Econ 102 Ch. 4.3-4.5 & 20

a two-good consumer optimum

*Consumer optimum is attained when the marginal utility of the last dollar spent on each good yields the same utility and income is completely exhausted*. In the situation in Table 20-1, the individual's income is $26. From columns 4 and 8 of Table 20-1, equal marginal utilities per dollar spent occur at the consumption level of four digital apps and two portable power banks (the marginal utility per dollar spent equals 7.3). Notice that the marginal utility per dollar spent for both goods is also (approximately) equal at the consumption level of three apps and one portable power bank, but here total income is not completely exhausted. Likewise, the marginal utility per dollar spent is (approximately) equal at five apps and three portable power banks, but the expenditures necessary for that level of consumption ($34) exceed the individual's income.

fig. 20-1

*Marginal utility is the difference between total utility derived from one level of consumption and total utility derived from another level of consumption within a given time interval*. when composing the graph involving marginal utility on the vertical axis, pair up the # of dig. apps downloaded per week with the outcome # of marginal utility ex. -> 4-5, marg. utility = 0 (*total utility hits its maximum here*) If we were able to assign specific values to the utility derived from downloading and utilizing digital apps each week, we could obtain a marginal utility schedule similar in pattern to the one shown in panel (a). In column 1 is the number of apps downloaded and used per week. Column 2 is the total utility derived from each quantity. Column 3 shows the marginal utility derived from each additional quantity, which is defined as the change in total utility due to a change of one unit of using downloaded apps per week. Total utility from panel (a) is plotted in panel (b). Marginal utility is plotted in panel (c), where you see that it reaches zero where total utility hits its maximum at between 4 and 5 units. In our example, when a person has already downloaded and utilized two digital apps in one week and then downloads and uses another, total utility increases from 16 utils to 19 utils. Therefore, the marginal utility (of downloading and utilizing one more app after already having downloaded and used two in one week) is equal to 3 utils.

rationing by random assignment or coupons

*Random assignment* is another way to ration goods. You may have been involved in a rationing-by-random-assignment scheme in college if you were assigned a housing unit. Sometimes rationing by random assignment is used to fill slots in popular classes. *Rationing by coupons* has also been used, particularly during wartime. In the United States during World War II, families were allotted coupons that allowed them to purchase specified quantities of rationed goods, such as meat and gasoline. To purchase such goods, they had to pay a specified price and give up a coupon.

price ceilings

*The rationing function of prices is prevented when governments impose price controls*. Price controls often involve setting a price ceiling Occasionally, a government will set a price floor—a minimum price below which a good or service may not be sold.

consumer optimum

A choice of a set of goods and services that maximizes the level of satisfaction for each consumer, subject to limited income

an example of a price change

A hypothetical demand curve for digital apps for a typical consumer during a specific time interval is presented in Figure 20-2. Suppose that at point A, at which the price per digital app is $5, the marginal utility of the last app consumed during the period is MUA. At point B, at which the price is $4 per app, the marginal utility is represented by MUB. When consumers respond to a reduction in the price of digital apps from $5 per app to $4 per app by increasing consumption, marginal utility falls. The movement is from point A, at which marginal utility is MUA, to point B, at which marginal utility is MUB, which is less than MUA. This brings about the equalization of the marginal utility per dollar spent across all purchases. (pg. 445)

import quota

A physical supply restriction on imports of a particular good, such as sugar. Foreign exporters are unable to sell in the United States more than the quantity specified in the import quota. (in a one year period) The United States has had import quotas on tobacco, sugar, and immigrant labor. For many years, there were import quotas on oil coming into the United States. There are also "voluntary" import quotas on certain goods. For instance, since the mid-2000s, the Chinese government has agreed to "voluntarily" restrict the amount of textile products China sends to the United States and the European Union.

minimum wage

A wage floor, legislated by government, setting the lowest hourly rate that firms may legally pay workers. Proponents favor higher minimum wages to ensure low-income workers a "decent" standard of living. Opponents counter that higher minimum wages cause increased unemployment, particularly among unskilled minority teenagers. Many states and cities have their own minimum wage laws that exceed the federal minimum. A number of municipalities refer to their minimum wage rules as "living wage" laws. Governments of these municipalities seek to set minimum wages consistent with living standards they deem to be socially acceptable—that is, overall wage income judged to be sufficient to purchase basic items such as housing and food.

does behavior economics better predict consumer choices?

Advocates of behavioral economics question whether utility theory is supported by the facts, which they argue are better explained by applying the assumption of bounded rationality. - Recall that this assumption states that human limitations prevent people from examining every possible choice available to them and thereby thwart their efforts to effectively pursue long-term personal interests. As evidence favoring the bounded rationality assumption, proponents of behavioral economics point to real-world examples that they claim violate rationality-based utility theory. For instance, economists have found that when purchasing electric appliances such as refrigerators, people sometimes buy the lowest-priced, energy-inefficient models even though the initial purchase-price savings often fail to compensate for higher future energy costs These and other observed behaviors, behavioral economists suggest, indicate that consumers do not behave as if they are rational. If the rationality assumption does not apply to actual behavior, they argue, it follows that utility-based consumer choice theory cannot, either. (pg.449)

who benefits from agricultural price supports?

Although agricultural price supports have traditionally been promoted as a way to guarantee "decent" earnings for low-income farmers, most of the benefits have in fact gone to the owners of very large farms. Price-support payments are made on a per-pound basis, not on a per-farm basis. Thus, traditionally, the larger the farm, the bigger the benefit from agricultural price supports. In addition, all of the benefits from price supports ultimately accrue to landowners on whose land price-supported crops grow.

price ceilings and black markets

As long as a price ceiling is below the market clearing price, imposing a price ceiling creates a shortage, as can be seen in Figure 4-3. At any price below the market clearing, or equilibrium, price of $1,000, there will always be a larger quantity demanded than quantity supplied—a shortage —*there is a tendency for the price to rise to its equilibrium level* --- But with a price ceiling, this tendency cannot be fully realized because everyone is forbidden to trade at the equilibrium price. The demand curve is D. The supply curve is S. The equilibrium price is $1,000. The government, however, steps in and imposes a maximum price of $600. At that lower price, the quantity demanded will be 15,000, but the quantity supplied will be only 5,000. There is a "shortage." The implicit price (including time costs) tends to increase to $1,400. If black markets arise, as they generally will, the equilibrium black market price will end up somewhere between $600 and $1,400. The actual quantity transacted will be between 5,000 and 10,000.

keeping price supports alive under a new name

Back in the early 1990s, Congress indicated an intention to phase out most agricultural subsidies by the early 2000s. Nevertheless, the federal government and several state governments have continued to support prices of a number of agricultural products, such as peanuts, through "marketing loan" programs. These programs advance funds to farmers to help them finance the storage of some or all of their crops. The farmers can then use the stored produce as collateral for borrowing or sell it to the government and use the proceeds to repay debts. Marketing loan programs raise the effective price that farmers receive for their crops and commit federal and state governments to purchasing surplus production. Consequently, they lead to outcomes similar to those of traditional price-support programs.

utility-related issue ex.

Companies now sell devices that the media have called stomach pacemakers. Physicians implant these devices near an abdominal nerve. The devices emit high-frequency electrical pulses that block electrical signals from the nerve to the brain—signals that the brain otherwise would interpret as messages to try to derive more satisfaction from consumption of additional food. - Two utility-related issues are associated with stomach pacemakers. The first involves the essential purpose of such devices. The second relates to whether purchasing such devices falls within a typical consumer optimum. - Because stomach pacemakers interfere with nerve signals to the brain that alter added satisfaction from the consumption of more food, the devices reduce the additional utility that a person derives from each additional bite. *The idea behind implanting a stomach pacemaker, therefore, is to speed the rate at which marginal utility from food consumption diminishes* Naturally, if marginal utility drops by a larger amount with each additional amount of food consumed, the point at which a person derives smaller utility gains from eating more bites is reached more rapidly. This fact can assist an individual in attaining an objective of reduced food intake and, hence, in achieving a goal of maintaining a lower body weight. Achievement of this broader goal could provide a significant overall utility gain, particularly for an individual with health issues caused by being overweight. An individual is unlikely to purchase a stomach pacemaker unless doing so generates a substantial gain in total utility. The reason is that the overall price of implanting a stomach pacemaker is about $30,000. Recall that at a *consumer optimum*, the marginal utility per dollar spent is equalized across all items purchased. An individual will opt to have a stomach pacemaker implanted alongside other forms of consumption only if this condition for a consumer optimum is satisfied. Because the price of a stomach-pacemaker implant is so high, the marginal utility from an implant would have to be sufficiently high to ensure equalization of the marginal utility per dollar spent on that device and items such as housing and entertainment. - thus, only people who would derive considerable overall utility gains—such as those with health issues that losing weight would alleviate—from the implantation of stomach pacemakers are likely to include such a device within a consumer optimum.

a two-good example - consumer optimum ex.

Consider a simple two-good example that appears in Table 20-1. During a given period, a consumer's income is $26. The consumer has to choose between spending income on downloads of digital apps at $5 per app and on purchasing portable power banks at $3 each. Let's say that when the consumer has spent all income on digital apps and portable power banks, the last dollar spent on a portable power bank yields 3 utils of utility but the last dollar spent on apps yields 10 utils. Wouldn't this consumer increase total utility if fewer dollars were spent on portable power banks and allocated to apps? The answer is yes. More dollars spent downloading apps will reduce marginal utility per last dollar spent, whereas fewer dollars spent on the consumption of portable power banks will increase marginal utility per last dollar spent. *The loss in utility from spending fewer dollars purchasing fewer portable power banks is more than made up by spending additional dollars on more digital apps. As a consequence, total utility increases* The consumer optimum—where total utility is maximized—occurs when the satisfaction per last dollar spent on both portable power banks and digital apps per week is equal for the two goods. *Thus, the amount of goods consumed depends on the prices of the goods, the income of the consumer, and the marginal utility derived from the amounts of each good consumed*. presents information on utility derived from consuming various quantities of digital apps and portable power banks. Columns 4 and 8 show the marginal utility per dollar spent on apps and portable power banks, respectively. If the prices of both goods are zero, individuals will consume each as long as their respective marginal utility is positive (at least five units of each and probably much more). It is also true that a consumer with unlimited income will continue consuming goods until the marginal utility of each is equal to zero. When the price is zero or the consumer's income is unlimited, there is no effective constraint on consumption.

rationing by waiting

Consider first come, first served as a rationing device. We call this rationing by queues, where queue means "line." Whoever is willing to wait in line the longest obtains the good that is being sold at less than the market clearing price. All who wait in line are paying a higher total outlay than the money price paid for the good. Personal time has an opportunity cost. *To calculate the total outlay expended on the good, we must add up the money price plus the opportunity cost of the time spent waiting* Rationing by waiting may occur in situations in which entrepreneurs are free to change prices to equate quantity demanded with quantity supplied but choose not to do so. This results in queues of potential buyers. It may seem that the price in the market is being held below equilibrium by some noncompetitive force. That is not true, however. Such queuing may arise in a free market when the demand for a good is subject to large or unpredictable fluctuations, and the additional costs to firms (and ultimately to consumers) of constantly changing prices or of holding sufficient inventories or providing sufficient excess capacity to cover peak demands are greater than the costs to consumers of waiting for the good. Common examples are waiting in line to purchase a fast-food lunch and queuing to purchase a movie ticket a few minutes before the next showing.

marginal utility cannot persistently increase

Consider for a moment the opposite possibility—increasing marginal utility. Under such a situation, the marginal utility after consuming, say, one hamburger would increase. Consuming the second hamburger would yield more utility to you, and consuming the third would yield even more. Thus, if increasing marginal utility existed, each of us would consume only one good or service! Rather than observing that "variety is the spice of life," we would see that monotony in consumption was preferred. *We do not observe such single-item consumption, and therefore we have great confidence in the concept of diminishing marginal utility*

total and marginal utility

Consider the satisfaction, or utility, that you receive each time you download and utilize digital apps. To make the example straightforward, let's say that there are thousands of apps to choose from each year and that each of them is of the same quality. Let's say that you normally download and utilize one app per week. You could, of course, download two, or three, or four per week. Presumably, each time you download and utilize another app per week, you will get additional satisfaction, or utility. The question that we must ask, though, is, given that you are already downloading and using one app per week, will the next one downloaded and utilized during that week give you the same amount of additional utility? That additional, or incremental, utility is called *marginal utility*, *where marginal means "incremental" or "additional."* (Marginal changes also refer to decreases, in which cases we talk about decremental changes.) The concept of marginality is important in economics because we can think of people comparing additional (marginal) benefits with additional (marginal) costs.

utility and utils

Economists once believed that utility could be measured. In fact, there is a philosophical school of thought based on utility theory called utilitarianism, developed by the English philosopher Jeremy Bentham (1748-1832) Bentham held that society should seek the greatest happiness for the greatest number. He sought to apply an arithmetic formula for measuring happiness. He and his followers developed the notion of measurable utility and invented the util to measure it For the moment, we will assume that we can measure satisfaction using this representative unit. Our assumption will allow us to quantify the way we examine consumer behavior. Thus, the first chocolate bar that you eat might yield you 4 utils of satisfaction. The first peanut cluster might yield 6 utils, and so on. Today, no one really believes that we can actually measure utils, but the ideas forthcoming from such analysis will prove useful in understanding how consumers choose among alternatives.

marginal utility, total utility, and the diamond-water paradox

Even though water is essential to life and diamonds are not, water is relatively cheap and diamonds are relatively expensive. This relative market valuation of diamonds over water sometimes is called the "diamond-water paradox."

optimizing consumption choices

Every consumer has a limited income, so choices must be made. Suppose that a consumer has made all of his or her choices about what to buy and in what quantities. *If the total level of satisfaction, or utility, from that set of choices is as great as it can be, we say that the consumer has optimized* When the consumer has attained an optimum consumption set of goods and services, we say that he or she has reached consumer optimum.

quantity restrictions

Governments can impose quantity restrictions on a market. The most obvious restriction is an outright ban on the ownership or trading of a good. It is currently illegal to buy and sell human organs. It is also currently illegal to buy and sell certain psychoactive drugs such as cocaine, heroin, and methamphetamine. In some states, it is illegal to start a new hospital without obtaining a license for a particular number of beds to be offered to patients. This licensing requirement effectively limits the quantity of hospital beds in some states. Some of the most common quantity restrictions exist in the area of international trade. The U.S. government, as well as many foreign governments, imposes import quotas on a variety of goods

purchasing power and real income

If the price of some item that you purchase goes down while your money income and all other prices stay the same, your ability to purchase goods goes up. That is to say, your effective *purchasing power* has increased, even though your money income has stayed the same. ex. If you purchase 20 e-books per year at $10 per e-book, your total outlay for e-books is $200. If the price goes down by 50 percent, to $5.00 per e-book, you would have to spend only $100 per year to purchase the same number of e-books. If your money income and the prices of other goods remain the same, it would be possible for you to continue purchasing 20 e-books per year and to purchase more of other goods. You will feel richer and will indeed probably purchase more of a number of goods, including perhaps even more e-books. - The converse will also be true. When the price of one good you are purchasing goes up, without any other change in prices or income, the purchasing power of your income drops. You will have to reduce your purchases of either the now higher-priced good or other goods (or a combination). = this produces an overall *real-income effect* - In general, this real-income effect is usually quite small. After all, unless we consider broad categories, such as housing or food, a change in the price of one particular item that we purchase will have a relatively small effect on our total purchasing power. Thus, we anticipate that the substitution effect will be more important than the real-income effect in causing us to purchase more of goods that have become cheaper and less of goods that have become more expensive.

a price change and the consumer optimum

If we start out at a consumer optimum and then observe a good's price decrease, we can predict that consumers will respond to the price decrease by consuming more of that good. This is because before the price change, the marginal utility per dollar spent on each good or service consumed was the same. Now, when a specific good's price is lower, it is possible to consume more of that good while continuing to equalize the marginal utility per dollar spent on that good with the marginal utility per dollar spent on other goods and services. *The purchase and consumption of additional units of the lower-priced good will cause the marginal utility from consuming the good to fall*. Eventually, it will fall to the point at which the marginal utility per dollar spent on the good is once again equal to the marginal utility per dollar spent on other goods and services. At this point, the consumer will stop buying additional units of the lower-priced good.

the notion of marginal utility

If you look carefully at panels (b) and (c) of Figure 20-1, the notion of marginal utility becomes clear. *In economics, the term marginal always refers to a change in the total*. The marginal utility of consuming three downloaded digital apps per week instead of two apps per week is the increment in total utility and is equal to 3 utils per week. All of the points in panel (c) are taken from column 3 of the table in panel (a). Notice that marginal utility falls throughout the graph. A special point occurs after four apps are downloaded and used per week because the total utility curve in panel (b) is unchanged after the consumption of the fourth app. *That means that the consumer receives no additional (marginal) utility from downloading and using five apps rather than four* This is shown in panel (c) as zero marginal utility. After that point, marginal utility becomes negative.

price floors and price supports in agriculture

Implementing Agricultural Price Supports - The nature of the supports is quite simple: The government simply chooses a support price for an agricultural product and then acts to ensure that the price of the product never falls below the support level. (price floor) Figure 4-4 shows the market demand for and supply of milk. Without a price-support program, competitive forces would yield an equilibrium price of $0.08 per pound and an equilibrium quantity of 15.4 billion pounds per year. Clearly, if the government were to set the support price at or below $0.08 per pound, the quantity of milk demanded would equal the quantity of milk supplied at point E, because farmers could sell all they wanted at the market clearing price of $0.08 per pound. Free market equilibrium occurs at E, with an equilibrium price of $0.08 per pound and an equilibrium quantity of 15.4 billion pounds. When the government sets a support price at $0.10 per pound, the quantity demanded is 15 billion pounds and the quantity supplied is 16 billion pounds. The difference is the surplus, which the government buys.

the main beneficiaries of agricultural subsidies

In 2002, Congress enacted the Farm Security Act, which perpetuated marketing loan programs and other subsidy and price-support arrangements for such farm products as wheat, corn, rice, peanuts, and soybeans. All told, the more than $9 billion in U.S. government payments for these and other products amounts to about 25 percent of the annual market value of all U.S. farm production. The government seeks to cap the annual subsidy payment that an individual farmer can receive at $360,000 per year, but some farmers are able to garner higher annual amounts by exploiting regulatory loopholes. The greatest share of total agricultural subsidies goes to the owners of the largest farming operations. At present, 10 percent of U.S. farmers receive more than 70 percent of agricultural subsidies. In 2014, Congress ended a number of direct subsidy payments to farmers. Under a new subsidy program, the government encourages farmers to purchase crop insurance policies. These policies provide farmers with extra payments if circumstances outside their control, such as too little or too much rain, harm their crops. Nevertheless, the government heavily subsidizes the farmers' insurance purchases.

the essential role of rationing

In a world of scarcity, there is, by definition, competition for what is scarce. After all, any resources that are not scarce can be obtained by everyone at a zero price in as large a quantity as everyone wants Air, for instance, can be burned in internal combustion engines. Once scarcity arises, there has to be some method to ration the available resources, goods, and services. The price system is one form of rationing. The others we mentioned are alternatives. Economists cannot say which system of rationing is "best." They can, however, say that *rationing via the price system leads to the most efficient use of available resources*. As explained in Appendix B (which follows this chapter), this means that generally in a freely functioning price system, all of the gains from mutually beneficial trade will be captured.

the functions of rental prices

In any housing market, rental prices serve three functions: 1. to promote the efficient maintenance of existing housing and to stimulate the construction of new housing 2. to allocate existing scarce housing among competing claimants 3. to ration the use of existing housing by current demanders *Rent controls interfere with all of these functions*

negative marginal utility

In our example, when marginal utility becomes negative, it means that the consumer is tired of consuming digital apps and would require some form of compensation to consume any more. When marginal utility is negative, an additional unit consumed actually lowers total utility by becoming a nuisance. Rarely does a consumer face a situation of negative marginal utility. Whenever this point is reached, goods in effect become "bads." Consuming more units actually causes total utility to fall so that marginal utility is negative. *A rational consumer will stop consuming at the point at which marginal utility becomes negative, even if the good is available at a price of zero*

consumer choice theory remains alive and well

In spite of the doubts expressed by proponents of behavioral economics, most economists continue to apply the assumption that people behave as if they act rationally with an aim to maximize utility. These economists continue to employ utility theory because of a fundamental strength of this approach: It yields clear-cut predictions regarding consumer choices that receive support from real-world evidence. In contrast, if the rationality assumption is rejected, any number of possible human behaviors might be considered. To proponents of behavioral economics, ambiguities about actual outcomes make the bounded rationality approach to consumer choice more realistic than utility-based consumer choice theory - Nevertheless, a major drawback is that no clearly testable predictions emerge from the many alternative behaviors that people might exhibit if they fail to behave as if they are rational. Certainly, arguments among economists about the "reasonableness" of rational consumers maximizing utility are likely to continue. So far, however, the use of utility-based consumer choice theory has allowed economists to make a wide array of predictions about how consumers respond to changes in prices, incomes, and other factors. In general, these key predictions continue to be supported by the actual choices that consumers make.

ex. - principle of substitution

Let's assume now that there are several goods, not exactly the same, and perhaps even very different from one another, but all contributing to consumers' total utility. If the relative price of one particular good falls, individuals will substitute in favor of the now lower-priced good and against the other goods that they might have been purchasing. Conversely, if the price of that good rises relative to the price of the other goods, people will substitute in favor of them and not buy as much of the now higher-priced good An example is the growth in purchases of tablet devices, or digital tablets, since the early 2010s. As the relative price of tablets has plummeted, people have substituted away from other, now relatively more expensive goods in favor of purchasing additional digital tablets.

the demand curve revisited

Linking the law of diminishing marginal utility and the rule of equal marginal utilities per dollar gives us a negative relationship between the quantity demanded of a good or service and its price. As the relative price of digital apps goes up, for example, the quantity demanded will fall, and as the relative price of digital apps goes down, the quantity demanded will rise. Figure 20-2 showed this demand curve for digital apps. As the price of digital apps falls, the consumer can maximize total utility only by purchasing more apps, and vice versa. In other words, the relationship between price and quantity desired is simply a downward-sloping demand curve. Note, though, that this downward-sloping demand curve (the law of demand) is derived under the assumption of constant tastes and incomes. You must remember that we are keeping these important determining variables constant when we look at the relationship between price and quantity demanded.

the policy of rent ceilings

More than 200 U.S. cities and towns, including Berkeley, California, and New York City, operate under some kind of rent control. Rent control is a system under which the local government tells building owners how much they can charge their tenants for rent. In the United States, rent controls date back to at least World War II. The objective of rent control is to keep rents below levels that would be observed in a freely competitive market.

why the price of diamonds exceeds the price of water

Notice in Figure 20-3 that the demand for water is many, many times the demand for diamonds (even though we really can't show this in the diagram). We draw the supply curve of water as S1 at a quantity of Qwater. The supply curve for diamonds is given as S2 at quantity Qdiamonds. At the intersection of the supply curve of water with the demand curve of water, the price per kilogram is Pwater. The intersection of the supply curve of diamonds with the demand curve of diamonds is at Pdiamonds. Notice that Pdiamonds exceeds Pwater. Diamonds sell at a higher price than water.

diminishing marginal utility

Notice that in panel (c) of Figure 20-1, marginal utility is continuously declining. This property has been named the principle of diminishing marginal utility There is no way that we can prove diminishing marginal utility. Nevertheless, diminishing marginal utility has even been called a law. This supposed law concerns a psychological, or subjective, utility that you receive as you consume more and more of a particular good.

why both landlords and and some tenants lose

Often, owners of rent-controlled apartments charge "key money" before allowing a new tenant to move in. This is a large up-front cash payment, usually illegal but demanded nonetheless—just one aspect of the black market in rent-controlled apartments. Poor individuals have insufficient income to pay the hefty key money payment, nor can they assure the owner that their rent will be on time or even paid each month. Because rent ceilings are usually below market clearing levels, apartment owners have little incentive to take any risk on low-income individuals as tenants. This is particularly true when a prospective tenant's chief source of income is a welfare check. Indeed, a large number of litigants in the New York housing courts are welfare mothers who have missed their rent payments due to emergency expenses or delayed welfare checks. Their appeals often end in evictions and a new home in a temporary public shelter—or on the streets.

rationing the current use of housing

Rent controls also affect the current use of housing because they restrict tenant mobility. Consider a family whose children have gone off to college. That family might want to live in a smaller apartment. In a rent-controlled environment, however, giving up a rent-controlled unit can entail a substantial cost. In most rent-controlled cities, rents can be adjusted only when a tenant leaves. This means that a move from a long-occupied rent-controlled apartment to a smaller apartment can involve a hefty rent hike. In New York, this artificial preservation of the status quo came to be known as "housing gridlock."

rent controls and construction

Rent controls discourage the construction of new rental units. Rents are the most important long-term determinant of profitability, and rent controls artificially depress them. Consider some examples. In a recent year in Dallas, Texas, with a 16 percent rental vacancy rate but no rent control laws, 11,000 new rental housing units were built. In the same year in San Francisco, California, only 2,000 units were built, despite a mere 1.6 percent vacancy rate. The major difference? San Francisco has had stringent rent control laws. In New York City, most rental units being built are luxury units, which are exempt from controls.

who loses and who gains from rent ceilings?

The big losers from rent ceilings are clearly property owners. There is, however, another group of losers—low-income individuals, especially single mothers, trying to find apartments. Some observers now believe that rent ceilings have worsened the problem of homelessness in cities such as New York.

real-income effect

The change in people's purchasing power that occurs when, other things being constant, the price of one good that they purchase changes. When that price goes up, real income, or purchasing power, falls, and when that price goes down, real income increases.

understanding the paradox

The diamond-water paradox is easily understood when we make the distinction between total utility and marginal utility. The total utility of water greatly exceeds the total utility derived from diamonds. What determines the price, though, is what happens on the margin. We have relatively few diamonds, so the marginal utility of the last diamond consumed is relatively high. The opposite is true for water. *Total utility does not determine what people are willing to pay for a unit of a particular commodity—marginal utility does* refer to fig. 20-3 We pick kilograms as a common unit of measurement for both water and diamonds. To demonstrate that the demand for and supply of water are immense, we have put a break in the horizontal quantity axis. Although the demand for water is much greater than the demand for diamonds, the marginal valuation of water is given by the marginal value placed on the last unit of water consumed. To find that, we must know the supply of water, which is given as S1. At that supply, the price of water is Pwater. But the supply for diamonds is given by S2. At that supply, the price of diamonds is Pdiamonds. The total valuation that consumers place on water is tremendous relative to the total valuation consumers place on diamonds. What is important for price determination, however, is the marginal valuation, or the marginal utility received.

attempts to evade rent ceilings

The distortions produced by rent ceilings lead to efforts by both property owners and tenants to evade the rules. These efforts lead to the growth of expensive government bureaucracies whose job it is to make sure that rent ceilings aren't evaded. In New York City, because rent on a rent-controlled apartment can be raised only if the tenant leaves, property owners have had an incentive to make life unpleasant for tenants in order to drive them out or to evict them on the slightest pretext. The city has responded by making evictions extremely costly for property owners. Eviction requires a tedious and expensive judicial proceeding. Tenants, for their part, routinely try to sublet all or part of their rent-controlled apartments at fees substantially above the rent they pay to the owner. Both the city and the property owners try to prohibit subletting and often end up in the city's housing courts—an entire judicial system developed to deal with disputes involving rent-controlled apartments. The overflow and appeals from the city's housing courts sometimes clog the rest of New York's judicial system.

applying marginal analysis to utility

The example in Figure 20-1 will clarify the distinction between total utility and marginal utility. The table in panel (a) shows the total utility and the marginal utility of downloading and using digital apps each week. *Marginal utility is the difference between total utility derived from one level of consumption and total utility derived from another level of consumption within a given time interval*. A simple formula for marginal utility is this:

price floors in the labor market

The minimum wage is the lowest hourly wage rate that firms may legally pay their workers.

principle of substitution

The principle that consumers shift away from goods and services that become priced relatively higher in favor of goods and services that are now priced relatively lower.

nonprice rationing devices

The result is fewer exchanges and nonprice rationing devices.

how to calculate equal amounts of marginal utility on goods/services

The rule simply states that a consumer maximizes personal satisfaction when allocating money income in such a way that the last dollars spent on good A, good B, good C, and so on, yield equal amounts of marginal utility. Marginal utility (MU) from good A is indicated by "MU of good A." For good B, it is "MU of good B." Our algebraic formulation of this rule, therefore, becomes The letters A, B, . . . , Z indicate the various goods and services that the consumer might purchase. *We know, then, that in order for the consumer to maximize utility, the marginal utility of good A divided by the price of good A must equal the marginal utility of any other good divided by its price*. Note, though, that the application of the rule of equal marginal utility per dollar spent does not necessarily describe an explicit or conscious act on the part of consumers. Rather, this is a model of consumer optimum.

the rationing function of prices

The synchronization of decisions by buyers and sellers that leads to equilibrium is called the rationing function of prices The plans of buyers and sellers, given the price, are not frustrated. It is the free interaction of buyers and sellers that sets the price that eventually clears the market. Price, in effect, rations a good to demanders who are willing and able to pay the highest price. Whenever the rationing function of prices is frustrated by government-enforced price ceilings that set prices below the market clearing level, a prolonged shortage results. There are ways other than price to ration goods. First come, first served is one method. Political power is another. Physical force is yet another. Cultural, religious, and physical differences have been and are used as rationing devices throughout the world.

substitution effect

The tendency of people to substitute cheaper commodities for more expensive commodities

tastes and preferences and utility

The utility that individuals receive from consuming a good depends on their tastes and preferences. These tastes and preferences are normally assumed to be given and stable for a particular individual. An individual's tastes determine how much utility that individual derives from consuming a good, and this in turn determines how that individual allocates his or her income to purchases of that good. But we cannot explain why tastes are different between individuals.

purchasing power

The value of money for buying goods and services. If your money income stays the same but the price of one good that you are buying goes up, your effective purchasing power falls, and vice versa.

graphical analysis

Total utility continues to rise until four digital apps are downloaded and utilized per week. This measure of utility remains at 20 utils through the fifth app, and at the sixth app per week it falls to 18 utils. We assume that at some quantity consumed per unit time period, boredom with consuming more digital apps begins to set in. Thus, at some quantity consumed, the additional utility from consuming an additional app begins to fall, so total utility first rises and then declines in panel (b).

black markets

Typically, an effective price ceiling leads to a black market. A black market is a market in which the price-controlled good is sold at an illegally high price through various methods. For example, if the price of gasoline is controlled at lower than the market clearing price, drivers who wish to fill up their cars may offer the gas station attendant a cash payment on the side (as happened in the United States in the 1970s and in China and India in the mid-2000s during price controls on gasoline). Indeed, the true implicit price of a price-controlled good or service can be increased in an infinite number of ways, limited only by the imagination.

analyzing utility

We can analyze in terms of utility the way consumers decide what to buy, just as physicists have analyzed some of their problems in terms of what they call force. No physicist has ever seen a unit of force, and no economist has ever seen a unit of utility. In both cases, however, these concepts have proved useful for analysis. Throughout this chapter, we will be discussing *utility analysis*, which is the analysis of consumer decision making based on utility maximization—that is, making choices with the aim of attaining the highest feasible satisfaction.

summing up the effects of an above- equilibrium minimum wage

We can conclude from the application of demand and supply analysis that a minimum wage established above the equilibrium wage rate typically has two fundamental effects. On the one hand, it boosts the wage earnings of those people who obtain employment. On the other hand, the minimum wage results in unemployment for other individuals. Thus, demand and supply analysis implies that the minimum wage makes some people better off while making others worse off.

economic effects of a minimum wage

What happens when the government establishes a floor on wages? The effects can be seen in Figure 4-5. We start off in equilibrium with the equilibrium wage rate of We and the equilibrium quantity of labor equal to Qe. A minimum wage, Wm, higher than We, is imposed. At Wm, the quantity demanded for labor is reduced to Qd, and some workers now become unemployed. Certain workers will become unemployed as a result of the minimum wage, but others will move to sectors where minimum wage laws do not apply. Wages will be pushed down in these uncovered sectors. The market clearing wage rate is We. The market clearing quantity of employment is Qe, determined by the intersection of supply and demand at point E. A minimum wage equal to Wm is established. The quantity of labor demanded is reduced to Qd. The reduction in employment from Qe to Qd is equal to the distance between B and A. That distance is smaller than the excess quantity of labor supplied at wage rate Wm. The distance between B and C is the increase in the quantity of labor supplied that results from the higher minimum wage rate.

an effective agricultural price floor

What happens, though, when the government sets the support price above the market clearing price, at $0.10 per pound? At a support price of $0.10 per pound, the quantity demanded is only 15 billion pounds, but the quantity supplied is 16 billion pounds. The 1-billion-pound difference between them is called the excess quantity supplied, or surplus. As simple as this program seems, its existence creates a fundamental question: How can the government agency charged with administering the price-support program prevent market forces from pushing the actual price down to $0.08 per pound? If production exceeds the amount that consumers want to buy at the support price, what happens to the surplus? Quite simply, if the price-support program is to work, the government has to buy the surplus—the 1-billion-pound difference. As a practical matter, the government acquires the 1-billion-pound surplus indirectly through a government agency. The government either stores the surplus or sells it to foreign countries at a greatly reduced price (or gives it away free of charge) under the Food for Peace program.

the substitution effect

What is happening as the price of digital app downloads falls is that consumers are substituting the now relatively cheaper digital apps for other goods and services, such as restaurant meals and live concerts. We call this the substitution effect of a change in the price of a good because it occurs when consumers substitute relatively cheaper goods for relatively more expensive ones. We assume that people desire a variety of goods and pursue a variety of goals. This means that few, if any, goods are irreplaceable in meeting demand. We are generally able to substitute one product for another to satisfy demand. This is commonly referred to as the principle of substitution

a consumer's response to a price change

When a consumer has optimally allocated all her income to purchases, the marginal utility per dollar spent at current prices of goods and services is the same for each good or service she buys. No consumer will, when optimizing, buy 10 units of a good per unit of time when the marginal utility per dollar spent on the tenth unit of that good is less than the marginal utility per dollar spent on a unit of some other item

effects on the existing supply of housing

When rental rates are held below equilibrium levels, property owners cannot recover the cost of maintenance, repairs, and capital improvements through higher rents The result has been abandoned buildings from Santa Monica, California, to New York City. Some owners have resorted to arson, hoping to collect the insurance on their empty buildings before the city claims them to pay back taxes.

utility theory

When you buy something, you do so because of the satisfaction you expect to receive from having and using that good. For everything that you like to have, the more you have of it, the higher the level of total satisfaction you receive. *Another term that can be used for satisfaction is utility, or want-satisfying power* This property is common to all goods that are desired. The concept of utility is purely subjective, however. There is no way that you or I can measure the amount of utility that a consumer might be able to obtain from a particular good, for utility does not imply "useful" or "utilitarian" or "practical." Thus, there can be no accurate scientific assessment of the utility that someone might receive by consuming a fast-food dinner or a movie relative to the utility that another person might receive from that same good or service.

beneficiaries of rent controls

Who benefits from rent ceilings? Ample evidence indicates that upper-income professionals benefit the most. These people can use their mastery of the bureaucracy and their large network of friends and connections to exploit the rent ceilings. Consider that in New York, actresses Mia Farrow and Cicely Tyson live in rent-controlled apartments, paying well below market rates. So do the former director of the Metropolitan Museum of Art and singer and children's book author Carly Simon.

price ceiling

a legal maximum price that may be charged for a particular good or service

price floor

a legal minimum price below which a good or service may NOT be sold. Legal minimum wages are an example Price floors have most often been applied to wages and agricultural products.

black market

a market in which goods are traded at prices ABOVE their legal maximum prices or in which illegal goods are sold

rent control

a price ceiling placed on rent

util

a representative unit by which utility is measured

price controls

govt.- mandated minimum or maximum prices that may be charged for goods and services

nonfunctional slack fill

has been a form of price adjustment for much longer than the existence of this term for the practice, which refers to a legal requirement for firms that engage in the practice to label clearly the adjusted contents of packages Thus, Wilson's decision about how to change the per-unit price of his company's product without altering the dollar amount on cans is the latest in a long line of similar actions by other sellers. For instance, firms that sell food items in packages have over the centuries engaged in a practice called "weight out," = - reducing the weight of the food sold in a package by placing less food inside while keeping the per-package price the same.

steps taken to arrive at consumer optimum

shows the steps taken to arrive at consumer optimum. Using the first digital app would yield a marginal utility per dollar of 10 (50 units of utility divided by $5 per digital app), while consuming the first portable power bank would yield a marginal utility per dollar of only 8.3 (25 units of utility divided by $3 per portable power bank). Because it yields the higher marginal utility per dollar, the app is purchased. This leaves $21 of income. Consuming the second digital app yields a higher marginal utility per dollar (9, versus 8.3 for a portable power bank), so this app is also purchased, leaving an unspent income of $16. Purchasing and consuming the first portable power bank now yield a higher marginal utility per dollar than the next digital app (8.3 versus 8), so the first portable power bank is purchased. This leaves income of $13 to spend. The process continues until all income is exhausted and the marginal utility per dollar spent is equal for both goods. [figure exp.] In each purchase situation described here, the consumer always purchases the good with the higher marginal utility per dollar spent. For example, at the time of the third purchase, the marginal utility per last dollar spent on digital apps is 8, but it is 8.3 for portable power banks, and $16 of income remains, so the next purchase will be a portable power bank. Here the price of digital apps is Pd=$5, the price of portable power banks is Pc=$3, MUd is the marginal utility of consumption of digital apps, and MUc is the marginal utility of consumption of portable power banks. - To restate, *consumer optimum requires the following*: A consumer's money income should be allocated so that the last dollar spent on each good purchased yields the same amount of marginal utility (when all income is spent), because this rule yields the largest possible total utility.

utility analysis

the analysis of consumer decision making based on utility maximization

principle of diminishing marginal utility

the principle that as more of any good or service is consumed, its extra benefit declines. Otherwise stated, increases in total utility from the consumption of a good or service become smaller and smaller as more is consumed during a given time period

utility

the want-satisfying power of a good or service