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Chapter 7Chapter 7

Consumer Choice and Consumer Choice and ElasticityElasticity

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OverviewOverview

Fundamentals of consumer choice Fundamentals of consumer choice and diminishing marginal utilityand diminishing marginal utility

Consumer equilibriumConsumer equilibrium Income and substitution effectIncome and substitution effect The market demand curveThe market demand curve Price elasticity of demandPrice elasticity of demand Income elasticityIncome elasticity Price elasticity of supplyPrice elasticity of supply

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Fundamentals of Consumer ChoiceFundamentals of Consumer Choice

1.1. Limited income necessitates choiceLimited income necessitates choice

2.2. Consumers make decisions Consumers make decisions purposefullypurposefully

3.3. One good can be substituted for One good can be substituted for anotheranother

4.4. Consumers must make decisions Consumers must make decisions without perfect informationwithout perfect information

5.5. The law of diminishing marginal The law of diminishing marginal utility applies to consumptionutility applies to consumption

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Marginal UtilityMarginal Utility

Marginal UtilityMarginal Utility: The benefit derived : The benefit derived from consuming an additional unit of from consuming an additional unit of the goodthe good

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Law of diminishing marginal utilityLaw of diminishing marginal utility

Law of Diminishing Marginal Law of Diminishing Marginal UtilityUtility: as the consumption of a : as the consumption of a product increases, the marginal product increases, the marginal utility derived from additional utility derived from additional consumption will eventually declineconsumption will eventually decline

Banana Eating Contest Results:Banana Eating Contest Results:

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Marginal Benefit and the Demand Marginal Benefit and the Demand CurveCurve

Marginal Benefit = The maximum price Marginal Benefit = The maximum price a consumer will be willing to pay for a consumer will be willing to pay for an additional unit of the product (the an additional unit of the product (the height of the demand curve)height of the demand curve)

Marginal Benefit falls as you move Marginal Benefit falls as you move down the demand curvedown the demand curve

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Consumer EquilibriumConsumer Equilibrium

Consumers will maximize utility by Consumers will maximize utility by ensuring that the last dollar spent on ensuring that the last dollar spent on each commodity yields an equal each commodity yields an equal degree of marginal utility:degree of marginal utility:

MUMUAA / P / PA A = MU= MUBB / P / PB B = ………… MU= ………… MUNN / P / PNN

Ex. Beer and WingsEx. Beer and Wings

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Responding to Price ChangesResponding to Price Changes

People will buy more (less) of a good as the People will buy more (less) of a good as the price of the good decreases (increases) price of the good decreases (increases) for two reasons:for two reasons:

When the price of a good decreases:When the price of a good decreases:1. Substitution effect: The good has become 1. Substitution effect: The good has become

cheaper relative to other goodscheaper relative to other goods

2. Income effect: It is as if your real income 2. Income effect: It is as if your real income has increased.has increased.

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Opportunity Cost of TimeOpportunity Cost of Time

The cost of time is different for The cost of time is different for different individuals:different individuals:

Those who earn a higher wage will Those who earn a higher wage will face a higher time costface a higher time cost

Ex. Meet me in the clubEx. Meet me in the club

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The Market Demand CurveThe Market Demand Curve

The market demand curve is the The market demand curve is the horizontal sum of the individual horizontal sum of the individual demand curvesdemand curves

Ex. Mario and LuigiEx. Mario and Luigi

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Price Elasticity of DemandPrice Elasticity of Demand

Price elasticity of demand indicates how Price elasticity of demand indicates how responsive consumers are to a change in responsive consumers are to a change in the products price.the products price.

Price elasticity of demand = %∆QPrice elasticity of demand = %∆QDD / %∆P / %∆P

Always negative, so we use the absolute Always negative, so we use the absolute value (ignore the negative sign) value (ignore the negative sign)

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Price Elasticity of DemandPrice Elasticity of Demand

If price elasticity of demand is:If price elasticity of demand is:

> 1: elastic> 1: elastic

= 1: unitary elastic= 1: unitary elastic

< 1: inelastic< 1: inelastic

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Price Elasticity of DemandPrice Elasticity of Demand

Elasticity will decrease as you move Elasticity will decrease as you move down a straight line demand curve.down a straight line demand curve.

Percent change in quantity decreasesPercent change in quantity decreases

Percent change in price increasesPercent change in price increases

Ex. Movie rentalsEx. Movie rentals

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Determinants of Price Elasticity of Determinants of Price Elasticity of DemandDemand

1.1. The most important determinant of The most important determinant of the price elasticity of demand is the the price elasticity of demand is the availability of substitutes availability of substitutes

Good Substitutes = Higher ElasticityGood Substitutes = Higher Elasticity

The more narrowly defined the product The more narrowly defined the product is the more elastic it is (because it is the more elastic it is (because it has more good substitutes)has more good substitutes)

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Determinants of Price Elasticity of Determinants of Price Elasticity of DemandDemand

2.2. Products share of the consumers Products share of the consumers total budgettotal budget

The larger the share of the consumer’s The larger the share of the consumer’s budget, the higher the elasticitybudget, the higher the elasticity

Ex. Lighters and Insurance Ex. Lighters and Insurance

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Time and Price Elasticity of Time and Price Elasticity of DemandDemand

When the price of a product increases, When the price of a product increases, consumers will reduce their consumers will reduce their consumption by a larger amount in consumption by a larger amount in the long run than in the short runthe long run than in the short run

(Known as the Second Law of Demand)(Known as the Second Law of Demand)

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Elasticity and Total RevenueElasticity and Total Revenue

Total Revenue (Expenditures) = Price Total Revenue (Expenditures) = Price X QuantityX Quantity

However, as price increases, the However, as price increases, the quantity sold decreasesquantity sold decreases

So, how do you increase Total So, how do you increase Total Revenue….Revenue….

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Elasticity and Total RevenueElasticity and Total Revenue

It depends on elasticityIt depends on elasticity

1.1. InelasticInelastic: The price effect : The price effect dominatesdominates

2.2. ElasticElastic: The quantity effect : The quantity effect dominatesdominates

3.3. Unitary elasticUnitary elastic: the effects are the : the effects are the same (no change in total revenue)same (no change in total revenue)

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Income elasticityIncome elasticity

Income elasticity measures the Income elasticity measures the responsive-ness of the demand for a responsive-ness of the demand for a good to a change in income.good to a change in income.

Income elasticity = %∆Q / %∆IIncome elasticity = %∆Q / %∆I

In this case, the sign does matter….In this case, the sign does matter….

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Income elasticityIncome elasticity

Income elasticity determines the type of good:Income elasticity determines the type of good:

1. Normal good: positive income elasticity1. Normal good: positive income elasticity

A.A. Necessity: income elasticity is between 0 Necessity: income elasticity is between 0 and 1and 1

B.B. Luxury: income elasticity is greater than 1 Luxury: income elasticity is greater than 1

2. Inferior good: negative income elasticity 2. Inferior good: negative income elasticity

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Price Elasticity of SupplyPrice Elasticity of Supply

Price elasticity of supply measures how Price elasticity of supply measures how responsive suppliers are to a change responsive suppliers are to a change in pricein price

Price elasticity of supply = %∆QPrice elasticity of supply = %∆QSS / %∆P / %∆P

In this case, the sign is always positiveIn this case, the sign is always positive

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Price Elasticity of SupplyPrice Elasticity of Supply

Similar to the price elasticity of Similar to the price elasticity of demand, the price elasticity of supply demand, the price elasticity of supply will be greater in the long run.will be greater in the long run.

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ReviewReview

1.1. Know the fundamentals of consumer Know the fundamentals of consumer choice and understand the law of choice and understand the law of diminishing marginal utilitydiminishing marginal utility

2.2. Know the idea behind the consumer Know the idea behind the consumer equilibrium and how to get thereequilibrium and how to get there

3.3. Know why the law of demand holds: Know why the law of demand holds: the income and substitution effectthe income and substitution effect

4.4. Know how to get the market demand Know how to get the market demand curvecurve

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ReviewReview

5.5. Be able to calculate price elasticity of Be able to calculate price elasticity of demand (from scratch!) and know what demand (from scratch!) and know what values correspond with inelastic, elastic, values correspond with inelastic, elastic, and unitary elastic goodsand unitary elastic goods

6.6. Know how elasticity affects changes in Know how elasticity affects changes in total revenuetotal revenue

7.7. Be able to calculate income elasticity and Be able to calculate income elasticity and know what values correspond with know what values correspond with necessities, luxuries and inferior goodsnecessities, luxuries and inferior goods

8.8. Be able to calculate price elasticity of Be able to calculate price elasticity of supplysupply