metropolitan state universityfaculty.metrostate.edu/bellasal/202/lec03.pdfsecond, if you add up the...

ECON 202 Lecture 3 1

Metropolitan State University ECON 202 – Microeconomics Lecture Notes 2 – Chapters 5 and 6 Consumer Choice Demand and Elasticity Chapter 5: Consumer Choice and Marginal Analysis First off, the important concept in this chapter is marginal utility, or the willingness to pay for one more unit of a good given the number of units you’ve consumed already. Second, if you add up the marginal utility you get from each unit that you consume, what you wind up with is total utility. Third, the law of diminishing marginal utility says that at some point as you consume more units of a good, the additional utility a person gets from consuming one more unit will begin to decline. As an example, consider your willingness to pay for the first gallon of water you get in a day versus your willingness to pay for the second gallon or the hundredth gallon. As the number of gallons of water you have consumed rises, your marginal willingness to pay (your marginal utility) for one more unit will get smaller and smaller. These ideas are expressed in a marginal utility schedule, such as this one. Imagine that Homer Simpson is sitting at work on a Friday afternoon thinking about how much he would like a few beers at Moe’s tavern. He thinks about his willingness to pay or his utility for each individual beer. He’s willing to pay $9 for the first beer. Having finished the first beer, he imagines that he would be willing to pay as much as $8 for the second. Having finished the second, he imagines that he would be willing to pay up to $7 for the third, and so on… His willingness to pay and the resulting marginal utility and total utility are given in the following table:

Quantity Marginal Utility Total Utility 1 $9 $9 2 $8 $17 3 $7 $24 4 $6 $30 5 $5 $35 6 $4 $39 7 $3 $42 8 $2 $44 9 $1 $45 10 $0 $45 11 -$1 $44


This marginal utility can be expressed in a graph:

$0

$2

$4

$6

$8

$10

0 1 2 3 4 5 6 7 8 9 10 11 12

Quantity

($2)

As an exercise, fill in the total utility values in the following table:

Quantity Marginal Utility Total Utility 1 $11

2 $9

3 $7

4 $5

5 $3

Now, imagine that Homer actually finishes his day at work and goes to Moe’s tavern. If Moe charges $8.50 for a beer, how many beers will Homer consume? If Moe charges $7.50 for a beer, how many will Homer consume? If Moe charges $3.50 for a beer, how many will Homer consume?


If Moe goes out of his mind and gives beer away for free (we’ll talk more about this later) how many will Homer conume? The key to these questions is to think of the marginal utility schedule as a marginal willingness to pay schedule, or a marginal value schedule. That is, it is the maximum amount that Homer is willing to pay for one more beer given the number he has consumed already. In terms of a graph, this can be though of in the following way: Consume each unit for which the marginal value (or marginal utility or marginal willingness to pay, they’re all the same thing) is greater than the price. In the following graph with a price of $5.50, Homer should consume four beers because the marginal value of each of the first four beers is greater than the price. His marginal value of the fifth beer is only $5, which is $0.50 less than the price, so he is not willing to pay the price for the fifth beer.

$0$1$2$3$4$5$6$7$8$9$10

0 1 2 3 4 5 6 7 8 9 10

Quantity

If the price of a beer rises, Homer will consume fewer beers. If the price of a beer falls, Homer will consume more beers. A cleaner version of this picture is as follows:


Diminishing Marginal Utility and Downward Sloping Demand Curves So, we have a marginal value schedule that tells you, for a particular quantity, what the marginal value or marginal utility or marginal willingness to pay is. In a graph, this is:

Now, a rational consumer will consume additional units as long as the marginal value or marginal utility is greater than the price. As a result, the marginal value relationship is also a demand relationship. That is, it also tells you, for a particular price, what quantity will be demanded.


So, we can rewrite Homer’s marginal value schedule as a demand schedule:

Quantity

Marginal Utility

Price

Quantity Demanded

1 $9 $9 1 2 $8 $8 2 3 $7 $7 3 4 $6 $6 4 5 $5 $5 5 6 $4 $4 6 7 $3 $3 7 8 $2 $2 8 9 $1 $1 9 10 $0 $0 10 11 -$1

Consumer Surplus Consumer surplus is the net benefit that a consumer gets from buying and consuming some units of a good. This is analogous to the supplier’s profit. Returning to Homer’s marginal value schedule, imagine that Moe is charging $4.50 for a beer. Homer’s consumer surplus for each quantity can be calculated:


Quantity

Marginal Value

Price

Marginal Consumer

Surplus

Total Consumer

Surplus 1 $9 $4.50 $4.50 $4.50 2 $8 $4.50 $3.50 $8.00 3 $7 $4.50 $2.50 $10.50 4 $6 $4.50 $1.50 $12.00 5 $5 $4.50 $0.50 $12.50 6 $4 $4.50 -$0.50 $12.00 7 $3 $4.50 -$1.50 $10.50 8 $2 $4.50 -$2.50 $8.00 9 $1 $4.50 -$3.50 $4.50 10 $0 $4.50 -$4.50 $0.00 11 -$1 $4.50 -$5.50 -$5.50

Homer’s total net benefit from buying and drinking beer, his total consumer surplus, is maximized when he purchases five beers. A slightly different way of expressing this is to think of Homer total value for a quantity of beer, which is the sum of his marginal values up to that quantity. The consumer surplus is the difference between his total value and his total expenditure:

Quantity

Marginal Value

Total Value (TV)

Price

Total Expenditure

(TE)

Total

Consumer Surplus (TV-TE)

1 $9 $9 $4.50 $4.50 $4.50 2 $8 $9+$8=$17 $4.50 $9.00 $8.00 3 $7 $17+$7=$24 $4.50 $13.50 $10.50 4 $6 $24+$6=$30 $4.50 $18.00 $12.00 5 $5 $30+$5=$35 $4.50 $22.50 $12.50 6 $4 $35+$4=$39 $4.50 $27.00 $12.00 7 $3 $39+$3=$42 $4.50 $31.50 $10.50 8 $2 $42+$2=$44 $4.50 $36.00 $8.00 9 $1 $44+$1=$45 $4.50 $40.50 $4.50 10 $0 $45+$0=$45 $4.50 $45.00 $0.00 11 -$1 $45-$1=$44 $4.50 $49.50 -$5.50

Here’s another example. Water is one of the things you consume. Imagine that the price of water is $1.50. How many to have? Make the decision and fill in the values in the table below:


Quantity Marginal Value

Total Value

Total Expenditure

Consumer Surplus

1 $5 2 $4 3 $3 4 $2 5 $1 6 $0 You should consume additional water until your marginal value falls to or below the price. Total Value is the sum of the marginal values up to that quantity. Consumer surplus is the difference between total value and total expenditure, sort of the consumer's version of profit, of the consumer's gain from the exchange. Here are the answers for the above table: Quantity Marginal

Value Total Value

Total Expenditure

Consumer Surplus

1 $5 $5 $1.50 $3.50 2 $4 $9 $3.00 $6.00 3 $3 $12 $4.50 $7.50 4 $2 $14 $6.00 $8.00 5 $1 $15 $7.50 $7.50 6 $0 $15 $9.00 $6.00 In terms of a graph, this is what consumer surplus looks like:


In more standard form, these graphs look like:


An Application: Cover Charges Sometimes, you have the opportunity to pay one price and then consume as much as you want at no additional cost. One example is an all-you-can-eat restaurant. A second example might be water use if you rent an apartment. You can consume additional units at zero marginal price. To turn this idea back to Homer, we might ask how much Homer would be willing to pay to get into Moe’s tavern if, once he got in, the price of beer was zero. Looking back at Homer’s demand schedule or marginal value schedule, we see that at a price of $0, he will choose to consume 10 beers and will have a total value of $45. This amount, $45, is the highest cover charge that Homer would be willing to pay to get into Moe’s if, once he was in, the price of beer would be zero. As a second interpretation, imagine that Moe offers Homer his choice of two pricing schemes. Homer can pay the regular price of $4.50 per beer, or he can buy a “heavy drinker” card that will let him get his beers for free that evening. At a price of $4.50/beer, Homer will consume four beers and have consumer surplus of $12.50. At a price of zero, Homer will consume ten beers and have consumer suplus (excluding the cover charge) of $45.00. The difference between these amounts of consumer surplus, $45.00 - $12.50 = $32.50, is the most that Homer would pay for a


heavy drinker card. This amount, $32.50, is the additional consumer surplus he gets from facing a lower price per beer. Example: The Diamond-Water Paradox Water is critical to life but is often very inexpensive. Diamonds have few practical uses but are very expensive. How can it be that something so critical is generally cheap while something so frivolous is so expensive? The answer lies in not confusing marginal value with total value. While the marginal value of another unit of water is very small, the total value of all the water you consume is huge because you get a great deal of consumer surplus from its consumption. The marginal value of another diamond may be very high, but there is very little consumer surplus in the diamond market.

more useful version of the Diamond-Water Paradox involves things like professional

he Law of Demand ates that as the cost of doing something rises, people will do less

Aathletes and nurses or movie stars and police officers. TThe Law of Demand stof it.


Chapter 6: Demand and Elasticity

rice of a good rises, the quantity demanded will

lasticity (more specifically, price elasticity of demand) goes beyond this to tell you, for

ore specifically, elasticity is defined as the percent change in quantity demanded

rice elasticity of demand (PED) is defined as the percentage change in the quantity of a

here are three mathematical definitions of this that may be useful. We’ll only be e

.

The law of demand states that as the pfall. Ea particular change in price, how much will quantity demanded change. Mdivided by the percent change in price. Pgood demanded divided by the percentage change in its price. Tconcerned with the first two of them. Which of these you should use depends on thinformation with which you are provided.

priceinchange%demandedquantityinchange%

PED = 1

2.

01

01

01

01

PPPPQQQQ

PED

+−+−

=

3.

QP

curvedemandofslope1

QP

dPdQ

)P(QdemandedQuantity

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xample 0 a good rises by 10% and the quantity demanded falls by 20%. What is the

EThe price of price elasticity of demand?

.2%10%20

P%Q%PED −=

−=

∆∆

=

xample 1 are scheduled to increase by 30% and PED has been estimated at -0.5.

EWater pricesWhat is the predicted change in quantity demanded?


%15Q%%30

Q%5.0P%Q%PED

−=∆→∆

=−

∆∆

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Example 2 PED for water has been estimated at -0.8 and you want to reduce consumption by 40%. By what percentage must you raise prices? Example 3 The price of water rises from $20/unit to $28/unit and, as a result, average household consumption falls from 8 units to 6 units. Calculate the PED.

.76

1412

848

142

488142

202820288686

PED−

=−

=⋅−

=

−

=

+−+−

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Because an increase in price is associated with a decrease in quantity demanded, PED is always negative. Elastic, Inelastic and Unit Elastic Demand and Relationship to Revenue If PED is less than -1 (-1.5, -2 and so on) demand is elastic. That is, a small percentage increase in price leads to a large percentage decrease in quantity demanded because consumers are very flexible. There are many substitutes to which they can switch if the price rises even a little bit. If PED is equal to –1, demand is unit elastic. That is, a percentage change in price will be matched by an equal negative percentage change in quantity demanded. If PED is greater than -1 (-0.9, -0.5, -0.1) demand is inelastic. That is, even a large percentage increase in price leads to only small percentage decreases in quantity demanded because consumers are very inflexible. There are few substitutes to which they can switch, even if price rises a lot. Elasticity depends on the availability of substitutes. If there are good substitutes available, consumers can switch easily and demand will be elastic. If there are no good substitutes, consumers cannot switch and demand will be inelastic.


Demand becomes more elastic as people have more time to adjust to the price change. If the price of gasoline rose to $5.00/gallon tomorrow, people would consume about the same quantity of gasoline as they now do on the next day because over a short period of time there is little a person can do to change their gasoline consumption. After five or ten years of facing this price, however, they would find many things they could change in their lives to avoid gas consumption and would be consuming much less. Elasticity depends critically on how broadly the good is defined. Demand for food is inelastic while demand for a Dick's Deluxe hamburger is probably elastic. Elasticity also depends on the percentage of income people spend on a good. The classic example here is salt. If the price of salt tripled, you'd probably consume about the same amount because it's generally a small portion of your expenditures. Finally, there is an important relationship between elasticity and the effect of a price change on revenue or expenditures:

Demand is Elastic Demand is Inelastic

Price Rises

Revenue Falls

Revenue Rises

Price Falls

Revenue Rises

Revenue Falls

For example, if demand is inelastic and price rises, even if it rises a lot, people will continue to consume about the same quantity and sellers’ revenues will rise. Change in demand versus change in quantity demanded A change in the price of the good itself results in a change in the quantity demanded, movement along a stable demand curve. A change in something else will result in a shift in the demand curve, also known as a change in demand.


Things that shift the demand curve and change demand 1. A change in income or wealth (normal and inferior goods) Kraft vs Western Family mac and cheese, Budweiser vs Red Hook labor-leisure choice and the confusion over wage and wealth 2. A change in the price of another good (substitutes and complements) Donald Trump and reservation gambling subs/comps in production (labor vs. Kapital, time and energy) Bootleg cigs in Canada Need for caution and consideration in public policy 3. Expectations of future price changes

"Speculation" is good because it smooths out prices and gets people to save today in anticipation of future scarcity.

4. A change in tastes or fashion This happens all the time, but this is a dangerous explanation for changes 5. A change in number of buyers in the market 6. Inflation 7. Taxes 8. Time to adjust (Short run vs. Long run demand curve) Two of these are worth a second mention: 1. Substitutes are things that replace each other, such as butter and margarine. If the price of a substitute rises, demand for that good increases. An increase in the price of margarine will increase the demand for butter, and vice versa. Complements are things that are typically used together, such as computer hardware and computer software. As the price of one decreases, demand for the other will increase, and vice versa. 2. Normal goods are things for which your demand increases as your income increases. These are things that you actually like consuming or, perhaps, dream of consuming. Examples might include good wine, books, nice clothing and great big SUVs with leather interiors. The opposite of a normal good is an inferior good, something for which your demand will decrease as your income increases. This includes almost everything I


consumed in grad school. Normal and inferior goods are specific to income ranges. Goods that you consider inferior are probably normal goods for people in developing countries. Goods that you consider normal might be inferior for a very wealthy person. The thing that will not cause a shift in the demand curve is a change in the price of the good itself.

metropolitan state universityfaculty.metrostate.edu/bellasal/202/lec03.pdfsecond, if you add up the...

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