Utility Analysis Chapter 21 & 21 Appendix Understanding consumer purchases! Understanding Demand!!

Understanding Demand! Why do demand curves slope down? 1. Income effect – the effect a price change has on a consumers real income. - the lower price gives the consumer more purchasing power to buy other goods or more of the same good. 2. Substitution effect – a lower price increases the relative attractiveness of a product. Overall the two effects make a consumer willing and able to buy more of a specific good at a lower price.

Understanding Demand! 3. Law of diminishing marginal utility – the satisfaction we receive typically declines as we consume more of it. We will only buy additional units of a product if the price falls. Utility, however, is very subjective. What one consumer values another may not.

Panty hose a 5 by former economist Travis? Would these two AP Econ students rate Pizza the same? Would these two AP Econ students rate soap the same? Would these two AP Econ students rate panty hose the same? Panty hose a 5 by former economist Travis?

Consumer Surplus If an ice cream cone costs $1.50, but Kelly would pay $2.00 for the ice cream cone than Kelly’s consumer surplus is $0.50 If a Hockey Stick costs 24.50, and Kris would pay $30.00 for a Hockey Stick than his consumer surplus is $5.50. They would feel good about their lucky purchases! All have received some UTILITY!

Consumer Surplus If a slice of pizza costs $1.50, but Adam would pay $2.00 for the slice of pizza than Adam’s consumer surplus is $0.50. If a new pair of football shoes costs $64.50, and Andy would pay $70.00 for a pair of football shoes than his consumer surplus is $5.50. They would feel good about their lucky purchases! Both have received some UTILITY!

Total Consumer Surplus Price $40 At a price of $30! $30 Total Cosumer Surplus $20 $10 Quantity

Consumer & Producer Surplus & Dead Weight Loss Consumer surplus D Q

Consumer & Producer Surplus & Dead Weight Loss Q

Consumer & Producer Surplus & Dead Weight Loss S + Tax Consumer Surplus S P2 Tax Revenue Dead Weight Loss P1 Producer Surplus D Q Q2 Q1

Dead Weight Loss P S P2 Price Floor P1 D Q Q2 Q1

Utility The want satisfying power of a good or service! Utility can be measured in $$$ but most people don’t think about a purchase’s money value! They think about how good they feel about their purchase!

Utils Utils can subjectively measure the value a consumer places upon a purchase. If 1 Util is low value and 10 Utils are high value, what’s your value of a mythical item say a “Krobrogel!” We measure utility by using Utils for illustrative purposes.

GHS

Assigning value by Utils Allows for subjectivity Allows for individuality Removes the need to be concerned with money or price initially A way to measure the satisfaction of consumers. A way to evaluate consumers purchasing decisions.

Assigning value by Utils Marginal Utility: The individual increment of value. The value received from consuming one more good or service. MU = Change in TU/ Change in Quantity Total Utility:The sum of the marginal utilities received when goods or services are consumed or purchased. Utility is Subjective Q1 = 10 MU: TU = 10 Utils Q2 = 8 MU: TU = 18 Utils

Irrational Consumption Rational vs. Irrational Consumption As we consume or purchase more our marginal utility declines while our total utility rises as long as we remain rational. This is why demand curves slope down!!! Irrational Consumption Most consumers are rational! Some consumers are not!!!

Consumer Surplus in Total MU >= P P S To Maximize Consumer Surplus a Rational Consumer Purchases as Long as MU >= P P D Q Q

Rational Consumers Follow the Law of Diminishing Marginal Utility As more of a product is consumed, acquired, or purchased, its individual value to you falls, but your total value rises. You eat faster at the beginning of a meal than at the end.

Utility Table Quantity Marginal Utils Total Utils 1 2 10 8 18 3 4 6 24 1 2 10 8 18 3 4 6 24 28 5 30

Marginal Utility Falls while Total Utility Rises. Quantity Marginal Utils Total Utils 1 2 10 8 18 3 4 6 24 28 5 30 Marginal Utility Falls while Total Utility Rises.

Choosing between Products? How do consumers allocate their incomes among various products?

The Law of Equal Marginal Utility! Rational Consumers and Wage Earners quickly learn to determine value per dollar. Rational Consumers purchase to gain the highest “Value per Dollar”. Value can be expressed using utility! The value of a good or service about to be purchased is a goods MU – Marginal Utility.

Making a purchase???? Big Mac or Pizza If the MU of a Big Mac is 20 and its price is $2, than its value per dollar or MU/P is 10. If the MU of a Pan Supreme is 30 and its price is $10, than its value per dollar or MU/P is 3.

Why are more Big Mac Purchased than Pizzas? Consumer may like pizza more than Big Macs, but rational consumers also understand the value of money. MU/P = 10 MU/P = 3 Rational consumers purchase where MU/P is greatest!

The Law of Equal Marginal Utility or the Final Purchase Rule or the Utility Maximization Rule Consumers will maximize Total Utility when final purchases give the same MU/P’s. MU/P Big Mac = 4 MU/P Fries = 4 MU/P Shake = 4

Case Studies on Utility AP Activity #11 MU = ^TU/^Q Max Consumer Surplus Rule: Buy as long as MU >= P Choosing be between products? Buy where MU/P is greatest Multiple Purchase Rule to Maximum satisfaction: MUx/Px = Muy/Py…Mun/Pn May 11th 2006

Quantity of Cheeseburgers PPC – Pizza and cheeseburgers 12 10 8 6 4 2 2 4 6 8 10 12 This consumer could purchase 2.5 Cheeseburgers or 5 Slices of Pizza with a budget of $5.00 Quantity of Cheeseburgers Price at $2.00 The red curve is an Indifference Curve and the dot is at the point of tangency or actual purchase amounts! We’ll learn more about that later on! Quantity of Pizza Priced at 1.00

What did the consumer purchase? 3 Slices of Pizza A 4th slice of pizza or a cheeseburger! Why? Because rational consumers purchase where their MU/P is highest and their total utility is highest. MU/P is value per dollar

Case Study #2 Budgeted Income $9.00 Double Cheeseburger costing $2.00   Budgeted Income $9.00 Double Cheeseburger costing $2.00 Quantity Marginal Utility Total Utility Marginal Utility/Dollar Purchase 1 14 7 3 or 4 2 12 26 6 5 or 6 3 10 36 5 4 8 44 50 Pizza by the Slice costing $1.00 9 17 24 30 35

Quantity of Cheeseburgers PPC – Pizza and cheeseburgers 12 10 8 6 4 2 This consumer could purchase 4.5 Cheeseburgers or 9 Slices of Pizza with a budget of $9.00 Quantity of Cheeseburgers Price at $2.00 The red curve is an Indifference Curve and the dot is at the point of tangency or actual purchase amounts! We’ll learn more about that later on! 2 4 6 8 10 12 Quantity of Pizza Priced at 1.00

What did the consumer purchase? 5 Slices of Pizza 2 Cheeseburgers Why? Because rational consumers purchase where their MU/P is highest! MU/P is value per dollar

Quantity of Cheeseburgers PPC – Pizza and cheeseburgers 12 10 8 6 4 2 2 4 6 8 10 12 This consumer could purchase 4 Cheeseburgers or 8 Slices of Pizza with a budget of $8.00 Quantity of Cheeseburgers Price at $2.00 The red curve is an Indifference Curve and the dot is at the point of tangency or actual purchase amounts! We’ll learn more about that later on! Quantity of Pizza Priced at 1.00

What did the consumer purchase? 3 Slices of Pizza 2 Cheeseburger A 4th slice of pizza could be bought but not a third cheeseburger. The consumer might save $1.00 Why? Because rational consumers purchase where their MU/P is highest! MU/P is value per dollar

Quantity of Cheeseburgers PPC – Pizza and cheeseburgers 12 10 8 6 4 2 2 4 6 8 10 12 This consumer could purchase 4.5 Cheeseburgers or 9 Slices of Pizza with a budget of $9.00 Quantity of Cheeseburgers Price at $2.00 The red curve is an Indifference Curve and the dot is at the point of tangency or actual purchase amounts! We’ll learn more about that later on! Quantity of Pizza Priced at 1.00

What did the consumer purchase? 3 Slices of Pizza 3 Cheeseburgers Why? Because rational consumers purchase where their MU/P is highest! MU/P is value per dollar

12 10 8 6 4 2 2 4 6 8 10 12 What is this??? PPC – Constant Cost Graph

Output! PPC – Constant Cost Graph What if the Axis's 12 10 8 6 4 2 2 4 6 8 10 12 What if the Axis's Were labeled wheat & oil? Quantity of Wheat In tons What is this now an Output or Input PPC? Quantity of Oil In millions of barrels Output!

PPC – Constant Cost Graph of Outputs 12 10 8 6 4 2 2 4 6 8 10 12 Quantity of Wheat In tons Quantity of Oil In millions of barrels

PPC – What if costs of an Output change? Quantity of Wheat In tons 12 10 8 6 4 2 2 4 6 8 10 12 Quantity of Wheat In tons Quantity of Oil In millions of barrels

Quantity of Wheat In tons Quantity of Oil In millions of barrels PPC – What happens if cost decrease? 12 10 8 6 4 2 2 4 6 8 10 12 Quantity of Wheat In tons Quantity of Oil In millions of barrels

Quantity of Wheat In tons Quantity of Oil In millions of barrels PPC – What happens if cost decreases for Oil only? 12 10 8 6 4 2 2 4 6 8 10 12 Quantity of Wheat In tons Quantity of Oil In millions of barrels

PPC – What if costs increase? 12 10 8 6 4 2 2 4 6 8 10 12 Quantity of Wheat In tons Quantity of Oil In millions of barrels

PPC – What if costs increase for only Wheat? 12 10 8 6 4 2 2 4 6 8 10 12 Quantity of Wheat In tons Quantity of Oil In millions of barrels

What if this is a Consumer and these are products??? 12 10 8 6 4 2 2 4 6 8 10 12 This is it still a PPC Curve! If product costs are constant, what limits purchase amounts? Quantity of A DI Quantity of B Introducing a Special PPC – The Budget Line!

A Consumer’s Budget Line From a Business Perspective a Customer’s Budget Line! 12 10 8 6 4 2 2 4 6 8 10 12 What sets the limits on a Budget Line? Quantity of A Quantity of B Schill 2003

A Customer’s Budget Line What sets the limits on a Budget Line? 12 10 8 6 4 2 2 4 6 8 10 12 The Prices of Good A & Good B Consumer/Customer Disposable Income (Unattainable) Quantity of A Price $1.50 DI = $12 (Attainable) Quantity of B Price $1.00 Schill 2003

A Customer’s/Consumer’s Budget Line 12 10 8 6 4 2 2 4 6 8 10 12 DI = $12 (Unattainable) Units of A Price $1.50 Units of B Price $1.00 Total Expenditures Quantity of A 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 DI = $12 (Attainable) Quantity of B Schill 2003

A Customer’s Budget Line 12 10 8 6 4 2 2 4 6 8 10 12 14 15 What if DI rises to $15? (Unattainable) Quantity of A Price $1.50 (Attainable) DI = $12 Quantity of B Price $1.00 Schill 2003

A Customer’s Budget Line What if the price of Good A Falls to $1.00??? 12 10 8 6 4 2 2 4 6 8 10 12 DI = $12 (Unattainable) Units of A Price $1.50 Units of B Price $1.00 Total Expenditures Quantity of A 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 (Attainable) Quantity of B Schill 2003

A Customer’s Budget Line 12 10 8 6 4 2 2 4 6 8 10 12 DI = $12 (Unattainable) Units of A Price $1.00 Units of B Price $1.00 Total Expenditures Quantity of A 12 0 $12 9 3 12 6 6 12 3 9 12 0 12 12 (Attainable) Quantity of B More of Good A can be purchased! Schill 2003

A Customer’s Budget Line What if prices rise? 12 10 8 6 4 2 2 4 6 8 10 12 DI = $12 (Unattainable) Units of A Price $1.50 Units of B Price $1.00 Total Expenditures Quantity of A 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 (Attainable) Quantity of B Schill 2003

A Customer’s Budget Line 12 10 8 6 4 2 2 4 6 8 10 12 DI = $12 (Unattainable) Units of A Price $3.00 Units of B Price $2.00 Total Expenditures Quantity of A 4 0 12 2 3 12 0 6 12 (Attainable) Quantity of B Schill 2003

A Customer’s Budget Line 12 10 8 6 4 2 2 4 6 8 10 12 DI = $12 (Unattainable) Units of A Price $3.00 Units of B Price $2.00 Total Expenditures Quantity of A 4 0 12 2 3 12 0 6 12 (Attainable) Quantity of B Schill 2003

a change in the quantity A Customer’s Budget Line Price changes cause a change in the quantity demanded of the items 12 10 8 6 4 2 2 4 6 8 10 12 Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 (Unattainable) Quantity of A (Attainable) Quantity of B

A Customer’s Product Indifference Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 j 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 Quantity of A An Indifference Schedule Combination Units of A Units of B j 12 2 Quantity of B

A Customer’s Product Indifference Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 j 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 k Quantity of A An Indifference Schedule Combination Units of A Units of B j 12 2 k 6 4 Quantity of B

A Customer’s Product Indifference Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 j 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 k Quantity of A l An Indifference Schedule Combination Units of A Units of B j 12 2 k 6 4 l 4 6 Quantity of B

A Customer’s Product Indifference Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 j 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 k Quantity of A l m An Indifference Schedule Combination Units of A Units of B j 12 2 k 6 4 l 4 6 m 3 8 Quantity of B

A Customer’s Product Indifference Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 j 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 k Quantity of A l m An Indifference Schedule I3 Combination Units of A Units of B j 12 2 k 6 4 l 4 6 m 3 8 Quantity of B

All Choices Equally Pleasing! A Customer’s Product Indifference Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 j 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 k Quantity of A l m An Indifference Schedule I3 Combination Units of A Units of B j 12 2 k 6 4 l 4 6 m 3 8 All Choices Equally Pleasing!

A Customer’s Product Indifference The slope represents the marginal rate of substi- tution, (MRS) Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 j 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 k Quantity of A l m An Indifference Schedule I3 Combination Units of A Units of B I1 j 12 2 k 6 4 l 4 6 m 3 8 Quantity of B All combinations are both equally pleasing and at each point the MU’s of A & B are equal

A Customer’s Product Indifference Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 If the consumer had greater income, more of either or both products could be purchased Quantity of A An Indifference Schedule Combination Units of A Units of B j 12 2 k 6 4 l 4 6 m 3 8 Quantity of B

A higher combination of choices will be preferred A Customer’s Product Indifference Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 j 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 A higher combination of choices will be preferred k Quantity of A l m An Indifference Schedule I3 Combination Units of A Units of B I2 I1 j 12 2 k 6 4 l 4 6 m 3 8 Quantity of B

A Customer’s Product Indifference Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 Quantity of A A family of all such expressions of indifference can be developed for every level of income An Indifference Schedule I4 I3 Combination Units of A Units of B I2 I1 j 12 2 k 6 4 l 4 6 m 3 8 Quantity of B

as an indifference map - A Customer’s Product Indifference Happiest on I4 Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 Quantity of A This is known as an indifference map - Higher levels are always preferred to lower levels An Indifference Schedule I4 I3 Combination Units of A Units of B I2 I1 j 12 2 k 6 4 l 4 6 m 3 8 Quantity of B

A Customer’s Equilibrium Position j Units of A Price $1.50 Units of B Price $1.00 Total Expenditures 12 10 8 6 4 2 2 4 6 8 10 12 Equilibrium occurs when the consumer selects the combination which reaches the highest attainable indifference curve (Unattainable) 8 0 $12 6 3 12 4 6 12 2 9 12 0 12 12 k Quantity of A l m An Indifference Schedule I4 (Attainable) I3 Combination Units of A Units of B I2 I1 j 12 2 k 6 4 l 4 6 m 3 8 Quantity of B

A Customer’s Equilibrium Position What happens if the price of B increases to $1.50 Equilibrium at $1 price for good B 4 units of A and 6 units of good B 12 10 8 6 4 2 2 4 6 8 10 12 Quantity of A I3 I1 Quantity of B

A Customer’s Equilibrium Position What happens if the price of B increases to $1.50 Equilibrium at $1 price for good B 4 units of A and 6 units of good B 12 10 8 6 4 2 2 4 6 8 10 12 PriceB QuantityB $1.00 6 Quantity of A I3 I1 Quantity of B

A Customer’s Equilibrium Position The budget line rotates reflecting the reduction in the quantity of B units which is attainable What happens if the price of B increases to $1.50 12 10 8 6 4 2 2 4 6 8 10 12 PriceB QuantityB $1.00 1.50 6 3 Quantity of A I3 I1 Quantity of B

A Customer’s Equilibrium Position The budget line rotates reflecting the reduction in the quantity of B units which is attainable What happens if the price of B increases to $1.50 12 10 8 6 4 2 2 4 6 8 10 12 PriceB QuantityB $1.00 1.50 6 3 Quantity of A By recording the various quantities demanded at the various prices yields the Demand schedule I3 I1 Quantity of B

Deriving the Demand Curve 12 10 8 6 4 2 As price of B rose from $1.00 to $1.50 Q Fell from 6 to 3! $1.50 1.00 .50 Wow! Price of B Quantity of A I3 I1 2 4 6 8 10 12 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of B Quantity of B As the price rose from $1.00 to $1.50 the budget line shifted in and the consumer shifted from I2 to I1 choosing 3 units of good B instead of 6!

The End! Prepare for a 60 Question Test!