Appendix: Chapter 6Appendix: Chapter 6

Delving Deeper Into Microeconomics

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning ObjectivesLearning Objectives

• Explain the role of utility maximization in consumer choice and use the concept of price elasticity.

• Explain the role of cost minimization in producer decisions and use the concept of price elasticity of supply

• Explain the incidence of a tax.

6A-2

Consumer ChoiceConsumer Choice

• The underlying explanation of the demand curve is based on the utility function.

• The utility function also tells us how much benefit a person gets from purchasing and consuming more of the same thing.

• Marginal utility is the added utility from consuming one more unit of a good.

• Diminishing marginal utility is the concept that marginal utility declines as consumption increases.

6A-3

The Utility Function of a The Utility Function of a Coffee DrinkerCoffee Drinker

Cups of Coffee in a Day

Utility

(Measured in Utils)

Marginal Utility

(Measured in Utils)

0 0

1 4 4

2 7 3

3 9 2

4 10 1

6A-4

Budget ConstraintBudget Constraint

• The utility function is not the only factor that determines what you buy and how much.

• Budget constraint is the combination of goods and services you are able to buy, given their prices and the amount of money you have available to spend.

• The budget constraint changes when prices and/or income changes.

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Example of Budget ConstraintExample of Budget Constraint

# of meals eaten out in month

# of movies seen in month

Price per meal

Price per movie

Cost of meals

Cost of movies

Total spending

3 0 $20 $10 $60 $0 $60

2 2 $20 $10 $40 $20 $60

1 4 $20 $10 $20 $40 $60

0 6 $20 $10 $0 $60 $60

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Utility MaximizationUtility Maximization

• The rational individual will select goods and services to maximize utility when subject to a budget constraint.

• Due to diminishing marginal utility, you are more likely to choose a combination of goods and services rather than one good.

• As a consumer, you are weighing the marginal utility of spending an extra dollar on one good or service versus another.

6A-7

Utility MaximizationUtility Maximization

• Consumers often make decisions that affect their spending decisions in the future.

• This kind of choice is called intertemporal utility maximization.– That is, decisions which involve a trade-off

between consumption today and consumption in the future.

– For example, a decision to cut back spending today to save for a home tomorrow.

6A-8

Price Elasticity of DemandPrice Elasticity of Demand

• A utility-maximizing consumer will change his or her purchases when prices change.

• The price elasticity of demand will determine how much the purchases will change.

• The price elasticity of demand is the percentage change in quantity demanded that results from a one percent change in price.– A price elasticity of 1 means that a 10% increase in

price leads to a 10% decrease in quantity demanded.

6A-9

Price Elasticity of DemandPrice Elasticity of Demand

– An elasticity of 2 means that a 10% increase in price leads to a 20% decrease in quantity demanded.

– An elasticity of 0.5 means that a 10% increase in prices leads to a 5% decrease in quantity demanded.

• Demand for a good or service is inelastic if its price elasticity is less than 1, and it is elastic if its price elasticity is greater than 1.

6A-10

Price Elasticity of GasolinePrice Elasticity of Gasoline

Price

(Dollars per Gallon)

Annual Quantity of Gasoline Demanded

(Gallons)

Before: $3.00 800

After: $3.30 780

Percentage change:

(3.30 - 3.00)/ 3.00 =

10%

Percentage change:

(780 - 800) / 800 = -2.5%

Elasticity: (-2.5% / 10%) = 0.25

6A-11

An Inelastic Demand Curve for An Inelastic Demand Curve for GasolineGasoline

Demand curve

780

$3.00

Price per gallon

800

Annual quantity of gasoline bought (gallons)

$3.30

6A-12

An Elastic Demand Curve for An Elastic Demand Curve for GasolineGasoline

Demand curve

640

$3.00

Price per gallon

800

Annual quantity of gasoline bought (gallons)

$3.30

6A-13

Producer DecisionsProducer Decisions

• Now we shift our analysis to the supply or production side of the economy.

• The cost function gives the cost of producing each level of output.

• Managers attempt to find the least expensive way of producing a given level of output.– This process is called cost minimization.

6A-14

Choosing the Right InputsChoosing the Right Inputs

• The producer’s choice of inputs depends on their relative prices.

• As an input becomes more expensive, all other things being equal, a business will want to use less of it.

• If the cost of labor rises, a business will attempt to use more capital and automate the production process.

6A-15

Substitutes and ComplementsSubstitutes and Complements

• Two inputs are substitutes if raising the price of one increases the quantity demanded for the other (holding output constant). – For example, factory workers in China are a

substitute for factory workers in the U.S.

• Two inputs are complements if raising the price of one decreases the quantity demanded of the other (holding output constant). – Cement and construction workers are an example.

6A-16

Cost Minimization ExampleCost Minimization Example

• Let’s look at the example of a small business. Suppose it must decide whether to buy its own copier or send out to a copy shop such as Kinko’s.– If the business buys a copier, it needs to lay out the

upfront cost, as well as the costs for toner and paper.

– To make a decision, it needs to know the actual cost of the machine and the price of a copy.

– The decision also depends on the scale of output.

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Copier DecisionCopier Decision

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Price Elasticity of SupplyPrice Elasticity of Supply

• The price elasticity of supply is the percentage increase in the quantity supplied, given a 1% increase in the price.

• Supply is elastic if a small change in price leads to a large change in the quantity supplied.

• Similarly, supply is inelastic if a big change in price leads to only a small change in the quantity supplied.

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Price Elasticity of SupplyPrice Elasticity of Supply

An Elastic Supply An Inelastic Supply

6A-20

Tax IncidenceTax Incidence

• The incidence or burden of a tax identifies the persons or businesses who ultimately have to pay a tax.

• The burden of the tax depends on the elasticity of supply and demand.

• The following slide shows the effect of taxing a market where demand is inelastic and supply is elastic.

6A-21

Taxation with Inelastic Demand Taxation with Inelastic Demand and Elastic Supplyand Elastic Supply

Inelastic demand curve

Original quantity

Original price

Price

After-tax quantity

Quantity

Elastic supply curve

After-tax price for buyer

After-tax price for seller

Tax

6A-22