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Chapter 7-12

ECN 104 Chapter Notes - Chapter 7-12: Marginal Utility, Indifference Curve, Budget Constraint


Department
Economics
Course Code
ECN 104
Professor
Teresa Fung
Chapter
7-12

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ECON FINAL
Consumer Choice and Utility Maximization
Economic Problem of Consumers
Limited income, unlimited wants
Budget line provides options
Consumers have different preferences of bundles on the budget line
Utility
The benefit/satisfaction from consuming goods or services
Total utility: total amount of satisfaction
o More consumption generally increases total utility
Marginal utility: extra satisfaction from consuming an additional unit
o Decreases as quantity increases law of diminishing marginal utility
Marginal Utility and Demand
Marginal utility rapidly falls for each successive unit
Considerable drop in price will cause increase in quantity demanded
o Inversely related downwards sloping
Theory of Consumer Choice
Consumer exhibits rational behaviour when wanting to get the most out of
their money
o Maximize total utility from goods/services
Consumers know clear cut preferences
o Know marginal utility from successive units of various products
Consumers are subjected to budget constraint
Responsive to price changes
Utility Maximization Rule
Consumer equilibrium is a situation where a consumer has allocated all his
or her available income in a way that maximizes their total utility, given the
price of goods and services
Total utility is maximized if:
o The consumers money income is allocated so that the last dollar
spent on each product purchase yields the same amount of marginal
utility
Example: A Combination of 2 Products
o Apples and Oranges
o Income: $10
o Pa= $1, Po= $2
o Marginal utility in per-dollar-spent basis
o At each step, spend where the marginal utility per dollar is the highest
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Marginal utility/price = marginal utility per dollar
At each step, spend where MU/$ is highest
In general, if MU/$ is unequal, spending should be allocated
o Away from the good where MU/$ is lower
o Towards the good where MU/$ is higher
MU of Product A = MU of product B
Price of A Price of B
Deriving the Demand Curve
Relationship between price and quantity demanded
Substitution effect
When the price of oranges fall, there is a substitution of now cheaper oranges
o Po down More oranges, less apples
Income effect
Increase in real income increases consumption of both apples and oranges
o Po down, Income up More oranges, less apples
Consumption Possibilities: A Consumer Budget Line
Describes limits to consumption choices
Budget equation: Expenditure = Income
Two products: A and B
o PAQA + PBQB = M
o Slope of budget line = relative price ratio
o =PB/PA
o Quantity of A Y axis, Quantity of B X axis
Characteristics of the Budget Line
Income changes
o Location of budget line changes with increase/decrease in money
income
o Increase in income parallel shift to the right
Price changes
o Shifts budget line
o Decrease in relative price ratio rotational shift to the right
Changes angle/slope of the budget line
Indifference Curves
Shows all the combinations of 2 products that will yield the same total
utility to a consumer
Reflects subjective information about consumer preferences
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Requires consumer to specify if a certain combination will yield more or less
satisfaction
o No need to specify the quantity of satisfaction
Indifference Curves Characteristics
Slope downwards
Slope = Marginal rate of substitution (MRS)
Convex to the origin
o Willingness to substitute B for A diminishes as more of B is obtained
Indifference Map
Series of indifference curves
Each curve to the right reflects a combination that yield more utility
Each curve reflects a different utility level and will never intersect
Consumer Equilibrium
The utility maximizing combination is the highest attainable combination on
the indifference curve
Equilibrium position is where the budget line is tangent to the highest
indifferent curve
Slope of budget line = slope of indifference curve
Measurement of Utility
Marginal utility theory assumes that utility is numerically measurable
Indifference curve approach requires only that consumers specify if a certain
combination will yield more or less satisfaction
At equilibrium, MRS = PB/PA
Applications and Extensions
New products (ie iphone, ipad, ipod)
o Better technology, better storage, better look/feel
o Higher MU-to-price ratio than the alternative product
Consumers shift away from the old products to increase total
utility
o New products succeed by enhancing consumers total utility
The Value of Time
o Ie Golf vs Concert
o Prices Golf: $30, Concert: $40
o Time Golf: 4 hours, Concert: 2 hours
o Price of golf is lower, however it takes up twice the amount of time
o Opportunity cost of time
Cash and Noncash Gifts
o Cash: more choices, match recipients preferences
Paradox of Value
o Price of water is low, price of diamond is high
o Water is essential, diamonds are luxury
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