Chapter 21 – Consumer Theory and Utility Maximization The Income Effect A. A change in price affects consumers’ real income. B. This change in real income affects the consumer’s ability to buy all sorts of products, not just the one for which the price changed. C. Demand for all normal goods will increase when the price of any other good goes down (and vice versa). D. Demand for inferior goods will increase when the price of any other good goes up (and vice versa).

Chapter 21 – Consumer Theory and Utility Maximization II. The Substitution Effect A. A change in price makes a good relatively more expensive or less expensive than other goods. B. If price goes up, consumers will switch purchases to other goods. C. If price goes down, consumers will switch from other goods and buy more of the good. D. The substitution effect and the income effect combine when prices change to affect consumer behavior. E. *Quirky weirdness about inferior goods.

The Law of Diminishing Marginal Utility As a consumer consumes more of a good, the satisfaction he or she gets from each additional unit decreases. The more of a good you consume, the less you will want the next unit.

The Income Effect, the Substitution Effect, and the Law of Diminishing Marginal Utility all explain why the demand curve slopes downward.

The Law of Diminishing Marginal Utility Total Utility: the total satisfaction you get from consuming a specific quantity of a good (e.g. 5 cheeseburgers). Marginal Utility: the amount of satisfaction you get from consuming one additional unit (the next cheeseburger). See the graphs on the next slide. This relationship between total utility and marginal utility is key for the rest of the course.

The Utility-Maximizing Rule I. To maximize satisfaction, a consumer should spend his money so that the last dollar spent on each good provides the same amount of marginal utility.

Cal Cool has $250 to spend on cell phones and sunglasses Cal Cool has $250 to spend on cell phones and sunglasses. The table below presents the utility from cell phones and sunglasses that Cal gets from quantities of each. Cell Phones Sunglasses Calculate Cal’s marginal utility for cell phones. Calculate Cal’s marginal utility for sunglasses.

Cal Cool has $250 to spend on cell phones and sunglasses Cal Cool has $250 to spend on cell phones and sunglasses. The table below presents the utility from cell phones and sunglasses that Cal gets from quantities of each. Cell Phones Sunglasses Calculate Cal’s marginal utility for cell phones. Calculate Cal’s marginal utility for sunglasses.

Cal Cool has $250 to spend on cell phones and sunglasses Cal Cool has $250 to spend on cell phones and sunglasses. The table below presents the utility from cell phones and sunglasses that Cal gets from quantities of each. Cell Phones Sunglasses The price of cell phones is $100 and a pair of sunglasses is $50. Determine the consumption bundle of cell phones and sunglasses that maximizes Cal’s utility.

Cal Cool has $250 to spend on cell phones and sunglasses Cal Cool has $250 to spend on cell phones and sunglasses. The table below presents the utility from cell phones and sunglasses that Cal gets from quantities of each. Cell Phones Sunglasses The price of cell phones is $100 and a pair of sunglasses is $50. Determine the consumption bundle of cell phones and sunglasses that maximizes Cal’s utility.

Homework Read Chapter 21, p. 372- 379. Do Study Question #5.

Marginal Utility per Dollar Snacks (Price = $4) Drinks (Price = $2) Quantity Total Utility Marginal Utility Marginal Utility per Dollar 1 15 12 2 25 21 3 31 29 4 34 36 5 42   6 47 7 50 8 52 $20 to spend.

Marginal Utility per Dollar Snacks (Price = $4) Drinks (Price = $2) Quantity Total Utility Marginal Utility Marginal Utility per Dollar 1 15  15 12  12 2 25 10  21  9 3 31  6 29  8 4 34  3 36  7 5 2  42   6 47  5 7 50 8 52  2 $20 to spend.

Marginal Utility per Dollar Snacks (Price = $4) Drinks (Price = $2) Quantity Total Utility Marginal Utility Marginal Utility per Dollar 1 15  15 3.75 12  12  6 2 25 10  2.5 21  9  4.5 3 31 1.5 29  8  4 4 34  3 .75 36  7  3.5 5 2  .5 42   6 47  5  2.5 7 50  1.5 8 52  2  1 $20 to spend.

Marginal Utility per Dollar Snacks (Price = $4) Drinks (Price = $2) Quantity Total Utility Marginal Utility Marginal Utility per Dollar 1 15  15 3.75 12  12  6 2 25 10  2.5 21  9  4.5 3 31 1.5 29  8  4 4 34  3 .75 36  7  3.5 5 2  .5 42   6 47  5  2.5 7 50  1.5 8 52  2  1 $20 to spend.

Chicken Wings cost $2 Doughnuts cost $1 $10 to spend. Quantity of Chicken Wings Marginal Utility of Chicken Wings Units of Doughnuts Marginal Utility of Doughnuts 1 10 4 2 9 3.5 3 8 7 2.5 5 6 1.5 4.5 .5 Chicken Wings cost $2 Doughnuts cost $1 $10 to spend.

Chicken Wings cost $2 Doughnuts cost $1 $10 to spend. Quantity of Chicken Wings Marginal Utility of Chicken Wings Quantity of Doughnuts Marginal Utility of Doughnuts 1 10 4 2 9 3.5 3 8 7 2.5 5 6 1.5 4.5 .5 Chicken Wings cost $2 Doughnuts cost $1 $10 to spend.

Excise Taxes Here’s what you need to know: What will the new equilibrium price and quantity be? How much of the tax will consumers and producers each pay? What will be the price buyers are actually paying? What will be the price sellers are actually getting? How much tax revenue will be collected? How much will deadweight loss be? What happens to consumer and producer surplus?

What’s Left – your questions? Anyone have any questions from this FRQ? FRQ - Movie Tickets