Unit 5: The Rational Consumer

Tonight We Will . . .

• Review last week’s discussion questions

• Review Chapter 10 content– Sample problem

• Homework Pointers

Discussion Q: Farmers Inelastic Demand in a

Supply Shift

Supply

Demand

$

Q

Why is demand for crops inelastic?

-Necessities-No substitutes-Short timeframe-Small % spend

Discussion Q: DVD Price

Demand

$

Q

5

Chapter 10

Utility/rational consumerMarginal utilityBudget lineOptimal consumption bundle How individual

consumers/marginal utility give rise to the market demand curve

Income and substitution effects

6

Utility

•How much satisfaction you get from consuming something

–Varies by person–Varies across quantities

•We will look at it vs. other goods and per unit consumed

•Rational consumers will try to maximize their utility across all products consumed, given their budget

•For this chapter, utility is measured in “Utils” not $

Marginal Utility• Utility, or satisfaction gained with each increment– Typically goes down, “Diminishing Marginal Utility”

• Unit 1 examples – “how much”– Eating potato chips– Doing Library research for a paper– Last week’s homework example?– How does this factor into bundled pricing?

• Marginal utility almost always diminishing, but exceptions– Drug addiction– Network effect– Constant examples?

8

What Diminishing Utility Looks Like Graphically

Check Your Thinking• Last unit’s homework showed Ari’s

willingness to pay for each successive pasta serving– In an all you can eat buffet, what is his

marginal utility, measured in $ or utils, for his last bite?

– Why do people overeat at all-you-can-eat?

10

We are all Constrained by Budgets

•A budget constraint requires that the cost of a consumer’s consumption bundle be no more than the consumer’s total income.

•A consumer’s consumption possibilities is the set of all consumption bundles that can be consumed given the consumer’s income and prevailing prices.

•We will be using only two products at all times

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•What does this remind you of? (Unit/Chap 2)•Why straight?

The Budget Line

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Changes in Income Shift the Budget Line

•What does this remind you of? (Unit/Chap 2)•Do you think the utility vs. clams function would be straight? Or curved?

13

Sammy’s Utility from Clam and Potato Consumption

•What would total utility graph look like for clams or potatoes?•How should he maximize utilis @ $20/week?

•Can he consume 5 lbs & 10 lbs?

14

Sammy’s Utility from Clam and Potato Consumption

• Total Utility 2 lb clams, 6 lbs potatoes?•Total Utility 5 lbs clams?•Total Utility 10 lbs potatoes?

15

Optimal Consumption in a Graph

•Where is Sammy’s consumption optimized?•Utility per $ spent?

16

Marginal Utility per Dollar: Another way of Getting to

Optimal Consumption

marginal utility one unit (utils)Price one unit of good

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Sammy’s Marginal Utility per Dollar

15 utils/lb$4/lb

= $3.75 u/$

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Marginal Utility per Dollar

If Sammy has in fact chosen his optimal consumption bundle, his marginal utility per dollar spent on clams and potatoes must be equal.

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Optimal Consumption Rule

•The optimal consumption rule says that when a consumer maximizes utility, the marginal utility per dollar spent must be the same for all goods and services in the consumption bundle.

Check Your Thinking #2

• Your instructor spends all her income on two goods: clothing and food. The marginal utility of the last unit of clothing is 10 utils, the last unit of food 20 utils. Clothing costs $5 per unit, Food costs $8 per unit.

• Is she spending her money wisely?– If not, how should she shift?

Check Your Thinking #2• Your instructor spends all her income on two

goods: clothing and food. The marginal utility of the last unit of clothing is 10 utils, the last unit of food 20 utils. Clothing costs $5 per unit, Food costs $8 per unit.

Good Marginal Utility/unit

Price ($)/unit

MU/P

Clothing 10 5

Food 20 2.5

Adapted from: Microeconomics the Easy Way, by Walter Wessels

Check Your Thinking #2• Your instructor spends all her income on two

goods: clothing and food. The marginal utility of the last unit of clothing is 10 utils, the last unit of food 20 utils. Clothing costs $5 per unit, Food costs $8 per unit.

Good Marginal Utility/unit

Price ($)/unit

MU/P

Clothing 10 5 2

Food 20 2.5 2.5

• How should she shift consumption?• Could she buy more of both food and clothing?

Adapted from: Microeconomics the Easy Way, by Walter Wessels

Check Your Thinking #3

• A grocery store has a fixed amount of shelf space, which it measures in sq ft. If the last sq ft of shelf space allocated to milk adds $10/mo to its profits, and the last sq ft of shelf space of cola adds $40/mo to its profits, how should the store reallocate its shelf space?

Adapted from: Microeconomics the Easy Way, by Walter Wessels

24

From Utility to the Demand Curve:

Individual and Market Demand

Why does Bert’s individual demand curve slope down?Why does Ernie’s?Why are they different?What happens when you add them together? (Assuming they are the entire clam market of Sesame Street)

Purchasing Power

• Inflation effects purchasing power• Income of $55,000/yr, 20% inflation• How is inflation calculated

(generally)• What happens to purchasing power?• By how much?

Purchasing Power

• Inflation effects purchasing power• Income of $55,000/yr, 20% inflation• How is inflation calculated

(generally)• What happens to purchasing power?• By how much?

– $55,000 x .2 = $11,000– Income effectively $44,000/yr

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The Income Effect• Change in the quantity consumed of that good that results from a change in the consumer’s purchasing power due to the change in the price of the good. (Think inflation/deflation, purchasing power, ”feeling” richer/poore.r)

Normal Goods: P($) up, Q demanded downInferior Goods: P($) up, Q demanded up

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The Substitution Effect

•The change in the quantity consumed of that good as the consumer substitutes other goods. (Think relative price of goods.)

Normal Goods: P($) up, Q demanded downInferior Goods: P($) up, Q demanded down