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Lecture 3

Week 3 study guide


Department
Economics for Management Studies
Course Code
MGEA02H3
Professor
Gordon Cleveland
Lecture
3

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Chapter 6 Consumer Behaviour Notes
6.1 Marginal Utility and Consumer Choice
x utility : the satisfaction or well-being that a consumer receives from consuming some good or service
x total utility : the total satisfaction resulting from the consumption of a given commodity by a consumer
x marginal utility : the additional satisfaction obtained by a consumer from consuming one additional unit of a commodity
Diminishing Marginal Utility
x the law of diminishing marginal utility, is as follows: the utility that any consumer derives from successive units of a particular
product consumed over some period of time diminishes as total consumption of the product increases (if the consumption of all
other products is unchanged)
Maximizing Utility
x utility-maximizing consumer allocates expenditures so that the utility obtained from the last dollar spent on each product is equal
x the condition required for a consumer to be maximizing utility, for any pair of products, is MUx / Px = MUy / Py
x this equation says that a utility-maximizing consumer will allocate expenditure so that the utility gained from the last dollar spent
on one product is equal to the utility gained from the last dollar spent on any other product
x when expenditure is adjusted to maximize utility, the value to the consumer of consuming the marginal unit of some good is just
equal to the opportunity cost—the value to the consumer of the money used to make the purchase
x another equation is MUx / MUy = Px / Py
x the right side of this equation is the relative price of the two goods and is determined by the market
x the left side is the relative ability of the two goods to add to utility, which is within a person’s control because in determining the
quantities of different goods to buy, a person also determines their marginal utilities
The Consumer’s Demand Curve
x a rise in the price of a product (with all other determinants of demand held constant) leads each consumer to reduce the quantity
demanded of the product
6.2 Income and Substitution Effects of Price Changes
x real income : income expressed in terms of the purchasing power of money income, that is, the quantity of goods and services
that can be purchased with the money income
The Substitution Effect
x substitution effect : change in quantity of good demanded resulting from û in its relative price (holding real income constant)
x the substitution effect increases the quantity demanded of a good whose price has fallen and reduces the quantity demanded of a
good whose price has risen
The Income Effect
x income effect : change in quantity of good demanded resulting from change in real income (holding relative prices constant)
x the income effect leads consumers to buy more of a product whose price has fallen, provided that the product is a normal good
The Slope of the Demand Curve
x because of the combined operation of the income and substitution effects, the demand curve for any normal commodity will be
negatively sloped; thus, a fall in price will increase the quantity demanded
x Giffen good : an inferior good for which the income effect outweighs the substitution effect so that the demand curve is
positively sloped
6.3 Consumer Surplus
The Concept
x consumer surplus : the difference between the total value that consumers place on all units consumed of a commodity and the
payment that they actually make to purchase that amount of the commodity
x for any unity consumed, consumer surplus is the difference between the maximum amount the consumer is prepared to pay for
that unit and the price the consumer actually pays
x the market demand curve shows the valuation that consumers place on each unit of the product; for any given quantity, the area
under the demand curve and above the price line shows the consumer surplus received from consuming those units
Applications
x because the market price of a product depends on both demand and supply, there is nothing paradoxical in there being a product
on which consumers place a high total value (such as water) selling for a low price and hence having a low marginal value
Summary
6.1 Marginal Utility and Consumer Choice
x Marginal utility theory distinguishes between the total utility from the consumption of all units of some product and the
incremental (or marginal) utility derived from consuming one more unit of the product.
x The basic assumption in marginal utility theory is that the utility consumers derive (over some given time period) from the
consumption of successive units of a product diminishes as the number of units consumed increases.
x Consumers are assumed to make their decisions in a way that maximizes their utility. Utility-maximizing consumers make their
choices such that the utilities derived from the last dollar spent on each product are equal. For two goods X and Y, utility will be
maximized when MUx / Px = MUy / Py.
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