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L10 - Consumer Demand Theory - 10092013.pdf

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James Pesando

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Principle of Diminishing Marginal Utility As a person consumes more of a good, the marginal utility of the good declines This principle, plus rational behaviour, explains: 1. The rule for maximizing total utility (satisfaction), given the consumer's budget constraint 2. Why demand curves slope downwards To maximize total utility (satisfaction), given your budget Allocate income so that Marginal Utility / Price (MU / P) is the same for all goods that you consume Q: Do people actually calculate MU / P before deciding to purchase a good? A: No. But: When one decides "it's a bargain" or "it's too much," one is subconsciously using the MU/P optimizing rule Q: Why might a store offer to sell a customer a 2nd pair of jeans at half-price? A: Marginal utility to customer of 2nd pair of jeans is much lower (so price must be lower for MU/P rule to justify purchase of 2nd pair) Implication #1: Demand Cures Slope Downward 1. Initial Equilibrium: MUx = MUy = … Px Py 2. Px increases to P1x: MUx < MUy = ... P1x Py If consumption of good x is unchanged 3. Consumer re-optimizes, by decreasing consumption of x, and thus increasing the marginal utility of x, until MU1x = MUy = … P1x Py where MU1x > MUx (qx1 < qx) P1x > Px Consumer Surplus Producer Surplus Used to measure welfare (benefits of markets) Important in public (economic) policy decisions Consumer Surplus Defination: Difference between the maximum a buyer would pay ofor a good and the price a buyer actually pays Example: Market Price $3 P Q Consumer Surplus 7 1 4 (7 - 3) 6 2 3 (6 - 3) 5 3 2 (5 - 3) 4 4 1 (4 - 3) 3 5 0 (3 - 3) 2 6 Not Relevant Consumer Surplus equals area under demand curve and above the price "Steplike" DD curves to illustrate numerical examples
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