1. Utility and Demand
Ap Micro 9/29

2. 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?

3. 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)

4. 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 

5. 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

6. 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

8. 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?

9. 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

10. 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