2.5%
10%
Elasticity: (-2.5%/10%) = 0.25
18-11
An Inelastic Demand Curve for
Gasoline
Price
per
gallon
Demand curve
$3.30
$3.00
780 800
Annual quantity of gasoline
bought (gallons)
18-12
An Elastic Demand Curve for
Gasoline
Price
per
gallon
Demand curve
$3.30
$3.00
640
800
Annual quantity of gasoline
bought (gallons)
18-13
Consumer Surplus
• Consumer surplus addresses the
question of how much consumers benefit
from a purchase.
• The net benefit of a purchase is the
maximum you would have been willing to
pay minus the actual price.
• The sum of the net benefits from all the
purchases is equal to the consumer
surplus.
18-14
Demand Schedule for Coffee
Suppose the consumer is willing to pay $3 for the first
cup, $2 for the second, $1 for the third, and $0.50 for the
fourth.
Price
Cups of Coffee
$0.50
4
$1
3
$2
2
$3
1
18-15
Consumer Surplus for Coffee
Willing to pay
for a cup of
coffee
$3.00
Market
price
Net benefit
$1.00
$2.00
$2.00
$1.00
$1.00
$1.00
$1.00
$0
Fourth
$0.50
cup
Consumer
surplus
$1.00
$0 (not
purchased)
$3.00
First cup
Second
cup
Third cup
18-16
Producer Decisions
• Now we shift our analysis to the supply or
production side of the economy.
• The cost function gives the cost of
producing each level of output.
• Managers attempt to find the least
expensive way of producing a given level
of output.
– This process is called cost minimization.
18-17
Choosing the Right Input
• The producer’s choice of inputs
depends on their relative prices.
• As an input becomes more expensive, all
other things being equal, a business will
want to use less of it.
• If the cost of labor rises, business will
attempt to use more capital and automate
the production process.
18-18
Substitutes and Complements
• Two inputs are substitutes if raising the price of
one increases the quantity demanded for the
other, holding output constant.
– For example, factory workers in China are a
substitute for factory workers in the US.
• Two inputs are complements if raising the price
of one decreases the quantity demanded of the
other, holding output constant.
– Cement and construction workers are an example.
18-19
Cost Minimization Example
• Let’s look at the example of a small business.
Suppose it must decide whether to buy its own
copier or send out to a copy shop such as
Kinko’s.
– If the business buys a copier, it needs to lay out the
upfront cost, as well as for toner and paper.
– To make a decision, it needs to know the actual cost
of the machine and the price of a copy.
– The decision also depends on the scale of output.
18-20
Copier Decision
18-21
Price Elasticity of Supply
• The price elasticity of supply is the
percentage increase in the quantity
supplied, given a 1% increase in the price.
• Supply is elastic if a small change in price
leads to a large change in the quantity
supplied.
• Similarly, supply is inelastic if a big
change in price leads to only a small
change in the quantity supplied.
18-22
Price Elasticity of Supply
An Elastic Supply
An Inelastic Supply
18-23
Tax Incidence
• The incidence or burden of a tax
identifies the persons or businesses who
ultimately have to pay a tax.
• The burden of the tax depends on the
elasticity of supply and demand.
• The following slide shows the effect of
taxing a market where demand is inelastic
and supply is elastic.
18-24
Taxation with Inelastic Demand and
Elastic Supply
Price
After tax
price for
buyer
Elastic supply
curve
Tax
Original price
After tax
price for
seller
Inelastic demand
curve
After tax
quantity
Original
quantity
Quantity
18-25