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

2. 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. 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. 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. 5 Household Consumption Behavior Gallons of Water per Month for Consumer A Index of Utility Total Utility 100200300400 Gallons of Water per Month for Consumer A Index of Utility Marginal Utility 100200300400

6. 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. 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. 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. 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. 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. 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. 12 Summary 3 Things Underlies a Demand Curve 1. The Law of Diminishing Marginal Utility 2. Substitution Effect 3. Income Effect

13. 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. 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. 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 = $.20 15 Bananas Avocados 5 12 9 12 Budget Line

16. 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. 17 Price Change and Budget Lines CASE 1: If price of banana doubled Bananas Avocados 15 5 Price Increase & Budget Line!

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

19. 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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