Consumers, Producers, and the Efficiency of Markets

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Consumers, Producers, and the Efficiency of
Markets
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• What is utility and how is it measured?
• What is the Law of Diminishing Marginal Utility?
• How do consumers maximize utility?
• How is utility related to the demand curve?
• What is consumer surplus?
• How is it related to the demand curve?

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Measuring Utility

• How much utility do you receive from eating
  donuts?

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Law of Diminishing Marginal Utility

• The more of a good a person consumes, the smaller
  the increase in total utility from consuming the
  good, all else equal
• In other words, marginal utility falls as we
  consume more and more donuts

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Finding the Optimal Bundle An Example

• Assume
• Isaac has 10 per week to spend on donuts and
  cookies
• Price of a donut 1.00
• Price of a cookie 2.00
• How many of each should Isaac buy?

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Finding the Optimal Bundle An Example
Cookies Cookies Cookies Cookies
Q TU MU MU per
0 0 ---- ----
1 25
2 45
3 60
4 70
Donuts Donuts Donuts Donuts
Q TU MU MU per
0 0 ---- ----
1 10
2 19
3 27
4 34
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The Consumer Optimum

• Occurs where the marginal utility per dollar
  spent on each good is equal

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The Law of Demand

• What happens if the price of a cookie rises to
  3.00?

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Finding the Optimal Bundle An Example
Cookies Cookies Cookies Cookies
Q TU MU MU per
0 0 ---- ----
1 25 25
2 45 20
3 60 15
4 70 10
Donuts Donuts Donuts Donuts
Q TU MU MU per
0 0 ---- ----
1 10 10 10
2 19 9 9
3 27 8 8
4 34 7 7
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The Law of Demand

• What happens if the price of a cookie rises to
  3.00?
• Quantity of cookies demanded falls

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A C T I V E L E A R N I N G 1 Optimal bundle

• Find the optimal quantity of both goods if the
  individual has 5 per week to spend on apples and
  oranges and they each are priced at 1

Apples Apples
Q TU
1 20
2 35
3 48
4 58
5 66
Oranges Oranges
Q TU
1 19
2 32
3 40
4 45
5 49
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Willingness to Pay (WTP)

• A buyers willingness to pay for a good is the
  maximum amount the buyer will pay for that good.
• WTP measures how much the buyer values the good.

Example 4 buyers WTP for an iPod
Name WTP
Anthony 250
Chad 175
Flea 300
John 125
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WTP and the Demand Curve

• Q If price of iPod is 200, who will buy an
  iPod, and what is quantity demanded?

Name WTP
Anthony 250
Chad 175
Flea 300
John 125
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WTP and the Demand Curve

• Derive the demand schedule

Qd
Who Buys?
P (price of iPod)
Nobody
301 up
Flea
251 300
Name WTP
Anthony 250
Chad 175
Flea 300
John 125
Anthony, Flea
176 250
Chad, Anthony, Flea
126 175
John, Chad, Anthony, Flea
0 125
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Consumer Surplus (CS)

• Consumer surplus is the amount a buyer is willing
  to pay minus the buyer actually pays
• CS WTP P

Suppose P 260. Fleas CS 300 260
40. The others get no CS because they do not buy
an iPod at this price. Total CS 40.
Name WTP
Anthony 250
Chad 175
Flea 300
John 125
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A C T I V E L E A R N I N G 2 Consumer
surplus
demand curve
P

• A. Find marginal buyers WTP at Q 10.
• B. Find CS for P 30.

Suppose P falls to 20.How much will CS increase
due to
C. buyers entering the market D. existing
buyers paying lower price
Q
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A More Formal Utility Analysis

• Economists can be more specific about the ways in
  which consumers maximize utility
• This material is from the Appendix to Chapter 6

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The Budget Constraint What the Consumer Can
Afford

• Two goods pizza and Pepsi
• A consumption bundle is a particular
  combination of the goods, e.g., 40 pizzas 300
  pints of Pepsi.
• Budget constraint the limit on the consumption
  bundles that a consumer can afford

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A C T I V E L E A R N I N G 3 Budget
constraint

• The consumers income 1,000 Prices 10 per
  pizza, 2 per pint of Pepsi
• A. If the consumer spends all his income on
  pizza, how many pizzas does he buy?
• B. If the consumer spends all his income on
  Pepsi, how many pints of Pepsi does he buy?
• C. If the consumer spends 400 on pizza, how
  many pizzas and Pepsis does he buy?
• D. Plot each of the bundles from parts A-C on a
  diagram that measures the quantity of pizza on
  the horizontal axis and quantity of Pepsi on the
  vertical axis, then connect the dots.

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The Slope of the Budget Constraint
Pepsis

• From C to D,
• ?Y (rise) 100 Pepsis
• ?X (run) 20 pizzas
• Slope 5
• Consumer must give up 5 Pepsis to get another
  pizza.

Pizzas
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The Slope of the Budget Constraint

• The slope of the budget constraint equals
• the rate at which the consumer can trade Pepsi
  for pizza
• the opportunity cost of pizza in terms of Pepsi
• the relative price of pizza

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A C T I V E L E A R N I N G 4 Exercise
Pepsis

• Show what happens to the budget constraint if
• A. Income falls to 800
• B. The price of Pepsi rises to 4/pint.

Pizzas
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A C T I V E L E A R N I N G 5 Inferior vs.
normal goods

• An increase in income increases the quantity
  demanded of normal goods and reduces the quantity
  demanded of inferior goods.
• Suppose pizza is a normal good but Pepsi is an
  inferior good.
• Use a diagram to show the effects of an increase
  in income on the consumers optimal bundle of
  pizza and Pepsi.

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Income and Substitution Effects

• A fall in the price of Pepsi has two effects on
  the optimal consumption of both goods.
• Income effect A fall in the price of Pepsi
  boosts the purchasing power of the consumers
  income, allowing him to reach a higher
  indifference curve.
• Substitution effect A fall in the price of Pepsi
  makes pizza more expensive relative to Pepsi,
  causes consumer to buy less pizza more Pepsi.

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The Substitution Effect for Substitutes and
Complements

• The substitution effect is huge when the goods
  are very close substitutes.
• If Pepsi goes on sale, people who are nearly
  indifferent between Coke and Pepsi will buy
  mostly Pepsi.
• The substitution effect is tiny when goods are
  nearly perfect complements.
• If software becomes more expensive relative to
  computers, people are not likely to buy less
  software and use the savings to buy more
  computers.

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A C T I V E L E A R N I N G 6 Income
substitution effects

• The two goods are skis and ski bindings.
• Suppose the price of skis falls. Determine the
  effects on the consumers demand for both goods
  if
• income effect gt substitution effect
• income effect lt substitution effect
• Which case do you think is more likely?

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One Last Issue

• Since an individual knows his or her own
  preferences better than anyone else, is cash the
  best gift for someone?