Warm-up: March 14, 2016 What is marginal utility? What is utility for that matter? Use the concept of marginal utility to explain the following: Newspaper vending machines are designed so that once you have paid for one paper, you can take more than one paper at a time. But soda vending machines, once you have paid for one soda, dispense only one soda at a time.

The Rational Consumer (3/14) Utility: Getting satisfaction Utility: satisfaction gained from consumption Consumption bundle: set of all goods and services a person consumes Utility function: relationship between consumption bundle and total utility generated Marginal utility: the change in total utility from consuming one more unit

Cassie’s Total Utility and Marginal Utility Total utility (utils) (a) Cassie’s Utility Function 70 15 13 11 9 7 5 3 1 –1 28 39 48 55 60 63 64 Total utility (utils) Marginal utility per clam (utils) 2 4 6 8 Quantity of clams 60 Utility function 50 40 30 20 10 1 2 3 4 5 6 7 8 9 Quantity of clams Marginal utility per clams (utils) ( b ) Cassie’s Marginal Utility Curve Figure Caption: Figure 10-1: Cassie’s Total Utility and Marginal Utility Panel (a) shows how Cassie’s total utility depends on her consumption of fried clams. It increases until it reaches its maximum utility level of 64 utils at 8 clams consumed and decreases after that. Marginal utility is calculated in the table. Panel (b) shows the marginal utility curve, which slopes down- ward due to diminishing marginal utility. That is, each additional clam gives Cassie less utility than the previous clam. 16 14 12 10 8 Marginal Utility Curve 6 4 2 –2 1 2 3 4 5 6 7 8 9 Quantity of clams

E. Principle of diminishing marginal utility: 1. Applies for vast majority of cases

Explain why a rational consumer who has diminishing marginal utility for a good would not consume an additional unit when it generates negative marginal utility, even when that unit is free. What might be an example of this? Marta drinks 3 cups of coffee a day, for which she has diminishing marginal utility. Which of her 3 cups generates the greatest increase in total utility? Which generates the least? 3. In each of the following cases, does the consumer has diminishing, constant, or increasing marginal utility? The more Mabel exercises, the more she enjoys each additional visit to the gym. Although Mei’s CD collection is huge, her enjoyment from buying another CD has not changed as her collection has grown. When Dexter was a struggling student, his enjoyment of a good restaurant meal was greater than now, when he has them more frequently.

II. Budgets and Optimal Consumption A. Budget constraint: the cost of consumption bundle cannot be more than consumer’s income B. Consumption possibilities: set of all consumption bundles that can be consumed given the consumer’s income and prevailing prices C. Budget line: all of the consumption bundles available to a consumer who spends all of his/her income

The Budget Line Sammy’s income = $20/week Potatoes = $2/lb; clams = $4/lb Quantity of potatoes (pounds) A B C D E F Consumption bundle 1 2 3 4 5 Quantity of clams (pounds) 10 8 6 Quantity of potatoes Unaffordable consumption bundles 10 A 8 B 6 C Affordable consumption bundles that cost all of Sammy's income 4 Affordable consumption bundles D 2 Figure Caption: Figure 10-2: The Budget Line The budget line represents all the possible combinations of quantities of potatoes and clams that Sammy can purchase if he spends all of his income. Also, it is the boundary between the set of affordable consumption bundles (the consumption possibilities) and unaffordable ones. Given that clams cost $4 per pound and potatoes cost $2 per pound, if Sammy spends all of his income on clams (bundle F), he can purchase 5 pounds of clams; if he spends all of his income on potatoes (bundle A), he can purchase 10 pounds of potatoes. E F Sammy’s Budget Line, BL 1 2 3 4 5 Quantity of clams (pounds) The budget line represents all the possible combinations of quantities of potatoes and clams that Sammy can purchase if he spends all of his income. It is also the boundary between the set of affordable consumption bundles (the consumption possibilities) and unaffordable ones.

Practice Problem The consumption bundle consists of movie tickets and buckets of popcorn. Each ticket costs $10, and each bucket of popcorn costs $5. The consumer’s income is $40. List the possible bundles, and create a budget line. In your diagram, put movie tickets on the vertical axis and popcorn on the horizontal axis.

D. Optimal consumption choice 1. Total utility maximized given the budget constraint

Sammy’s Budget and Total Utility Sammy’s total utility is the sum of the utility he gets from clams and the utility he gets from potatoes. 10

Optimal Consumption Bundle Sammy’s Budget Line Quantity of potatoes (pounds) The optimal consumption bundle… A 10 B 8 C 6 D 4 E 2 F BL 1 2 3 4 5 Quantity of clams (pounds) (b) Sammy’s Utility Function Sammy’s total utility is maximized at bundle C, where he consumes 2 pounds of clams and 6 pounds of potatoes. This is Sammy’s optimal consumption bundle. Total utility (utils) 80 B C D Figure Caption: Figure 10-3: Optimal Consumption Bundle Panel (a) shows Sammy’s budget line and his six possible consumption bundles. Panel (b) shows how his total utility is affected by his consumption bundle, which must lie on his budget line. The quantity of clams is measured from left to right on the horizontal axis, and the quantity of potatoes is measured from right to left. His total utility is maximized at bundle C, where he consumes 2 pounds of clams and 6 pounds of potatoes. This is Sammy’s optimal consumption bundle. 70 A 60 E 50 Utility function 40 … maximizes total utility given the budget constraint 30 F 20 10 1 2 3 4 5 Quantity of clams (pounds) 10 8 6 4 2 Quantity of potatoes (pounds)

Food for Thought on Budget Constraints Budget constraints aren’t just about money. In fact, there are many other budget constraints affecting our lives. Examples are: Limited amount of closet space for clothes. A fixed number of hours in a day. A dieter on the Weight Watchers plan is only allowed a maximum number of points regarding the food they can eat each day whereby each food is assigned a certain number of points. The dieter is just like a consumer choosing a consumption bundle: points are the equivalent of prices, and the overall point limit is the equivalent of total income.

III. Spending the Marginal Dollar (3/15) A. Marginal utility per dollar: how much add’l utility one gets from spending an add’l dollar on either good

Marginal Utility per Dollar Total utility (utils) MU / P P P If Sammy has, in fact, chosen his optimal consumption bundle, his marginal utility per dollar spent on clams and potatoes must be equal. 6 At the optimal consumption bundle, the marginal utility per dollar spent on clams is equal to the marginal utility per dollar spent on potatoes. 5 4 B C 3 2 C Figure Caption: Figure 10-4: Marginal Utility per Dollar Sammy’s optimal consumption bundle is at point C, where his marginal utility per dollar spent on clams, MUC/PC, is equal to his marginal utility per dollar spent on potatoes, MUP/PP. This illustrates the optimal consumption rule: at the optimal consumption bundle, the marginal utility per dollar spent on each good and service is the same. At any other consumption bundle on Sammy’s budget line, such as bundle Bin Figure 10-3, represented here by points BC and BP, consumption is not optimal: Sammy can increase his utility at no additional cost by reallocating his spending. 1 B P MU C / P 1 2 3 4 5 Quantity of clams (pounds) 10 8 6 4 2 Quantity of potatoes (pounds)

The rule: Marginal analysis solves “how much” decisions by setting the marginal benefit of some activity equal to its marginal cost.

Utility from notebooks Bernie spends his income on notebooks and Beyonce CDs. (save some room on the right side of each table) Quantity of notebooks Utility from notebooks 2 70 4 130 6 180 8 220 10 250 Quantity of CDs Utility from CDs 1 80 2 150 3 210 4 260 5 300

The price of a notebook is $5, the price of a CD is $10, and Bernie has $50 to spend. Which consumption bundles can Bernie consume if he spends all his money? Calculate total utility for each consumption bundle. What is Bernie’s optimal consumption choice? c. For each product, add a “marginal utility” and “marginal utility per dollar” column to your charts. d. Graph the marginal utilities per dollar spent for each product. What is Bernie’s optimal consumption level?

0 notebooks, 5 CDs = 300 total utils 8 notebooks, 1 CD = 300 total utils 10 notebooks, 0 CDs = 250 total utils

Notebooks CDs Quantity TU MU MU/P 2 70 35 7 4 130 30 6 180 25 5 8 220 20 10 250 15 3 Quantity TU MU MU/P 1 80 8 2 150 70 7 3 210 60 6 4 260 50 5 300 40 What if Bernie was currently buying 2 notebooks and 4 CDs? How should he alter his consumption maximize utility?

Mrs. Johnson spends her entire daily budget on potato chips, at a price of $1 each, and onion dip at a price of $2 each. At her current consumption bundle, the marginal utility of chips is 12 utils and the marginal utility of dip is 30 utils. Mrs. Johnson should (A) do nothing; she is consuming her utility maximizing combination of chips and dip (B) increase her consumption of chips until the marginal utility of chip consumption equals 30 (C) decrease her consumption of chips until the marginal utility of chip consumption equals 30 (D) decrease her consumption of chips and increase her consumption of dip until the marginal utility per dollar is equal for both goods (E) increase her consumption of chips and increase her consumption of dip until the marginal utility per dollar is equal for both goods

Dorothy has a daily income of $20, each cup of coffee costs $1 and each scone costs $4. The table below provides us with Dorothy's marginal utility (MU) received in the consumption of each good. As a utility-maximizing consumer, which combination of coffee and scones should Dorothy consume each day? Cups of Coffee MU of Coffee # of Scones MU of scones 1 10 30 2 8 24 3 6 20 4 16 5 14 (A) 2 coffee and 2 scones (B) 5 coffee and 6 scones (C) 3 coffee and 2 scones (D) 4 coffee and 4 scones (E) 4 coffee and 16 scones (A) 2 coffee and 2 scones (B) 5 coffee and 6 scones (C) 3 coffee and 2 scones (D) 4 coffee and 4 scones (E) 4 coffee and 16 scones

Utility and the Demand Curve (3/16) Substitution effect Price of notebooks falls = MU/P increases  maximize utility by buying more notebooks, fewer CDs Price of product increases and quantity demanded falls = law of demand (downward sloping curve) Good absorbs small share of customer’s overall spending = substitution effect is supreme

2. Income effect a. Food and housing = large percentage of spending for typical consumers b. Ex: price of rent increases. Family feels poorer  will demand smaller apt (less housing) and fewer other goods c. Exception: inferior goods i. Ex: Rice in central China (large % of income). Price of rice falls  leads household to feel “richer”. Will NOT buy more rice when price decreases, but will buy more relatively expensive foods instead :O “Giffen good” Or…price decreases, quantity demanded decreases