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ECONOMICS 200PRINCIPLES OF MICROECONOMICS

Professor Lucia F. Dunn

Department of Economics

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Household Consumption Behavior

UtilityUtility:

Satisfaction or Pleasure; Want-Satisfying Power

Marginal Utility (MU)Marginal Utility (MU):

The last extra bit of utility a consumer gets from consuming the last extra unit of the item.

Paradox:Paradox:Water Cheap

Diamond Expensive

Utility and Marginal Utility (1)

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Household Consumption Behavior

* Value is determined by marginal utility from last unit consumed

Law of Diminishing Marginal UtilityLaw of Diminishing Marginal Utility:

The more you consume of a certain good, the less you value additional units of it.

Utility and Marginal Utility (2)

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Household Consumption Behavior

Cardinal Approach – Exact Numbers

- can’t use this with utility

Ordinal Approach – Rank Order

- this is used with utility

•Goal of Consumer:

To maximize total utility

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Household Consumption Behavior

Gallons of Water per Month for Consumer A

Index of UtilityTotal Utility

100 200 300 400

Gallons of Water per Month for Consumer A

Index of Utility

Marginal Utility

100 200 300 400

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Household Consumption Behavior

Gallons of Water

Index of Utility

Total Utility

Gallons of Water

Index of Utility

MU

In this case, we say that an extra unit has “disutility”.

Disutility!Disutility!

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Household Consumption Behavior

Condition To Reach Consumer Equilibrium (1)

MU per dollar spent on commodity #1 should be the same as the

MU per dollar on commodity #2 (and the same for all goods).

So:

where: MUi= MU of a unit of commodity i

Pi= Price of good i

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3

2

2

1

1

PMU

PMU

PMU

We will consider two goods only.

Rearranging we get:2

1

2

1

PP

MUMU

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Household Consumption Behavior

Condition To Reach Consumer Equilibrium (2)

Example:

Good #1 is Avocado; PA = 60 cents

Good #2 is Banana; PB = 20 cents

So:

So, for the consumer to reach equilibrium we must have:

3B

A

MUMU

320.60.

B

A

PP

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INTUITIVE REASONING:

Intuitively, if an avocado costs 3 times as much as a banana, the last avocado consumed should bring the consumer 3 times the happiness as the last banana.

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Household Consumption Behavior

If PA increases to 80cents, then:

420.80.

B

A

PP

So:43

B

A

B

A

PPand

MUMU

What must consumer do to restore equilibrium?

1. Can NOT change prices

2. Must change MU by altering consumption

- Want: MUA/MUB = 4

- Must either raise numerator or lower denominator

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Household Consumption Behavior

If consume MORE of good A, MUA decreases.

If consume LESS of good B, MUB increases.

Q

MU

MU

Q1

MU1

Q2

MU2

Index of Marginal Utility

So: When PA goes up, QD of good A should go down.

* Hence the Law of Diminishing Marginal Utility is one thing that explains the negative slope of a demand curve.

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Summary

3 Things Underlies a Demand Curve3 Things Underlies a Demand Curve

1. The Law of Diminishing Marginal Utility

2. Substitution Effect

3. Income Effect

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Consumer Surplus

Market for Ball Point Pens

D

p

Q

S

This is a difference between value in use and value in exchange.

70c

60c

0 1

50c

10

40c

20

30c

40

Thousands of Pens per Month

Consumer SurplusConsumer Surplus: The difference between what a consumer actually

pays for an item and what he would be willing to pay.

ConsumerSurplus!

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Consumer Surplus

p

Q

We Can Measure Consumer Surplus on a Demand Diagram.

0

A

Po

Qo

BCS

TR

CSCS: The area under a demand curve and above the price line.

Area: PoAB

TRTR: Total Revenue

Area: OPoBQo

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Budget Lines (1)

Budget line will let us determine what is feasible for a consumer to purchase given her/his income and the prices of goods.

Example:Example: (1) Consumer’s Total Income = $3.00 (2) Price of Avocados = $ .60 (3) Price of Bananas = $ .20

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Bananas

Avocados5

12

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1 2

Budget LineBudget Line

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Budget Lines (2)

Get any combination of Bananas and Avocados on or below the budget line.

Example:Example: 12 Bananas — 1 Avocado 9 — 2 6 — 3 3 — 4

But, 13 Bananas - 1 Avocado

cost $3.20: Not Attainable!

So: Budget line shows all the attainable combinations of two

goods given the price of the goods and the consumer’s

income.

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Price Change and Budget Lines

CASE 1: If price of banana doubled

Bananas

Avocados

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217

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Price IncreasePrice Increase& Budget Line!& Budget Line!

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Price Change and Budget Lines

CASE 2: If price of avocado doubled

Bananas

Avocados

15

212 5

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Price Change and Budget Lines

When the price of one good changes relative to the price of another good, we say we have had a change in RELATIVE PRICE.

i.e. The Ratio of prices --

B

A

PP

has changed.

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