Transcript Chapter 7 - micro

Chapter 7
Consumer Choice and Elasticity
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Overview
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Fundamentals of consumer choice and
diminishing marginal utility
Consumer equilibrium
Income and substitution effect
The market demand curve
Price elasticity of demand
Income elasticity
Price elasticity of supply
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Fundamentals of Consumer Choice
1.
2.
3.
4.
5.
Limited income necessitates choice
Consumers make decisions purposefully
One good can be substituted for another
Consumers must make decisions without
perfect information
The law of diminishing marginal utility
applies to consumption
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Marginal Utility
Marginal Utility: The benefit derived from
consuming an additional unit of the good
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Law of diminishing marginal utility
Law of Diminishing Marginal Utility: as
the consumption of a product increases,
the marginal utility derived from additional
consumption will eventually decline
Banana Eating Contest Results:
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Marginal Benefit and the Demand
Curve
Marginal Benefit = The maximum price a
consumer will be willing to pay for an
additional unit of the product (the height
of the demand curve)
Marginal Benefit falls as you move down the
demand curve
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Consumer Equilibrium
Consumers will maximize utility by ensuring
that the last dollar spent on each
commodity yields an equal degree of
marginal utility:
MUA / PA = MUB / PB = ………… MUN / PN
Ex. Beer and Wings
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Responding to Price Changes
People will buy more (less) of a good as the price
of the good decreases (increases) for two
reasons:
When the price of a good decreases:
1. Substitution effect: The good has become
cheaper relative to other goods
2. Income effect: It is as if your real income has
increased.
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Opportunity Cost of Time
The cost of time is different for different
individuals:
Those who earn a higher wage will face a
higher time cost
Ex. Meet me in the club
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The Market Demand Curve
The market demand curve is the horizontal
sum of the individual demand curves
Ex. Mario and Luigi
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Price Elasticity of Demand
Price elasticity of demand indicates how
responsive consumers are to a change in
the products price.
Price elasticity of demand = %∆QD / %∆P
Always negative, so we use the absolute
value (ignore the negative sign)
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Price Elasticity of Demand
If price elasticity of demand is:
> 1: elastic
= 1: unitary elastic
< 1: inelastic
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Price Elasticity of Demand
Elasticity will decrease as you move down a
straight line demand curve.
Percent change in quantity decreases
Percent change in price increases
Ex. Movie rentals
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Determinants of Price Elasticity of
Demand
1.
The most important determinant of the
price elasticity of demand is the
availability of substitutes
Good Substitutes = Higher Elasticity
The more narrowly defined the product is
the more elastic it is (because it has
more good substitutes)
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Determinants of Price Elasticity of
Demand
2.
Products share of the consumers total
budget
The larger the share of the consumer’s
budget, the higher the elasticity
Ex. Lighters and Insurance
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Time and Price Elasticity of
Demand
When the price of a product increases,
consumers will reduce their consumption
by a larger amount in the long run than in
the short run
(Known as the Second Law of Demand)
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Elasticity and Total Revenue
Total Revenue (Expenditures) = Price X
Quantity
However, as price increases, the quantity
sold decreases
So, how do you increase Total Revenue….
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Elasticity and Total Revenue
It depends on elasticity
1.
2.
3.
Inelastic: The price effect dominates
Elastic: The quantity effect dominates
Unitary elastic: the effects are the
same (no change in total revenue)
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Income elasticity
Income elasticity measures the responsiveness of the demand for a good to a
change in income.
Income elasticity = %∆Q / %∆I
In this case, the sign does matter….
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Income elasticity
Income elasticity determines the type of good:
1. Normal good: positive income elasticity
A.
Necessity: income elasticity is between 0 and 1
B.
Luxury: income elasticity is greater than 1
2. Inferior good: negative income elasticity
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Price Elasticity of Supply
Price elasticity of supply measures how
responsive suppliers are to a change in
price
Price elasticity of supply = %∆QS / %∆P
In this case, the sign is always positive
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Price Elasticity of Supply
Similar to the price elasticity of demand, the
price elasticity of supply will be greater in
the long run.
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Review
1.
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4.
Know the fundamentals of consumer
choice and understand the law of
diminishing marginal utility
Know the idea behind the consumer
equilibrium and how to get there
Know why the law of demand holds: the
income and substitution effect
Know how to get the market demand
curve
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Review
5.
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Be able to calculate price elasticity of demand
(from scratch!) and know what values
correspond with inelastic, elastic, and unitary
elastic goods
Know how elasticity affects changes in total
revenue
Be able to calculate income elasticity and know
what values correspond with necessities,
luxuries and inferior goods
Be able to calculate price elasticity of supply
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