Microeconomics Chapter 6

Marginal Analysis

A consumer will maximize his or her total well-being if the last dollar spent on each good provide the same marginal (additional) utility.

Law of Diminishing Marginal Utility

As a consumer purchases more of a good in a specific time period, the additional satisfaction enjoyed from the additional unit of the good will diminish; if what you give up is more than what you get, then you stop; each additional unit yields fewer utils

6.03 How does diminishing marginal utility affect the decision about how much of a good to purchase compared to another good with the same price?

Because of the law of diminishing marginal utility, the marginal utility of the good purchased will eventually begin to diminish as more and more is purchased. If the marginal utility of the purchased good falls below the marginal utility of other possible purchases that cost the same amount, the buyer will not buy additional units of the first good, and will instead buy more of the other goods that now have a higher marginal utility. But not all goods cost the same amount. See if you can work out the logic when prices differ.

6.11 Describe in your own words what the relationship is between prices and marginal utilities when a consumer is considering how much to consume.

If consumers want to maximize total satisfaction, they will consume goods so that the marginal utility per dollar spent on each good is equal. If a consumer can gain more satisfaction by spending an additional dollar on cereal than he can on spending that dollar on fruit, he will give up the fruit and buy the cereal. But, as he changes his spending patterns, the additional satisfaction gained from more cereal will begin to diminish and the additional satisfaction gained from the less fruit will rise. (Be sure that you can explain why one marginal utility increases and the other decreases.) He will continue switching until the marginal utility gained from spending another dollar on cereal is just equal to the marginal utility gained from spending another dollar on fruit.

6.04 How does a consumer maximize satisfaction when goods have different prices?

If two goods cost the same, it's pretty straightforward to compare marginal utilities. But what if they do not cost the same? It's not accurate to only think of how much marginal utility you get for different goods if their prices are different. For example, you would probably get a higher marginal utility from a new car than a pizza, but a new car has a much higher price than a pizza, so comparing one more car to one more pizza is not comparing "like" things. You need some way of creating a common point of comparison between two goods that have different prices. Thinking of how much utility you would get per dollar spent on each good makes the comparison of cars and pizzas possible.

6.02 Explain why the marginal utility of water may be quite high at low levels of consumption, but eventually diminish as you increase your consumption.

If you are very thirsty, then that first glass of water will bring you a great deal of satisfaction and happiness. The second glass might continue to increase your satisfaction but probably will not taste as good as that first glass. By the time you get to the fourth glass, you may be struggling to get it down, and the fifth glass might actually cause you distress.

Real Income

Income adjusted for price changes; a measure of the amount of goods and services one can purchase.

6.09 Are marginal utilities of all goods equal to all other marginal utilities if consumers are maximizing their satisfaction? Explain why or why not.

No. It is the ratio of marginal utilities to prices that are equal. For most people, the marginal utility of an additional Mercedes will be greater than that of an additional plum. But a Mercedes costs much more than a plum, so we need to take into account how much it costs to achieve the additional utility from each. When a dollar "buys" the same amount of satisfaction from each good, then there will be no further incentive to change your buying choices.

6.14 Is it possible for an inferior good to violate the law of demand?

Remember the definition of an inferior good—one that you want less of as your income increases (and more of when your income decreases). In the case of a normal good, the income and substitution effect work in the same direction: as price falls, quantity increases, and vice versa. In the case of an inferior good, the income and substitution effects work in opposite directions. A price decrease works the same as before - you will substitute toward the now-cheaper good, increasing the quantity that you buy. And a price decrease still increases real income. The difference is that when your real income increases and you are consuming an inferior good, you will buy less of it than before. In this case, the income effect leads to a decrease in quantity when the price falls. Theoretically, if the income effect is quite large - larger than the substitution effect - a price decrease could actually cause the amount you wish to purchase to decrease, leading to a positively-sloped demand curve. This is extremely rare, and some economists question whether it could happen at all.

Marginal Utility

The change in total utility or satisfaction resulting from consuming one more unit of a good or service

Consumer Surplus

The difference between the total value to the consumer of consuming a specific amount of a good and the amount the consumer must pay for that amount of the good

6.01 What do you think will happen to marginal utility (that is, the satisfaction gained from consuming each additional good) as one consumes more of a good?

The more of something you consume, the less satisfaction another unit will bring you. Sometimes you consume so much of something, that consuming one more will actually lower your overall satisfaction - eating too much pizza, for example!

6.19 How does consumption benefit consumers if the marginal cost just equals the marginal benefit?

The reason that consumers benefit is that the marginal cost is not equal to the marginal benefit for every unit consumed. It is likely that for a first unit of consumption, a consumer is willing to pay a relatively high price. Given diminishing marginal utility and the resulting law of demand, a consumer will be willing to pay less for a second unit and even less for the third. As long as the price consumers are willing to pay (representing the marginal benefit) is greater than the price the consumers have to pay (representing the marginal cost), consumers will increase consumption and be better off from doing so.

Utility

The satisfaction gained from consuming a good or service

Diamond-Water Paradox

The supply of water, relative to demand for water, is such that the equilibrium price of water is low. Given the relatively large supply, consumers are not willing to pay very much for the last glass of water. However, the value of the first glass of water is extremely high. And the total value that consumers gain from consumption of water as measured by consumer surplus is quite high. The supply of diamonds is such that the equilibrium price of diamonds is quite high. Equilibrium prices are shown relative the demand in Figure 6.12. However, the value (consumer surplus) enjoyed from water is very large and is represented by the darkened triangular areas in Figure 6.13. The consumer surplus from diamonds is really very small.

Total Utility

The total amount of satisfaction enjoyed from consuming a specific amount of a good or service

6.27 Who suffers the greater loss of consumer surplus when the price increases: those with elastic demands or those with inelastic demands?

Those with elastic demand. Because they are more sensitive to price changes, they will reduce their consumption by more than those with an inelastic demand.

6.23 Given that water is essential to life and diamonds are not, why are diamonds so much more expensive than water (in most parts of the world)?

Water is much more plentiful than diamonds are, so although diamonds are not a necessity, the supply of them is much less than the supply of water.

6.10 Assume that you are only consuming apples and plums and you are maximizing your utility. The price of apples is $1 each and the price of plums is $.25 each. Describe what will happen to the utility-maximizing choice if the price of plums increases to $.50.

With the new prices, if you give up one apple, you will now get two plums (not four, as before). Since the marginal utility of an apple is four times the marginal utility of a plum at the old level of consumption, but the price of an apple is now only double that of a plum, you can increase your satisfaction by increasing your consumption of apples (which also means that your consumption of plums will decrease). Looked at another way, if apples are twice as expensive as plums, you will maximize your satisfaction when the marginal utility of apples is twice that of plums. Again, as you increase your consumption of apples, you will experience diminishing marginal utility. As you decrease your consumption of plums, marginal utility will increase.