economics - isb charter schoolisbcharterschool.org/pdf/hwdmdmu.pdf · •price ceilings & price...

Part V:

Ch 13 – Pgs. 267-285 •Law of Diminishing Marginal Utility •Price Ceilings & Price Floors •Blackmarkets

ECONOMICS What does it mean to me?

The LAW of

DIMINISHING

MARGINAL

UTILITY

In what kind

of machines

are

newspapers

sold?

Why don’t we sell Coca-

Cola in machines similar

to those we use to sell

newspapers?

The value of a 2nd newspaper

diminishes fast…..unlike the

value of Coca-Cola.

People use this information to

make appropriate machines.

REASON:

This is called the

LAW of DIMINISHING

MARGINAL UTILITY

The value given to the amount of gratification

derived from something will decrease with each

additional unit of that item.

TOTAL UTILITY is the total amount of

satisfaction a person gets from consuming a specific

quantity (such as 20 units).

This law operates ALWAYS

with respect to time.

How much do you make?

Week? Month? Year?

-----> $1000 ???

The period of time in which you make $1000 will

make a difference in the amount of money you

have to spend.

Day?

What day would be

most likely for

newspapers be stolen

from the machines?

The answer is: Sunday

because that is coupon day.

However, people can still get TOO

MANY coupons, so the law still

applies.

The relationship between an

individual’s consumption bundle

and the total amount of utility is

called the UTILITY FUNCTION.

The utility function differs for

each person.

We will measure Utility in

hypothetical units called UTILS.

Candy

0

1

2

3

4

5

6

7

Total Utility

0

10

18

24

28

30

30

28

Marginal

Utility

10

8

6

4

2

0

-2

30

20

10

0 1 2 3 4 5 6 7

Total

Utility

Units consumed

**As more of a product is consumed, total utility

increases at a diminishing rate, reaches a

maximum, and then declines.

Candy

0

1

2

3

4

5

6

7

Total Utility

0

10

18

24

28

30

30

28

Marginal

Utility

10

8

6

4

2

0

-2

10

8

6

4

2

0 1 2 3 4 5 6 7

Marginal

Utility

Units consumed

** Marginal utility reflects the change in total utility.

10

8

6

4

2

0 1 2 3 4 5 6 7

Marginal

Utility

Units consumed

30

20

10

0 1 2 3 4 5 6 7

Total

Utility

Units consumed

1) When MU is zero in graph b, total utility in graph a is:

a) also zero b) neither rising nor falling c) negative

d) rising, but at a declining rate

10

8

6

4

2

0 1 2 3 4 5 6 7

Marginal

Utility

Units consumed

30

20

10

0 1 2 3 4 5 6 7

Total

Utility

Units consumed

2) Suppose the person represented here experienced a diminished taste for candy.

As a result:

a) TU curve would get steeper b) MU curve gets flatter

c) TU & MU would shift downward d) MU curve (not TU) would

collapse to horizontal axis

Debbie makes $20 and cokes are $2

and chips are $4 a pound.

How does Debbie decide HOW MUCH

to consume based on the fact that the

more cokes she consumes, the fewer

chips she can purchase?

The answer is to determine the

Marginal Utility per dollar.

The equation we will use is:

MUx Muy

Px Py

____ = ____

Qcoke Ucoke MUper/coke MU$

0 0

1 15

2 25

3 31

4 34

5 36

Calculate Debbie’s MU per dollar for coke

The price per coke is $4

15

10

6

3

2

3.75

2.5

1.5

.75

.5

Qcoke Ucoke MUper/coke MU$

0 0

1 15

2 25

3 31

4 34

5 36

Calculate Debbie’s MU per dollar for Chips/pound.

The price per pound of chips

is $2.

15

10

6

3

2

Qcoke Ucoke MUper/coke MU$

0 0

1 11.5

2 21.4

3 29.8

4 36.8

5 42.5

6 47

7 50.5

8 53.2

9 55.2

10 56.7

11.5

9.9

8.4

7

5.7

4.5

3.5

2.7

2

1.5

3.75

2.5

1.5

.75

.5

5.75

4.95

4.2

3,5

2.85

2.25

1.75

1.35

1.00

.75

Qcoke Ucoke MUper/coke MU$

0 0

1 15

2 25

3 31

4 34

5 36

Calculate Debbie’s MU per dollar for coke

Debbie’s optimal

consumption is 2 cokes and

6 pounds of chips because

she consumes these

amounts, her MU per dollar

is 2.

15

10

6

3

2

Qcoke Ucoke MUper/coke MU$

0 0

1 11.5

2 21.4

3 29.8

4 36.8

5 42.5

6 47

7 50.5

8 53.2

9 55.2

10 56.7

11.5

9.9

8.4

7

5.7

4.5

3.5

2.7

2

1.5

3.75

2.5

1.5

.75

.5

5.75

4.95

4.2

3,5

2.85

2.25

1.75

1.35

1.00

.75

Optimum Consumption and the

Budget Line

10

8

6

4

2

0 1 2 3 4 5 6 Quantity

of Coke

Quantity

of chips

(pounds)

Assume that Debbie earns $20. Coke is $4 a can

and chips are $2 a pound.

The budget line represents all the

possible combinations of coke

and chips Debbie can purchase.

If Debbie wants to consume 1

more coke, she must give up 2

pounds of chips.

NOTE: (Slope of the line is -2)

10

8

6

4

2

0 1 2 3 4 5 6 Quantity

of Coke

Quantity

of chips

(pounds)

Changes in income shifts the

budget line.

Now, let’s apply the

Law of Marginal Utility

to artificial pricing

systems such as

those applied by

governments.

What happens when

prices are “fixed” by

the government?

Let’s look at a graph which

shows the average

consumption of beer in the

United States.

PRICE CEILINGS &

PRICE FLOORS

(Consumer Surplus &

Producer Surplus)

$4

$3

$2

$1

Beers per

week

0 1 2 3 4 5 6 7

S

D

E

Ge

In this

example, the

average beers

consumed per

week is 6

at an

average

price of

$2.50.

$4

$3

$2

$1

Beers per week 0 1 2 3 4 5 6 7

S

D

E

This chart illustrates the effects upon

people if they were forced to go from

Ge to zero.

Ge

You might be

willing to pay

$4 for your first

beer, but price

is $2.50 …..now

you are $1.50

better off. This

is called

CONSUMER

SURPLUS.

The 9th beer is

worth to people

what it is worth to

people.

It is different for

everybody.

$4

$3

$2

$1

Beers per

week

0 1 2 3 4 5 6 7

S

D

E

Ge

From the

suppliers’

standpoint,

they could

supply at a

lower price but

they CAN get

more. This is

called

PRODUCER

SURPLUS.

$4

$3

$2

$1

Beers per

week

0 1 2 3 4 5 6 7

S

D

E

Ge

The

colored

area is the

total value

to society

of the cost

of 6 beers.

Consumer

Surplus

Producer

Surplus

$4

$3

$2

$1

Beers per week 0 1 2 3 4 5 6 7

S

D

E

Ge

Four beers is

not enough

(too little,

inefficient)

….This is

called

DEADWEIGHT

loss.

What if government mandate limited the

maximum number of beers one could drink to 4

per week? Government

Mandated

Supply

$4

$3

$2

$1

Beers per

week

0 1 2 3 4 5 6 7

S

D

E

Ge

What if government mandate limited

the maximum price of a beer to $1.00?

Consumers

would want to

buy more beer.

10

However,

suppliers

would not

want to

produce as

much beer.

$4

$3

$2

$1

Beers per week 0 1 2 3 4 5 6 7

S

D

E

Ge

If government

limited the

maximum

price of a

beer to $1.00,

it would

create a

shortage.

shortage

Producers will not want to

produce for low prices.

The legal maximum price that

can be charged is called a

PRICE CEILING. A legal

minimum price that can be

charged is called a PRICE

FLOOR. Price ceilings and

floors keep markets from

reaching equilibrium.

Politically popular ideas include:

--$ minimums on inputs (wages).

--$ maximums on outputs (prices).

When POLITICS vs.

ECONOMICS => Politics always

wins

$4

$3

$2

$1

Beers per week 0 1 2 3 4 5 6 7

S

D

E

Ge

The

government

mandating

the

maximum

price of a

beer is

called a

PRICE

CEILING.

shortage

A price ceiling keeps the market from

reaching equilibrium.

$4

$3

$2

$1

Beers per week 0 1 2 3 4 5 6 7

S

D

E

Ge

shortage

The shortage created from the price

ceiling will result in increased demand.

X

The increased demand

and a willingness to pay

higher prices will result

in a BLACK MARKET for

beer.

$5

$4

$3

$2

$1

Labor 0 1 2 3 4 5 6 7

S

D

E

Ge

When the government mandates a the

minimum price of something, it is called

a PRICE FLOOR.

The

minimum

wage is an

example of

a price

floor.

$5

$4

$3

$2

$1

Labor 0 1 2 3 4 5 6 7

S

D

E

Ge

The minimum wage increases the number of

people who want to work (supply of labor). . .

. . . And

decreases the

number of

businesses

who want to

hire (demand

for labor)

Creating a

SURPLUS

of labor.

SURPLUS

A price floor stops the market

from reaching equilibrium

and creates a surplus.

A price ceiling stops the

market from reaching

equilibrium and creates a

shortage.

CONCLUSION:

Typically, the

government jumps

in during a surplus,

buys the surplus….

and the surplus rots.

Using economic principles

and the impact of government

mandate, why was the 18th

Amendment to the U.S.

Constitution considered “the

great experiment that failed?”

QUESTION 1:

$5

$4

$3

$2

$1

Beers per week 0 1 2 3 4 5 6 7

S

D

E

Ge

ANSWER: The 18th Amendment created a

shortage of alcohol for consumption

When the price of

alcohol increased

under black

market conditions,

this initiated the

development of

the syndicate and

the notoriety of

such underworld

figures as Al

Capone.

Using economic principles,

explain the impact of

government mandates on the

supply and demand of the

illegal marijuana market.

QUESTION 2:

$300

$250

$200

$150

$100

$ 50

Marijuana use 0 1 2 3 4 5 6 7

S

D

E

Ge

ANSWER: In 1937, the government reduced the

availability of marijuana to zero by making it illegal.

Because

people have

been willing to

pay a high

price for the

product, black

market

conditions

have existed

since the

shortage was

created.

This created a shortage in the market.

In 1973, President Nixon froze

gasoline prices after the

OPEC cartel created a

shortage in the United States.

What impact did this have on

the market economy at that

time?

QUESTION 3:

$4

$3

$2

$1

Gallons of Gas 0 1 2 3 4 5 6 7

S

D

E

Ge

ANSWER:

President

Nixon initiated

a price ceiling

of $1.60.

shortage

REMEMBER: Producers will not

want to produce for low prices.

Consequently, a

shortage existed

because gas

companies were

taking a loss.

This resulted in

long lines and

gas stations

running out of

fuel.

Using economic principles

and the impact of government

mandate, explain what would

happen if cigarette smoking

were made illegal.

What would be the opportunity

cost of making cigarettes

illegal?

QUESTION 4:

$10

$8

$6

$4

$2

Cigarette use 0 1 2 3 4 5 6 7

S

D

E

Ge

ANSWER: The government would reduce the supply of

cigarettes to zero by making it illegal.

Because some

people will be

willing to pay

a high price

for the

product, black

market

conditions will

exist and the

price of

cigarettes will

increase.

This will create a shortage in the market.

ANSWER: The opportunity costs

would include:

•Lower environmental costs

•Cleaner air

•Lower costs for health care

•Healthier population

•Higher unemployment for lost jobs

Many experts contend that the Food and

Drug Administration (FDA) directly creates

the high price of prescription drugs. Do

you agree? Why or why not? Explain

your answer.

Question

5:

$100

$80

$60

$40

$20

Drug use 0 1 2 3 4 5 6 7

S

D

E

Ge

ANSWER: The FDA, a government regulatory agency, reduces the

supply of certain drugs by making them unavailable to certain

people through the use of prescriptions.

Because

doctors

prescribe drugs

for illness and

the patient

requests good

health, they pay

the higher price

created by the

government.

This results in a

limited market.

In May 2001, President Bush visited with

Governor Gray of California to discuss the

energy crisis in that state. It will take 10 years

to build the power plants necessary to provide

the electricity needed to support the

population and costs will skyrocket as demand

exceeds supply. Governor Gray is requesting

that President Bush place a federal price

ceiling on the cost of energy. Why did

President Bush refuse?

Question

6:

$D

$C

$B

$A

Kilowatts 0 a b c d e f g

S

D

E

Ge

ANSWER: President Bush

realizes that a

price ceiling will

result in a shortage

of electricity.

shortage

REMEMBER: Producers will not

want to produce for low prices.

Limiting the price

that power

companies can

charge for

electricity will cause

them to lose money,

not produce

efficiently, and

result in a shortage

of power.

THE END

Compiled by Virginia Meachum

Economics Teacher, Coral Springs High

School, Florida

Sources:

Economics, by Krugman, Wells.

Economics, by McConnell, Brue

Economics, by Mankiw