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What is Utility?
Satisfaction, happiness, benefit
Util
A unit of measure of utility
Total Utility
The amount of satisfaction obtained by consuming specified amounts of a product per period of time.
Example: TU(X) = U(X) = 16 X X2 where X is the amount a good that is consumed in a given period of time. 5 units of the product per period of time yields 55 utils of satisfaction
Marginal Utility
The change in total utility ((TU) resulting from a one unit change in consumption ((X). MU = (TU/ (X
When the changes in consumption are infinitesimally small, marginal utility is the derivative of total utility. MU = dTU/dX
In general, the derivative of a total function is the marginal function. The marginal function is the slope of the total function.
Total Utility
TU
X1 Marginal Utility MU
X2
X1
X2
Example: If TU = 15 X + 7X2 (1/3) X3, find (a) the MU function, (b) the point of diminishing marginal utility, & (c) the satiation point.
MU = dTU/dX = 15 +14X X2 Diminishing MU is where MU has a maximum, or the derivative of MU is zero. 0 = dMU/dx = 14 2X X=7 c. Satiation is where TU reaches a maximum or its derivative (which is MU) is zero. How do we determine where MU = 15 +14X X2 = 0 ? a. b.
If the previous example were about eating free cookies at a party, youd eat 15 of them. That is where you become satiated. After 15 cookies, you begin to feel a bit bloated.
When you have more than one product, the marginal utility is a partial derivative.
Calculating partial derivatives is no more difficult than calculating other derivatives. You just treat all variables as constants, except the one with which you are taking the derivative. We denote the partial derivative of Z with respect to X as xZ/xX instead of dZ/dX. Example: Z = X2 +3XY + 5Y3 To take the partial derivative with respect to X, pretend Y is a constant (like 4). Then, xZ/xX = 2X + 3Y .
Similarly, to take the partial derivative with respect to Y, pretend X is a constant (like 4). So,
xZ/xY = 3X + 15Y2 .
Indifference Curve
A set of combinations of goods that are viewed as equally satisfactory by the consumer.
Indifference Map
A collection of indifference curves
Assumptions
1. The consumer can rank all bundles of commodities. 2. If bundle A is preferred to bundle B and B is preferred to C, then A is preferred to C. (This property is called transitivity.) 3. More is better.
clothing
food
clothing
IC2
IC1
food
clothing
D B IC2
IC1
food
Indifference curves are convex [the slopes of ICs fall as we move from left to right, or we have a diminishing marginal rate of substitution (MRS)]
clothing
A B
food
When we have lots of clothing & not much food (as near A & B), we are willing to give up a lot of clothing to get a little more food. When we have lots of food & not much clothing (as near C & D), we are willing to give up very little clothing to get a little more food.
Odd special cases that are not consistent with the characteristics listed previously.
Perfect Complements
tires
IC2 8
IC1
You need exactly 4 tires with 1 car body (ignoring the spare tire). Having more than 4 tires with 1 car body doesnt increase utility. Also having more than 1 car body with only 4 tires doesnt increase utility either.
Car bodies
Perfect Substitutes
Mini-packs
10
5 IC2 IC1
Jumbo packs
Consider two packs of paper; the mini-pack has 100 sheets & the jumbo pack has 500 sheets. No matter how many mini-packs or jumbo packs you have, you are always willing to trade 5 mini-packs for 1 jumbo pack. Since the rate at which youre willing to trade is the slope of the IC, and that rate is constant, your ICs have a constant slope. That means they are straight lines.
As you get more of a bad, you need more of a good to compensate you, to keep you feeling equally happy. So IC of a good & a bad slopes upward.
Neutral Good
Neutral good IC1 IC2 IC3
Desired good
Addict
Substance 1
Substance 2
The more substance 1 the addict has the more he/she is willing to give up of substance 2 to get a little more of 1 (& vice versa). So the ICs are concave instead of convex.
The slope of the indifference curve is the rate at which you are willing to trade off one good to get another good. It is called the marginal rate of substitution or MRS.
Food F
Suppose points A & B are on the same indifference curve & therefore have the same utility level. Lets break up the move from A to B into 2 parts. ApD: (TU = (C (MUC) DpB: (TU = (F (MUF) ApB: 0 = (TU = (C (MUC) + (F (MUF) (C (MUC) = (F (MUF) (C/(F = MUF / MUC
So along an indifference curve, the slope or MRS is the negative of the ratio of the marginal utilities (with the MU of the good on the horizontal axis in the numerator). MRS = MUX / MUY
For example,
Clothing C IC1 =90
IC2 = 96
A B
Food F
Suppose IC1 is the 90-util indifference curve & IC2 is the 96-util indifference curve. Point A is 7 units of food & 6 of clothing. B is 9 units of food & 5 of clothing. Since an additional unit of clothing gives you 6 more utils of satisfaction, the MU of clothing must be 6. Since an additional 2 units of food also give you 6 more utils of satisfaction, the MU of food must be 3. So, MRS = MUF / MUC = -3/6 = -0.5 . Youd give up 2 units of food to get 1 units of clothing.
Example: Budget constraint for $24 of income, and $3 & $4 for the prices of the two goods. If you spent all $24 on the 1st good, you could buy 8 units. If you spent all $24 on the 2nd good, you could buy 6 units. So we have the intercepts of the budget constraint. The slope of the line connecting these two points is (Y/(X = 6/8 = 3/4 = 0.75 .
(0,6)
(8,0)
Lets generalize. Keep in mind that income was $24 and the prices of the goods were $3 & $4. The equation of the budget constraint in our example was 3X + 4Y = 24.
So the budget constraint is p1X + p2Y = I Solving for Y in terms of X, p2Y = I p1X, or Y = I /p2 (p1/p2)X So from our slope-intercept form, we see that the intercept is I /p2, and the slope is p1/p2 . The intercept is income divided by the price of the good on the vertical axis. The slope is the negative of the ratio of the prices, with the price of the good on the horizontal axis in the numerator.
(8,0)
(0,6)
Y
(0,9) (0,6)
(8,0)
(12,0)
Suppose the price of the good on the X-axis increased. If we bought only the good whose price increased, we could afford less of it. If we bought only the other good, our purchases would be unchanged. So the budget constraint would pivot inward about the Y-intercept. For example, if the price increased from $3 to $4, our $24 would only buy 6 units.
(0,6)
(6,0)
(8,0)
Similarly, if the price of the good on the Y-axis increased, the budget constraint would pivot in about the X-intercept.
Y
(0,6) (0,4)
Suppose the price of the 2nd good increased from $4 to $6. If you bought only that good, with your $24, your $24 would only buy 4 units of it.
(8,0)
Lets combine our indifference curves & budget constraint to determine our utility maximizing point.
Y
IC1 IC3 IC2
Point A doesnt maximize our utility & it doesnt spend all our income. (Its below the budget constraint.)
Y
IC1
IC3 IC2
Points B & C spend all our income but they dont maximize our utility. We can reach a higher indifference curve.
C 0
Y
IC1
IC3 IC2
Point E is our utility-maximizing point. We cant do any better than at E. Notice that our utility is maximized at the point of tangency between the budget constraint & the indifference curve.
E
Recall from Principles of Microeconomics, to maximize your utility, you should purchase goods so that the marginal utility per dollar is the same for all goods.
If there were just two goods, that means that MU1/P1 = MU2/P2 Multiplying both sides by P1/MU2, we have MU1/MU2 = P1/P2 . The expression on the right is the negative of the slope of the budget constraint. The expression on the left is the negative of the slope of the indifference curve. So the slope of the indifference curve must be equal to the slope of the budget constraint. If at a particular point, two functions have the same slope, they are tangent to each other. That means your utility-maximizing consumption levels are where your indifference curve is tangent to the budget constraint. This is the same conclusion we reached using our graph.
Example: If TU = 10X + 24Y 0.5 X2 0.5 Y2, the prices of the two goods are 2 and 6, and we have $44, how much should you consume of each good? Taking the derivatives of TU we have MU1 = 10 X and MU2 = 24 Y Since MU1/MU2 = P1/P2 , we have
(10 X) / (24 Y) = 2 / 6 , or 60 6 X = 48 2Y , or 6X 2Y = 12 . This an equation with two unknowns. Our budget constraint provides us with a 2nd equation. Combining the two equations, we can solve for X & Y. The budget constraint is 2X + 6Y = 44 .
So,
X= 4.
Two Normal Goods As income increases, the budget constraint shifts out & we are able to reach higher & higher ICs. The points of tangency are at higher & higher levels of consumption of both goods.
Y3 Y2 Y1 A B
X1 X2 X3
Income-Consumption Curve The curve that traces out these points is called the income-consumption curve. For two normal goods, the curve slopes upward. It may be convex (as drawn here), concave, or linear.
Y3 Y2 Y1 A B
X1 X2 X3
Y
IC1 IC2 IC3
Y1 Y2 Y3
B C
X1
X2
X3
Income-Consumption Curve
The result is a downward sloping income-consumption curve.
Y
IC1 IC2 IC3
Y1 Y2 Y3
B C
X1
X2
X3
Engel Curve
Income
C I3 I2 I1 A B
X1 X2 X3
The Engel Curve shows the quantity of a good purchased at each income level. The graph has income on the vertical axis and the quantity of the good on the horizontal. It slopes up for normal goods & down for inferior goods.
We can also look at consumption levels of two goods when the price of one of them changes.
Suppose there is an increase in the price of the 1st good (the good on the X-axis). The budget constraint pivots inward. Here we see X drop & Y increase. In this case, our 2 goods are substitutes.
Y3 Y2 Y1
X3
X2
X1
Y3 Y2 Y1
X3
X2
X1
If we look at the price of a good & the amount of it consumed, we have the demand curve for our particular individual.
P
P1 P2 P3
As the price decreases the quantity demanded increases & vice versa.
X1 X2 X3
We can separate the effect of a change in the price of a good on its consumption level into two parts: the income effect & the substitution effect. Suppose the price of the first good increases. The budget constraint was originally the blue line and we were at A consuming quantities XA & YA. After the price change, the budget constraint is the red line, and were at B consuming XB & YB .
X
YB YA
XB
XA
We first want to capture the effect of the price change without the effect of the change in income.
We draw a line parallel to the new budget constraint and tangent to the old indifference curve. This will reflect the new relative prices, but since we are tangent to the old indifference curve we are just as well off as initially. Under those circumstances we would be at point H (for hypothetical). Since the 1st good is now relatively more expensive compared to the 2nd, we will substitute, increasing Y & decreasing X.
H YH YB YA B A
XB XH
XA
XB XH
XA
H YH YB YA B A
XB XH
XA
H YH YB YA B
XB XH
XA
YB YA YH A H
XA XH XB
YB YA YH A H
XA XH XB
Total Effect
The total effect is to move from A to B. X has increased. Both the substitution & income effects led to an increase in X. Y has also increased in this case. The substitution effect decreased consumption of the 2nd good, but the income effect increased it by more than the substitution effect decreased it.
B A H
YB YA YH
XA XH XB
What if the price changed of an inferior good? The substitution effect would be the same but the income effect would be the opposite.
An inferior good for which the IE is larger than the SE is called a Giffen good. It is a good for which consumption rises when the price increases, and consumption falls when the price decreases.
We previously looked at the demand curve for individuals. How do we get the market demand curve from the demand curve for individuals? We just horizontally sum up the individual demand curves.
1 2
3 Person C
4 Market
Person A
Person B
1 2
3 Person C
4 Market
Person A
Person B
1 2
Person A
Person B
Person C
Market
Total Revenue
TR = PQ
Average Revenue
total revenue per unit of output AR = TR / Q = (PQ) / Q =P AR & P are the same function of Q.
Marginal Revenue
The additional revenue associated with an additional unit of output MR = dTR / dQ
P = f(Q) = 10 AR = P = 10
D = AR =MR
10
TR = PQ = 10 Q MR = dTR / dQ = 10
Q TR slope = MR = 10
So D, AR, & MR are the same horizontal function. TR is an upward sloping line with a constant slope. Implications for revenue: Every time you sell another unit of output, revenue increases by the price, which is constant.
D = AR MR P Q
TR
P = f(Q) = 8 3Q AR = P = 8 3Q TR = PQ = (8 3Q) Q = 8Q 3Q2 MR = dTR / dQ = 8 6Q D & MR have the same vertical intercept. MR is twice as steep as D. (The slope of MR is -6; the slope of D is -3) Implications for revenue: Revenue increases more & more slowly & then decreases more & more quickly.
MR P Q
TR
Elasticity
Responsiveness or sensitivity of one variable to a change in another variable (% change in X) = -----------------------(% change in Y)
Arc Elasticity
Q/(avg Q) [Q2 Q1] / [(Q1+Q2)/2] --------------- = -------------------------------P/(avg P) [P2 P1] / [(P1+P2)/2]
Q/(avg Q) [Q2 Q1] / [(Q1+Q2)/2] = --------------- = -------------------------------P/(avg P) [P2 P1] / [(P1+P2)/2] [40 60] / [(60+40)/2] -20 / 50 -0.4 = ------------------------------ = ------------ = ------- = -2.0 [11 9] / [(9+11)/2] 2 / 10 0.2 The negative sign indicates that price & quantity move in opposite directions. The negative sign is sometimes dropped with the understanding that price & quantity are still moving in opposite directions.
Point Elasticity
dQ / Q = ---------dP / P dQ P = ----- ---dP Q
What is the relationship between elasticity & the slope of the demand curve?
dQ / Q = ---------dP / P dQ P 1 P = ----- ---- = -------- ---dP Q dP/dQ Q
= (1/slope) (P/Q) So, if 2 demand curves pass through the same point (& therefore have the same values of P & Q at that point), the flatter curve (curve with the smaller slope) has the greater elasticity at that point.
Example
P
E D1 D2 Q
P 24 12
Relationship between Elasticity & Total Revenue Price increase: | | > 1: P o Q q TRq | | < 1: P o Q q TR o | | = 1: P o Q q TR unchanged
Relationship between Elasticity & Total Revenue Price decrease: | | > 1: P q Q o TR o | | < 1: P q Q o TR q | | = 1: P q Q o TR unchanged
The most profitable place to be is in the elastic portion of the demand curve. In the inelastic portion of the demand curve, marginal revenue is negative (additional units of output lower total revenue). While this is true in general, we can demonstrate it in the linear demand case.
Recall that for a linear demand curve, marginal revenue is twice as steep as the demand curve.
P | |>1 | |=1 MR P | |<1 D Q So when MR = 0 at the midpoint, | | = 1. From the graph, we can see that above the midpoint where | | > 1, MR > 0 & TR is increasing. Below the midpoint, where | | < 1 , MR < 0 & TR is decreasing. TR Q So MR reaches the horizontal axis when the demand curve is only halfway there.
Notice that the demands for wheat & cotton are not very responsive to price changes, whereas the demands for haddock and movies are very responsive.
So far the only elasticity that we have discussed is price elasticity of demand. There are other types of elasticities. Each type can be computed as arc elasticity or point elasticity.
Note that flour & margarine are inferior goods, milk is not very responsive to income changes, & books & restaurant consumption are income elastic.
Notice that the cross elasticity of demand for Y with respect to the price of X is not necessarily equal to the cross elasticity of demand for X with respect to the price of Y.