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Chapter 8.docx

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Economics 1021A/B
Brendan Murphy

Chapter 8: Utility and Demand Consumption Choices Your consumption choices are categorized under two broad headings: Consumption Possibilities All the things you can afford to buy (which are different combinations of goods and services that are limited by your income and the prices that you must pay) A Consumer’s Budget Line Marks the boundary between those combinations of goods and services that a household can afford to buy and those that it cannot afford. As you move along the BL, the number of goods and services change in correlation to each other (giving up one for the other) It marks the boundary between what is affordable and unaffordable for someone. All the points on and under it are affordable whereas the points above it are unaffordable. Changes in Consumption Possibilities Consumption possibilities change when income or price changes. A rise in income shifts the budget line left but leaves the slope unchanged. A change in price changes the slope of the line. The budget line shows what is possible; [references determine which possibility is chosen. Preferences The goal of a theory of consumer choice is to derive the demand curve from a deeper account of how consumers make their buying plans. That is, we want to explain what determines demand and marginal benefit. One approach: Utility: benefit or satisfaction that a person gets from the consumption of goods and services Total Utility Is the total benefit that a person gets from he consumption of all different goods and services. (more consumption generally gives more total utility) We can measure this by giving a value to a certain amount of a good and asking one to use the given units to measure total utility (ex. 1 movie is 50 units, 2 movies is 90 units, 3 movies is 122 units..) Marginal Utility Is the change in total utility that results from a one-unit increase in the quantity of a good consumed. Subtract the total utility from another as you increase by one unit (90-50=40 units, 122-90=32 units..) Positive marginal utility: total utility increases as the quantity consumed increases Diminishing marginal utility: as total utility increases, marginal utility decreases Utility-Maximizing Choice A Spreadsheet Solution Find the Just-Affordable Combinations All the rows on a table show combinations that exhaust one’s budget. Find the Total Utility for Each Just-Affordable Combination Add up the two total utilities from each service or good. Consumer Equilibrium Is a situation in which a consumer has allocated all of his or her available income in the way that maximizes his or her total utility, given the prices of goods and services (point on table where total utility is highest). Choosing at the Margin Marginal Utility per Dollar Marginal utility is the increase on total utility that results from consuming one more unit of a good…whereas the marginal utility per dollar from a good that results from spending one more dollar on it. To calculate marginal utility/marginal utility per dollar: MU/P (Marginal utility from the good/its price) Utility-Maximizing Rule Spend all available income: exhaust all income to maximize utility Equalize the Marginal Utility per Dollar: highest total utility between both goods Higher up on the budget line; too much good X and total utility would increase by receiving more good Y Lower on budget line; too much good Y and total utility would increase by receiving more good X By picking point by using utility maximizing rule, you cannot move from that point without making yourself worse off (where marginal utility per dollar of good X equal “ of good Y) The Power of Marginal Analysis If marginal utility per dollar from good X exceeds the marginal utility per dollar good Y, do more good X and less good Y (and vice versa) More generally, if the marginal gain from an action exceeds the marginal loss, take the action. Revealing Preferences MU =YU X XP /P Y X -This equation says that the MU from good Y is equal to MU of good X multiplied by the relative price of good Y in term of good X (number of good X that must be forgone to get 1 good Y) Predictions of Marginal Utility Theory The marginal utility theory predicts: 1) the law of dema
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