Chapter 10

Real Income

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Assumptions:

1. All goods have utility 2. There is no saving 3. Marginal utility diminishes over time

Properties of Indifference Curve Analysis

1. Indifference Curves never cross 2. The further out an indifference curve lies (the further it is from the origin) the higher the level of utility 3. Indifference Curves are down sloping 4. Convex to the origin

Characteristics of utility

1. not the same as usefulness 2. subjective 3. difficult to quantify

When the price of a normal good increases, consumers will decrease their consumption of that good because the good has become relatively more expensive compared to other goods. The opposite is true of inferior goods. This effect is called the substitution effect.

Another result of a price increase is that the amount of goods and services that an individual can purchase falls because the price of one good has increased. This, in effect, reduces an individual's income. This phenomenon is called the income effect. An inferior good is a good for which demand increases when income decreases.

Utility Maximizing Rule

Consumer allocates his or her income so that the last dollar spent on each product yields the same amount of extra (marginal) utility.

Inferior Goods

Increase in price causes consumers' purchasing power to drop and increases consumption (and vice versa). P ↑ , m ↓ , Qd ↑ P ↓ , m ↑ , Qd ↓ * Real income and quantity demanded have an inverse relationship * Price and quantity demanded same direction

Normal Goods

Increase in price causes consumers' purchasing power to drop and reduces consumption (and vice versa). P ↑ , m ↓ , Qd ↓ P ↓ , m ↑ , Qd ↑ *Real income and quantity demanded are in sync, same direction

Giffen Good Example:

Irish potatoes: an inferior good that took up so much of an average person's income that when potato prices rose, purchasing power dropped and they had to eat more of all inferior goods (including potatoes!)

The income effect

The change in the quantity consumed of a good that results from a change in the consumer's purchasing power due to the change in the price of the good.

Law of Diminishing Marginal Utility

added satisfaction declines as a consumer acquires additional units of a given product

Diminishing marginal utility

each additional unit of a good adds less to utility than the previous unit

Giffen Good

hypothetical inferior good for which the income effect outweighs the substitution effect and the demand curve slopes upward.

Marginal Utility (MU)

the change in utility from consuming an additional unit the extra satisfaction a person obtains from consuming one more unit of a good or service

Marginal Rate of Substitution (MRS)

the rate at which a consumer is willing to substitute one good for another and still maintain the same level of satisfaction MRS = - delta y/ delta x

Total Utility

the total amount of satisfaction Total Utility = sum of marginal utility

Utility

value or satisfaction from consumption

negative marginal utility

when the consumption of an additional unit of a good or service makes a person worse off

diminishing marginal utility

when the consumption of an additional unit of a good or service provides the person with a smaller increase in satisfaction than previous units

Indifference Map

○ Series of indifference curves where each curve reflects different amounts of utility. ○ Each successive curve outward reflects a higher level of utility

Equilibrium at Tangency

○ The consumer's equilibrium position ○ Where the budget Line is tangent to the Indifference Curve ○ Utility is maximized when: MRS equals the ratio of the price of X to the price of Y MRS = Px/ Py

Indifference Curve Analysis

○Use rankings or order of preference for products ○Takes into account the consumer's budget ○A curve that defines the combinations of two goods that give a consumer the same level of satisfaction ○The consumer is indifferent as to which combination to purchase

compare apples and oranges

◘ How much extra utility (MU) will you get from spending your next dollar on apples? On oranges? ◘ Maximize the utility per dollar spent.

The substitution effect

◘ The change in the quantity consumed of that good as the consumer substitutes the good that has become relatively cheaper in place of the good that has become relatively more expensive. ◘ The impact that a change in a product's price has on its relative expensiveness and consequently on the quantity demanded.