UTILITY AND

DEMAND7CHAPTE

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7-1© 2003 Pearson Education Canada Inc.

Household Consumption ChoicesA household’s consumption choices are determined by: Consumption possibilities Preferences

• Consumption Possibilities: Budget Constraint

• The budget constraint refers to the limits imposed on household choices by income, wealth, and product prices

• The choice set or opportunity set refers to the set of options that is defined and limited by a budget constraint.

Table 6.1Possible Budget Choices of a Person Earning $1000 per Month After Taxes

Option Monthly Rent

Food OtherExpenses

Total Available?

A $400 $250 $350 $1000 Yes

B 600 200 200 1000 Yes

C 700 150 150 1000 Yes

D 1000 100 100 1200 No

Choice Sets: An Example

Budget Constraint and Opportunity Set for Trudee and Mark

• Points A, B, and C are each on the budget constraint, meaning that Trudee and Mark have spent their income.

• Point D does not spend the entire $200 and point E is unattainable as it would cost more than $200.

The Effect of a Decrease in Price on Trudee and Mark’s Budget Constraint

• When the price of a good decreases, in this case Thai meals fall from $20 to $10, the budget constraint swivels to the right, increasing the opportunities available and expanding choice.

The Basis of Choice: Utility

• Utility is the satisfaction, or reward, a product yields relative to its alternative. It is the basis for choice.

• Marginal utility is the additional satisfaction gained by the consumption or use of one more unit of something.

• Total utility is the total amount of satisfaction obtained from consumption of a good or service.

Law of Diminishing Marginal Utility

• The more of any one good consumed in a given period, the less satisfaction (utility) is generated by consuming each additional (marginal) unit of the same good.

Allocation of Fixed Expenditures per Week Between Two Alternatives

Frank’s utility maximizing decision between basketball games and trips to the club.

Frank’s Total and Marginal Utility of Trips to the Club

Utility-Maximizing Rule

• A utility maximizing consumer allocates his or her expenditures such that the marginal utility per dollar spent on each activity is equal:

MUx = MUy

Px Py

Predictions of Marginal Utility Theory

•A Rise in the Price of Pop

Now suppose the price of pop rises.

We know that MUP/PP falls, so before the consumer changes the quantities consumed, MUP/PP < MUM/PM.

To restore consumer equilibrium (maximum total utility) the consumer decreases the quantity of pop consumed to drive up the MUP and increases the quantity of movies consumed to drive down MUM. These changes restore MUM/PM = MUP/PP.

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POSSIBILITIES,

PREFERENCES, AND

CHOICES

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8-12© 2003 Pearson Education Canada Inc.

Consumption Possibilities• The Budget Equation

– We can describe the budget line by using a budget equation.– The budget equation states that:

– Expenditure = IncomePPQP + PMQM = Y

QP = Y/PP – (PM/PP)QM

• The term Y/PP is Lisa’s real income in terms of pop.• A household’s real income is the income expressed as a quantity of goods

the household can afford to buy.• Lisa’s real income in terms of pop is the point on her budget line where it

meets the y-axis.

• The term PM/PP is the relative price of a movie in terms of pop.

• A relative price is the price of one good divided by the price of another good.• It is the magnitude of the slope of the budget line.• The relative price shows how many pops must be forgone to see an additional

movie.8-13

Preferences and Indifference Curves–An indifference curve is a line that shows combinations of goods among which a consumer is indifferent. –All the points above the indifference curve are preferred over the points on the curve.

–And all the points on the indifference curve are preferred over the points below the curve.

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Preferences and Indifference Curves

–An indifference curve above I1 is I2 . All the points on I2 are preferred to those on I1 .

–For example, point J is preferred to either point C or point G.

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Preferences and Indifference Curves•Marginal Rate of Substitution–The marginal rate of substitution, (MRS) measures the rate at which a person is willing to give up good y (the good measured on the y-axis) to get an additional unit of good x (the good measured on the x-axis) and at the same time remain indifferent (remain on the same indifference curve).

•The marginal rate of substitution is the ratio at which a household is willing to substitute good Y for good X. • MRS = MUx / MUy

–The magnitude of the slope of the indifference curve measures the marginal rate of substitution.

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Preferences and Indifference Curves

–A diminishing marginal rate of substitution is the key assumption of consumer theory.–A diminishing marginal rate of substitution is a general tendency for a person to be willing to give up less of good y to get one more unit of good x, and at the same time remain indifferent, as the quantity of good x increases.

–If the indifference curve is relatively steep, the MRS is high.

–In this case, the person would be willing to give up a large quantity of y to get a bit more x.

–If the indifference curve is relatively flat, the MRS is low.

–In this case, the person would be willing to give up a small quantity of y to get more x.

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Preferences and Indifference Curves

–Figure shows the diminishing MRS of movies for pop.

–At point C, Lisa is willing to give up 2 six-packs to see one more movie—her MRS is 2.

–At point G, Lisa is willing to give up 1/2 a six-pack to see one more movie—her MRS is 1/2.

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Preferences and Indifference Curves•Degree of Substitutability

–The shape of the indifference curves reveals the degree of substitutability between two goods.

–Figure shows the indifference curves for ordinary goods, perfect substitutes, and perfect complements.

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Predicting Consumer Behaviour–The consumer’s best affordable point (Consumer Utility-Maximizing equilibrium):

Is on the budget lineIs on the highest attainable indifference curveHas a marginal rate of substitution

between the two goods equal to the relative price of the two goods

–Here, the best affordable point is C.

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Predicting …–Figure illustrates the price effect and shows how a demand

curve is generated.–Initially, the price of a movie is $6 and Lisa consumes at point C in part (a) and at point A in part (b).

–The price of a movie then falls to

$3. The budget line rotates outward.

–Lisa’s best affordable point is now J in part (a).

–In part (b), Lisa moves to point B, which is a movement along her

demand curve for movies.8-21

Predicting Consumer Behaviour• Substitution Effect and Income Effect

– For a normal good, a fall in price always increases the quantity consumed.

– We can prove this assertion by dividing the price effect into two parts:

1. Substitution effect:

– is the effect of a change in price on the quantity bought when the consumer remains indifferent between the original situation and the new situation.

2. Income effect:

– When a good is a normal good, the quantity consumed changes in the same direction as the change in income.

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Substitution EffectWhen the relative price (opportunity cost) of a good or service rises, people seek substitutes for it, so the quantity demanded decreases.When the price of a product falls, that product becomes more attractive relative to potential substitutes.

Income EffectWhen the price of a good or service rises relative to income, people cannot afford all the things they previously bought, so the quantity demanded decreases.When the price of a product falls, a consumer has more purchasing power with the same amount of income and is better off.

Predicting Consumer Behaviour

–We’re going to break the move from C to J into two parts.

–The first part is the substitution effect, and the second is the income effect.

–The price of a movie falls from $6 to $3 and her budget line rotates outward.

–Lisa’s best affordable point is then J.

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Predicting Consumer Behaviour

–To isolate the substitution effect, we give Lisa a hypothetical pay cut.

–Lisa is now back on her original indifference curve but with a lower price of movies, and her best affordable point is K.

–The move from C to K is the substitution effect.

–The direction of the substitution effect never varies: a fall in price brings an increase in the quantity bought.

–The substitution effect is the first reason why the demand curve slopes downward.

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Predicting Consumer Behaviour–To isolate the income effect, we reverse the hypothetical pay cut and restore Lisa’s income to its original level (its actual level).

–Lisa is on indifference curve I2 and her best affordable point is J.

–The move from K to J is the income effect.

–For Lisa, movies are a normal good.

–When her income increases, she sees more movies—the income effect is positive.

–For a normal good, the income effect reinforces the substitution effect and is the second reason why the demand curve slopes downward.

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ORGANIZING PRODUCTIO

N9CHAPTE

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9-27© 2003 Pearson Education Canada Inc.

Profit = Total Revenue (TR) - Total Cost (TC)

Where Total Revenue is the receipts from the sale of a product (P x q)

Profit The Firm’s Goal

– A firm’s goal is to maximize profit.

• Profit is the difference between total revenue and total costs.

Economists measure profit based on an opportunity cost measure of cost.

The Firm and Its Economic Problem

–A firm’s opportunity cost of producing a good is the best, forgone alternative use of its factors of production, usually measured in dollars.

–Explicit costs are costs paid directly in money.

–Implicit costs are costs incurred when a firm uses its own capital or its owners’ time for which it does not make a direct monetary payment.

The implicit rental rate of capital is made up of:– Economic depreciation

–is the change in the market value of capital over a given period.– Interest forgone

–is the return on the funds used to acquire the capital

The opportunity cost of the owner’s labour spent running the business is the wage income forgone by not working in the next best alternative job.

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Calculating Total Revenue, Total Cost and Profit For a Small Belt Firm

Technology and Economic Efficiency

–Technological efficiency occurs when a firm produces a given level of output by using the least amount of inputs.–Economic efficiency occurs when the firm produces a given level of output at the least cost.

–An economically efficient production process is also technologically efficient.

–A technologically efficient process may not be economically efficient.

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OUTPUT AND COSTS 1

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Decision Time Frames–The short run is a time frame in which the quantity of one or more resources used in production is fixed.

–For most firms, the capital, called the firm’s plant, is fixed in the short run.

–Other resources used by the firm (such as labour, raw materials, and energy) can be changed in the short run.

–The long run is a time frame in which the quantities of all resources—including the plant size—can be varied.

Short-Run Technology Constraint

•Product Schedules–Total product is the total output produced in a given period.

–The production function or total product function is a numerical or mathematical expression of a relationship between inputs and outputs.

–It shows units of total product as a function of units of inputs.

–The marginal product of labour is the change in total product that results from a one-unit increase in the quantity of labour employed, with all other inputs remaining the same.

–Marginal product is the additional output that can be produced by adding one more unit of a specific input, ceteris paribus.

–The average product of labour is equal to total product divided by the quantity of labour employed.

–The average product is the average amount produced by each unit of a variable factor of production.

Law of Diminishing Returns

• The law of diminishing returns states that when additional units of an input are added to fixed inputs after a certain point, the marginal product of the variable input declines.

Labor Total Marginal AverageUnits Product Product Product0 0 --- ---1 10 10 10.02 25 15 12.53 35 10 11.74 40 5 10.05 42 2 8.46 42 0 7.0

Production Function (Sandwich Making)

Short-Run Technology Constraint

–The total product curve is similar to the PPF.

–It separates attainable output levels from unattainable output levels in the short run.

Typical Production Function

• Marginal and average product curves can be derived from total product curves.

• The marginal product of labour is the slope of the total product curve.

• Average product follows marginal product; it rises when marginal product is above it and falls when marginal product is below it.

Short-Run Cost

–To produce more output in the short run, the firm must employ more labour, which means that it must increase its costs. –We describe the way a firm’s costs change as total product changes by using three cost concepts and three types of cost curve:– Total cost– Marginal cost– Average cost

Short-Run Cost•Total Cost–A firm’s total cost (TC) is the cost of all resources used.–Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output.

–A fixed cost is any cost that a firm bears in the short run that does not depend on its level of output. These costs are incurred even if the firm is producing nothing. There are no fixed costs in the long run.

–Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do change with output.

–A variable cost is any cost that a firm bears that depends on the level of production chosen

Labor Output Total Total Total

(workers/D) fixed cost variable cost cost

TFC TVC TC

0 0 25 0 251 4 25 25 502 10 25 50 753 13 25 75

1004 15 25 100

1255 16 25 125

150

Total Costs

Short-Run Cost–Figure shows a firm’s total cost curves.–Total fixed cost is the same at each output level.–Total variable cost increases as output increases.

–Total cost, which is the sum of TFC and TVC, also increases as output increases.

Short-Run Cost• Marginal Cost

– Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total product (producing one more unit of output).– Marginal costs reflect changes in variable costs.

– In the short run, every firm is constrained by some fixed input that leads to diminishing returns to variable inputs and that limits its capacity to produce. As the firm approaches capacity, it becomes increasingly costly to produce more output. Marginal costs ultimately increase with output in the short run.

– Over the output range with increasing marginal returns, marginal cost falls as output increases.

– Over the output range with diminishing marginal returns, marginal cost rises as output increases.

Declining Marginal Product Implies That Marginal Cost Will Eventually Rise With Output

Short-Run Cost•Average Cost–Average cost measures can be derived from each of the total cost measures:

–Average fixed cost (AFC) is total fixed cost per unit of output.

–Average variable cost (AVC) is total variable cost per unit of output.

–Average total cost (ATC) is total cost per unit of output.

ATC = AFC + AVC

L Outp. Total Total Total Marginal Average Average Average

fixed C variable C C Cost fixed C variable C total C

TFC TVC TC MC AFC AVC ATC

0 0 25 0 251 4 25 25 50 6.25 6.25 6.25

12.52 10 25 50 75 4.17 2.50 5

7.53 13 25 75 100 8.33 1.92 5.77

7.694 15 25 100 125 12.50 1.67 6.67

8.335 16 25 125 150 25 1.56 7.81

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Total Costs; Marginal Cost; Average Costs

Short-Run Cost–The ATC curve is also U-shaped. –The MC curve is very special.–Where AVC is falling, MC is below AVC.–Where AVC is rising, MC is above AVC.–At the minimum AVC, MC equals AVC.

Short-Run Cost•Shifts in Cost Curves–The position of a firm’s cost curves depend on two factors:– Technology– Prices of productive resources

Long-Run Cost

•Long-Run Average Cost Curve–The long-run average cost curve is the relationship between the lowest attainable average total cost and output when both the plant size and labour are varied.

–The long-run average cost curve is a planning curve that tells the firm the plant size that minimizes the cost of producing a given output range.

–Once the firm has chosen that plant size, it incurs the costs that correspond to the ATC curve for that plant.

Long-Run Cost

Figure 10.8 illustrates the long-run average cost (LRAC) curve.

Long-Run Cost•Economies and Diseconomies of Scale–Economies of scale are features of a firm’s technology that lead to falling long-run average cost as output increases.–Diseconomies of scale are features of a firm’s technology that lead to rising long-run average cost as output increases.–Constant returns to scale are features of a firm’s technology that lead to constant long-run average cost as output increases.

Long-Run Cost

Figure 10.8 illustrates economies and diseconomies of scale.

Long-Run Cost–A firm experiences economies of scale up to some output level.

–Beyond that output level, it moves into constant returns to scale or diseconomies of scale.

–Minimum efficient scale is the smallest quantity of output at which the long-run average cost reaches its lowest level.

–If the long-run average cost curve is U-shaped, the minimum point identifies the minimum efficient scale output level.