Utility and Demand Ap Micro 9/29

Warm Up Let’s say the price of clams increases. Does this affect the marginal utility I get? Does it affect the marginal utility per dollar? How?

Substitution Effect Substitution Effect: the change in the quantity consumed as the consumer substitutes the good that has become relatively cheaper in place of the original good which has become relatively more expensive Ex. Price of notebooks falls = MU/P increases ► maximize utility by buying more notebooks, fewer CDs Price of product decreases and quantity demanded increases = law of demand (downward sloping curve) If good absorbs small share of customer’s overall spending = substitution effect is the main or only reason for demand to slope downward (most goods)

Income Effect Income Effect: Change in the quantity of a good consumed that results from a change in thee overall purchasing power of consumer due to a change in the price of that good Food and housing = large percentage of spending for typical consumers Ex: price of rent increases. Family feels poorer ► demand will get smaller apt (less housing) and fewer other goods Exception: inferior goods that make up large of income Ex: Rice in central China. 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 -- “Giffen good” Giffen good: an inferior good that comprises a large portion of income Or…price decreases, quantity demanded decreases 

Applications iPods – new products succeed by enhancing consumers’ total utility Diamond – Water paradox Water has much more total utility than diamonds Diamonds have a higher marginal utility Value of time – your time is valuable Medical care purchases – insurance coverage Cash vs. non cash gifts

Utility from notebooks Practice Problems 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

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