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The Economics of Consumers
Study Questions
1. What are the kinds of goods consumers spend their income on?
2. What is diminishing marginal utility? 3. How do consumers maximize utility over
several products? 4. What is the difference between an
inelastic demand and an elastic demand?
Study Questions
5. What is the main factor affecting supply elasticity?
6. Why would retailers prefer taxes to be levied on inelastic goods rather than elastic goods?
Income Earners
Owners of land resources – rent Owners of labor – wages/salary Owners of financial capital – interest
Owners of capital goods – return on investment
Entrepreneurs – profit, if successful
What do we do with our Income?
Pay taxes. Save some. Spend the rest.
Consumer Spending
Durable goods Nondurable goods Services
Utility
This is the amount of satisfaction, usefulness or pleasure we get from consuming a specific item at one particular time.subjective; intensely personal and situationalwe use our value system to assign utility
Utility
Marginal utility – the added utility we will get out of consuming one more of a good.Marginal cost – the added cost of obtaining
one more of a good. Total utility – the sum of all the utility we
obtain when we consume a series of a good.
Diminishing Marginal Utility
As you consume more and more of a good, your marginal utility decreases.
As your marginal utility decreases, you become less interested in consuming another unit of the good.When MU falls below MC, you will decide to
stop consuming more units of this good
Figure 3-1. Diminishing Marginal Utility
0 1 2 3 4 5 6 7slices of pizza
util
ity
MU
MC
Demand and Diminishing MU
If the sales person wants us to buy more of his goods, he must offer it to us at a lower price. the added units are less valuable to us due to
diminishing MU, so we will buy them only if they come at a lower price (MC is decreased).
Comparing Value to Price
Consumers choose from many products. The next item a consumer should buy is
the one with the highest MU per dollar (MU/P) spent. This increases TU the greatest.
The consumer maximizes TU when the next choices all have the same MU/P.
Utility Theory
• The more pleasure (satisfaction, utility) we get from a product, the higher the price we’re willing to pay for it.– Utility: the pleasure or satisfaction obtained from
using a good or service.– Total utility: the amount of satisfaction obtained
from the consumption of a series of products.– Marginal utility: the change in total utility obtained
by consuming one additional (marginal) unit of a product.
19-13
Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (a)
TU and MUTacos consumed in 1 meal
TU MU
0 0
1 10 10
2 18 8
3 24 6
4 28 4
5 30 2
6 30 0
7 28 -2
As more of a product is consumed, Total utility increases at aDiminishing rate.
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01234567
010182428303028
10 8 6 4 2 0 -2
Units consumed per meal
Units consumed per meal
30
20
10
To
tal
Uti
lity
(u
tils
)M
arg
ina
l U
tili
ty (
uti
ls)
10 8 6 4 2 0 -2
TU
MU
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01234567
010182428303028
10 8 6 4 2 0 -2
Units consumed per meal
Units consumed per meal
30
20
10
To
tal
Uti
lity
(u
tils
)M
arg
ina
l U
tili
ty (
uti
ls)
10 8 6 4 2 0 -2
TU
MU
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
ObserveDiminishing
MarginalUtility
Utility Theory (cont'd)
Observations
Marginal utility falls as more is consumed.
Marginal utility equals zero when total utility is at its maximum.
Diminishing Marginal Utility
As long as marginal utility > 0, total utility increases. When marginal utility becomes negative, total utility maxes out and then decreases.
19-19
Diminishing Marginal Utility
Law of Diminishing Marginal Utility = the marginal utility of a good declines as more of it is consumed in a given period of time.
As long as MU is increasing TU must be increasing.
When MU is not increasing (diminishing) each unit added yields less utility
Example: Newspaper Vending Machines versus Candy Vending Machines Newspaper machines do not prevent people
from taking more than one paper. Why not dispense candy the same way?
The answer is found in the concept of diminishing marginal utility.
Can you think of a circumstance under which a substantial number of newspaper purchasers might be inclined to take more than one newspaper from a vending machine?
Optimizing Consumption Choices
Assumption: Consumer is rationalPurchases with preferences in mindLimited incomeSelects best combination of goods attainable.
A choice of a set of goods and services that maximizes the level of satisfaction for each consumer, subject to limited income
Utility maximization – consumers want to get the most satisfaction from consumption choices
Let’s look at concept of Marginal Utility per dollar spent
Last dollar spent yields equal portions of utility
MU of product A = MU of product BPrice of product A Price of product B
And the consumer’s income is all spent.
Total and Marginal Utility from Consuming Music Album Downloads ($5) and Cappuccinos ($3) on an Income of $26
Step one: Calculate your marginal utility (albums)Step two: Calculate the Marginal utility/dollarStep three: Repeat step one and two for (cappuccinos)Step four: Look for exact or near exact amounts for MU/$Step five: check your work – find number to purchase for both and multiply
Price and Quantity The demand curve
slopes downward because of diminishing marginal utility.
In order to justify buying more, the price must be lower.
At $0.25, the consumer buys 12 ounces (point f).
19-25
Upsetting Consumer Equilibrium
Advertising: tries to get us to increase our MU for its good.notifies us when P of its good is lower.both will upset consumer equilibrium.and we will buy more of the advertised good.
How do demand and supply change in response to changes in price and quantity?=Elasticity
Elasticity of Demand and Elasticity of Supply
Bottom Line on Elasticity of Supply
If producers are relatively responsive to price changes supply is elastic
If producers are relatively insensitive to price changes supply is inelastic
When a large percentage change in price brings about a small percentage change in quantity supplied = inelastic….
(examples: Rise in costs of computers… takes time to shift resources)
Over Time… more plants built, more engineers trained, and more computers supplied
When a small percentage change in price brings about a large percentage change in quantity supplied = elastic
Example: Cowboys beat Philadelphia Eagles for wildcard playoff… T-shirt producer can raise his price just a “tad” and sell a ton more shirts…
TIME AND ELASTICITY OF SUPPLY
Sm
D1
D2
Ss
D1
D2
SL
D1
D2
Note: perfectly inelastic. (price)(quantity)
Inelastic (price) (quantity)
Elastic (price) (quantity)
See relationship between small percentage increase in P and Q that follows.
Remember
Supplier is looking at revenueRevenue Test = P x Q = TR
What is profit?TR-TC
Question is: If I decrease the price of steak $1 what will happen to my revenue?
Math for Measuring Price Elasticity
Problem: Sirloin steak drops $4.00 to $3.00
Butcher sales increase from 500 lbs to 1,000 lbs
e Formula: Pe = % Change in Q
% Change in P
500 lbs to 1000 lbs = 500 / 500 = 1 (Q change = 100%)
$4.00 to $3.00 = 1/ 4 = .25
1 / .25 = 4
The steak at this price is very elastic.
Anything over 1 is elastic.
Helpful HintsTo find coefficient of price elasticity
supply or demand simply:
Find % change in quantity and % change in price, then divide Q/P
Hint: former-current/formerPrice increase $1 to $2, quantity decrease 10 to 8
1/1 x 100 = 100% = P
2/10 x 100 = 20% = Q
20/100 = .2 = inelastic
Bottom Line for Elasticity of Demand
The responsiveness or (sensitivity) of consumers to a price change is measured by a product’s price elasticity of demand
Inelastic demand perfectly inelastic totally elastic
Elastic Demand = A small percentage change in price brings about a large percentage change in QD
Example: cars, steak, CDs, gold jewelry
Inelastic Demand = Large percentage change in price brings about a small percentage change in QD.
Drugs, gasoline, cigarettes, personal items, deodorant,
Measuring Elasticity
Elasticity = (%change in Q)/(%change in P) If elasticity > 1, demand is elastic. If elasticity < 1, demand is inelastic. If elasticity = 1, demand is unitary.
All of the inelastic demand concepts depend on available substitutes
Price of steak goes too high… substitute chicken
Price of gasoline too high… no substitute
Income Effect
Income effect simply indicates that at a lower price one can afford more of the good without giving up alternative goods.
Determinants of Elasticity Necessity vs Luxuries ….examples: critical
medicines, addiction, gas to drive, new car, boat, diamond ring….
Availability of Substitutes…Zirconia, salt substitute, powdered milk, tea vs coffee…
Proportion of Income…the higher the price of a good relative to a consumers’ income, the greater the price elasticity of demand.
Time….As a rule, product demand is more elastic the longer the time period under consideration.
Figure 3-2. Demand Curve Elasticity
Steep demand curves are inelastic Small % change in Q in
response to a big change in P
Shallow (nearly flat) demand curves are elastic Large % change in Q in
response to a small change in P
P
Q
Dinelastic
Delastic
QP
Steep = inelastic
Shallow = elastic
What does that mean?
If elasticity is greater than 1, demand is elastic.
Price change causes revenue to change in opposite direction Decrease in price will increase TR
Inelastic demand is defined as an elasticity of less than 1 (anything from 0 to .99)
Price changes causes TR to change in same direction. Decrease in price causes TR to fall
Unit elastic is 1 No change
Price elasticity is 0 because an increase in price will not decrease revenue…nor will it increase revenue… there is no change in revenue with unit elastic.
How can we calculate coefficient of price elasticities?Let’s re-visit our last example
Let’s say that price is increased from $1.00 to $2.00 for a candy bar…..
The quantity demanded decreases from 10 to 8….
How will this producer know if the price increase brings in more $ relative to decrease in demand or otherwise????
Percent change in P1-2=1/1 x 100 = 100% change in P
Percent change in Q10-8 = 2/10 = 20% change in Q
Response/trigger…..Hence:E = 20/100 =.2 (% change in Q / % change in P)Trigger was the price…. Response the quantityPrice moves…(trigger)… quantity change (response)Because % change is less than 1, candy producer
will not increase revenue by increasing price.
Taxes and Elasticity
Burden of a Tax the product does not pay the taxpeople pay the tax
consumers? producers/sellers?
who carries the burden of a tax?
Taxes and Elasticity
Inelastic Goods;add a taxseller increases P by the amount of the tax inelastic response; consumers cut back only a
littleseller takes the tax out of increased sales
revenuesbuyer carries most of the burden of the tax
Taxes and Elasticity
Elastic Goods;add a taxseller increases P by the amount of the taxelastic response; consumers cut back by a
large amountsales revenue decreases; seller takes the tax
out of profitsseller carries most of the burden of the tax
THE END!