EC 201 Lecture 6
Dr. Bresnock
EC 201
Cal Poly Pomona
Dr. Bresnock
Lecture 6
Explanations for the “Law of Demand”
(1) Diminishing Marginal Utility (DMU) -- the additional satisfaction that a consumer receives from consuming equal additional units of a good or service decreases as more units are consumed. (And visa versa)
(2) Income Effect -- as the price of a good increases the consumer’s “real income”, or purchasing power, declines. Consequently as the P s the consumer purchases less of the good or service and less of other goods or services and visa versa.
(3) Substitution Effect -- among goods that a consumer considers to be substitutes, the consumer will purchase more units of the relatively cheaper good and visa versa. This is a “relative price”, or “relative attractiveness” concept. Remember that the consumer is indifferent between substitute goods to satisfy their need.
Concept of Utility
“Utility” -- means satisfaction; want-satisfying power. A “util” means a unit of satisfaction, happiness, “jollies”. Utility does not mean usefulness. Utility is a subjective, or concept.
Measuring Utility -- two methods:
(1) Cardinal Utility -- quantitative evaluation of satisfaction. Ex. temperature of 100° vs 50°. Numbers indicate that the 100° temperature is twice as hot as the 50° temperature. Note: With cardinal utility, the size of the difference in the numerical value matters.
(2) Ordinal Utility -- qualitative assessment of satisfaction. Ex. A is preferred to B. Note: With ordinal utility, the ordering, or ranking, of the consumer’s preference matter. Numerical value simply denotes the order or rank but not a specific quantitative comparison. (Indifference curve analysis presents this type of utility approach and is typically covered in advanced microeconomics courses).
Total vs. Marginal Utility
Total Utility -- the total amount of satisfaction that a consumer receives from consuming a certain amount of a good or service. Ex. the satisfaction of consuming 8 units.
Marginal Utility – the additional satisfaction that a consumer receives from consuming an additional unit of a good or service. Ex. the satisfaction of consuming the 8th unit.
Table 1 Total vs. Marginal Utility
(1) / (2) / (3)# of Cookies / Total Utility (utils) / Marginal Utility (utils)
0 / 0
1 / 24 / 24
2 / 42 / 18
3 / 54 / 12
4 / 60 / 6
5 / 60 / 0
6 / 54 / -6
Graph 1 Total vs. Marginal Utility
Theory of Consumer Behavior: Major Elements
(1) Rational Behavior -- the consumer will maximize Total utility given his or her limited budget, or “money” income.
(2) Preferences -- the consumer’s preferences are known, and can, at least, be ranked.
(3) Budget Constraint -- the consumer’s “money” is limited, or scarce relative to their wants. This will be represented as:
I = PXQX + PYQY where I is the consumer’s money income and X and Y are the quantities of Goods X and Y
(4) Prices -- the consumer is assumed to be a “price taker” not a price maker.
Consumer’s Objective -- may be stated in two ways. First…
Let TUX = Total Utility of Good X TUY = Total Utility of Good Y
MUX = Marginal Utility of Good X MUY = Marginal Utility of Good Y
PX = Price of Good X PY = Price of Good Y
(1) Total Approach -- allocate all of the consumer’s income so as to maximize the consumer’s Total utility. Consumer chooses quantities of goods and services so that this condition is met.
Max. TUX + TUY
(2) Marginal Approach -- allocate all of the consumer’s income so that when the last $ is spent on each good, it will yield the same marginal utility per dollar. Consumer chooses quantities of goods and services so that this condition is met. This condition guarantees that the consumer’s Total will be maximized. Thus the quantities of Goods X and Y are chosen so that
Consumer Equilibrium MUX = MUY
PX PY
At this point, the utility/$ for Good X is equal to the utility/$ for Good Y. This is a stable equilibrium so there is no incentive for the consumer to alter his/her quantities of the two goods.
Consumer Disequilibria
(1) MUX > MUY
PX PY
The consumer is not maximizing Total utility given this inequality. At this point, the utility/$ for Good X is greater than the utility/$ for Good Y. The consumer will be motivated to adjust his/her quantities of the two goods so as to increase his/her total utility. In this case, the consumer will buy more X and less Y. As a result, the consumer will move closer to the consumer equilibrium.
(2) MUX < MUY
PX PY
The consumer is not maximizing Total utility given this inequality. At this point, the utility/$ for Good Y is greater than the utility/$ for Good X. The consumer will be motivated to adjust his/her quantities of the two goods so as to increase his/her total utility. In this case, the consumer will buy more Y and less X. As a result, the consumer will move closer to the consumer equilibrium.
Table 2 Consumer Theory Example
Let: I = Income = $12 (this is the consumer’s “money” income or budget)
PX = Price of Good X = $3
PY = Price of Good Y = $1
(1) / (2) / (3) / (4) / (5) / (6) / (7) / (8)Unit of Product / MUX / TUX / MUY / TUY
1 / 60 / 22
2 / 45 / 16
3 / 33 / 11
4 / 24 / 8
5 / 18 / 6
6 / 15 / 5
Original Consumer Equilibrium:
NOW let: I = Income = $12 (same as before)
PX = Price of Good X = $3 (same as before)
PY′∙ = Price of Good Y = $2 (price increase)
New Consumer Equilibrium:
Graph 2 The Demand for Good Y
Diamond-Water Paradox
Why is water, an essential good, priced so low, and diamonds, a nonessential good, priced so high? What do total utility and marginal utility have to do with this?
MUwater (low) = MUdiamonds (high)
Pwater (low) Pdiamonds (high)
Consumer will select a large number of units of water but few units of diamonds. The marginal utility of water is low due to large use, but the total utility will be high. The marginal utility of diamonds is high due to limited use, but the total utility will be low.
Key point = Prices relate marginal utility not total utility.
Value of Time
Consumer account for the value of time associated with the use of some goods and/or services. Basically the consumer looks at the “full price” = market price + value of time.
Key point = Prices of goods or services being compared should be the “full prices” when there are differences in the amount of time associated with consuming the goods. The value of time is typically specified as a certain wage multiplied by the number of hours involved in consumption of the good or service.
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