The Economics of Consumers

Study Questions

1. What are the kinds of goods consumers spend their income on?

2. What is diminishing marginal utility? 3. How do consumers maximize utility over

several products? 4. What is the difference between an

inelastic demand and an elastic demand?

Study Questions

5. What is the main factor affecting supply elasticity?

6. Why would retailers prefer taxes to be levied on inelastic goods rather than elastic goods?

Income Earners

Owners of land resources – rent Owners of labor – wages/salary Owners of financial capital – interest

Owners of capital goods – return on investment

Entrepreneurs – profit, if successful

What do we do with our Income?

Pay taxes. Save some. Spend the rest.

Consumer Spending

Durable goods Nondurable goods Services

Utility

This is the amount of satisfaction, usefulness or pleasure we get from consuming a specific item at one particular time.subjective; intensely personal and situationalwe use our value system to assign utility

Utility

Marginal utility – the added utility we will get out of consuming one more of a good.Marginal cost – the added cost of obtaining

one more of a good. Total utility – the sum of all the utility we

obtain when we consume a series of a good.

Diminishing Marginal Utility

As you consume more and more of a good, your marginal utility decreases.

As your marginal utility decreases, you become less interested in consuming another unit of the good.When MU falls below MC, you will decide to

stop consuming more units of this good

Figure 3-1. Diminishing Marginal Utility

0 1 2 3 4 5 6 7slices of pizza

util

ity

MU

MC

Demand and Diminishing MU

If the sales person wants us to buy more of his goods, he must offer it to us at a lower price. the added units are less valuable to us due to

diminishing MU, so we will buy them only if they come at a lower price (MC is decreased).

Comparing Value to Price

Consumers choose from many products. The next item a consumer should buy is

the one with the highest MU per dollar (MU/P) spent. This increases TU the greatest.

The consumer maximizes TU when the next choices all have the same MU/P.

Utility Theory

• The more pleasure (satisfaction, utility) we get from a product, the higher the price we’re willing to pay for it.– Utility: the pleasure or satisfaction obtained from

using a good or service.– Total utility: the amount of satisfaction obtained

from the consumption of a series of products.– Marginal utility: the change in total utility obtained

by consuming one additional (marginal) unit of a product.

19-13

Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (a)

TU and MUTacos consumed in 1 meal

TU MU

0 0

1 10 10

2 18 8

3 24 6

4 28 4

5 30 2

6 30 0

7 28 -2

As more of a product is consumed, Total utility increases at aDiminishing rate.

TOTAL AND MARGINAL UTILITYTacos

consumedper meal

TotalUtility,Utils

MarginalUtility,Utils

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10 8 6 4 2 0 -2

Units consumed per meal

Units consumed per meal

30

20

10

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tili

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10 8 6 4 2 0 -2

TU

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0 1 2 3 4 5 6 7

1 2 3 4 5 6 7

TOTAL AND MARGINAL UTILITYTacos

consumedper meal

TotalUtility,Utils

MarginalUtility,Utils

01234567

010182428303028

10 8 6 4 2 0 -2

Units consumed per meal

Units consumed per meal

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ObserveDiminishing

MarginalUtility

Utility Theory (cont'd)

Observations

Marginal utility falls as more is consumed.

Marginal utility equals zero when total utility is at its maximum.

Diminishing Marginal Utility

As long as marginal utility > 0, total utility increases. When marginal utility becomes negative, total utility maxes out and then decreases.

19-19

Diminishing Marginal Utility

Law of Diminishing Marginal Utility = the marginal utility of a good declines as more of it is consumed in a given period of time.

As long as MU is increasing TU must be increasing.

When MU is not increasing (diminishing) each unit added yields less utility

Example: Newspaper Vending Machines versus Candy Vending Machines Newspaper machines do not prevent people

from taking more than one paper. Why not dispense candy the same way?

The answer is found in the concept of diminishing marginal utility.

Can you think of a circumstance under which a substantial number of newspaper purchasers might be inclined to take more than one newspaper from a vending machine?

Optimizing Consumption Choices

Assumption: Consumer is rationalPurchases with preferences in mindLimited incomeSelects best combination of goods attainable.

A choice of a set of goods and services that maximizes the level of satisfaction for each consumer, subject to limited income

Utility maximization – consumers want to get the most satisfaction from consumption choices

Let’s look at concept of Marginal Utility per dollar spent

Last dollar spent yields equal portions of utility

MU of product A = MU of product BPrice of product A Price of product B

And the consumer’s income is all spent.

Total and Marginal Utility from Consuming Music Album Downloads ($5) and Cappuccinos ($3) on an Income of $26

Step one: Calculate your marginal utility (albums)Step two: Calculate the Marginal utility/dollarStep three: Repeat step one and two for (cappuccinos)Step four: Look for exact or near exact amounts for MU/$Step five: check your work – find number to purchase for both and multiply

Price and Quantity The demand curve

slopes downward because of diminishing marginal utility.

In order to justify buying more, the price must be lower.

At $0.25, the consumer buys 12 ounces (point f).

19-25

Upsetting Consumer Equilibrium

Advertising: tries to get us to increase our MU for its good.notifies us when P of its good is lower.both will upset consumer equilibrium.and we will buy more of the advertised good.

How do demand and supply change in response to changes in price and quantity?=Elasticity

Elasticity of Demand and Elasticity of Supply

Bottom Line on Elasticity of Supply

If producers are relatively responsive to price changes supply is elastic

If producers are relatively insensitive to price changes supply is inelastic

When a large percentage change in price brings about a small percentage change in quantity supplied = inelastic….

(examples: Rise in costs of computers… takes time to shift resources)

Over Time… more plants built, more engineers trained, and more computers supplied

When a small percentage change in price brings about a large percentage change in quantity supplied = elastic

Example: Cowboys beat Philadelphia Eagles for wildcard playoff… T-shirt producer can raise his price just a “tad” and sell a ton more shirts…

TIME AND ELASTICITY OF SUPPLY

Sm

D1

D2

Ss

D1

D2

SL

D1

D2

Note: perfectly inelastic. (price)(quantity)

Inelastic (price) (quantity)

Elastic (price) (quantity)

See relationship between small percentage increase in P and Q that follows.

Remember

Supplier is looking at revenueRevenue Test = P x Q = TR

What is profit?TR-TC

Question is: If I decrease the price of steak $1 what will happen to my revenue?

Math for Measuring Price Elasticity

Problem: Sirloin steak drops $4.00 to $3.00

Butcher sales increase from 500 lbs to 1,000 lbs

e Formula: Pe = % Change in Q

% Change in P

500 lbs to 1000 lbs = 500 / 500 = 1 (Q change = 100%)

$4.00 to $3.00 = 1/ 4 = .25

1 / .25 = 4

The steak at this price is very elastic.

Anything over 1 is elastic.

Helpful HintsTo find coefficient of price elasticity

supply or demand simply:

Find % change in quantity and % change in price, then divide Q/P

Hint: former-current/formerPrice increase $1 to $2, quantity decrease 10 to 8

1/1 x 100 = 100% = P

2/10 x 100 = 20% = Q

20/100 = .2 = inelastic

Bottom Line for Elasticity of Demand

The responsiveness or (sensitivity) of consumers to a price change is measured by a product’s price elasticity of demand

Inelastic demand perfectly inelastic totally elastic

Elastic Demand = A small percentage change in price brings about a large percentage change in QD

Example: cars, steak, CDs, gold jewelry

Inelastic Demand = Large percentage change in price brings about a small percentage change in QD.

Drugs, gasoline, cigarettes, personal items, deodorant,

Measuring Elasticity

Elasticity = (%change in Q)/(%change in P) If elasticity > 1, demand is elastic. If elasticity < 1, demand is inelastic. If elasticity = 1, demand is unitary.

All of the inelastic demand concepts depend on available substitutes

Price of steak goes too high… substitute chicken

Price of gasoline too high… no substitute

Income Effect

Income effect simply indicates that at a lower price one can afford more of the good without giving up alternative goods.

Determinants of Elasticity Necessity vs Luxuries ….examples: critical

medicines, addiction, gas to drive, new car, boat, diamond ring….

Availability of Substitutes…Zirconia, salt substitute, powdered milk, tea vs coffee…

Proportion of Income…the higher the price of a good relative to a consumers’ income, the greater the price elasticity of demand.

Time….As a rule, product demand is more elastic the longer the time period under consideration.

Figure 3-2. Demand Curve Elasticity

Steep demand curves are inelastic Small % change in Q in

response to a big change in P

Shallow (nearly flat) demand curves are elastic Large % change in Q in

response to a small change in P

P

Q

Dinelastic

Delastic

QP

Steep = inelastic

Shallow = elastic

What does that mean?

If elasticity is greater than 1, demand is elastic.

Price change causes revenue to change in opposite direction Decrease in price will increase TR

Inelastic demand is defined as an elasticity of less than 1 (anything from 0 to .99)

Price changes causes TR to change in same direction. Decrease in price causes TR to fall

Unit elastic is 1 No change

Price elasticity is 0 because an increase in price will not decrease revenue…nor will it increase revenue… there is no change in revenue with unit elastic.

How can we calculate coefficient of price elasticities?Let’s re-visit our last example

Let’s say that price is increased from $1.00 to $2.00 for a candy bar…..

The quantity demanded decreases from 10 to 8….

How will this producer know if the price increase brings in more $ relative to decrease in demand or otherwise????

Percent change in P1-2=1/1 x 100 = 100% change in P

Percent change in Q10-8 = 2/10 = 20% change in Q

Response/trigger…..Hence:E = 20/100 =.2 (% change in Q / % change in P)Trigger was the price…. Response the quantityPrice moves…(trigger)… quantity change (response)Because % change is less than 1, candy producer

will not increase revenue by increasing price.

Taxes and Elasticity

Burden of a Tax the product does not pay the taxpeople pay the tax

consumers? producers/sellers?

who carries the burden of a tax?

Taxes and Elasticity

Inelastic Goods;add a taxseller increases P by the amount of the tax inelastic response; consumers cut back only a

littleseller takes the tax out of increased sales

revenuesbuyer carries most of the burden of the tax

Taxes and Elasticity

Elastic Goods;add a taxseller increases P by the amount of the taxelastic response; consumers cut back by a

large amountsales revenue decreases; seller takes the tax

out of profitsseller carries most of the burden of the tax

THE END!