Part V:Part V:•Law of Diminishing Marginal UtilityLaw of Diminishing Marginal Utility•Price Ceilings & Price FloorsPrice Ceilings & Price Floors•BlackmarketsBlackmarkets

ECONOMICSWhat does it mean to me?

The LAW of The LAW of DIMINISHING DIMINISHING MARGINAL MARGINAL

UTILITYUTILITY

In what kind In what kind of machines of machines

are are newspapers newspapers

sold?sold?

Why don’t we sell Coca-Why don’t we sell Coca-Cola in machines similar Cola in machines similar to those we use to sell to those we use to sell

newspapers?newspapers?

The value of a 2nd newspaper diminishes fast…..unlike the value of Coca-Cola.

People use this information to make appropriate machines.

REASON:

This is called the

LAW of DIMINISHING LAW of DIMINISHING MARGINAL UTILITYMARGINAL UTILITY

The value given to the amount of gratification derived from something will decrease with each

additional unit of that item.

TOTAL UTILITY is the total amount of satisfaction a person gets from consuming a specific

quantity (such as 20 units).

This law operates ALWAYS with respect to time.

How much do you make?

Week? Month? Year?

-----> $1000 ???

The period of time in which you make $1000 will make a difference in the amount of money you

have to spend.

Day?

What day would be most likely for newspapers be stolen from the machines?

The answer is: Sunday

because that is coupon day.

However, people can still get TOO MANY coupons, so the law still applies.

The relationship between an individual’s consumption bundle and the total amount of utility is called the UTILITY FUNCTION.

The utility function differs for each person.

We will measure Utility in hypothetical units called UTILS.

Candy

0

1

2

3

4

5

6

7

Total Utility

0

10

18

24

28

30

30

28

Marginal Utility

10

8

6

4

2

0

-2

30

20

10

0 1 2 3 4 5 6 7

Total Utility

Units consumed

**As more of a product is consumed, total utility increases at a diminishing rate, reaches a

maximum, and then declines.

Candy

0

1

2

3

4

5

6

7

Total Utility

0

10

18

24

28

30

30

28

Marginal Utility

10

8

6

4

2

0

-2

10

8

6

4

2

0 1 2 3 4 5 6 7

Marginal Utility

Units consumed

** Marginal utility reflects the change in total utility.

10

8

6

4

2

0 1 2 3 4 5 6 7

Marginal Utility

Units consumed

30

20

10

0 1 2 3 4 5 6 7

Total Utility

Units consumed

1) When MU is zero in graph b, total utility in graph a is:

a) also zero b) neither rising nor falling c) negative

d) rising, but at a declining rate

10

8

6

4

2

0 1 2 3 4 5 6 7

Marginal Utility

Units consumed

30

20

10

0 1 2 3 4 5 6 7

Total Utility

Units consumed2) Suppose the person represented here experienced a diminished taste for candy.

As a result:

a) TU curve would get steeper b) MU curve gets flatter

c) TU & MU would shift downward d) MU curve (not TU) would collapse to horizontal

axis

Debbie makes $20 and cokes are $2 and chips are $4 a pound.

How does Debbie decide HOW MUCH to consume based on the fact that the more cokes she consumes, the fewer

chips she can purchase?

The answer is to determine the Marginal Utility per dollarMarginal Utility per dollar.

The equation we will use is:

MUx Muy

Px Py

____ = ____

Qcoke Ucoke MUper/coke MU$

0 0

1 15

2 25

3 31

4 34

5 36

Calculate Debbie’s MU per dollar for coke

The price per coke is $4

15

10

6

3

2

3.75

2.5

1.5

.75

.5

Qcoke Ucoke MUper/coke MU$

0 0

1 15

2 25

3 31

4 34

5 36

Calculate Debbie’s MU per dollar for Chips/pound.

The price per pound of chips is $2.

15

10

6

3

2

Qcoke Ucoke MUper/coke MU$

0 0

1 11.5

2 21.4

3 29.8

4 36.8

5 42.5

6 47

7 50.5

8 53.2

9 55.2

10 56.7

11.5

9.9

8.4

7

5.7

4.5

3.5

2.7

2

1.5

3.75

2.5

1.5

.75

.5

5.75

4.95

4.2

3,5

2.85

2.25

1.75

1.35

1.00

.75

Qcoke Ucoke MUper/coke MU$

0 0

1 15

2 25

3 31

4 34

5 36

Calculate Debbie’s MU per dollar for coke

Debbie’s optimal consumption is 2 cokes and 6 pounds of chips because

she consumes these amounts, her MU per dollar

is 2.

15

10

6

3

2

Qcoke Ucoke MUper/coke MU$

0 0

1 11.5

2 21.4

3 29.8

4 36.8

5 42.5

6 47

7 50.5

8 53.2

9 55.2

10 56.7

11.5

9.9

8.4

7

5.7

4.5

3.5

2.7

2

1.5

3.75

2.5

1.5

.75

.5

5.75

4.95

4.2

3,5

2.85

2.25

1.75

1.35

1.00

.75

Optimum Consumption and the Optimum Consumption and the Budget LineBudget Line

10

8

6

4

2

01 2 3 4 5 6 Quantity

of Coke

Quantity of chips (pounds)

Assume that Debbie earns $20. Coke is $4 a can and chips are $2 a pound.

The budget line represents all the possible combinations of coke

and chips Debbie can purchase.

If Debbie wants to consume 1 more coke, she must give up 2

pounds of chips.

NOTE: (Slope of the line is -2)

10

8

6

4

2

01 2 3 4 5 6 Quantity

of Coke

Quantity of chips (pounds)

Changes in income shifts the budget line.

Now, let’s apply the Law of Marginal UtilityLaw of Marginal Utility

to artificial pricing systems such as those applied by

governments.

What happens when prices are “fixed” by

the government?

Let’s look at a graph which shows the average

consumption of beer in the United States.

PRICE CEILINGS & PRICE FLOORS

(Consumer Surplus & Producer Surplus)

$4

$3

$2

$1

Beers per week

0 1 2 3 4 5 6 7

S

D

E

Ge

In this example, the average beers consumed per week is 6

at an average price of $2.50.

$4

$3

$2

$1

Beers per week0 1 2 3 4 5 6 7

S

D

E

This chart illustrates the effects upon people if they were forced to go from

Ge to zero.

Ge

You might be You might be willing to pay willing to pay $4 for your first $4 for your first beer, but price beer, but price is $2.50 …..now is $2.50 …..now you are $1.50 you are $1.50 better off. This better off. This is called is called CONSUMER CONSUMER SURPLUS.SURPLUS.

The 9th beer is worth to people

what it is worth to people.

It is different for everybody.

$4

$3

$2

$1

Beers per week

0 1 2 3 4 5 6 7

S

D

E

Ge

From the From the suppliers’ suppliers’ standpoint, standpoint, they they could could supply at a supply at a lower price but lower price but they they CAN CAN get get more. This is more. This is called called PRODUCER PRODUCER SURPLUS.SURPLUS.

$4

$3

$2

$1

Beers per week

0 1 2 3 4 5 6 7

S

D

E

Ge

The The colored colored area is the area is the total valuetotal value to society to society of the cost of the cost of 6 beers.of 6 beers.

Consumer Surplus

Producer Surplus

$4

$3

$2

$1

Beers per week0 1 2 3 4 5 6 7

S

D

E

Ge

Four beers is Four beers is not enough not enough (too little, (too little,

inefficient) inefficient) ….This is ….This is

called called DEADWEIGHT DEADWEIGHT

loss.loss.

What if government mandate limited the What if government mandate limited the maximum number of beers one could drink to 4 maximum number of beers one could drink to 4 per week?per week?

Government Mandated Supply

$4

$3

$2

$1

Beers per week

0 1 2 3 4 5 6 7

S

D

E

Ge

What if government mandate limited What if government mandate limited the maximum price of a beer to $1.00?the maximum price of a beer to $1.00?

Consumers would want to buy more beer.

10

However, suppliers would not

want to produce as much beer.

$4

$3

$2

$1

Beers per week0 1 2 3 4 5 6 7

S

D

E

Ge

If If government government limited the limited the maximum maximum price of a price of a

beer to $1.00, beer to $1.00, it would it would create a create a

shortage.shortage.

shortage

Producers will not want to produce for low prices.

The legal maximum price that can be charged is called a PRICE CEILINGPRICE CEILING. A legal minimum price that can be charged is called a PRICE PRICE FLOORFLOOR. Price ceilings and

floors keep markets from reaching equilibriumequilibrium..

Politically popular ideas include:

--$ minimums on inputs (wages).

--$ maximums on outputs (prices).

When POLITICS vs. POLITICS vs. ECONOMICS => ECONOMICS => Politics always Politics always

winswins

$4

$3

$2

$1

Beers per week0 1 2 3 4 5 6 7

S

D

E

Ge

The The government government mandating mandating

the the maximum maximum price of a price of a

beer is beer is called a called a PRICE PRICE

CEILINGCEILING..

shortage

A price ceiling keeps the market from reaching equilibrium.

$4

$3

$2

$1

Beers per week0 1 2 3 4 5 6 7

S

D

E

Ge

shortage

The shortage created from the price ceiling will result in increased demand.

X

The increased demand and a willingness to pay higher prices will result in a BLACK MARKET for

beer.

$5

$4

$3

$2

$1

Labor0 1 2 3 4 5 6 7

S

D

E

Ge

When the government mandates a the When the government mandates a the minimum price of something, it is called minimum price of something, it is called a a PRICE FLOORPRICE FLOOR..

The minimum wage is an example of a price floor.

$5

$4

$3

$2

$1

Labor0 1 2 3 4 5 6 7

S

D

E

Ge

The minimum wage increases the number of people who want to work (supply of labor). . .

. . . And decreases the number of businesses who want to hire (demand for labor)

Creating a SURPLUS of labor.

SURPLUS

A price floor stops the market from reaching equilibrium and creates a surplus.

A price ceiling stops the market from reaching equilibrium and creates a shortage.

CONCLUSION:

Typically, the government jumps

in during a surplus, buys the surplus….

and the surplus rots.and the surplus rots.

Using economic principles and the impact of government

mandate, why was the 18th Amendment to the U.S.

Constitution considered “the great experiment that failed?”

QUESTION 1:

$5

$4

$3

$2

$1

Beers per week0 1 2 3 4 5 6 7

S

D

E

Ge

ANSWER: The 18th Amendment created a shortage of alcohol for consumption

When the price of alcohol increased under black market conditions, this initiated the development of the syndicate and the notoriety of such underworld figures as Al Capone.

Using economic principles, explain the impact of

government mandates on the supply and demand of the illegal marijuana market.

QUESTION 2:

$300

$250

$200

$150

$100

$ 50

Marijuana use0 1 2 3 4 5 6 7

S

D

E

Ge

ANSWER: In 1937, the government reduced the availability of marijuana to zero by making it illegal.

Because people have been willing to pay a high price for the product, black market conditions have existed since the shortage was created.

This created a shortage in the market.

In 1973, President Nixon froze gasoline prices after the OPEC cartel created a

shortage in the United States. What impact did this have on the market economy at that

time?

QUESTION 3:

$4

$3

$2

$1

Gallons of Gas0 1 2 3 4 5 6 7

S

D

E

Ge

ANSWER: ANSWER: President President Nixon initiated Nixon initiated a price ceiling a price ceiling of $1.60.of $1.60.

shortage

REMEMBER: Producers will not want to produce for low prices.

Consequently, a Consequently, a shortage existed shortage existed because gas because gas companies were companies were taking a loss. taking a loss. This resulted in This resulted in long lines and long lines and gas stations gas stations running out of running out of fuel.fuel.

Using economic principles and the impact of government mandate, explain what would happen if cigarette smoking

were made illegal.

What would be the opportunity cost of making cigarettes

illegal?

QUESTION 4:

$10

$8

$6

$4

$2

Cigarette use0 1 2 3 4 5 6 7

S

D

E

Ge

ANSWER: The government would reduce the supply of cigarettes to zero by making it illegal.

Because some people will be willing to pay a high price for the product, black market conditions will exist and the price of cigarettes will increase.

This will create a shortage in the market.

ANSWER: The opportunity costs would include:

•Lower environmental costs

•Cleaner air

•Lower costs for health care

•Healthier population

•Higher unemployment for lost jobs

Many experts contend that the Food and Drug Administration (FDA) directly creates the high price of prescription drugs. Do you agree? Why or why not? Explain

your answer.

Question 5:

$100

$80

$60

$40

$20

Drug use0 1 2 3 4 5 6 7

S

D

E

Ge

ANSWER: The FDA, a government regulatory agency, reduces the supply of certain drugs by making them unavailable to certain people through the use of prescriptions.

Because doctors prescribe drugs for illness and the patient requests good health, they pay the higher price created by the government.

This results in a limited market.

In May 2001, President Bush visited with Governor Gray of California to discuss the

energy crisis in that state. It will take 10 years to build the power plants necessary to provide

the electricity needed to support the population and costs will skyrocket as demand exceeds supply. Governor Gray is requesting

that President Bush place a federal price ceiling on the cost of energy. Why did

President Bush refuse?

Question 6:

$D

$C

$B

$A

Kilowatts0 a b c d e f g

S

D

E

Ge

ANSWER: ANSWER: President Bush realizes that a price ceiling will result in a shortage of electricity.

shortage

REMEMBER: Producers will not want to produce for low prices.

Limiting the price Limiting the price that power that power companies can companies can charge for charge for electricity will cause electricity will cause them to lose money, them to lose money, not produce not produce efficiently, and efficiently, and result in a shortage result in a shortage of power.of power.

THE END

Compiled by Virginia Meachum Economics Teacher, Coral Springs High

School, Florida

Sources:

Economics, by Krugman, Wells.

Economics, by McConnell, Brue

Economics, by Mankiw