CHAPTER 5DEMAND AND CONSUMER BEHAVIOR

I. CHAPTER OVERVIEW

Now that you know the basics of market behavior, you are ready to do more in-depth analysis of the demandcurve. This chapter asks, “What makes consumers tick?” and provides you with an opportunity to applyconsumer theory to different situations. In a market economy, consumer theory is very important; just thinkabout the number of firms and agencies that exist to sell a whole host of products to consumers! Firms competefiercely for the dollars that consumers bring to the marketplace. The theory that this chapter develops will giveyou some clues as to the nature of this competition.

Consumer theory formalizes behavior that should be very familiar to you. You, your classmates, yourfriends, and their families are all consumers who ordinarily have only a limited amount of money to spend inany given period of time on the goods and services that they need or want. Each good has a market price thatusually cannot be altered by bargaining or haggling. You must decide which goods to buy and how much ofeach good to buy knowing from the quoted prices that each purchase will exhaust part of your limited incomeor budget, but also knowing what you like and what you do not like. Chapter 5 involves careful analysis ofthis decision-making process.

II. LEARNING OBJECTIVES

After you have read Chapter 5 in your text and completed the exercises in this Study Guide chapter, you shouldbe able to:

1. Define total utility and marginal utility and explain the difference between these two measures ofconsumer satisfaction.2. Explain the law of diminishing marginal utility and its importance in economic analysis.3. Show that an individual’s utility is maximized for a given income when the marginal utility derivedfrom the last dollar spent on each good is the same for all goods purchased.4. Express the utility-maximizing rule mathematically, and show how it combines with the law ofdiminishing marginal utility to produce downward-sloping demand curves.5. Define substitution and income effects and explain how they work to produce downward-slopingdemand curves.6. Explain how market demand curves are derived from the horizontal summation of individual demandcurves.7. Describe the paradox of value and resolve it through application of the utility-maximizing rule.8. Discuss what is meant by the term consumer surplus, and illustrate the concept using examples and ademand curve.

III. REVIEW OF KEY CONCEPTS

Match the following terms from column A with their definitions in column B.A B

__ Utility 1. Denotes the percentage change in quantity demanded divided by the percentagechange in income, all else held fixed.

__ Marginal utility 2. Represents the sum of the individual demands at each price.__ Utilitarianism 3. Given two goods, an increase in the price of one causes a decrease in the demand

for the other.__ Law of 4. Explains why the price of a diamond is greater than the price of a gallon of

diminishing water.marginal utility

__ MU1/P1 = 5. States that when the price of a good rises, consumers will tend to substitute MU2/P2 = ... = other goods for the one whose price is rising in order to satisfy their needs less MU per $ spent expensively.__ Market demand 6. Measures the want-satisfying power of a good or service.

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__ Income elasticity 7. Given two goods, an increase in the price of one causes an increase in thedemand for the other.

__ Substitutes 8. States that as the amount of a good consumed increases, the marginal utility ofthat good tends to diminish.

__ Complements 9. Measures the increase in total utility when an additional unit of a good isconsumed.

__ Ordinal Utility 10. The gap between the total utility of a good and its total market value.__ Substitution effect 11. “The greatest happiness of the greatest number.”__ Income effect 12. Denotes the impact of a price change on a good's quantity demanded that results

from the effect of the price change on consumers' real income.__ Demerit goods 13. Describes the market basket of goods that will bring the consumer maximum

satisfaction.__ Paradox of value 14. Goods whose consumption is deemed harmful.__ Consumer 15. Consumers only need to determine their preference ranking of bundles of

surplus commodities.

IV. SUMMARY AND CHAPTER OUTLINE

This section summarizes the key concepts from the chapter.

A. Choice and Utility Theoryl. Utility measures the want-satisfying power of a good or service. Marginal utility is the rate at whichutility changes as each additional unit of a particular good is consumed. As with other marginal concepts,marginal utility measures the change in a total value when an additional unit of something else is used.2. The law of diminishing marginal utility holds that as the amount of a good consumed increases, themarginal utility of that good tends to diminish. That is, the more you have of any one thing, the less anadditional unit of it is worth to you. This ties nicely into the paradox of value discussed later in the chapter.People are not willing to pay much for an additional gallon of water because they have so much of it that anadditional gallon has a low marginal utility. However, notice that when water becomes more scarce, as it doesduring droughts or in deserts, the price climbs, reflecting the fact that consumers under these circumstancesplace a higher value on additional gallons of it.3. Utility is an important concept for economists, but there is no cardinal measure of it. That is, there is noscale or instrument upon which utility can be measured. Instead, we rely on ordinal measures, which simplyrank items relative to one another. For example, instead of saying that I get 10 utils from consuming an appleand 5 utils from consuming a banana, I can only say that I get more utility from an apple than from a banana.This type of ordinal measure is sufficient for economists to use utility theory to develop an understanding ofconsumer behavior.

B. Consumer Equilibrium Condition1. Utility is maximized subject to a budget constraint if the ratios of marginal utility to price for all goods areequal, i.e., if the marginal utility of the last dollar spent is the same regardless of where it is spent. Stateddifferently, utility maximization requires that for any goods X and Y:

MUX /PX = MUY / PY

2. Utility theory helps to explain why demand curves are generally downward-sloping, as was argued inChapters 3 and 4. As the price of good X falls, the quantity of X consumed rises, and so MUX falls withprice.3. Substitution and income effects also help to explain the negative correlation between price and quantitydemanded. Substitution effects describe the fact that as prices change along a demand curve, consumerssubstitute relatively cheaper goods into their market baskets. Income effects describe the fact that as priceschange along a demand curve, money income is held fixed, but real income or purchasing power changes. Thismeans that consumers are not able to buy as much at higher prices.

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For example, suppose a consumer increases her purchases of apples from 4 to 6 when the price of applesfalls from 50 cents to 25 cents per apple. She purchases more apples and substitutes them into her marketbasket in place of oranges, bananas, and other fruit that is now relatively more expensive. (Substitution effect.)She is able to buy more apples because she has more purchasing power. When the price was 50 cents, shespent a total of $2.00 on 4 apples. The same 4 apples now cost only $1.00! She has an additional $1.00 ofpurchasing power to spend on apples, or any other good in her market basket, even with no increase in herbudget. (Income effect.)

C. From Individual to Market Demand1. Market demand curves reflect, for any price, the total quantity demanded across many individuals. Theyare the “horizontal sum” of individual demand curves.2. As illustrated in Chapter 3, the demand for a good shifts when any factor other than the price of the gooditself changes. When money income changes, demand curves shift; the magnitude of this shift depends uponincome elasticity, which measures the percentage change in quantity demanded resulting from some percentagechange in income. When prices of other goods change, demand curves shift; the magnitude of this shiftdepends upon cross price elasticities, which measure the percentage change in quantity demanded resultingfrom some percentage change in the price of another good.3. Goods can be either normal or inferior. With a normal good, as income increases, demand increases (orshifts to the right). With an inferior good, as income increases, demand decreases (or shifts to the left). Forexample, for many people cars and stereos are normal goods. For many people, used clothes and Spam areinferior goods. Remember, though, that definitions of normal and inferior goods are subjective and based uponindividual preferences.4. Goods can be related in two different ways. Complements are goods that are consumed together.Substitutes are goods that are consumed in place of one another. Goods are independent when the consumptionof one does not depend on or affect consumption of the other.5. Demerit goods are goods whose consumption is deemed harmful. Governments sometimes intervene todiscourage consumption of such goods; for example, in the United States the government prohibits the sale anduse of certain addictive drugs, such as heroin and cocaine.

D. Paradox of Valuel. The paradox of value addresses the somewhat counterintuitive observation that water costs less thandiamonds in spite of the fact that water sustains life and diamonds are often simply decorative. This can beexplained by the fact that water is relatively abundant, and hence in great supply, but diamonds are relativelyscarce. Note that the total utility from water is greater than the total utility from diamonds.

E. Consumer Surplusl. Consumer surplus represents the difference between what people would have been willing to pay for a givenquantity of some good, one unit at a time, and how much they actually had to pay in a market quoting oneprice for all units. Remember that a demand curve represents the maximum amount that consumers would bewilling and able to pay for each unit of a good. Also remember that from our model, there is a single marketprice paid for all units of a good exchanged. (Price dispersion will be discussed in a later chapter.) This meansthat consumers typically receive a “surplus;” that is, some consumers receive value from a good or service inexcess of the amount that they paid for it.

V. HELPFUL HINTS

l. Utility theory would be much more concrete if we could somehow measure utility, or consumersatisfaction. Just think, we could then ask consumers to strap their “utilmeters” onto their wrists before theywalk into the grocery store or mall, and they could simply purchase those goods that bring the highestutilmeter reading per dollar spent. For example, a consumer in the cookie aisle of the grocery store couldchoose between the Oreos and the Chips Ahoy by holding each one in turn and checking to see which productgot the highest number of utils.

This might be nice, but this sort of cardinal representation of utility is not possible. Utility is a subjectivenotion. It changes over time; some things that you like now you may not have liked or needed as a child.(Coffee or beer, for example?) If I say, “I got a marginal utility of 200 from the last cookie I ate,” it would beimpossible for you to place this on a meaningful scale. Thus, we have to be happy with ordinal measures of

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utility, that is, with our ability to say “I like A better than B” or “I like B better than A” or “I like A and Bexactly the same amount.” This sort of measurement is fine for our purposes as economists.2. Grab a box of cookies, or a bag of potato chips, or something else that you like to eat and think carefullyabout the concepts of total utility, marginal utility, and the law of diminishing marginal utility. The marginalutility of, say, cookies is the additional satisfaction that you get from consuming each additional cookie. Thetotal utility you get is the total of the marginal utilities from each cookie; that is, when you have finished yoursnack, total utility is the total amount of satisfaction that you got from eating those cookies. The law ofdiminishing marginal utility should hold; as you eat more and more cookies, eventually your marginal utilitywill fall. Does this principle hold for you?3. Income elasticities and cross price elasticities are very similar to price elasticities of supply and demandthat you learned about in Chapter 4. However, there are some important differences. Price elasticities ofdemand and supply measure moves along a demand or a supply curve, because price is measured on the Y axis.Income elasticity and cross price elasticities measure shifts in the demand curve as factors other than the price ofthe product are changing. This is an important distinction to make.4. Notice that the sign of an income elasticity or of a cross price elasticity gives you important information.A positive income elasticity means that a good is normal, but a negative income elasticity means that a good isinferior. A positive cross price elasticity means that the two goods are substitutes, but a negative cross priceelasticity means that the two goods are complements.

VI. MULTIPLE CHOICE QUESTIONS

These questions are organized by topic from the chapter outline. Choose the best answer from the optionsavailable.

A. Choice and Utility Theoryl. The marginal utility of a commodity is:

a. an indication of the last use to which the commodity has been put or the use to which it would nextbe put if more were available.b. equal to the price of that commodity.c. the ratio of the total utility generated by consuming that commodity to the total utility of all othercommodities that are consumed.d. the extra utility yielded by consuming each successive unit of that commodity.e. the same thing as the total utility derived from consuming that commodity.

2. If the marginal utility of a commodity is zero, then:a. total utility for this commodity has reached a maximum.b. the commodity in question has no utility; i.e., it is not one that consumers want to use.c. the paradox of value must have been reached.d. the consumer has reached his or her equilibrium position with respect to purchase of this commodity.e. total utility for this commodity must be zero also.

3. The law of diminishing marginal utility states that:a. as the amount of a good consumed increases, the total utility of that good tends to diminish.b. as the amount of a good consumed decreases, the total utility of that good tends to diminish.c. as income increases, marginal utility tends to diminish.d. as the amount of a good consumed increases, the marginal utility of that good tends to diminish.e. when the price of a good increases, marginal utility tends to diminish.

Use the following information to answer questions 4 and 5. Albert consumes five Oreo cookies. The marginalutility of the first cookie is 10 utils; of the second, 12 utils; of the third, 8 utils; of the fourth, 3 utils; and ofthe fifth, -2 utils.4. When he consumes these five cookies, his total utility from cookies is:

a. -2 utilsb. 1 util.c. 31 utilsd. 35 utils.e. not enough information to calculate total utility.

5. The law of diminishing returns sets in after the:a. first cookie.b. second cookie.

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c. third cookie.d. fourth cookie.e. fifth cookie.

6. If total utility reaches its maximum, then:a. marginal utility is at its maximum.b. marginal utility is zero.c. marginal utility is negative.d. this is always the amount the consumer should buy.

B. Consumer Equilibrium Condition7. When a consumer is maximizing his or her utility subject to the constraint of income and given prices,then the:

a. total satisfaction derived from each commodity must equal the total satisfaction derived from everyother commodity.b. ratio of the total satisfaction derived from any commodity to the price of that commodity must beequal for all commodities.c. satisfaction derived from the last tiny unit of each commodity bought must be equal for allcommodities.d. ratio of the total satisfaction derived from any commodity to the total expenditure on that commoditymust be equal for all commodities.e. none of the preceding descriptions is necessarily correct.

8. The equilibrium condition for a consumer who is spending all of his or her budget on two commodities, Aand B, is given by:

a. MUA = MUBb. MUA / PB = MUB / PAc. MUA / PA = MUB /PBd. PA = PBe. none of the above.

9. You have $20 per week available to spend as you wish on commodities A and B. The prices of thesecommodities, the quantities you now buy, and your evaluation of the utility provided by these quantities arerecorded in Table 5-1. You are currently spending your entire weekly budget.

TABLE 5-1Total Marginal

Price Bought Utility UtilityA $.70 20 500 30B $.50 12 l000 20

For maximum satisfaction, you should buy:a. less of A and more of B.b. the same quantity of A but more of B.c. more of A and less of B.d. more of A and the same quantity of B.e. the same amount of A and B.

10. The price of good X is $1.50 and that of good Y is $1.00. If a consumer considers the marginal utility ofY to be 30 utils, and is maximizing utility with respect to purchases of X and Y, then he or she must considerthe marginal utility of X to be:

a. 15 utilsb. 20 utilsc. 30 utils.d. 45 utils.e. not enough information to tell.

11. If, in question 9, the figure of 30 utils had been the total (rather than marginal) utility of Y, whichalternative would be correct with respect to the total utility of X?

a. 15 utilsb. 20 utils

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c. 30 utils.d. 45 utils.e. not enough information to tell.

12. Homer does not have to work on Saturday, and he is trying to decide how to spend his afternoon. Hedecides that he can either watch TV or play baseball with Bart. The total utility that he would derive from eachpursuit is independent of the other and is given in Table 5-2.

TABLE 5-2 Total Utility

Hours Spent TV Baseball 1 16 10 2 24 18 3 31 24 4 37 30

If Homer has 4 hours to allocate between TV and baseball, what combination would he choose to maximize hisutility?

a. 4 hours of baseball.b. 3 hours of TV and 1 hour of baseball.c. 2 hours of TV and 2 hours of baseball.d. 3 hours of TV and l hour of baseball.e. 4 hours of TV.

13. In question 11, at this utility-maximizing combination of TV and baseball, the marginal utility of:a. TV is 8 and of baseball is 8.b. TV is 24 and of baseball is 18.c. TV is 40 and of baseball is 28.d. TV is 31 and of baseball is 24.e. both goods are indeterminate.

14. The income effect captures which of the following economic phenomena?a. If money incomes fall, people will purchase less of any given commodity.b. A decrease in the price of a major purchase has an effect similar to an increase in income, and this mayprompt people to buy more of that good.c. The quantity of a good purchased may actually decrease as people’s incomes rise.d. As people’s incomes rise, they save proportionately more out of income, so they actually spend asmaller fraction of their incomes.e. If the price of a good drops, it is as though the prices of all other goods have risen, in relative terms,so smaller quantities of those other goods will tend to be bought.

15. You regard goods X and Y as substitutes. If the price of X rises and neither good is inferior, the incomeeffect should induce you to purchase:

a. more Y only if the price of X is less than the price of Y.b. less of good Y.c. the same amount of Y.d. more Y only if the price of X is greater than the price of Y.e. none of the above.

16. Which alternative in question 14 would have been correct if it had referred to the substitution effect ratherthan the income effect?

a. If money incomes fall, people will purchase less of any given commodity.b. A decrease in the price of a major purchase has an effect similar to an increase in income, and this mayprompt people to buy more of that good.c. The quantity of a good purchased may actually decrease as people’s incomes rise.d. As people’s incomes rise, they save proportionately more out of income, so they actually spend asmaller fraction of their incomes.e. If the price of a good drops, it is as though the prices of all other goods have risen, in relative terms,so smaller quantities of those other goods will tend to be bought.

17. A consumer moves to a new equilibrium position as a result of some change either in market price or inincome. In this new equilibrium situation, marginal utilities are all lower than they were in the oldequilibrium situation. Tastes or preferences are unchanged. This consumer is:

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a. definitely worse off in the new situation.b. definitely better off in the new situation.c. worse off in the new situation if income has changed, but not otherwise.d. better off in the new situation if price has changed, but not otherwise.e. better off or worse off in the new situation; the information given does not necessarily indicate one orthe other.

18. Assume the marginal utility of good X is 10, the price of X is $5, the marginal utility of good Y is 25,and the price of Y is $25. What should the consumer do to maximize his/her utility?

a. Buy more X and less Y.b. Buy more Y and less X.c. This is an equilibrium point.d. Not enough information is given to answer this question.

C. From Individual to Market Demand19. The market demand curve is the:

a. vertical summation of the individual demand curves.b. horizontal summation of the individual demand curves.c. equilibrium price and quantity exchanged in the market at a given point in time.d. relatively inelastic portion of the individual demand curve.e. individual demand curve with the highest elasticity of demand at every price.

20. Suppose a market is composed of two consumers with the demand curves shown in Figure 5-1. Themarket demand curve is given by which panel of Figure 5-2:

a. (a)b. (b)c. (c)d. (d)e. (e)

Figure 5-1

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Figure 5-2

21. A consumer’s demand curve for any given commodity is most likely to shift to the right with:a. an increase in the price of substitutes or a decrease in the price of complements.b. an increase in the price of either substitutes or complements.c. a decrease in the price of substitutes or an increase in the price of complements.d. a decrease in the price of either substitutes or complements.e. none of these cases.

22. Suppose that the income elasticity of demand for new houses is 2.3. If consumer incomes increase by 2percent, you could expect the quantity of new houses to:

a. increase by 2.3 percent.b. increase by 2 percent.c. increase by 4.6 percent.d. decrease by 1 percent.e. decrease by 4.6 percent.

23. Suppose that when the price of Coke increases by 2 percent, the quantity of Bacardi Rum purchasedincreases by 4 percent. (Assume everything else is held fixed.) This means that the:

a. income elasticity of demand is 2 and the goods are complements.b. cross price elasticity is 2 and the goods are substitutes.c. cross price elasticity is -.5 and the goods are complements.d. price elasticity of demand for Coke is -2 and the goods are complements.e. price elasticity of demand for Bacardi is .5 and the goods are substitutes.

D. Paradox of Value24. The paradox of value occurs because:

a. prices of commodities are not always proportional to the total satisfaction that they give us.b. it is impossible to explain the price of a commodity in terms of either demand factors alone or supplyfactors alone.c. it is impossible to explain why people’s tastes are what they are or why they vary from one person tothe next.d. prices of commodities always perfectly reflect the amount of value that they bring to the consumer.e. none of the above.

25. The paradox of value is best illustrated by which of the following?a. The quantity of diamonds demanded increases as price decreases.b. Suppliers are willing and able to supply more water when the price increases, everything else heldfixed.c. Consumers must pay more for diamonds than they pay for water, even though water is a necessity anddiamonds are a luxury for most people.d. Consumers will substitute diamonds into their market basket when the price of diamonds falls.e. Diamonds and water do not mix.

26. The demand for addictive substances is highly dependent on past consumption. For heavy users ofcocaine, demand is:

a. highly inelastic so that government prohibition has little impact on price.b. highly elastic so that government prohibition has a great impact on price.c. highly inelastic so that government prohibition has a great impact on price.d. highly elastic so that government prohibition has little impact on price.e. perfectly elastic since users can get all they want to consume at the market price.

E. Consumer Surplus27. Consumer surplus is defined as the:

a. difference between the total utility of a good and the maximum amount that consumers are willing topay for it.b. difference between the total utility of a good and the market price.c. sum of the total utility of a good and its market price.d. total revenue that producers receive from selling a particular good.

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e. sum of the marginal utilities for all consumers of a good.28. The idea of “consumer surplus” reflects the notion that:

a. the gain consumers obtain with some purchases exceeds the gain suppliers obtain from selling.b. purchasing many goods is a real bargain for consumers, because they would have been willing to paymore than they actually do in order to get them.c. the marginal utility of the first units of a product consumed may exceed the total utility which theproduct supplies.d. total utility increases either when consumer incomes rise or when the prices they must pay for goodsfall.e. when demand is price-inelastic, buyers can obtain a larger quantity for the expenditure of less money.

Use Figure 5-3 to answer questions 27 and 28.

Figure 5-3

Figure 5-4

29. If this good is provided for free, consumer surplus will be:a. $5.b. 10 units.c. $16.d. $25.e. $50.

30. If the price of this good is $2, consumer surplus will be:a. $2.b. $9.c. $12.d. $25.e. $50.

VII. PROBLEM SOLVING

The following problems are designed to help you apply the concepts that you learned in this chapter.

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A. Choice and Utility Theoryl. a. If the total utilities associated with the consumption of 1, 2, and 3 units of B were to be, respectively,

100, 160, and 200, then the corresponding marginal utilities would be _________________,_________________, and __________________.b. Which of the following sets of total utility figures (designated for 1, 2, 3, and 4 units of B consumed)illustrates the idea of diminishing marginal utility?(1) 200, 300, 400, 500.(2) 200, 450, 750, 1100.(3) 200, 400, 1600, 9600.(4) 200, 250, 270, 280.c. Which of the following sets of marginal utility figures (once again defined for 1, 2, 3, and 4 units ofB consumed) would likewise illustrate the diminishing marginal utility principle?(1) 200, 150, 100, 50.(2) 200, 300, 400, 500.(3) 200, 200, 200, 200.(4) 200, 250, 270, 280.d. In Figure 5-4, plot the total and marginal utility curves for the set of marginal utility figures that youchose in part c.

TABLE 5-3 Total Apples Apples Bananas Bananas Cherries Cherries Units (Total Utility) (Marginal Utility) (Total Utility) (Marginal Utility) (Total Utility) (Marginal Utility) 1 10 _____ 100 _____ 6 _____ 2 19 _____ 150 _____ 12 _____ 3 27 _____ 175 _____ 18 _____ 4 34 _____ 187 _____ 24 _____ 5 40 _____ 193 _____ 30 _____ 6 45 _____ 196 _____ 36 _____ 7 49 _____ 197 _____ 42 _____ 8 52 _____ 197 _____ 48 _____

B. Consumer Equilibrium Condition2. In Table 5-3, three sets of total utility values are described for Betty White, who is using apples, bananas,and cherries to make a fruit salad. The three sets of utility values are assumed to be independent of oneanother. That is, the amount of utility you get for any given quantity of apples is not affected by the amountof bananas or cherries you happen to be consuming. This is not necessarily true in real life; apples and bananasmight, for example, be close substitutes. The assumption of independence is made here only for the sake ofsimplicity and clarity.

a. Complete the information on marginal utilities for apples, bananas, and cherries in Table 5-3.b. Suppose that Betty has $15 per week to spend on these three types of fruit. These are the only goodsavailable, or at least the only goods in which Betty has any interest. Let the price of apples be $1 per unit,the price of bananas be $2 per unit, and the price of cherries be $1 per unit. How much of each fruit shouldBetty purchase for maximum satisfaction with her $15? Carefully explain your reasoning.c. Suppose that all prices double and that Betty’s budget doubles. That is, the price of apples is $2.00,the price of bananas is $4.00, the price of cherries is $2.00, and Betty has $30 to spend. How does herutility-maximizing decision change? Explain.

3. Two “effects” explain why more of a commodity is bought if its price falls and why less is bought if itsprice rises. In this question and the one following, we use the idea of marginal utility to examine in detail thenature of these two effects.

a. Specifically, these effects are (1) the (substitution / institutional) effect and (2) the (envy / income)effect.

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Table 5-4 shows the levels of total utility (TU) associated with different quantities of commodities Xand Y, measured in satisfaction units. (Commodities X and Y are the only ones you can buy, or the onlyones in which you are interested.) Calculate the MU of X and Y.

TABLE 5-4No. of UnitsConsumed MU of X TU of X MU of Y TU of Y

3 32 348 20 1304 ___ 376 ___ 1485 ___ 400 ___ 1646 ___ 420 ___ 1787 ___ 436 ___ 1908 ___ 448 ___ 2009 ___ 456 ___ 208

10 ___ 461 ___ 21311 ___ 464 ___ 216

b. Suppose that the prices of X and of Y are $2.40 and $1.00, respectively, and that you have just $20per period to spend. Given the data in Table 5-4, what will your equilibrium or maximum-satisfaction X-Y combination be? In this situation, you will buy ___ units of X and ___ units of Y. The total utilityyou obtain, from X and Y combined, will be ___.c. Now let the price of X drop from $2.40 to $1.00. The price of Y is still $1.00, and you still have $20to spend. What will your new equilibrium position be; you will now buy ___ units of X and ___ units ofY.

In the new situation, the quantity of X has (increased / decreased). This is not surprising, since X’sprice has fallen. The quantity of Y has (increased / decreased). Why this should happen is notimmediately obvious. Y’s price has not fallen; indeed, the price of Y has risen relative to the price of X.d. What has happened is this: In part b you were spending considerably more than half your income onX. The reduction in X’s price considered in part c had an effect similar to a substantial rise in yourincome. In fact, your total satisfaction level has climbed from the original total of 600 utils to (620 / 664 /670 / 674) utils. How so? You have used the practical equivalent of a larger income to buy more X andmore Y.

When X’s price falls, there are two effects that operate on your desire to purchase X and Y. Insofar asX and Y are substitutes, you will be disposed to buy (more / less) Y and more X. But countering this isthe income effect just discussed, which makes you inclined to buy (more / less) X and (more / less) Y. Inthis case, the income effect won out over the substitution effect. Had X and Y been “better” substitutes forone another, then the quantity of Y chosen might have fallen instead of rising.

C. From Individual to Market Demand4. a. Table 5-5 records the quantities of some good X that each of three people demand for a variety of

prices. Fill in the column indicated for the market demand schedule if these are the only three peopleinterested in X at any price.

TABLE 5-5Individual Individual Individual Market

Price A B C Demand$8 2 0 0 _____7 3 0 1 _____6 4 0 3 _____5 5 0 5 _____4 6 1 7 _____3 7 3 10 _____2 8 5 14 _____

b. On the diagrams in Figure 5-5, plot the demand curves for each of the consumers, and plot the marketdemand curve.

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Figure 5-5

E. Consumer Surplusc. From your diagrams in Figure 5-5, you can see that if the market price is $4, consumer surplus is$___ for individual A, $___ for individual B, and $___ for individual C.d. If the market price increases to $5, total consumer surplus in this market changes from $___ to $___.

VIII. DISCUSSION QUESTIONS

Answer the following questions, making sure that you can explain the work you did to arrive at the answers.

1. A consumer has $50 per week to spend on either commodity X, whose price is $5, or commodity Y,whose price is $4. For each of the four cases below, indicate whether or not this consumer is “at equilibrium,”i.e., deriving the maximum-attainable satisfaction. If you lack sufficient information to answer, explain why.If you know the consumer is not at equilibrium, indicate the required direction of movement (e.g., “buy moreof X and less of Y,” “buy less of X and more of Y,” “buy more of both,” etc.).

a. Purchases are now 2 of X and 10 of Y. Total utility of X at this level is 500 utils; total utility of Y is400 utilsb. Purchases are now 6 of X and 5 of Y. Total utility of X at this level is 400 utils, and the marginalutility of X is 60 utils. Total utility of Y is 800 utils, and the MU of Y is 30 utils.c. Purchases are now 6 of X and 5 of Y. The MU of X at this level is 25 utils; the MU of Y is 20 utilsd. Purchases are now 6 of X and 4 of Y. The MU of X at this level is 25 utils; the MU of Y is 20 utils.

2. What does it mean when we refer to utility as an “ordinal” measure, rather than a “cardinal” measure? Whatcontribution did Jeremy Bentham make to utilitarianism? Explain.3. Mr. Economist says, “Consumers always find their optimal bundle of consumer goods when the marginalutility of the last unit of each good is equal.” Do you agree?4. Tables 5-2 and 5-3 in your textbook list estimates of price elasticities of demand and income elasticities forvarious goods.

a. Income elasticity for automobiles is listed as 2.5. If incomes rise by 5 percent, what will happen tothe quantity of automobiles demanded? Are automobiles an inferior good?b. The income elasticity for margarine is -.2. If income falls by 2 percent, what will happen to thequantity of margarine demanded? What type of good is margarine?c. The price elasticity of demand for medical insurance is .31. If the quantity demanded has fallen by 10percent, what must have happened to the price? What type of good is medical insurance?

5. As the environment becomes increasingly polluted, communities have to pay increasingly more money forclean air and clean water. Does this mean that the paradox of value is no longer valid?6. In recent years, California has toyed with the idea of legalizing the purchase and sale of marijuana. Givenwhat you know about consumer demand and addictive substances, would you recommend this policy change?Why or why not?7. Consumer surplus is defined as the difference between what consumers are willing to pay and what theyactually pay for a good or service. Why do firms not capture this surplus? That is, why do firms not chargepeople the maximum amount they are willing to pay, rather than a market-determined price?

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IX. ANSWERS TO STUDY GUIDE QUESTIONS

III. Review of Key Concepts6 Utility9 Marginal utility

11 Utilitarianism8 Law of diminishing marginal utility

13 MU1/P1 = MU2/P2 = . . . = MU per $ spent2 Market demand1 Income elasticity7 Substitutes3 Complements

15 Ordinal Utility5 Substitution effect

12 Income effect14 Demerit goods4 Paradox of value

10 Consumer surplus

VI. Multiple Choice1. D 2. A. 3. D 4. C 5. B 6. B7. E 8. C 9. C 10. D 11. E 12 C

13. A 14. B 15. B 16. E 17. B 18. A19. B 20. A 21. A 22. C 23. B 24. A25. C 26. C 27. B 28. B 29. D 30. B

VII. Problem Solvingl. a. 100, 60, 40

b. 4c. 1d. See Figure 5-4.

2. a. See Table 5-3.b. Betty will maximize her utility by setting the ratios of the marginal utility to the price equal for allgoods. This results in her purchasing 5 units of apples, 4 units of bananas, and 2 units of cherries.c. If all prices and her budget double, Betty’s utility-maximizing decision will not change. The ratios ofthe marginal utilities to the prices of the products still fall, but the increase in income will allow her topurchase more goods.

Figure 5-4

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TABLE 5-3 Total Apples Apples Bananas Bananas Cherries Cherries

Units (Total Utility) (Marginal Utility) (Total Utility)(Marginal Utility)(Total Utility)(Marginal Utility) 1 10 10 100 100 6 62 19 9 150 50 12 63 27 8 175 25 18 64 34 7 187 12 24 65 40 6 193 6 30 66 45 5 196 3 36 67 49 4 197 1 42 6

8 52 3 197 0 48 6 3. a. substitution, income

b. 5, 8, 600 unitsc. 10, 10, increased, increasedd. 674, less, more, more

4. a. See Table 5-5.

TABLE 5-5Individual Individual Individual Market

Price A B C Demand$8 2 0 0 27 3 0 1 46 4 0 3 75 5 0 5 104 6 1 7 143 7 3 10 202 8 5 14 27

b. See Figure 5-5.

Figure 5-5

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c. 14, 0, 9d. 23, 13

VIII. DISCUSSION QUESTIONS

l. a. Not enough information to tell. Need marginal utility data.b. Not at equilibrium. Buy more X and less Y.c. At equilibrium. MU/P are equal for the two goods.d. Not at equilibrium. MU/P are equal for the two goods, but there is income left over.

2. Ordinal measures involve rankings; cardinal measures involve absolute numbers based upon some well-defined, universal scale. Jeremy Bentham proposed that society should be organized so as to generate the“greatest good for the greatest number.” This led to the development of social policies designed to generate thegreatest utility for society.3. No. The optimal bundle of goods is found where the ratio of the marginal utility of one good to its priceis equal to the ratios of the marginal utilities of all other goods to their prices.4. a. The quantity of automobiles demanded will rise by 12.5 percent. Automobiles are not an inferior

good; as income rises, consumption increases.b. The quantity of margarine demanded will rise by .4 percent. Margarine is an inferior good.c. The price must have increased by 32.26 percent. Medical insurance is a necessity.

5. No. The prices of water and air are rising because people’s marginal utility of clean air and water is rising.6. Since many users of marijuana tend to be casual users with highly elastic demands, higher prices inducedby government prohibition encourage them to substitute into legal drugs like alcohol and tobacco. Hence,legalizing the purchase and sale of marijuana may lead to a marginally lower price, but a dramatically increasedquantity demanded.12. It is difficult for firms to capture consumer surplus because it is difficult for them to determine how much

money a consumer would be willing to pay for a good or service.

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