1 Chapter 7 Consumer Choice and Elasticity

2 Overview  Fundamentals of consumer choice and diminishing marginal utility  Consumer equilibrium  Income and substitution effect  The market demand curve  Price elasticity of demand  Income elasticity  Price elasticity of supply

3 Fundamentals of Consumer Choice 1. Limited income necessitates choice 2. Consumers make decisions purposefully 3. One good can be substituted for another 4. Consumers must make decisions without perfect information 5. The law of diminishing marginal utility applies to consumption

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

5 Law of diminishing marginal utility Law of Diminishing Marginal Utility: as the consumption of a product increases, the marginal utility derived from additional consumption will eventually decline Banana Eating Contest Results:

6 Marginal Benefit and the Demand Curve Marginal Benefit = The maximum price a consumer will be willing to pay for an additional unit of the product (the height of the demand curve) Marginal Benefit falls as you move down the demand curve

7 Consumer Equilibrium Consumers will maximize utility by ensuring that the last dollar spent on each commodity yields an equal degree of marginal utility: MU A / P A = MU B / P B = ………… MU N / P N Ex. Beer and Wings

8 Responding to Price Changes People will buy more (less) of a good as the price of the good decreases (increases) for two reasons: When the price of a good decreases: 1. Substitution effect: The good has become cheaper relative to other goods 2. Income effect: It is as if your real income has increased.

9 Opportunity Cost of Time The cost of time is different for different individuals: Those who earn a higher wage will face a higher time cost Ex. Meet me in the club

10 The Market Demand Curve The market demand curve is the horizontal sum of the individual demand curves Ex. Mario and Luigi

11 Price Elasticity of Demand Price elasticity of demand indicates how responsive consumers are to a change in the products price. Price elasticity of demand = %∆Q D / %∆P Always negative, so we use the absolute value (ignore the negative sign)

12 Price Elasticity of Demand If price elasticity of demand is: > 1: elastic > 1: elastic = 1: unitary elastic = 1: unitary elastic < 1: inelastic < 1: inelastic

13 Price Elasticity of Demand Elasticity will decrease as you move down a straight line demand curve. Percent change in quantity decreases Percent change in price increases Ex. Movie rentals

14 Determinants of Price Elasticity of Demand 1. The most important determinant of the price elasticity of demand is the availability of substitutes Good Substitutes = Higher Elasticity The more narrowly defined the product is the more elastic it is (because it has more good substitutes)

15 Determinants of Price Elasticity of Demand 2. Products share of the consumers total budget The larger the share of the consumer’s budget, the higher the elasticity Ex. Lighters and Insurance

16 Time and Price Elasticity of Demand When the price of a product increases, consumers will reduce their consumption by a larger amount in the long run than in the short run (Known as the Second Law of Demand)

17 Elasticity and Total Revenue Total Revenue (Expenditures) = Price X Quantity However, as price increases, the quantity sold decreases So, how do you increase Total Revenue….

18 Elasticity and Total Revenue It depends on elasticity 1. Inelastic: The price effect dominates 2. Elastic: The quantity effect dominates 3. Unitary elastic: the effects are the same (no change in total revenue)

19 Income elasticity Income elasticity measures the responsive- ness of the demand for a good to a change in income. Income elasticity = %∆Q / %∆I In this case, the sign does matter….

20 Income elasticity Income elasticity determines the type of good: 1. Normal good: positive income elasticity A. Necessity: income elasticity is between 0 and 1 B. Luxury: income elasticity is greater than 1 2. Inferior good: negative income elasticity

21 Price Elasticity of Supply Price elasticity of supply measures how responsive suppliers are to a change in price Price elasticity of supply = %∆Q S / %∆P In this case, the sign is always positive

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

23 Review 1. Know the fundamentals of consumer choice and understand the law of diminishing marginal utility 2. Know the idea behind the consumer equilibrium and how to get there 3. Know why the law of demand holds: the income and substitution effect 4. Know how to get the market demand curve

24 Review 5. Be able to calculate price elasticity of demand (from scratch!) and know what values correspond with inelastic, elastic, and unitary elastic goods 6. Know how elasticity affects changes in total revenue 7. Be able to calculate income elasticity and know what values correspond with necessities, luxuries and inferior goods 8. Be able to calculate price elasticity of supply