Consumer Choices and Economic Behavior

Ch 3

Utility Concepts

Utility: satisfaction received from consuming goods Cardinal utility: satisfaction levels that can be measured or specified with numbers (units = utils) Ordinal utility: satisfaction levels that can be ordered or ranked Marginal utility: the additional utility received per unit of additional unit of an item consumed (U/ X)

Diminishing Marginal Utility

The law of diminishing marginal utility: The more of one good consumed in a given period, the less satisfaction (utility) generated by consuming each additional (marginal) unit of the same good.

Diminishing Marginal Utility and Downward-Sloping Demand

40

25 15 D 0 5 10 Thai meals per month

25

Diminishing marginal utility helps to explain why demand slopes down. Marginal utility falls with each additional unit consumed, so people are not willing to pay as much.

Price per meal ($)

Indifference curve Analysis Utility Assumptions

1.

2.

3.

Complete (or continuous) can rank all bundles of goods Consistent (or transitive) preference orderings are logical and consistent Consumptive (nonsatiation) more of a normal good is preferred to less

More of a Good is Preferred to Less

The shaded area represents those combinations of X and Y that are unambiguously preferred to the combination X*, Y*. Ceteris paribus, individuals prefer more of any good rather than less. Combinations identified by ? involve ambiguous changes in welfare since they contain more of one good and less of the other.

Indifference Curve

Indifference Curve A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction.

Curves further from origin represent higher utility levels

Budget Constraint

The maximum Q combinations of goods that can be purchased given ones income and the prices of the goods.

Budget Constraint Variables

I (or M) = the amount of income or money that a consumer has to spend on specified goods and services.

X = Y = Px = PY =

the quantity of one specific good or one specific bundle of goods the quantity of a second specific good or second specific bundle of goods the price or per unit cost of X the price or per unit cost of Y

Budget Line Equation Income = expenses I = PxX+PYY Y = l/PY (Px/PY)X straight line equation

The Opportunity Set

Y

I/PY Budget Line PX PY I/PX X

Budget Line: Axis Intercepts & Slope

Vertical Axis Intercept = I/PY = max Y (X = 0) Horizontal Axis Intercept = I/PX = max X (Y = 0) - Slope = PX/PY = Y/X

Changes in the Budget Line

Changes in Income Increases lead to a parallel,

outward shift in the budget line. Decreases lead to a parallel, Y downward shift.

Changes in the Budget Line

Changes in Price A decrease in the price of good X rotates the budget line counter-clockwise. An increase rotates the budget line clockwise.
Y New budget line for a price decrease

I / Px

I / Px2

A bad good, or an economic bad is an item that a consumer does not like or enjoy, which means their total satisfaction level is lower the more of the item they have. This also means the marginal utility of the item is negative.

MRS & MU
MRS: Marginal rate of Substitution = slope of indifference curve = -Y/ X = the rate at which a consumer is willing to exchange Y for 1more (or less) unit of X U = 0 along given indiff curve MUx(X)+MUY(Y) = 0 - Y/ X = MUx/MUY

Consumer Equilibrium (U Max)

The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction.

Equal Slopes Condition (for consumer equilibrium)

MUX/MUY MUX/PX

= PX/PY

= MUY/PY

Price Change: Income and Substitution Effects

THE IMPACT OF A PRICE CHANGE

Economists often separate the impact of a price change into two components:

the substitution effect; and the income effect.

THE IMPACT OF A PRICE CHANGE

The substitution effect involves the substitution of good x1 for good x2 or viceversa due to a change in relative prices of the two goods. The income effect results from an increase or decrease in the consumers real income or purchasing power as a result of the price change. The sum of these two effects is called the price effect.

Normal, Inferior & Giffen Goods

Normal Good: (Negative) Income Effect + (Negative) Substitution Effect = (Negative) Price Effect => downward sloping demand curve Inferior Good: (Positive) Income effect < (negative) substitution effect = (Negative) Price Effect => downward sloping demand curve Giffen Good: (Positive) Income effect > (negative) substitution effect = (Positive) Price Effect => upward sloping demand curve

Water Diamond Paradox

Why is water so cheap even if it is so essential for life? Why diamonds are so expensive even if it is not essential? The answer lies in marginal utility