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MICROECONOMICS
PROF RUSHEN CHAHAL
2/12/2012
Chapter 6
y
y y y y y y
Utility Law of diminishing marginal utility Total and Marginal Utility Maximizing utility subject to a budget constraint Utility Maximization and Demand Indifference curves and budget constraint curves
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Learning objectives
y Discuss how the income effect and substitution
effect lead to a downward sloping demand curve. y Explain why marginal utility diminishes. y Practice the step by step utility-maximizing process. y Apply the rule of utility maximization y Relate utility maximization to the demand curve. y Understand indifference curves and budget constraints.
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downward sloping
y Here are 2 effects (noun) that affect (verb) demand: 1. The substitution effect a lower price of a good causes a person to buy more of that good instead of alternative goods. 2. The income effect the change in the quantity demanded caused by a price changes effect on real income which measures a persons purchasing power.
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lower prices, people buy more of a good y One reason for this is the substitution effect y When the price of a good falls, people will substitute that good for alternative goods y The opportunity cost of buying this good has now decreased
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substitute good than the good with the higher price y The opportunity cost of buying the higher priced good has increased y If the price of Nike shoes increases, people will start to buy Adidas and Reebok instead, substituting away from Nike
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demand to be downward sloping y When the price of a good decreases, your real income (purchasing power) increases y You can now buy more of everything
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price of gas is $2 a gallon y Youre spending $50 a week on gas y Now the price of gas decreases to $1 a gallon y You can now buy 50 gallons of gas a week for the same amount of money, or you can buy 25 gallons of gas and more of other goods
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Utility
y Before, we looked at the idea of marginal benefit and
consumer surplus y We saw that marginal benefit was the additional value that one received from consuming one more unit of a good y A similar (almost exact same!) concept is utility
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Utility
y Why do we buy goods? y In order to gain utility y Utility satisfaction received from consumption of a
good. y (This satisfaction can translate directly to the value, or marginal benefit, we get from the good)
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Utility
y Though utility is not measurable, we can act as
though it were
y Well use a util as a measure of the amount of
illustration only.
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Utility
y Total utility the satisfaction a person receives
y In other words: it is the additional utility we get from consuming one more unit of a good (You can see this is the same thing as marginal benefit)
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Marginal Utility =
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0 First Slice
Prof. Rushen Chahal
Second Slice
Pizza
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going to be decreasing The first unit of a good is the most satisfying The second unit provides less utility The third even less utility Etc.
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Marginal utility decreases over a short period of time, but after a long time it can increase again.
Tomorrow I
will want to eat more dumplings when I am hungry again. They will no longer have negative marginal utility.
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the greatest utility y The second gave me less satisfaction, thus less marginal utility (total utility is still rising though)
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y The 6th dumpling gave me no utility. y This is what we call the satiation point. y At the satiation point, there is no more utility from
unit consumed provides zero marginal utility; associated with maximum total utility.
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Satiation point
Prof. Rushen Chahal
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CANNOT spend more than their income y The budget constraint, a consumers income, limits the amount of total utility that a person can get y Utility maximization is achieved when the consumers choices provide the greatest amount of utility for a specific amount of income.
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is 30 utils y We could say Im getting 10utils/dollar y What if I buy a second movie ticket, and receive 27 utils from buying it y The second ticket is providing me with 9utils/dollar y So how do we use this information?
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If the marginal utility per dollar of product X is greater than the marginal utility per dollar of product, consumers should purchase more of product X. Conversely, if the marginal per dollar of product Y is greater than the marginal utility of product Y, consumers should purchase more of product Y.
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of water. y At this combination the utility per dollar she receives from buying the last ticket is equal to the utility per dollar she receives from buying the last bottle of water, so her total utility is also maximized.
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Utility maximization causes demand to slope downward. $3 $2 Denises demand 4 5 Quantity of movies
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downward sloping:
1. The substitution effect 2. The income effect 3. The law of diminishing marginal utility
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Indifference Curves
y In economic terms, when people are indifferent to
the choices before them, they obtain the same amount of utility from each of those choices. y An indifference curve shows the combinations of two goods that provide an individual with equal amounts of utility. y An indifference curve slopes downward.
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Indifference Curves
Rays indifference curve between shrimp and chicken wings reveals combinations of the two products that would leave him equally satisfied. Prof. Rushen Chahal
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Indifference Curves
y The marginal rate of substitution is the quantity of
one good that must be given up as the consumption of the other good increases by one unit and total utility remains constant.
y The marginal rate of substitution can be expressed
as:
Marginal rate of substitution
Prof. Rushen Chahal
Change in the consumption of one good Change in the consumption of another good
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Indifference Curves
(A) (B) (C) (D)
BETWEEN CHANGE IN CHANGE IN MARGINAL POINTS: CONSUMPTION CONSUMPTION RATE OF OF JUMBO OF CHICKEN SUBSTITUTION SHRIMP WINGS = (C/B) A and B (2-1) = 1 (5-8) = -3 3 B and C (3-2) = 1 (3-5) = -2 2 C and D (4-3) = 1 (2-3) = -1 1
Indifference Curves
y So far weve only been focusing on one indifference
curve y This curve has shown all the different combinations of two goods that will yield the same total utility y But consumers have many different indifference curves, showing the many different levels of total utility they will enjoy at different levels of consumption y This idea can be shown by an indifference map
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Indifference Maps
Good 2
Good 1
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Budget Constraints
y Consumer choice is limited by the amount of money
that people can spend and the prices of the goods they buy. y The budget constraint is a curve that shows a consumers consumption possibilities for two goods. y Points outside the budget constraint require more income than is currently available and thus cannot be purchased now.
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Budget Constraints
The budget constraint will be a downward-sloping straight line, with the slope equal to -(price of one good/price of another good).
The slope of Rays budget constraint is -(price of shrimp/price of wings) 2/12/2012 = -1/.25 = -4.
buy? y The choose the goods that will maximize their satisfaction, given the limited budget they face y This means consumers will consume:
1. on the budget line, NOT below it and NOT above it 2. on the highest possible indifference curve
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A is within the budget but is not as good as B. B is on the highest indifference curve that is within the budget, so it is the best we can afford. C is better than B but is outside the budget so it is not possible.
10
DVDs (6 Yuan)
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