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ECON Exam 2

# ECON Exam 2 - ECON Exam#2 Review Sheet Chapter 20 Using...

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S diamonds Price S water MU = P diamond MU = P water D water D diamonds Q water Q diamonds Quantity Price Elastic region \$5 \$4 Inelastic region \$1 D \$0 5 4 Quantity 1 0 ECON Exam #2 Review Sheet: Chapter 20 Using marginal thinking to explain how the world works (2 examples) Diamond-water paradox – explains why water is essential to life and cheap, but diamonds which do not sustain life are expensive Marginal utility is determined by the price Total utility is determined by the amount of consumer surplus (area under the demand curve and above the price) Pink area-water, blue area-diamonds Pink area is much larger than the blue area which explains why water is more valuable (in total) than diamonds Water gives us more totally utility than diamonds do, but water is also very plentiful so we take it for granted Unfair comparison between how a person feels about a small quantity of something rare (diamond) and a large amount of a plentiful good (water) that we take for granted Diminishing utility- the principle that as more of any good or service is consumed, its extra benefit declines- the more of a good thing isn’t always better Increases in total utility from consumption of a good or service becomes smaller and smaller as more is consumed during a given time period, people prefer variety What are the assumptions behind consumer choice Consumers always choose the highest valued alternative (transitivity is often violated) One good can be substituted for another

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Decisions are made without perfect information The law of diminishing marginal utility limits consumption Diminishing Marginal Utility- see above 2 problems – see the samples below The equal marginal principle is used to determine which items will bring us the most utility Equal marginal utilities per dollar spent An individual will increase her rate of consumption of a product as long as the MU (marginal utility) exceeds the opportunity cost Chapter 21 Inelastic- whenever the outcome is more important than the price; the demand is insensitive to price; price is secondary to the desire to attain a certain amount of the good Elastic- price sensitive Connection between elasticity and profits (2 questions)-want to produce at unitary elasticity (point in the middle of demand) or below the quantity (elastic) revenues are maximized when demand is unitary When the price drops from \$5 to \$4 this causes the quantity purchased to rise from 0 to 1. On a percentage basis the quantity change is infinite in response to small price change. This means that the price elasticity of demand is elastic. When the price drops from \$1 to \$0 this causes the quantity purchased to rise from 4 to 5. On a percentage basis the quantity change is now small and the price drop is infinite. This means that the price elasticity of demand is inelastic.
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ECON Exam 2 - ECON Exam#2 Review Sheet Chapter 20 Using...

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