Appendix: Chapter 6 Delving Deeper Into Microeconomics McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning Objectives Explain the role of utility maximization in consumer choice and use the concept of price elasticity. Explain the role of cost minimization in producer decisions and use the concept of price elasticity of supply Explain the incidence of a tax. 6A-2

Consumer Choice The underlying explanation of the demand curve is based on the utility function. The utility function also tells us how much benefit a person gets from purchasing and consuming more of the same thing. Marginal utility is the added utility from consuming one more unit of a good. Diminishing marginal utility is the concept that marginal utility declines as consumption increases. 6A-3

The Utility Function of a Coffee Drinker Cups of Coffee in a Day Utility (Measured in Utils) Marginal Utility (Measured in Utils) A-4

Budget Constraint The utility function is not the only factor that determines what you buy and how much. Budget constraint is the combination of goods and services you are able to buy, given their prices and the amount of money you have available to spend. The budget constraint changes when prices and/or income changes. 6A-5

Example of Budget Constraint # of meals eaten out in month # of movies seen in month Price per meal Price per movie Cost of meals Cost of movies Total spending 30$20$10$60$0$60 22$20$10$40$20$60 14$20$10$20$40$60 06$20$10$0$60 6A-6

Utility Maximization The rational individual will select goods and services to maximize utility when subject to a budget constraint. Due to diminishing marginal utility, you are more likely to choose a combination of goods and services rather than one good. As a consumer, you are weighing the marginal utility of spending an extra dollar on one good or service versus another. 6A-7

Utility Maximization Consumers often make decisions that affect their spending decisions in the future. This kind of choice is called intertemporal utility maximization. –That is, decisions which involve a trade-off between consumption today and consumption in the future. –For example, a decision to cut back spending today to save for a home tomorrow. 6A-8

Price Elasticity of Demand A utility-maximizing consumer will change his or her purchases when prices change. The price elasticity of demand will determine how much the purchases will change. The price elasticity of demand is the percentage change in quantity demanded that results from a one percent change in price. –A price elasticity of 1 means that a 10% increase in price leads to a 10% decrease in quantity demanded. 6A-9

Price Elasticity of Demand –An elasticity of 2 means that a 10% increase in price leads to a 20% decrease in quantity demanded. –An elasticity of 0.5 means that a 10% increase in prices leads to a 5% decrease in quantity demanded. Demand for a good or service is inelastic if its price elasticity is less than 1, and it is elastic if its price elasticity is greater than 1. 6A-10

Price Elasticity of Gasoline Price (Dollars per Gallon) Annual Quantity of Gasoline Demanded (Gallons) Before: $ After: $ Percentage change: ( )/ 3.00 = 10% Percentage change: ( ) / 800 = -2.5% Elasticity: (-2.5% / 10%) = A-11

An Inelastic Demand Curve for Gasoline Demand curve 780 $3.00 Price per gallon 800 Annual quantity of gasoline bought (gallons) $3.30 6A-12

An Elastic Demand Curve for Gasoline Demand curve 640 $3.00 Price per gallon 800 Annual quantity of gasoline bought (gallons) $3.30 6A-13

Producer Decisions Now we shift our analysis to the supply or production side of the economy. The cost function gives the cost of producing each level of output. Managers attempt to find the least expensive way of producing a given level of output. –This process is called cost minimization. 6A-14

Choosing the Right Inputs The producer’s choice of inputs depends on their relative prices. As an input becomes more expensive, all other things being equal, a business will want to use less of it. If the cost of labor rises, a business will attempt to use more capital and automate the production process. 6A-15

Substitutes and Complements Two inputs are substitutes if raising the price of one increases the quantity demanded for the other (holding output constant). –For example, factory workers in China are a substitute for factory workers in the U.S. Two inputs are complements if raising the price of one decreases the quantity demanded of the other (holding output constant). –Cement and construction workers are an example. 6A-16

Cost Minimization Example Let’s look at the example of a small business. Suppose it must decide whether to buy its own copier or send out to a copy shop such as Kinko’s. –If the business buys a copier, it needs to lay out the upfront cost, as well as the costs for toner and paper. –To make a decision, it needs to know the actual cost of the machine and the price of a copy. –The decision also depends on the scale of output. 6A-17

Copier Decision 6A-18

Price Elasticity of Supply The price elasticity of supply is the percentage increase in the quantity supplied, given a 1% increase in the price. Supply is elastic if a small change in price leads to a large change in the quantity supplied. Similarly, supply is inelastic if a big change in price leads to only a small change in the quantity supplied. 6A-19

Price Elasticity of Supply An Elastic SupplyAn Inelastic Supply 6A-20

Tax Incidence The incidence or burden of a tax identifies the persons or businesses who ultimately have to pay a tax. The burden of the tax depends on the elasticity of supply and demand. The following slide shows the effect of taxing a market where demand is inelastic and supply is elastic. 6A-21

Taxation with Inelastic Demand and Elastic Supply Inelastic demand curve Original quantity Original price Price After-tax quantity Quantity Elastic supply curve After-tax price for buyer After-tax price for seller Tax 6A-22