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Economic Costs

Explicit and Implicit Costs


Economic Cost (opportunity cost)- the economic cost of any resource used to produce a good is the value or worth the resource would have in its best alternative use, whether those resources are owned by others or by the firm. Explicit Costs - the monetary payments (or cash expenditures) a firm makes to those who supply labor services, materials, fuel, transportation services. Such money payments are for the use of resources owned by others.

For example, an explicit cost would be the salaries paid to workers. Implicit Costs - the opportunity costs a firm makes when it uses its self-owned, selfemployed resources. For firms, implicit costs are the money payments that self-employed resources could have earned in their best alternative use. For example, an implicit cost would be the money lost from renting the work space out to other people. Forgone wages, forgone interest, forgone lent etc. Normal profit as a cost: The minimum profit needed in order for the business venture to be worthwhile for the firm to maintain open, as opposed to going into another field of work. This falls under implicit costs.This would be the cost of using your entrepreneurial skills for one company instead of for something else. Normal profit represents the value that you place on your entrepreneurial ability. Economic Profit (Pure Profit)

Economic Profit = Total Revenue - Economic Cost (economic costs = explicit + implicit costs) If a firm is earning only enough revenue to cover its costs, it means the firm is meeting all explicit and implicit costs (including a normal profit). the entrepreneur is receiving just enough payment (a normal profit) to continue to be in the present line of production. even when economic profit is zero, the firm will continue producing economic profit=covering normal profit If a firm's total revenue > all firm's economic costs (explicit & implicit), any economic profit (also known as pure profit or residual) goes to the entrepreneur An economic profit is not a cost as it is a return in excess of normal profit that is required in order to retain entrepreneur in particular line of production Short-Run and Long-Run

Plant Capacity; the size of the factory building, the amount of machinery and equipment, and other capital resources Fixed Plant (short run) - The period that is too brief for a firm to alter its plant capacity, but long enough for a change in the degree to which the plant is used. In this period, the firm's capacity is invariable, or fixed, but it can use the existing capacity more or less intensively to vary its output.

For example: If SAMSUNG hires 100 extra workers to make more televisions, we are talking about the short run. Variable Plant (long run)- This is a period long enough for the firm to adjust the quantities of all resources that it employs, including the plant capacity. This is included in the long run because adjusting factors such as plant number or equipment take a relatively longer time to respond to. From the industry's viewpoint, the long run also includes enough time for firms to exit or enter the industry. For example: If SAMSUNG builds new production facilities and installs new equipment, we are talking about the long run.

Short-run Production Relationships


Total Product (TP): total output of a particular good/service producedMarginal Product (MP): extra output or added product associated with adding a unit of a variable resource to the production process MP = (Change in TP/ Change in Labor Input ) Average Product (AP): output per unit of labor input (a.k.a. labor productivity) AP = (TP / Units of Input)
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Law of Diminishing Returns: As successive units of a variable resource (eg. labor) are added to a fixed resource (eg. capital or land), beyond some point the marginal product that can be attributed to each additional unit of variable resource will decrease.

Rationale: If a factory hires more workers to work with a constant amount of capital (ex. equipment), marginal output start to rise as the factory specialize and become more efficient. However, after a certain point, output will increase at a decreasing rate. This is when diminishing returns sets in, because additional workers do not add to as much efficiency per worker. Then at one point, total efficiency is lost because of overcrowding, and marginal product will decrease. This is why the world CANNOT be fed from a single flower pot. The law of diminishing returns assumes that all units of labor are of equal quality, each successive worker is presumed to have the same innate ability, motor coordination, education, training, and work experience. Graphical Portrayal:

Both marginal product (MP) curve and average product (AP) curve presents the Law of Diminishing Returns. At first additional worker yields increasing MP, but when diminishing returns is encountered, MP will decrease, eventually causing AP to decrease as well. When MP lies above AP, AP rises. When MP lies below AP, AP falls. MP intersects AP at its maximum value When MP crosses the X-axis, it signifies a move from diminishing marginal returns to negative marginal returns.

Short-run Production Costs


Fixed, Variable, and Total Costs:

Fixed Cost: costs that do not change with the level of output. Even if you produce nothing, you must still pay your fixed costs. Beyond current control Examples: Rental payments, interest on a firm's debts, insurance premiums, and a portion of deprecation on equipment and buildings, insurance premiums Variable Cost: costs that change with the amount of output. Total Variable Costs are the sum of all of the variable costs, and costs that change with level of output. Variable costs first increase by a decreasing amount, but later it increase by increasing amounts (due to MP curve) Examples: payments for materials, fuel, power, transportation services, labor, etc. Can be controlled in the short run by changing production levels

Total Cost: The sum of fixed cost and variable cost at each level of output increases by the same amount as variable cost Because the total cost is simply the variable cost + fixed cost, it is a graphically simple curve to outline. TC = TFC + TVC

Area between TC (total cost) and TVC (total variable cost) equals the TFC (total fixed costs), since TC-TVC=TFC.

Per Unit, or Average, Costs AFC: average fixed costs which is the total fixed cost divided by the quantity AFC = TFC/Q declines as output increases (spreading the overhead) AVC: average variable costs which is the total variable cost divided by the quantity AVC = TVC/Q declines as variable resources (labor) increase output, reaches a minimum, and then increases again as the Law of Diminishing Returns sets in at the low levels of output production is relatively inefficient and costly.

ATC: Average Total Cost ATC = TC/Q = TFC/Q + TVC/Q = AFC + AVC Can be found graphically by adding vertically the AFC and AVC curves Vertical distance between ATC and AVC curves measures AFC at any level of output The vertical distance between ATC and AVC curves will continue to decrease, as the AFC continues to decrease.

Marginal Cost

Calculations: (TC / Q) Marginal decisions: Since marginal cost indicates the extra cost of producing one more unit of production, firms can decide how many units to produce in order to save production costs most effectively. Graphical portrayal:

Marginal cost first falls sharply but suddenly rises, depicting that variable costs + total costs increase at first at a decreasing rate and then at an increasing rate.

Marginal Decisions: A firm's decisions as to what output level to produce are typically marginal decisions, i.e., decisions to produce a few more or a few less units. MC and MP:Marginal product and marginal cost are reflective. When marginal product increases, marginal cost decreases. However, when diminishing returns set in, additional output requires more cost so marginal cost increases when marginal product decreases Marginal product is the amount of product produced from each additional worker. Thus, as long as themarginal product of each worker rises, the marginal cost of retaining that worker will decrease. Where the law of diminishing returns sets in is where the marginal product of each worker is no longer rising, and therefore the marginal cost of retaining each additional worker will rise. (Paper Chain Link experiment) Relation of MC to AVC and ATC: The Marginal Cost curve intersects the Average Variable Cost (AVC) curve and the Average Total Cost (ATC) curve at their minimum point. This is because when Marginal Cost is below the Average Variable Cost and the Average Total Cost, they decrease, whereas when MC is above the AVC or the ATC, they increase. Why does this happen for AVC? Diminishing returns effect: The more output produced, the more variable input required to produce more units. Why does this happen for the ATC? Spreading out effect: Initially, with rises in output, fixed costs are spread out over all the units of output, thereby decreasing AFC and therefore, the ATC.

Diminishing returns effect: The more output produced, the more variable input required to produce more units. For example: If your econ average was a 90 , but then you got an 80 on your test, your average would drop. However if your econ average was a 90 but you got an 100 on your test, your average would rise. Shifts of the Cost Curves:

change in resource cost change in technology When the price of labor or some other variable input rise, AVC, ATC, and MC would rise and those cost curves would all shift upward. The MC curve and the AVC curve are mirror images of the MP and AP curves. When MP rises, MC falls, and vice versa. When AP rises, AVC falls, and vice versa.

Long-run Production Costs


The Long-run: Period of time long enough for firms to change the quantities of all resources employed including capital and new factories. In the long run, there is no distinction between FC and VC because all resources (therefore costs) are variable in the long run In the long run, an industry and the individual firms it comprises can undertake all desired resource adjustments or in other words, they can change the amount of all inputs used. The long run allows sufficient time for new firms to enter or for existing firms to leave an industry. Firm size and costs Change from small scale to large scale, ATC will decrease at first, but it increase after. All resources and costs are variable The long-run cost curve

The green, orange, yellow, pink, blue curves are separate short run curves. The long run curve is created by combining all the lowest ATC at any output of the short run curves. * If the number of possible plant sizes is very large, the long-run average-total-cost curve approximates a smooth curve. Economies of scale, folowed by diseconomies of scale, cause the curve to be U-shaped. Economies and Diseconomies of Scale Economies of Scale: A firm achieves economies of scale when it is able to decrease the per unit cost of production (ATC) as output increases. This can be achieved through cost advantages such as:

Labor Specialization: as plant size increases, more workers are hired and labor becomes increasingly specialized. workers work fewer and fewer tasks and thus become more skilled at those tasks, and production is efficient For example: Workers assemble specific parts of cars in an assembly line. Compared to many workers working on one car at a time, the assembly line is much more efficient. Workers become more proficient in their specialized area, making him highly efficient in that one area. Greater labor specialization eliminates the loss of time that comes with each worker's shift from one task to another. Managerial Specialization: a larger plant means an increasingly specialized management.

For example, sales specialists will solely supervise sales, marketing specialists will solely supervise marketing. Overall, efficiency increases and unit costs decrease Efficient Capital: larger plants can afford better, more efficient equipment Other: advertising costs fall per unit of output as more units are produced and sold. Production and marketing skills increase as the firm produces and sells more output. (learning by doing) Example: The Daily Newspaper. Reporters, delivery trucks, photographers, editors, management, printers, and all the paper resources go into making a newspaper. However, in most large cities, this newspaper only costs 50 cents. The reason for this is that the fixed costs are spread out and that economies of scale is achieved. The large number of consumers allows the publisher to specialize labor and large printing presses. Diseconomies of Scale: This is an increase in ATC as output increases. This is usually attributed to the difficulty of efficiently controlling and coordinating a firm's operations as it becomes a large-scale producer. (The beast becomes too big to handle!)

Overexpansion of management leads to: Bureaucratic red tape Miscommunication Slower decision-making Lower action in the face of changes in consumer tastes or technology Workers are more inclined to slack or shirk if they are far removed or alienated from employers. This also leads to greater dissatisfaction with work. More costs are needed to hire more managers. A good example of this is with General Motors. It became far too big to handle, and thus split into smaller, far more profitable companies such as Cadillac etc. Constant Returns to Scale:

exist between where economies of scale end and diseconomies scale begin. long run AC(average cost) does not change --> ATC range constant 5 types of Economies of Scale: 1. Managerial Economies of scale: The ability of a business to outsource and hire new people depending on its size 2. Technological: The ability of a business to require new capital 3. Marketing: The ability of a business to get discounts for supplies 4. Financial: The ability to get loans from banks or use assets in order to purchase more technology 5. Risk Bearing: The ability of a company to diversify Minimum efficient scale and industry structure

Minimum efficient scale: lowest level of output at which a firm can minimize its long-run ATC. This is where economies of scale are reached and where, past this point, diseconomies of scale beging to appear. The shape of the LATC and where the MES lies determines the industry structure.

LATC1: Where economies of scale are reached quickly and where diseconomies of scale quickly begin, i.e. where MES is reached at a low level of input, the industry supports many small producers. Examples: apparel, food processing, furniture, wood products, snowboard, and smallappliance industries LATC2: Where economies of scale exist over a wide range and MES occurs only at high output, efficient production will only be achieved by a few very large firms. Smaller firms, unable to produce at small quantities efficiently, cannot compete. This can, in extreme cases, lead to a natural monopoly. Examples: the aircraft, information technology and internet service provider industries. A natural monopoly is a relatively rare market situation in which average total cost is minimized when only one firm produces the particular good or service. LATC3: Where there is an extended range of constant returns to scale, many quantities produced have the same level of efficiency, allowing for many firms of different sizes to coexist. Examples: the apparel, small-appliance and furniture industries.

Extensions of Demand and Supply Analysis Price Elasticity of Demand


The Price-Elasticity Coefficient and Formula: Price elasticity of demand = consumers' responsiveness/sensitivity to a product's price change A product is elastic if a small change in its price elicits very large changes in the quantity demanded. Movement on the demand curve ex. products that are not required in people's daily lives are often elastic products. (not necessity but luxury) A product is inelastic if a big price change elicits very little influence on the quantity demanded. Minimal movement on the demand curve ex. products that are required in people's daily lives are often inelastic products. (not luxury but necessity) It is important to keep in mind that elasticity involves percentage change in price and quantity demanded; not absolute change.

Midpoint Formula for calculating elasticity: We use the formula in computing the price-elasticity coefficient. Ex: A change of $4-$5 along a demand curve is a 25% increase, but the opposite price change from $5-$4 along the same curve is a 20% decrease. Since elasticity should be the same whether price rises or falls, the midpoint formula is needed. This formula simply averages the two prices and the two quantities as the reference points for computing the percentages. Ex: the reference point for the $5-$4 and $4-$5 price range is $4.50. Eliminates the "up vs. down" problem Drop the negative sign.

Ed = %Change in quantity %Change in price (Sum of quantities/2) (Sum of prices/2)

Interpretations of Ed: Elastic: Ed> 1 ; When % change in price elicits a larger % change than from change in quantity demanded

When price increase 20%, quantity demand decrease more than 20% Inelastic: Ed < 1 ; When % change in price elicits a smaller % change than % change from quantity demanded When price increase 20%, quantity demand decrease less than 20% Unit elasticity: Ed = 1 ; When % change in price will cause the exact same % change in quantity demanded; i.e. % change in quantity demanded = % change in price. Perfectly Inelastic: If a price change creates no change at all in quantity demanded. Ed= 0, change in price is irrelevant to demand. Graph: Demand line = parallel to the vertical axis. Example: Insulin for diabetes; insulin is essential for diabetics to live, therefore, if the price increases by any amount they still have to buy it. Perfectly Elastic: Ed= Infinite; a small price reduction causes buyers to change purchases from zero to all they can get. Graph: Demand line = parallel to the horizontal axis. Example: Gift certificates; if gift certificates that are worth $100 are being sold for $90 people will buy as much as they can because they are getting a free $10.

The Total-Revenue Test: Total Revenue = Total amount a seller receives for a product during a certain time period. TR = Price x Quantity demanded and sold Total revenue and price elasticity of demand are related (see below) . Price Elasticity and the Total-Revenue Curve: Elastic (Ed>1) Price ; TR Price ; TR [Price and revenue move in opposite directions] Percentage of quantity demanded is larger than percentage on change of price

Inelastic (Ed<1)

Price ; TR Price ; TR [Price and revenue move in same direction] Price ; TR unchanged Price ; TR unchanged

Percentage of the average quantity demanded is smaller than percentage of the average price Percentage of the average quantity demand = percentage of average price

Unitary (Ed=1)

Price Elasticity along a Linear Demand Curve: elasticity varies in different price ranges of the same demand curve.

Determinants of Price Elasticity of Demand: (remember SPLAT!) 1. Substitutability: Direct relationship between the number of substitute goods of a product and the elasticity of the product # of substitutes up = elasticity up # of substitutes down= elasticity down (ex): If Reebok running shoes are the only choice of running shoes available, its number of substitutes is low and people would not be very sensitive towards its price changes because they need running shoes anyway. Hence, elasticity goes down. If other companies such as Nike and Adidas start to manufacture running shoes as well, the number of substitutes would go up and if Reebok still increases its prices, people would buy the substitutes instead. Hence, elasticity goes up. 2. Proportion of Income: If other things are equal, there's a direct relationship between the price of good relative to income and the elasticity of demand of the good. The higher the price of a good relative to consumer's incomes, the greater the price elasticity of demand. (ex) Price of toothpaste up by 10% = few dollars extra. Consumers will still buy the toothpaste since its still relatively cheap.

Price of sports car up by 10% = few thousand dollars extra. Consumers will react sharply to the price increase because the original price of the good is already so high. 3. Luxuries vs. Necessities: Necessities = inelastic, we NEED it no matter what price; ex: food Luxuries = elastic, we can do without it; ex: Designer handbag 4. Addictiveness: If the product is very addictive (i.e. cigarettes) people will continue to buy the product regardless of price 5. Time: Basically, Short time (Less durable) to consider whether to buy a product = inelastic. No time to adjust to price change Long time ( durable) to consider whether to buy a product = elastic. Plenty of time creates consumer sensitivity (The longer the time the more elastic the good becomes.) Applications of Price Elasticity of Demand: Large crop yields: Demands for a majority of farm products are mostly inelastic, with Ed around 0.20 or 0.25. An increase in output of farm products causes a decrease in their prices and the incomes of farmers. Therefore, farmers find large crop yields undesirable Excise Taxes: The government focuses on products with high Ed If products with high elasticity are greatly affected by taxes enforced by the government, total revenue of these products will decrease and affect the market greatly. Higher taxes on elastic products are therefore undesirable. Decriminalization of Illegal Drugs: Debates have been going on about whether or not drugs should be legalized, like alcohol and cigarettes. Many are now saying that the government is losing too much money on the war against drugs: the need for more prison cells, a larger police force and the increasing number of people dying. If drugs are legalized, the government could gain some money through taxes. Some argue that drugs are more elastic than people think. Besides the portion of consumers that are inelastic, there are also some people who are "occasional users" and can abstain from or substitute drugs with other things such as alcohol.

Price Elasticity of Supply


Price Elasticity of Supply: The degree of price elasticity of supply depends on how easily - and therefore quickly - producers can shift resources between alternative uses. Unlike PED, there is no Total Revenue Test for Price Elasticity of Supply. Because there is a direct relationship between Price & Total revenue, they always move together. DETERMINANT OF PRICE ELASTICITY OF SUPPLY: TIME! THREE PERIODS: Market period--> short run --> long run

Price Elasticity of Supply: the Market Period: The period that occurs when the time immediately after a change in market price is too short for producers to respond with a change in quantity supplied. Suppliers cannot be picky with the price they sell their goods for Some goods do not even have a market period (time is too short for any response) It has a Vertical Supply Curve (meaning it is inelastic)

Price Elasticity of Supply: the Short Run (fixed-plant period): supply is more elastic, but not terribly so, as the time period is short The period of time is not enough to change the output significantly; producers have less time to react to the change ex. if gasoline prices rise, in the short run, producers are stuck with their current less fuel efficient machines and still need to produce the same output. When given time to adjust, producers can introduce fuel efficient machines, and production cost will drop and yield more quantity supplied. Thus PES becomes more elastic plants intensify production and output by working longer hours, having workers work overtime, and using all available resources to the max It has a steeper slope than that of the supply curve in the long run

Price Elasticity of Supply: the Long Run (variable-plant period): supply becomes more elastic over a longer period of time. Why? because over time, new technology will adapt to the change in price to create more efficiency, and more time is allowed to allocate resources to a different field or allocate more resources to the same field TIME is the major determinant of the price elasticity of supply!!! Noticeably More Horizontal Slope

ex. in the long-run, firms have time to change their size and adjust their production plants to suit whatever new product they want to produce. <--Graph: as the time increases, supply becomes more elastic; the slope decreases (becomes less slanted), thus a small change in price yields a huge change in quantity supplied

Applications of Price Elasticity of Supply: Antiques and Reproduction antiques are impossible to reproduce because these product have high inelastic supply. price of the product is only slightly affected by the changes of supply and demand. Even though some other products are found, they are minimally affected. Volatile Gold Prices Price of gold is volatile, sometimes shooting upwards one moment and dramatically decreasing the next. This happens because of shifts in demand and highly inelastic supply. Gold production is expensive and time consuming to process.

Cross Elasticity and Income Elasticity of Demand


Cross Elasticity of Demand: This measures how sensitive consumer purchases of one product (X) are to a change in the price of some other product (Y) Substitute Goods

Cross elasticity of demand is positive if the sales of product X moves in the same direction as a change in the price of product Y larger positive cross-elasticity coefficient = greater substitutability between the two products Complementary Goods Cross elasticity is negative: increase in price of product X decreases the demand for product Y Larger negative cross-elasticity coefficient = greater complementarity between the two goods Independent Goods Zero/near-zero cross elasticity = two products are unrelated A change in one product's price has no effect on the other product's demand Application A product's substitutability, measured by the cross-elasticity coefficient, is important in businesses and government because the demand for their products is directly affected by the price of other products. Income Elasticity of Demand: Remember: income is a determinant of demand! This measures the degree to which consumers respond to a change in their incomes by buying more or less of a particular good. Inferior Goods

A negative income-elasticity coefficient represents an inferior good (Ex. retread tires, cabbage, used clothing). A negative coefficient means that the income and quantity demanded move in opposite directions. i.e. as the income increases, the demand for the good decreases meaning it is inferior Normal Goods

A positive income-elasticity coefficient represents a normal good; income and quantity demanded move in same direction

Insights Coefficients of income elasticity of demand provide insights into the economy and helps explains why events are happening in the economy.

Consumer and Producer Surplus


Consumer Surplus: The benefit surplus received by a consumer or consumers in a market. The difference between the maximum price a consumer is willing to pay for a product and the actual price. Consumers gain a greater total utility in dollar terms (total satisfaction) *Utility Surplus arises because consumers pay the equilibrium price when they are willing to pay more *Before equilibrium, any additional product purchased would increase total utility (as the utility is greater than the cost) *Total consumer surplus=sum of individual consumer surplus

Producer Surplus: The benefit surplus received by producers in markets. The difference between the actual price a producer receives and the minimum acceptable price. There is a direct relationship between equilibrium price and the amount of producer surplu

Efficiency Revisited:

Implications on Efficiency: market equilibrium price and quantity represent two kinds of efficiency. Productive efficiency: competition forces producers to use the best techniques and combinations of resources to produce their output. Firms that are productively inefficient are competed out of business, because they cannot sell for the market price. Allocative efficiency: the correct quantity of output is produced relative to other goods and services. Just the right amount of resources are being used to make a good or service when market is in equilibrium. Points on demand curve = marginal beneft (MB) Points on supply curve = marginal cost (MC) Ceteris parabus, competitive markets produce equilibrium prices and quantities that maximize the sume of consumer + producer surplus

Allocative efficency occurs at quantity levels in which: 1. MB = MC 2. Maximum willingness to pay = minimum acceptable price 3. Combined consumer + producer surplus is at a maximum Efficiency Losses (or Deadweight Loss): Reductions of combined consumer and producer surplus

Associated with underproduction or overproduction of a product creates an efficiency loss called deadweight loss. Under most conditions, however, the competitive market makes sure that the "right amount" of a particular good gets produced. Deadweight losses can occur when price ceilings or price floors are imposed on the market. These price ceilings or price floors may appear to protect consumers or producers, respectively, but they result in a loss of either consumer or producer surplus, leading to deadweight losses and lack of efficiency in the market. DWL occurs because there is not an optimal and efficient use of all resources, thus the shaded area below is lost from total consumer and producer surplus.

Consumer Behavior and Utility Maximization Law of Diminishing Marginal Utility


Definition: Consumers will buy as much as pleases them, with their income. As each additonal unit is purchased, the excess satisfaction gained from each purchase decreases, until it becomes irrational to continue purchasing. For example, one slice of pizza may give you much satisfaction, as does the second slice. The third slice makes you extremely full, while the fourth slice makes you nauseous. At this point, it becomes irrational for you to purchase additional slices of pizza.

"Utility": satisfaction or pleasure one gets from consuming it. Utility is subjective, as a specific product can vary from person to person. Ex. eyeglasses have utility to someone who has poor eyesight but has no utility with a person with perfect vision. Utils - imaginary unit of measurement for utility Utility is not the same as "usefulness"

Total Utility: TU the total amount of satisfaction or pleasure a person derives from consuming some specific quantity.Total Utility is equal to all of the marginal utilities added together. Marginal Utility: the extra satisfaction a consumer realizes from an additional unit of that product. Consumers want to maximize the total utility not marginal utility.

Marginal Utility and Demand: The diminishing marginal utility provides a simple rationale for the law of demand. Itsupports the idea that price must decrease in order for quantity demand to increase. Therefore, the downward slope of the demand slope is due to the behavior of consumers, as well as the decreasing amount of marginal utility for each good purchased. There are many factors that affect this, including price of good and the situation utility of each good.

Theory of Consumer Behavior


Basics

The Theory of Consumer Behavior, like the Law of Demand, can be explained by the Law of Diminishing Marginal Utility. Consumer Behavior is how consumers allocate their money incomes among goods and services. Consumer Choice and Budget Constraint: Rational behavior: The consumer is a rational person, who tries to use his or her money income to derive the greatest amount of satisfaction, or utility, from it. Consumers want to get "the most for their money" or, to maximize their total utility. Rational behavior also "requires" that a consumer not spend too much money irrationally by buying tons of items and stock piling them for the future, or starve themselves by buying no food at all. Consumers (we assume) all engage in rational behavior. Preferences: Each consumer has preferences for certain of the goods and services that are available in the market. Buyers also have a good idea of how much marginal utility they will get from successive units of the various products they might purchase. However, the amount of marginal & total utility that the people will get will be different for every individuals in the group because all individuals have different taste and preferenes. Budget Constraint: The consumer has a fixed, limited amount of money income. Because each consumer supplies a finite amount of human and property resources to society, he or she earns only limited income. Every consumer faces a budget constraint There is infinite demand, but limited income Prices: Goods are scarce because of the demand for them. Each consumers purchase is a part of the total demand in a market. However, since consumers have a limited income, they must choose the most satisfying combination of goods based partially on prices. For producers, a lower price is needed in order to induce a consumer to buy more of their product. Utility Maximizing Rule: To maximize satisfaction, a consumer should allocate his or her money so that the last dollar spent on each product, yields the same amount of marginal (extra) utility. When marginal utility are equivalent, consumer is in a equilibrium. Marginal Utility per dollar:

Rational consumers should compare extra utility from each product with its added price. Although spending all of one's income yields the greatest total utility, saving can be regarded as "commodity", that yields utility. MU/$ is found by taking the Marginal utility per good over the price of each good. This can be used to determine a buying pattern, and to help figure out what goods will be bought when.

If marginal utility increases, then total utility increases If marginal utility decreases, then total utility decreases Algebraic Restatement: MU of product A/Price of A = MU of product B/price of B (this is when the consumer is at equilibrium) MU of A = 6units/Price of A = $1 < MU of B = 18units/Price of B = $2, therefore, 6 < 9 (This concludes that the consumer can increase total utility by purchasing more of product B than product A. MUa = MUb Pa Pb

Utility Maximization and the Demand Curve

Utility Maximization rule: In order to maximize satisfaction, a consumer should allocate his or her money/ income so that the last dollar spent on each product yields the same amount of utility. Marginal utility per $ should be equal for each product you buy. Algebraically:Marginal Utility of A / Price of A = Marginal Utility of B/Price of B Deriving the Demand Schedule and Curve: A downward sloping demand curve is derived by changing the price of one product in the consumer-behavior model and then noting how that changes the maximum utility received from that demanded product. A demand schedule can simply be observed by finding alternate prices that a particular product is sold at and then finding the quantity of that product that the consumer will purchase. The Income Effect (explains why demand curves are downsloping)

The impact that a change in the price of a product has on a consumer's real income and consequently on the quantity demanded of that good. If the price of salt increases by $0.05, this has a little impact on the consumers total income. However if the price of a car rises by $10,000, there is a lot of impact on the consumers total income, and quantity demanded may fall. - Substitution is employed to restore equilibrium caused by an imbalance. Such imbalance occurs when the price of product A falls and leads to the last dollar spent on imaginary product B to yield more utility than it did on the last dollar spent on A.

The Substitution effect (Explains why demand curves are downsloping)

The impact that a change in a product's price has on its relative expensiveness and consequently on the quantity demanded. The income and subsitution effects explain why the downward slope of a demand curve. Example: When the price of Beef sky rockets from $1 per pound to $4 per pound, the Qd will decrease. This causes the downward slope of beef, and in return will change other substitute good's Qd.

Applications and Extensions

DVDs and DVDPlayers: DVDs and DVD players are complementary goods. Price of DVDs have declined only slightly, but the price of the DVD player has decreased significantly, from $1000 from the time of its introduction to the market in 1997 to less than $100 now. The lower price for DVD players has expanded their sales and increased the demand for DVD movies. The greater technology of the DVD has made the VCR obsolete. The Diamond-Water Paradox: The paradox asks: Why would water, essential to life, be priced below diamonds, which have much less usefulness? Based on the supply relativity, diamonds are much more rare and costly to produce than water; hence one of the reasons why the price is much greater despite being a luxury good. Also, water provides less marginial utility than diamonds as it can be consumed readily; thus, based on the utility maximizing rule provided above (in DVDs and DVD Players), the

equilibrium reached creates the price difference in prices of water and diamonds.*MU of water (low) / Price of Water (low) = MU of diamonds (high) / Price of diamonds (high) The total utility of water is high since it is consumed in large quantities. On the other hand, the total utility of diamonds is lower than those of water due to its low consumption. The relative prices of water and diamonds is related to the marginal utility, not total utility. This paradox is illustrated in the graph below: