Principles of Microeconomics – Mr. Lilly

Topic 4 Skills

1. Know the following facts about demand curves: that a market demand curve shows the amount of a commodity buyers would like to purchase at various prices; and that a demand curve summarizes the preferences and choices of consumers, but contains no information about producers. Know that the starting point in our analysis of consumer behavior is an assumption that consumers act rationally; and more specifically, that they seek to maximize their total utility subject to a budget constraint; and that we further assume that their satisfaction, or utility, is a positive function of the amounts of goods and services they consume, and is not affected by anything else, including but not limited to the amounts of goods and services other people consume, their sense of being needed or valued by others, or the quality of their relationships with others.

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2. Know the five things that must be assumed to be constant in order to draw a demand curve, and understand why we could not draw a demand curve if any one of the five was not constant. Given a description of a change in any one of the five things, be able to say whether demand would increase or decrease.

Demand Curve Assumptions

•Length of period is finite and known to all parties.

•Consumer tastes do not change during the period.

•Income levels of consumers do not change during the period.

•Number of consumers in the market does not change during the period.

The prices and types of all other commodities (but especially substitutes) do not change during the period.

An increase or decrease in the quantity demanded can only occur (is only defined) if all five of the things held constant by the assumptions remain constant.

I will never ask you to evaluate a simultaneous change in one of the assumptions and in the price of the good. First the assumption will change, then the price of the good will change

(Slide 2) A demand curve predicts just one component of consumers’ behavior: it predicts how many bicycles they will buy in the bicycle market. The independent variable in this model is the price of bicycles. The dependent variable in this model is the number of bicycles demanded.

3. Know that a movement along a demand curve is referred to as an “increase (or decrease) in the quantity demanded” and that a shift in the demand curve is called an “increase (or decrease) in demand.” Know that an “increase in the quantity demanded” can only occur in response to a change in the price of the item, so that if anything else changes and that change has an impact on the demand for this product, we can conclude that we are witnessing an “increase (or decrease) in demand,” not an “increase (or decrease) in the quantity demanded.” Know that when we say “demand increased,” it means that consumers in aggregate are willing to buy more of the product at every price. Know that if the demand curve shifts to the right (or up,) we say “demand increased” and that if the demand curve shifts to the left (or down,) we say “demand decreased.”

About Demand Curves

•A movement along the demand curve is called an “increase (or decrease) in the quantity demanded.”

•If any of the things held constant by the assumptions changes, the demand curve will shift.

•If the demand curve shifts to the right, we say “demand increased.”

•If the demand curve shifts to the left, we say “demand decreased.”

Remember: An decrease in the price of bicycles DOES NOT CAUSE AN INCREASE IN THE DEMAND FOR BICYCLES. It causes an increase in the quantity demanded.

4. Know that utility is not easily measured or compared between people, but that economists can still use consumer theory to draw many interesting conclusions about the benefits of market systems; all that is needed is that each individual consumer know their own preferences and be able to identify which bundles of goods give them the most satisfaction. Know the definition of marginal utility. Know the law of diminishing marginal utility, which says that for most goods, the additional utility derived from consuming one more unit of a good (per time period) will tend to diminish as the quantity of that good already being consumed increases. Know that another way of describing this phenomenon is to say “for most goods, total utility increases - but at a decreasing rate - as the level of consumption increases.” Given a table of the consumer’s total utility at various levels of consumption for a single good, and given the consumer’s current level of consumption, be able to determine the consumer’s total utility and marginal utility.

(Slide 12) the marginal benefit from consuming X decreases as we get to higher and higher quantities of X. This phenomenon is called the LAW OF DIMINISHING MARGINAL UTILITY.

(Slide 13) The Law of Diminishing Marginal Utility

“The additional utility derived from consuming one more unit of a good (per time period) will tend to diminish as the quantity of that good already being consumed per time period increases.”

5. Given a table showing the consumer’s total level of utility as a function of the levels of consumption of two products (see figure 5.3 as an example,) be able to determine the following: which combination of goods yields the highest utility; which combinations of goods are preferred to any specified combination of goods; and what the marginal utility of consuming one more unit of a good is given any combination of goods as the starting point. Know what the term “utility maximization” means. Know that when a consumer is utility maximizing subject to a budget constraint in the two-good case, that if the price of one of the goods increases, the consumer will generally choose to consume less of that good. Thus, we gain some insight into why individual demand curves slope downward by studying utility maximization in the two-good case. (See the discussion on pages 109-113 of the textbook for a refresher.)

(109) utility maximization = an assumption that people try to achieve the highest level of utility given their budget constraint.

6. Know what a budget constraint is (definition,) and what is held constant as you move along it. Know that a budget constraint contains no information about a consumer’s preferences. Given the prices of two commodities and a consumer’s total budget constraint, be able to identify affordable and unaffordable bundles of those two goods. Know what effect an increase or decrease in a consumer’s income will have on the budget constraint.

(108) budget constraint = an income limitation on a person’s expenditure on goods and services.

7. Understand the term marginal benefit. Know that it is defined as the consumer’s marginal willingness to pay to consume one more unit, and is obtained by imagining that we ask the consumer “how much would you be willing to pay to consume one more unit of x, given your income and your current level of consumption of x and y,” and that we have to assume the consumer responds truthfully. Understand that although marginal benefit shares many characteristics in common with marginal utility, it is not quite the same thing. For example, like marginal utility, marginal benefit is believed to decline with increasing levels of consumption for virtually all goods; but marginal benefit is measured in dollars and is thus comparable from one person to the next, while marginal utility is measured in utils and therefore is not comparable from one person to the next. Also know that, unlike marginal utility, a person’s marginal benefit will be affected by their income. A rich person and a poor person might experience the same amount of marginal utility from one more game of bowling, but the rich person’s marginal benefit will be much higher.

(114) marginal benefit = the increase in the benefit from, or the willingness to pay for, one more unit of a good.

8. Understand that the individual demand curve can be interpreted (in its vertical interpretation) to provide the consumer’s marginal benefit (or marginal willingness to pay) at various levels of consumption. (See the derivation of the individual demand curve on pages 114-116.) Know that basically all that is needed to go from a stair step individual demand curve such as that shown in figure 5.6 to a smooth demand curve such as that shown in figure 5.7 is an assumption that fractional quantities (tenths, hundredths, etc.) of the commodity can be consumed. Know that utility maximization requires or implies that a consumer will consume each good up to the point that marginal benefit of the next unit falls below the price, since for all consumption levels below that point, consuming one more unit of the good (per unit time) would increase the consumer’s total welfare. This leads to the price equals marginal benefit rule: The consumer will expand the consumption of each and every good to the point at which price equals marginal benefit for that good. Know what Adam Smith’s diamond-water paradox is and how the price equals marginal benefit rule can be used to explain this paradox.

(117) Diamond-water paradox = The price of diamonds will be high if the marginal benefit of diamond is high(total benefit low). The price of water will be low if the marginal benefit of water is low(total benefit high).

9. Know that the market demand curve is derived graphically by adding the quantity demanded by all individuals in the market at each specified price – a procedure known as “horizontal summation.” Understand what vertical summation would be and why that would NOT give you a valid market demand curve. Understand the horizontal and vertical interpretations of the market demand curve. (Lecture only.)

Two Ways to Interpret the Market Demand Curve

•Horizontal interpretation: If the price is X, the aggregate quantity demanded will be Y.

•Vertical interpretation: If the quantity currently being consumed is X, all consumers (currently consuming non-zero quantities) will be willing to pay a price of $Y per pound to fractionally increase their consumption of this product.

10. Know what consumer surplus is. Given a graph of a demand curve and a price line, be able to identify the portion of the diagram the area of which provides a measure of consumer surplus. (See figures 5.9 and 5.10.) Given a consumer≈s willingness to pay for each unit of a given commodity and given the price of that commodity, be able to calculate the consumer≈s consumer surplus.

(119) consumer surplus = the difference between what a person is willing to pay for an additional unit of a good 愺 the marginal benefit 愺 and the market price of the good; for the market as a whole, it is the sum of all the individual consumer surpluses, or the area below the market demand curve and above the market price.

11. Know what a budget line is. Know what is held constant as we move along a given budget line. Given the total income or budget of a consumer and the prices of two commodities, be able to draw the consumer≈s budget line. Know what effect an increase or decrease in a consumer≈s income will have on the budget line. Be able to show that effect graphically. Know what effect an increase or decrease in the price of either of the two goods will have on the budget constraint. Be able to show that effect graphically. Given the prices of two goods, P_A and P_B, be able to express the slope of the budget line as a function of these two variables.

(Slide 21) Budget Line for a Consumer

Slope= -Px/Py (price of x/ price of y, in this case, =-2/4)

12. Know what an indifference curve is. Know what remains constant as you move along an indifference curve. Know that indifference curves do not contain any information about the prices or affordability of various bundles of goods. Be able to recognize from a graph of two or more indifference curves which indifference curves represent higher levels of utility. Given a graph of a set of indifference curves and a budget line, be able to identify the point that represents the utility maximizing combination of goods. Know that such a point is always found where the budget line is tangent to one of the indifference curves, and be able to explain why this is so. Know that at such a point, the slope of the budget line will be equal to the slope of the indifference curve.

(125-126) indifference curve = consumer is indifferent among all points on the curve. The indifference curve slopes downward from left to right.

(127) tangent point = the highest level of utility the consumer can achieve subject to the budget constraint.

13. Know what the ¨income effect慍 and the ¨substitution effect慍 mean. Given a graph such as the one shown in figure 5A.9 on page 128 of the Taylor text, be able to identify the income effect and the substitution effect of an increase or decrease in the price of X on the quantity of X consumed. Know that the income effect and the substitution effect explain the two reasons why individual demand curves for the vast majority of products are downward-sloping. Understand the apparent paradox that, even though the income of the consumer(s) is assumed to be held constant when a demand curve is drawn, that both the income effect and the substitution effect of a price change contribute to the downward slope of the demand curve.

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We draw the indifference curves with this kind of curvature whenever we believe that the law of diminishing marginal utility holds for both goods 愺 which is 99%+ of the time as we mentioned earlier. As the consumer moves toward a zero amount of good Y and a high amount of good X (point B and the unmarked point,) we believe that they would require ever-increasing amounts of good X to compensate them for the loss of one additional unit of good Y.

(116) individual demand curve = a curve showing the relationship between quantity demanded of a good by an individual and the price of the good.

(118) market demand curve = the horizontal summation of all the individual demand curves for a good; also simply called the demand curve.

price of the good; for the market as a whole, it is the sum of all the individual consumer surpluses, or the area below the market demand curve and above the market price.

(Slide 30)I said there are two reasons a person will buy less of a good when itˇs prices rises:

1. Because their money can be better spent on other things, and

2. Because it impoverishes them somewhat.