markets, maximizers, and efficiency

Markets, Maximizers, and Efficiency

Nothing can have value without being an object of utility.

-Karl Marx

Slide 1 of 32

A Brief overview

We all want to consume things…but how do we decide

what we’ll consume?

This module will begin exploring that decision process from the individual

perspective.

We’ll see how an individual maximizes their satisfaction through

careful analysis.

Then, we’ll turn to markets and see how they help us allocate resources

efficiently.

Slide 2 of 32

Before we begin, a definition:

Utility – the satisfaction or pleasure a consumer obtains from the consumption of a good or service.

We’ll discuss utility a lot in the next two modules. Since it measures the satisfaction we all get from our choices, it

is central to the study of consumer behavior!

Slide 3 of 32

Utility = Satisfaction

Think about that term Sport Utility Vehicle –  It is a vehicle that offers

consumers the towing capacity of a pickup truck and the passenger capacity of a minivan.

–  It is the best of both worlds and is likely to satisfy more people

For example, here is a Sport Utility Vehicle

Utility is a term we use all the time.

Slide 4 of 32

Utility is a vague but necessary idea for studying maximizers

•  Utility is subjective –  Two individuals may see different

value in the same good or service

•  Utility is difficult to quantify –  Utility is measured (abstractly) in

“utils” by economists.

For example, I hate green peppers. I get no utility out of them. You may

love them.

We may like the same thing but how do we

know who likes it more? Well we don’t. To control for this, economists use the term “utils”. It is a

made up word used to measure the magnitude to which you enjoy or obtain satisfaction from a good or service.

I know…this idea of ‘utils’ is making you shake your head. But economists love to measure things so please

bare with us!

Our reading material gets around this by discussing it in terms of “points” as in the number of points that can be earned on a test. While helpful, that does not address

the many other things we analyze in our lives.

Slide 5 of 32

Now that we understand utility and utils, we can analyze how consumer’s make their decisions

Let’s use these ideas to discuss total and marginal utility.

Marginal means ‘additional’. It is a term that we use a lot in Microeconomics because so many decisions are made “at the margin”.

For example, should I hire one more employee? Should I produce one more unit? Should I eat one more slice of pizza?

These are all marginal decisions (i.e. “one more”). Slide 6 of 32

Let’s consider the individual

Individuals conduct complex analysis when making nearly every decision.

They weigh the “pros” and “cons”.

In economics, we call that “marginal cost marginal benefit analysis”.

The cost is your opportunity cost – the next best thing you gave up when

you made a choice.

The benefit is the extra utility (i.e. marginal utility) you enjoy from the

thing that you chose.

Slide 7 of 32

We select items based on each items’ marginal utility as it compares to its marginal cost

I think pizza is a great example for marginal utility.

Why? Because we don’t sit down and intend to eat 5 slices. We eat one slice and continue to decide to add slices until we are full. We make decisions

one slice at a time or “at the margin”.

Marginal Utility – the extra utility obtained from consuming one more unit of a good or service

Slide 8 of 32

A numeric example may help

Let’s assume you could measure

how much satisfaction you

get from eating a slice of pizza in

utils.

Your first slice of pizza might

provide you with 10 utils

Two slices of pizza might provide you with a total of 18

utils

Three slices of pizza might

provide you with a total of 24 utils and

so on…

Marginal Utility (MU) is the additional utility obtained from consuming one more unit of a good or service. You can see the value in utils obtained from consuming each slice of pizza

above.

Your first slice of pizza brought you

10 utils. Your second brought you

8 utils. Your third brought you 6 utils

and so on.

10-0=10

18-10=8

24-18=6

Slide 9 of 32

Total utility rises as we consume more

of a good or service, but

eventually levels off!

These concepts can be shown graphically too

This highlights the Law of Diminishing Marginal

Utility. Added satisfaction declines as you consume more of a good or service.

Eventually, it can (and will) turn

negative!

Marginal utility starts in positive

territory but declines.

Slide 10 of 32

The Law of Diminish Marginal Utility is common sense

The Law of Diminishing Marginal Utility should make

sense to you: You use it everyday!

My first slice of pizza was delicious!

Total Utility

Marginal Utility

10 10 My second slice of pizza was great…but

not as good as the first! 18 8

My third slice of pizza was good. 24 6 My fourth slice of pizza was tasty, but I

am getting full! 28 4

The fifth slice was ok, but now I am stuffed. 30 2

I could have done without the sixth slice. 30 0 Ugh. I wish I didn’t eat the seventh slice.

My stomach hurts! 28 -2

Not that marginal utility is diminishing!

Here is what you might say when eating pizza:

Slide 11 of 32

Consumers also measure costs

Perhaps the first piece of pizza has a cost of two utils.

That is the opportunity cost of consuming that pizza.

In other words, you could have bought something else with the money you used for pizza and the next best thing was worth

two utils to you.

In a previous module, we learned that was called

opportunity cost.

We also learned that it increased as more units are

consumed in what is called the “law of increasing opportunity

costs”. The second piece of pizza increases costs by 4 utils.

And marginal costs rise from there as each successive unit requires greater and greater

sacrifice.

There is probably is something you’d rather have more…a drink perhaps.

Slide 12 of 32

We can analyze these costs and benefits graphically

Lets start by graphing the Marginal Cost Curve.

The first piece of pizza had a cost of 2 utils.

The marginal cost of the second piece is even higher.

And for each successive piece, marginal costs rises as more and more is sacrificed to

get pizza.

That should make sense to you – it is easy to imagine that at some point, the cost of an extra piece of pizza seems high. How many slices can

you eat after all?

Slide 13 of 32

We can now compare marginal costs and marginal benefits

In this case, you’d gladly buy the first unit…its marginal benefit exceed its costs.

That is true for the second unit as well.

The third unit is “break even”…let’s assume you’d

buy it.

The fourth (and beyond) are unattractive – costs outweigh

benefits.

We’ve now added the Marginal Utility curve.

Note that the first piece brings in a lot of utility.

Maybe you are hungry. And it is hot and tasty.

Marginal Utility falls off from there as each piece is less

satisfying than the last.

Consumers conduct what is called Marginal Cost

Marginal Benefit Analysis for each of their actions.

Slide 14 of 32


Through Marginal Cost Marginal Benefit Analysis we arrive at the purchase of 3

units.

That maximizes utility, represented by this shape.

It is the net benefit obtained by this consumer, if they

choose to consumer three units.

But what if they do not…

What if they consumer two or four units.

Net Benefit

Slide 15 of 32

We are now seeing how consumers make decisions based on marginal benefits and marginal costs…that is a

key learning outcome!


Suppose this consumer stops after consuming two

units.

In this case, some of the net benefit is forgone.

Specifically, the lost net benefit illustrated by the red colored triangle is no longer

enjoyed.

Net Benefit

These losses in net benefits are referred to as dead

weight loss.

Dead Weight Loss - “the loss of a benefit from a failure to carry out an activity at the efficient level.”

Slide 16 of 32


In this case, the fourth unit has a cost that exceeds the

benefit.

The fourth unit takes away from net benefit.

Specifically, the net benefit is reduced by the amount

illustrated by the red colored triangle.

Net Benefit

What if a consumer chooses more than 3 units?

Slide 17 of 32

Consumers compare costs and benefits when making choices

But I think we can agree that consumers seek to maximize their utility.

Ok…admittedly, people do not sit around all day calculating these numbers out loud.

We all want the best, right?

And we know our actions have costs…for anything we do, we are giving something else up.

Slide 18 of 32

Let’s turn our attention to markets

Have you ever bought anything and thought “I got a really good deal!”

In economics, we’d call that “Consumer Surplus”

Slide 19 of 32

So what is consumer surplus?

Consumer Surplus – The difference between the maximum price a consumer (or set of consumers) would pay for an item and its market price

This concept is best shown graphically…

Slide 20 of 32

A visual definition of Consumer Surplus

We’ve learned that this market, if left alone, would find this equilibrium.

We’ve also learned that, if left alone, price would be $6 and 6 units would be sold.

Let’s look at the experience of individual

consumers in this market!

Slide 21 of 32

Slide ‹#› of 32

Consumer surplus graphically

If you added all the benefits of all consumers together, you’d see total

consumer surplus.

As such, the total value of all consumer surplus is the area of this triangle.

Each of the consumer’s purchasing this item would be willing to pay more than the market price…with the exception of

the very last one.

Slide 23 of 32

Producer Surplus

Let’s turn our attention to Producer Surplus

Slide 24 of 32

Consumer’s aren’t the only one with surplus benefits

Producer Surplus – The difference between the actual price a producer receives (the market price) and the minimum price they would be willing to accept

This concept can also be shown graphically…

Slide 25 of 32


The same idea applies to producers.

Let’s look at this individual producer.

She is willing to produce this item for $3

But she doesn’t have to – she can sell it for $6.

She is receiving a benefit –she’d be willing to produce this item at $3 but can

sell it at $6…that is called producer surplus.

For h

er, i

t’s w

orth

$3!

Slide 26 of 32


If you added all these benefits together, you’d see total consumer surplus.

It is the area of this triangle.

Slide 27 of 32

In this market, a significant amount of surplus benefits would accrue

A

B

C

In this market, the total value of consumer and producer surplus

combined is the area of the triangle denoted by ABC.

It is the total benefit gained by society.

Here is the important point:

Economists LOVE markets because they benefit society. When a market sets the price, Consumer and Producer surplus is

maximized.

And when that happens, economists call those markets “efficient”.

Slide 28 of 32

However, when markets are interfered with, “Efficiency” can be affected

Imagine that you have a market represented by this supply and demand

curve. Price is set at $6.

Imagine that a government deems this price too low and implements a price

floor of $8.

What happens to Consumer and Producer Surplus?

Consumer Surplus falls and Producer Surplus increases.

Note the new quantity resulting from the price

floor!

Consumer Surplus

Producer Surplus

Also notice how some of these benefits simply vanish.

Those losses are referred to as

“Dead Weight Loss”.

Slide 29 of 32

When markets are interfered with, there can be consequences to consumer and producer surplus

Dead Weight Loss (also called efficiency loss) – For a market, dead weight loss is represented by reductions in combined consumer and producer surplus resulting from the under or over allocation of resources to the production of a good.

Dead Weight Loss – losses in either consumer or producer surplus that occur when a market does not reach equilibrium on its own.

In English

Slide 30 of 32

Society’s benefits and Dead Weight Loss

Keep in mind that consumer and producer surpluses normally accrue to

society – both consumers and producers.

Any policy that would cause dead weight loss (such as this) to occur would be

detrimental to society as a whole.

While it may be in society’s best interest to do so, it should be considered

carefully!

Slide 31 of 32

In Summary

We’ve learned that consumers weigh benefits and costs prior to making any

decision.

In conducting this analysis, they seek to maximize their utility.

We’ve also learned that markets, when working well, allow the net

benefit to society to be maximized.

In the right conditions, and if they are left alone, markets will maximize this benefit…but they are not always left

alone!

Slide 32 of 32

markets, maximizers, and efficiency

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