ECON 208 Lecture Notes - Opportunity Cost, Inferior Good, Ceteris Paribus

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Chapter 6
Oct.25.12
Marginal utility and consumer choice
- Consumers are motivated to maximize their utility
- Utility: satisfaction derived from goods/services consumed
- Total utility: full satisfaction resulting from consumption of some product by
a consumer
- Marginal utility: additional satisfaction from consuming one more unit of
some product
- Utility can be compared: assumptions to compare total and marginal
- individuals know the utility from different actions
- individuals can compare the utility from different actions
Diminishing marginal utility
- ceteris paribus: utility that any consumer derives from successive units of a product
is assumed to diminish as total consumption of the product increases (marginal
utility falls as consumption rises)
Utility schedules and graphs
When product consumption increases:
- total utility increases
- marginal utility decreases
Total utility, marginal utility, & demand curve
- shape of the marginal utility = shape of the demand curve
Maximizing utility
1. Consumer’s decision
- consumers seek to maximize total utility subject to the constraints they face
(income and market prices)
- utility-maximizing consumer allocates expenditures so that utility obtained
from the last dollar spent on each product is equal
- consumer adjusts consumption in response to changes in relative prices
2. Alternative interpretation
3. Realistic?
Consumer’s demand curve
- when there is a change in the product’s price:
o if the price of X rises, then
o when the consumer reduces consumption of X the marginal utility
rises
Income and substitution effect of price changes
- change in price has two effects: changes relative price and consumers’ real income
Income effect
- if the price of the good is lowered then the consumer becomes richer (keeps more
income)
- normal good: consumers buy more of a product that has a price decrease
- inferior good: consumers buy less of a product that has a price decrease
Substitution effect
- the good that now has a lower price becomes more attractive
- increases quantity demanded of a good whose relative price has fallen
- reduces the quantity demanded of a good whose relative price has increased
Slope of a demand curve
- overall effect of a price change is the combination of the income and substitution
effects
- for price decreases:
- substitution effect increases quantity demanded
- income effect could go either way
- size of these effects will determine the slope of the demand curve:
- normal goods: substitution and income effects move right
- inferior goods: substation effect moves right, income effect moves left by a
smaller margin
- giffen goods: income effect outweighs substitution effect, income effect
moves left and substitution effect moves right by a smaller margin
Application to taxation
- income and substitution effects are not limited to demand analysis
- supply of labor and supply of household savings can be used to break down effects
- changes in wages and interest rates have income and substitution effects
- income-tax rates effect incentive to work and save
- individuals can:
- work and earn
- enjoy leisure (viewed as a normal/consumption good), opportunity cost of
not making wages
- do taxes discourage work effort:
- i.e. taxes = 33%, change in wages from $15 to $18
- substitution effect: leisure becomes more expensive and less attractive
- income effect: able to make higher income, more demand for leisure
- i.e. taxes = change from 33 to 22%, wages = $15
- to evaluate the effect of taxes on work effort we have to know the size of
these effects
Consumer surplus
Concept
- surplus = what the consumer is willing to pay the actual cost
- value placed by a consumer on the total consumption can be estimated:
1. Net valuations that the consumer places on each unit can be summed
2. consumer may be asked how much they are willing to pay to consumer the
total amount if the alternative would be to consumer none
- important for the consumer to understand the difference between marginal and
total value
Paradox of value
- water is cheap but invaluable
- diamonds are expensive but mostly unnecessary
- total value = area under the curve
- marginal value = height of the curve where it intersects with the supply curve
- market price depends on both demand and supply: no paradox to have a
product with high total value (i.e. water) selling for a low price (hence a low
marginal value)