1 ECONOMICS 200 PRINCIPLES OF MICROECONOMICS Professor Lucia F. Dunn Department of Economics

2 Household Consumption Behavior Utility Utility: Satisfaction or Pleasure; Want-Satisfying Power Marginal Utility (MU) (MU): The last extra bit of utility a consumer gets from consuming the last extra unit of the item. Paradox: WaterCheap DiamondExpensive Utility and Marginal Utility (1)

3 Household Consumption Behavior * Value is determined by marginal utility from last unit consumed Law of Diminishing Marginal Utility Utility: The more you consume of a certain good, the less you value additional units of it. Utility and Marginal Utility (2)

4 Household Consumption Behavior Cardinal Approach – Exact Numbers - can’t use this with utility Ordinal Approach – Rank Order - this is used with utility Goal of Consumer: To maximize total utility

5 Household Consumption Behavior Gallons of Water per Month for Consumer A Index of Utility Total Utility Gallons of Water per Month for Consumer A Index of Utility Marginal Utility

6 Household Consumption Behavior Gallons of Water Index of Utility Total Utility Gallons of Water Index of Utility MU In this case, we say that an extra unit has “disutility”. Disutility!

7 Household Consumption Behavior Condition To Reach Consumer Equilibrium (1) MU per dollar spent on commodity #1 should be the same as the MU per dollar on commodity #2 (and the same for all goods). So: where: MU i = MU of a unit of commodity i P i = Price of good i We will consider two goods only. Rearranging we get:

8 Household Consumption Behavior Condition To Reach Consumer Equilibrium (2) Example: Good #1 is Avocado; PA PA = 60 cents Good #2 is Banana; PB PB = 20 cents So: So, for the consumer to reach equilibrium we must have:

9 INTUITIVE REASONING: Intuitively, if an avocado costs 3 times as much as a banana, the last avocado consumed should bring the consumer 3 times the happiness as the last banana.

10 Household Consumption Behavior If P A increases to 80cents, then: So: What must consumer do to restore equilibrium? 1.Can NOT change prices 2.Must change MU by altering consumption - Want: MU A /MU B = 4 - Must either raise numerator or lower denominator

11 Household Consumption Behavior If consume MORE of good A, MU A decreases. If consume LESS of good B, MU B increases. Q MU Q1Q1 MU 1 Q2Q2 MU 2 Index of Marginal Utility So: When P A goes up, Q D of good A should go down. * Hence the Law of Diminishing Marginal Utility is one thing that explains the negative slope of a demand curve.

12 Summary 3 Things Underlies a Demand Curve 1. The Law of Diminishing Marginal Utility 2. Substitution Effect 3. Income Effect

13 Consumer Surplus Market for Ball Point Pens This is a difference between value in use and value in exchange. 70c 60c 01 50c 10 40c 20 30c 40 Thousands of Pens per Month Consumer Surplus Surplus: The difference between what a consumer actually pays for an item and what he would be willing to pay. Consumer Surplus!

14 Consumer Surplus We Can Measure Consumer Surplus on a Demand Diagram. 0 A PoPo QoQo B CS TR CS CS: The area under a demand curve and above the price line.  Area: P o AB TR TR: Total Revenue  Area: OP o BQ o

15 Budget Lines (1) Budget line will let us determine what is feasible for a consumer to purchase given her/his income and the prices of goods. Example: (1) Consumer’s Total Income = $3.00 (2) Price of Avocados = $.60 (3) Price of Bananas = $ Bananas Avocados Budget Line

16 Budget Lines (2) Get any combination of Bananas and Avocados on or below the budget line. Example: 12 Bananas — 1 Avocado 9 — 2 6 — 3 3 — 4 But, 13 Bananas - 1 Avocado cost $3.20: Not Attainable! So: Budget line shows all the attainable combinations of two goods given the price of the goods and the consumer’s income.

17 Price Change and Budget Lines CASE 1: If price of banana doubled Bananas Avocados 15 5 Price Increase & Budget Line!

18 Price Change and Budget Lines CASE 2: If price of avocado doubled Bananas Avocados 15 5

19 Price Change and Budget Lines When the price of one good changes relative to the price of another good, we say we have had a change in RELATIVE PRICE. i.e. The Ratio of prices -- has changed.

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