blanchard_ch07 - 9160335_CH07_p149-168.qxp 6/22/09 8:59 AM...

Info iconThis preview shows page 1. Sign up to view the full content.

View Full Document Right Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: 9160335_CH07_p149-168.qxp 6/22/09 8:59 AM Page 149 PA RT THREE Households’ Choices 7 Utility and Demand After studying this chapter, y ou will be able to: ■ Describe preferences using the concept of utility, distinguish between total utility and marginal utility, and explain the marginal utility theory of consumer choice ■ Use marginal utility theory to predict the effects of changes in prices and incomes and to explain the paradox of value ■ Describe some new ways of explaining consumer choices You want Coldplay’s latest hit album, Viva la Vida, and you want the Justin Timberlake and Madonna single, Four Minutes. Will you download the album and the single? Or will you buy two CDs? Or will you buy the album on a CD and download the single? What determines our choices as buyers of recorded music? And how much better off are we because we can download a song for 99 cents? You know that diamonds are expensive and water is cheap. The theory of consumer choice that you’re going to study in Doesn’t that seem odd? Why do we place a higher value on use- this chapter answers questions like the ones we’ve just posed. less diamonds than on essential-to-life water? You can think of The main purpose of this theory is to explain the law of many other examples of this paradox. For example, paramedics demand and the influences on buying plans. To explain the who save people’s lives get paid a tiny fraction of what a theory, we will study the choices of Lisa, a student who loves National Hockey League player earns. Do we really place less movies and has a thirst for soda. But the theory explains all value on the people who take care of the injured and the sick choices including your choices in the market for recorded than we place on those who provide us with entertaining hockey music as well as the paradox that the prices of water and dia- games? Reading Between the Lines answers this question. monds are so out of proportion with their benefits. 149 9160335_CH07_p149-168.qxp 150 6/22/09 8:59 AM Page 150 CHAPTER 7 Utility and Demand ◆ Maximizing Utility Your income and the prices that you face limit your consumption choices. You can buy only the things that you can afford. But you still have lots of choices. Of all the alternative combinations of goods and services that you can afford, what will you buy? The economist’s answer to this question is that you will buy the goods and services that maximize your utility. Utility is the benefit or satisfaction that a person gets from the consumption of goods and services. To understand how people’s choices maximize utility, we distinguish between two concepts: Lisa’s Utility from Movies and Soda TABLE 7.1 M ovies Quantity Total Marginal utility (per month) utility ■ Total utility Marginal utility Total Utility Total utility is the total benefit that a person gets from the consumption of all the different goods and services. Total utility depends on the level of consumption—more consumption generally gives more total utility. To make the concept of total utility more concrete, think about the choices of Lisa, a student who spends all her income on two goods: movies and soda. We tell Lisa that we want to measure her utility from these two goods. We can use any scale that we wish to measure utility and give her two starting points: (1) we will call the total utility from no movies and no soda zero utility; and (2) we will call the total utility she gets from seeing 1 movie a month 50 units. We then ask Lisa to tell us, using the same scale, how much she would like 2 movies, and more, up to 10 a month. We also ask her to tell us, on the same scale, how much she would like 1 case of soda a month, 2 cases, and more, up to 10 cases a month. In Table 7.1, the columns headed “Total utility” show Lisa’s answers. Looking at those numbers, you can say quite a lot about how much Lisa likes soda and movies. She says that 1 case of soda gives her 75 units of utility—50 percent more than the utility that she gets from seeing 1 movie. But you can also see that her total utility from soda climbs more slowly than her total utility from movies. By the time she is buying 9 cases of soda and seeing 9 movies a month, she gets almost the same utility from each good. And at 10 of each, she gets 0 0 1 50 2 90 3 122 4 150 5 176 6 200 7 222 8 ■ Soda 242 9 259 10 275 . . . . 50 . . . . 40 . . . . 32 . . . . 28 . . . . 26 . . . . 24 . . . . 22 . . . . 20 . . . . 17 . . . . 16 Cases (per month) Total Marginal utility utility 0 0 1 75 2 123 3 159 4 183 5 205 6 225 7 238 8 248 9 255 10 260 . . . . 75 . . . . 48 . . . . 36 . . . . 24 . . . . 22 . . . . 20 . . . . 13 . . . . 10 .... 7 .... 5 more total utility from movies (275 units) than she gets from soda (260 units). Marginal Utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed. In Table 7.1, the columns headed “Marginal utility” show Lisa’s marginal utility from movies and soda. You can see that if Lisa increases the soda she buys from 1 to 2 cases a month, her total utility from soda increases from 75 units to 123 units. For Lisa, the marginal utility from the second case each month is 48 units (123 – 75). The marginal utility numbers appear midway between the quantities of soda because it is the change in the quantity she buys from 1 to 2 cases that produces the marginal utility of 48 units. Marginal utility is positive, but it diminishes as the quantity consumed of a good increases. Marginal utility Positive Marginal Utility All the things that people enjoy and want more of have a positive marginal utility. Some objects and activities can generate negative marginal utility—and lower total utility. Two examples are hard labor and polluted air. But the goods and services that people value and that we are think- 9160335_CH07_p149-168.qxp 6/22/09 8:59 AM Page 151 Maximizing Utility Graphing Lisa’s Utility Schedules Figure 7.1(a) illustrates Lisa’s total utility from soda. The more soda Lisa consumes in a month, the more total utility she gets. Her total utility curve slopes upward. Figure 7.1(b) illustrates Lisa’s marginal utility from soda. It is a graph of the marginal utility numbers in Table 7.1. This graph shows Lisa’s diminishing marginal utility from soda. Her marginal utility curve slopes downward as she consumes more soda. We’ve now described Lisa’s preferences. Our next task is to see how she chooses what to consume to maximize her utility. Units of utility Diminishing Marginal Utility As Lisa sees more movies, her total utility from movies increases but her marginal utility from movies decreases. Similarly, as she consumes more soda, her total utility from soda increases but her marginal utility from soda decreases. The tendency for marginal utility to decrease as the consumption of a good increases is so general and universal that we give it the status of a principle—the principle of diminishing marginal utility. You can see Lisa’s diminishing marginal utility by calculating a few numbers. Her marginal utility from soda decreases from 75 units from the first case to 48 units from the second case and to 36 units from the third. Her marginal utility from movies decreases from 50 units for the first movie to 40 units for the second and 32 units for the third. Lisa’s marginal utility diminishes as she buys more of each good. You can confirm that the principle of diminishing marginal utility applies to your own utility by thinking about the following two situations: In one, you’ve been studying all through the day and evening, and you’ve been too busy finishing an assignment to go shopping. A friend drops by with a can of soda. The utility you get from that soda is the marginal utility from one can. In the second situation, you’ve been on a soda binge. You’ve been working on an assignment all day but you’ve guzzled ten cans of soda while doing so, and are now totally wired. You are happy enough to have one more can, but the thrill that you get from it is not very large. It is the marginal utility from the nineteenth can in a day. Total Utility and Marginal Utility FIGURE 7.1 250 Increasing total utility… Total utility 200 150 100 50 0 1 2 3 4 5 Quantity (cases per month) (a) Total utility Units of utility ing about here all have positive marginal utility: total utility increases as the quantity consumed increases. 151 80 …and diminishing marginal utility 60 40 Marginal utility 20 0 1 2 3 4 5 Quantity (cases per month) (b) Marginal utility The figure graphs Lisa’s total utility and marginal utility from soda based on the numbers for the first 5 cases of soda a month in Table 7.1. Part (a) shows that her total utility increases as her consumption of soda increases—increasing total utility. The bars along the total utility curve show the extra total utility from each additional case of soda—marginal utility. Part (b) shows that Lisa’s marginal utility from soda diminishes as her consumption of soda increases— diminishing marginal utility. The bars that measure marginal utility get shorter as soda consumption increases. animation 9160335_CH07_p149-168.qxp 152 6/22/09 8:59 AM Page 152 CHAPTER 7 Utility and Demand The Utility-Maximizing Choice Suppose that Lisa earns $40 a month and she spends it all on movies and soda. The prices that she faces are $8 for a movie and $4 for a case of soda. Lisa’s most direct way of finding the quantities of movies and soda that maximize her utility is to make a spreadsheet like Table 7.2. The rows of the table show the combinations of movies and soda that Lisa can afford and that exhaust her $40 income. She can afford smaller quantities of movies and soda than those in the table, but smaller quantities don’t maximize her utility. Why? Because her marginal utilities of movies and soda are positive, so the more of each that she buys, the more total utility she gets. Table 7.2 shows the total utility that Lisa gets from the just-affordable quantities of movies and soda. The middle column adds the total utility from movies to the total utility from soda. This number, the total utility from movies and soda, is what Lisa wants to maximize. In row A, Lisa watches no movies and buys 10 cases of soda. She gets no utility from movies and 260 units of utility from soda. Her total utility from movies and soda (the center column) is 260 units. In row C, highlighted in the table, Lisa sees 2 movies and buys 6 cases of soda. She gets 90 units of utility from movies and 225 units of utility from soda. Her total utility from movies and soda is 315 units. This combination of movies and soda maximizes Lisa’s total utility. This is the best Lisa can do, when she has only $40 to spend and given the prices of movies and cases. If Lisa buys 8 cases of soda, she can see only 1 movie. She gets 298 units of total utility, 17 less than the maximum attainable. If she sees 3 movies, she can buy only 4 cases of soda. She gets 305 units of total utility, 10 less than the maximum attainable. We’ve just described Lisa’s consumer equilibrium. A consumer equilibrium is a situation in which a consumer has allocated all of his or her available income in the way that maximizes his or her total utility, given the prices of goods and services. Lisa’s consumer equilibrium is 2 movies and 6 cases of soda. To find Lisa’s consumer equilibrium, we measured her total utility from all the affordable combinations of movies and soda. But a simpler way of finding a consumer equilibrium uses the idea that choices are made at the margin—an idea that you first met in Chapter 1. Let’s look at this approach. TABLE 7.2 Lisa’s Utility-Maximizing Combinations Movies $8 Quantity (per month) Total utility Total utility from movies and soda Soda $4 Total Cases utility (per month) A 0 0 260 260 10 B 1 50 298 248 8 C 2 90 315 225 6 D 3 122 305 183 4 E 4 150 273 123 2 F 5 176 176 0 0 Choosing at the Margin A consumer’s total utility is maximized by following the rule: ■ Spend all the available income Equalize the marginal utility per dollar for all goods Spend All the Available Income Because more con- sumption brings more utility, only those choices that exhaust income can maximize utility. For Lisa, combinations of movies and soda that leave her with money to spend don’t give her as much total utility as those that spend her entire income of $40 a month. Equalize Marginal Utility per Dollar We’ve defined marginal utility as the increase in total utility from consuming one more unit of a good. Marginal utility per dollar is the marginal utility from a good obtained by spending one more dollar on that good. The distinction between these two marginal concepts is clearest for a good that is infinitely divisible, such as gasoline. You can buy gasoline by the smallest fraction of a gallon and literally choose to spend one more or one less dollar at the pump. When you buy a movie ticket or a case of soda, you must spend your dollars in bigger lumps. But the principles that apply at the gas pump also apply at the movie house and the convenience store. Let’s see how this marginal approach works. 9160335_CH07_p149-168.qxp 6/22/09 8:59 AM Page 153 Maximizing Utility The Basic Idea The basic idea behind the utility maximizing rule is to move dollars from good A to good B if doing so increases the utility from good A by more than it decreases the utility from good B. Such a utility-increasing move is possible if the marginal utility per dollar from good A exceeds that from good B. But buying more of good A decreases its marginal utility. And buying less of good B increases its marginal utility. So by moving dollars from good A to good B, total utility rises, but the gap between the marginal utilities per dollar gets smaller. So long as a gap exists—so long as the marginal utility per dollar from good A exceeds that from good B, total utility can be increased by spending more on A and less on B. But when enough dollars have been moved from B to A to make the two marginal utilities per dollar equal, total utility cannot be increased further. Utility is maximized. TABLE 7.3 153 Equalizing Marginal Utilities per Dollar Movies Soda ( $8 each) ($4 per case) Marginal utility M arginal per Quantity utility dollar A 0 0 B 1 50 C 2 40 D 3 E F Cases Marginal utility Marginal per utility dollar 10 5 1.25 6.25 8 10 2.50 5.00 6 20 5.00 32 4.00 4 24 6.00 4 28 3.50 2 48 12.00 5 26 3.25 0 0 Lisa’s Marginal Calculation Let’s apply the basic idea to Lisa. To calculate Lisa’s marginal utility per dollar, we divide her marginal utility numbers for each quantity of each good by the price of the good. Table 7.3 shows these calculations for Lisa. The rows of the table are affordable combinations of movies and soda. In row B, Lisa sees 1 movie a month and consumes 8 cases of soda a month. Her marginal utility from seeing 1 movie a month is 50 units. Because the price of a movie is $8, Lisa’s marginal utility per dollar from movies is 50 units divided by $8, or 6.25 units of utility per dollar. Lisa’s marginal utility from soda when she consumes 8 cases of soda a month is 10 units. Because the price of soda is $4 a case, Lisa’s marginal utility per dollar from soda is 10 units divided by $4, or 2.50 units of utility per dollar. When Lisa consumes 1 movie and 8 cases of soda a month, her marginal utility per dollar from movies exceeds her marginal utility per dollar from soda. If Lisa spent an extra dollar on movies and a dollar less on soda, her total utility would increase. She would get 6.25 units from the extra dollar spent on movies and lose 2.50 units from the dollar less spent on soda. Her total utility would increase by 3.75 units (6.25 – 2.50). But if Lisa sees more movies and consumes less soda, her marginal utility from movies falls and her marginal utility from soda rises. Too Few Movies and Too Much Soda In row D, Lisa sees 3 movies a month and consumes 4 cases of soda. Her marginal utility from seeing the third movie a month is 32 units. At a price of $8 a movie, Lisa’s marginal utility per dollar from movies is 32 units divided by $8, or 4 units of utility per dollar. Lisa’s marginal utility from soda when she buys 4 cases a month is 24 units. At a price of $4 a case, Lisa’s marginal utility per dollar from soda is 24 units divided by $4, or 6 units of utility per dollar. When Lisa sees 3 movies and consumes 4 cases of soda a month, her marginal utility from soda exceeds her marginal utility from movies. If Lisa spent an extra dollar on soda and a dollar less on movies, her total utility would increase. She would get 6 units from the extra dollar spent on soda and she lose 4 units from the dollar less spent on movies. Her total utility would increase by 2 units (6 – 4). But if Lisa sees fewer movies and consumes more soda, her marginal utility from movies rises and her marginal utility from soda falls. Too Many Movies and Too Little Soda In Table 7.3, if Lisa moves from row B to row C, she increases the movies she sees from 1 to 2 a month and she decreases the soda she consumes from 8 to 6 cases a month. Her marginal utility per dollar from movies falls to 5 and her marginal utility per dollar from soda rises to 5. Similarly, if Lisa moves from row D to row C, she Utility-Maximizing Movies and Soda 9160335_CH07_p149-168.qxp 154 6/22/09 8:59 AM Page 154 CHAPTER 7 Utility and Demand decreases the movies she sees from 3 to 2 a month and she increases the soda she consumes from 4 to 6 cases a month. Her marginal utility per dollar from movies rises to 5 and her marginal utility per dollar from soda falls to 5. At this combination of movies and soda, Lisa is maximizing her utility. If she spent an extra dollar on movies and a dollar less on soda, or an extra dollar on soda and a dollar less on movies, her total utility would not change. Call the marginal utility from movies MUM and the price of a movie PM. Then the marginal utility per dollar from movies is MUM/PM. Call the marginal utility from soda MUS and the price of a case of soda PS. Then the marginal utility per dollar from soda is MUS/PS. When Lisa maximizes utility, The Power of Marginal Analysis The method we’ve just used to find Lisa’s utility-maximizing choice of movies and soda is an example of the power of marginal analysis. Lisa doesn’t need a computer and a spreadsheet program to maximize utility. She can achieve this goal by comparing the marginal gain from having more of one good with the marginal loss from having less of another good. The rule that she follows is simple: If the marginal utility per dollar from movies exceeds the marginal utility per dollar from soda, see more movies and buy less soda; if the marginal utility per dollar from soda exceeds the marginal utility per dollar from movies, buy more soda and see fewer movies. More generally, if the marginal gain from an action exceeds the marginal loss, take the action. You will meet this principle time and again in your study of economics, and you will find yourself using it when you make your own economic choices, especially when you must make big decisions. Units of Utility In maximizing total utility by making the marginal utility per dollar equal for all goods, the units in which utility is measured do not matter. Any arbitrary units will work. In this respect, utility is like temperature. Predictions about the freezing point of water don’t depend on the temperature scale; and predictions about a household’s consumption choice don’t depend on the units of utility. When we introduced the idea of utility, we arbitrarily chose 50 units as Lisa’s total utility from 1 movie. But we could have given her any number. And as you’re now about to discover, we didn’t even need to ask Lisa to tell us her preferences. We can figure out Lisa’s preferences for ourselves by observing what she buys at various prices. To see how, we need to use a bit of math. MUS/PS = MUM/PM. Multiply both sides of this equation by PS to obtain MUS = MUM * PS/PM. This equation says that the marginal utility from soda, MUS, is equal to the marginal utility from movies, MUM, multiplied by the ratio of the price of soda, PS, to the price of a movie, PM. For Lisa, when PM = $8 and PS = $4 we observe that in a month she goes to the movies twice and buys 6 cases of soda. So we know that her MUS from 6 cases of soda equals her MUM from 2 movies multiplied by $4/$8 or 0.5. If we call MUM from the second movie 40, then MUS from the sixth case of soda is 20. If we observe enough prices and quantities, we can construct an entire utility schedule for an arbitrary starting value. Review Quiz ◆ 1 2 3 4 5 What is utility and how do we use the concept of utility to describe a consumer’s preferences? What is the distinction between total utility and marginal utility? What is the key assumption about marginal utility? What two conditions are met when a consumer is maximizing utility? Explain why equalizing the marginal utility per dollar from each good maximizes utility. Work Study Plan 7.1 and get instant feedback. 9160335_CH07_p149-168.qxp 6/22/09 8:59 AM Page 155 Predictions of Marginal Utility Theory ◆ Predictions of Marginal Utility Theory We’re now going to use marginal utility theory to make some predictions. You will see that marginal utility theory predicts the law of demand. The theory also predicts that a fall in the price of a substitute of a good decreases the demand for the good and that for a normal good, a rise in income increases demand. All these effects, which in Chapter 3 we simply assumed, are predictions of marginal utility theory. To derive these predictions, we will study the effects of three events: ■ ■ ■ A fall in the price of a movie A rise in the price of soda A rise in income A Fall in the Price of a Movie With the price of a movie at $8 and the price of soda at $4, Lisa is maximizing utility by seeing 2 movies and buying 6 cases of soda each month. Then, with no change in her $40 income and no change in the price of soda, the price of a movie falls from $8 to $4. How does Lisa change her buying plans? A person’s preferences don’t change just because a price has changed. With no change in her preferences, Lisa’s marginal utilities in Table 7.4 are the same as those in Table 7.1. But because the price of a movie has changed, the marginal utility per dollar from movies changes. In fact, with a halving of the price from $8 to $4, the marginal utility per dollar from movies has doubled. The numbers in Table 7.4 show Lisa’s marginal utility per dollar from movies for each quantity of movies. The table also shows Lisa’s marginal utility from soda for each quantity. New Marginal Utilities per Dollar from Movies Equalizing the Marginal Utilities per Dollar You can see that if Lisa continues to see 2 movies a month (row A), her marginal utility per dollar from movies is 10 units and if Lisa continues to buy 6 cases of soda (row B), her marginal utility per dollar from soda is only 5 units. Lisa is buying too much soda and too few movies. If she spends a dollar more on movies and a dollar less on soda, her total utility increases by 5 units (10 – 5). You can also see that if Lisa continues to buy 6 cases of soda and sees 4 movies (row B), her marginal TABLE 7.4 Finding the New Quantities of Movies and Soda You can find the effect of a fall in the price of a movie on the quantities of movies and soda that Lisa buys in a three-step calculation. The lower price of a movie means that Lisa can afford more movies or more soda. Table 7.4 shows her new affordable combinations. In row A, if she continues to see 2 movies a month, she can now afford 8 cases of soda and in row B, if she continues to buy 6 cases of soda, she can now afford 4 movies. Lisa can afford any of the combinations shown in the rows of Table 7.4. The next step is to find her new marginal utilities per dollar from movies. Affordable Combinations How a Change in the Price of Movies Affects Lisa’s Choices Movies Soda ( $4 each) ($4 per case) Marginal utility M arginal per Quantity utility dollar 1. Determine the just-affordable combinations of movies and soda at the new prices. 2. Calculate the new marginal utilities per dollar from the good whose price has changed. 3. Determine the quantities of movies and soda that make their marginal utilities per dollar equal. 155 Cases Marginal utility Marginal per utility dollar 0 C 5 1.25 12.50 9 7 1.75 2 40 10.00 8 10 2.50 32 8.00 7 13 3.25 4 28 7.00 6 20 5.00 5 B 10 50 3 A 0 1 26 6.50 5 22 5.50 6 24 6.00 4 24 6.00 7 22 5.50 3 36 9.00 8 20 5.00 2 48 12.00 9 17 4.25 1 75 18.75 10 16 4.00 0 0 9160335_CH07_p149-168.qxp 8:59 AM Page 156 CHAPTER 7 Utility and Demand utility per dollar from movies is 7 units and her marginal utility per dollar from soda is only 5 units. Lisa is still buying too much soda and seeing too few movies. If she spends a dollar more on movies and a dollar less on soda, her total utility increases by 2 units (7 – 5). But if Lisa sees 6 movies and buys 4 cases of soda a month (row C ), her marginal utility per dollar from movies (6 units) equals her marginal utility per dollar from soda. If Lisa moves from this allocation of her budget, her total utility decreases. She is maximizing utility. Lisa’s increased purchases of movies results from a substitution effect—she substitutes the now lowerpriced movies for soda—and an income effect—she can afford more movies. A Change in Demand Lisa’s decrease in the quantity of soda that she buys is the change in the quantity of soda that she plans to buy each month at a given price of soda when the price of a movie changes. It is a change in her demand for soda. We illustrate a change in demand by a shift of a demand curve. Figure 7.2(b) shows Lisa’s demand for soda. The price of soda is fixed at $4 a case. When the price of a movie is $8, Lisa buys 6 cases of soda on demand curve D0. When the price of a movie falls to $4, Lisa buys 4 cases of soda on demand curve D1. The fall in the price of a movie decreases Lisa’s demand for soda. Her demand curve for soda shifts leftward. For Lisa, soda and movies are substitutes. 8 Quantity demanded increases 4 D 0 A Change in the Quantity Demanded Lisa’s increase 2 4 6 8 Quantity (movies per month) (a) Demand for movies Price (dollars per case) in the quantity of movies that she sees is a change in the quantity demanded. It is the change in the quantity of movies that she plans to see each month when the price of a movie changes and all other influences on buying plans remain the same. We illustrate a change in the quantity demanded by a movement along a demand curve. Figure 7.2(a) shows Lisa’s demand curve for movies. When the price of a movie is $8, Lisa sees 2 movies a month. And when the price of a movie falls to $4, she sees 6 movies a month. Lisa moves downward along her demand curve for movies. The demand curve traces the quantities that maximize utility at each price, with all other influences remaining the same. You can also see that utilitymaximizing choices generate a downward-sloping demand curve. Utility maximization with diminishing marginal utility implies the law of demand. A Fall in the Price of a Movie FIGURE 7.2 Price (dollars per movie) 156 6/22/09 Lisa's demand for soda when the price of a movie is ... 8 ... $8 ... $4 4 D0 D1 0 2 4 6 8 Quantity (cases per month) (b) Demand for soda When the price of a movie falls and the price of soda remains the same, the quantity of movies demanded by Lisa increases, and in part (a), Lisa moves along her demand curve for movies. Also, when the price of a movie falls, Lisa’s demand for soda decreases, and in part (b), her demand curve for soda shifts leftward. For Lisa, soda and movies are substitutes. animation 9160335_CH07_p149-168.qxp 6/22/09 8:59 AM Page 157 Predictions of Marginal Utility Theory Now suppose that with the price of a movie at $4, the price of soda rises from $4 to $8 a case. How does this price change influence Lisa’s buying plans? We find the answer by repeating the three-step calculation with the new price of soda. Table 7.5 shows Lisa’s new affordable combinations. In row A, if she continues to buy 4 cases of soda a month she can afford to see only 2 movies; and in row B, if she continues to see 6 movies a month, she can afford only 2 cases of soda. Table 7.5 show Lisa’s marginal utility per dollar from soda for each quantity of soda when the price is $8 a case. The table also shows Lisa’s marginal utility per dollar from movies for each quantity. If Lisa continues to buy 4 cases of soda a month (row A), her marginal utility per dollar from soda is 3. But she must cut her movies to 2 a month, which gives her 12 units of utility per dollar from movies. Lisa is buying too much soda and too few movies. If she spends a dollar less on soda and a dollar more on movies, her utility increases by 9 units (12 – 3) . But if Lisa sees 6 movies a month and cuts her soda back to 2 cases (row B), her marginal utility per dollar from movies (6 units) equals her marginal utility per dollar from soda. She is maximizing utility. Lisa’s decreased purchases of soda results from an income effect—she can afford fewer cases and she buys fewer cases. But she continues to buy the same quantity of movies. TABLE 7.5 Lisa’s Demand for Soda Now that we’ve calculated the effect of a change in the price of soda on Lisa’s buying plans, we have found two points on her demand curve for soda: When the price of soda is $4 a case, Lisa buys 4 cases a month; and when the price rises to $8 a case, she buys 2 cases a month. Figure 7.3 shows these points on Lisa’s demand curve for soda. It also shows the change in the quantity of soda demanded when the price of soda rises and all other influences on Lisa’s buying plans remain the same. In this particular case, Lisa continues to buy the same quantity of movies. This outcome does not always occur. It is a consequence of Lisa’s utility schedule. With different marginal utilities, she might have decreased or increased the quantity of movies that she sees when the price of soda changes. You’ve seen that marginal utility theory predicts the law of demand—the way in which the quantity demanded of a good changes when its price changes. Next we’ll see how marginal utility theory predicts the effect of a change in income on demand. FIGURE 7.3 Price (dollars per case) A Rise in the Price of Soda 8 Quantity demanded decreases 4 Soda ( $4 each) ($8 per case) Marginal utility M arginal per Quantity utility dollar Cases Marginal utility Marginal per utility dollar D 0 0 0 2 40 4 B A Rise in the Price of Soda How a Change in the Price of Soda Affects Lisa’s Choices Movies A 157 5 22 2.75 12.00 4 24 6 28 7.00 3 36 4.50 6.00 2 48 6.00 8 20 5.00 1 75 9.38 10 16 4.00 0 0 6 4 Quantity (cases per month) 3.00 24 2 When the price of soda rises and the price of a movie and Lisa’s income remain the same, the quantity of soda demanded by Lisa decreases. Lisa moves along her demand curve for soda. animation 9160335_CH07_p149-168.qxp 6/22/09 8:59 AM Page 158 CHAPTER 7 Utility and Demand 158 A Rise in Income Suppose that Lisa’s income increases from $40 to $56 a month and that the price of a movie is $4 and the price of a case of soda is $4. With these prices and with an income of $40 a month, Lisa sees 6 movies and buys 4 cases of soda a month (Table 7.4). How does the increase in Lisa’s income from $40 to $56 change her buying plans? Table 7.6 shows the calculations needed to answer this question. If Lisa continues to see 6 movies a month, she can now afford to buy 8 cases of soda (row A); and if she continues to buy 4 cases of soda, she can now afford to see 10 movies (row C ). In row A, Lisa’s marginal utility per dollar from movies is greater than her marginal utility per dollar from soda. She is buying too much soda and too few movies. In row C, Lisa’s marginal utility per dollar from movies is less than her marginal utility per dollar from soda. She is buying too little soda and too many movies. But in row B, when Lisa sees 8 movies a month and buys 6 cases of soda, her marginal utility per dollar from movies equals that from soda. She is maximizing utility. Figure 7.4 shows the effects of the rise in Lisa’s income on her demand curves for movies and soda. The price of each good is $4. When Lisa’s income Movies Soda ( $4 each) ($4 per case) Marginal utility M arginal per Quantity utility dollar Marginal utility Marginal per utility dollar Cases 4 10 5 1.25 6.50 9 7 1.75 24 6.00 8 10 2.50 7 B 7.00 26 6 A 28 5 22 5.50 7 13 3.25 8 5.00 6 20 5.00 17 4.25 5 22 5.50 10 C 20 9 16 4.00 4 24 6.00 rises to $56 a month, she sees 2 more movies and buys 2 more cases of soda. Her demand curves for both movies and soda shift rightward—her demand for both movies and soda increases. With a larger income, the consumer always buys more of a normal good. For Lisa, movies and soda are normal goods. Price (dollars per case) The Effects of a Rise in Income Price (dollars per movie) FIGURE 7.4 Lisa’s Choices with an Income of $56 a Month TABLE 7.6 Lisa's demand for movies when her income is ... ... $56 a month Lisa's demand for soda when her income is ... ... $56 a month ... $40 a month ... $40 a month 4 4 D1 D1 D0 0 6 4 8 10 Quantity (movies per month) D0 0 2 4 6 8 Quantity (cases per month) (a) Demand for movies (b) Demand for soda When Lisa’s income increases, her demand for movies and her demand for soda increase. Lisa’s demand curves for movies, in part (a), and for soda, in part (b), shift rightward. For Lisa, movies and soda are normal goods. animation 9160335_CH07_p149-168.qxp 6/22/09 8:59 AM Page 159 Predictions of Marginal Utility Theory The Paradox Resolved The paradox is resolved by distinguishing between total utility and marginal utility. The total utility that we get from water is enormous. But remember, the more we consume of something, the smaller is its marginal utility. We use so much water that its marginal utility— the benefit we get from one more glass of water or another 30 seconds in the shower—diminishes to a small value. Diamonds, on the other hand, have a small total utility relative to water, but because we buy few diamonds, they have a high marginal utility. When a household has maximized its total utility, it has allocated its income in the way that makes the marginal utility per dollar equal for all goods. That is, the marginal utility from a good divided by the price of the good is equal for all goods. This equality of marginal utilities per dollar holds true for diamonds and water: Diamonds have a high price and a high marginal utility. Water has a low price and a low marginal utility. When the high marginal utility from diamonds is divided by the high price of a diamond, the result is a number that equals the low marginal utility from water divided by the low price of water. The marginal utility per dollar is the same for diamonds and water. Value and Consumer Surplus Another way to think about the paradox of value and illustrate how it is resolved uses consumer surplus. Figure 7.5 explains the paradox of value by using this idea. The supply of water in part (a) is perfectly elastic at price PW, so the quantity of water consumed is QW and the consumer surplus from water is the large green area. The supply of diamonds in part (b) is perfectly inelastic at the quantity QD, so the price of a diamond is PD and the consumer surplus from diamonds is the small green area. Water is cheap but brings a large consumer surplus, while diamonds are expensive but bring a small consumer surplus. FIGURE 7.5 The Paradox of Value Price of water The price of water is low and the price of a diamond is high, but water is essential to life while diamonds are used mostly just for decoration. How can valuable water be so cheap while a relatively useless diamond is so expensive? This so-called paradox of value has puzzled philosophers for centuries. Not until the theory of marginal utility had been developed could anyone give a satisfactory answer. Consumer surplus from water PW S D 0 QW Quantity of water (a) Water Price of a diamond The Paradox of Value 159 S Consumer surplus from diamonds PD D 0 QD Quantity of diamonds (b) Diamonds Part (a) shows the demand for and supply of water. Supply is perfectly elastic at the price PW. At this price, the quantity of water consumed is QW and consumer surplus is the large green triangle. Part (b) shows the demand for and supply of diamonds. Supply is perfectly inelastic at the quantity QD. At this quantity, the price of a diamond is PD and consumer surplus is the small green triangle. Water is valuable—has a large consumer surplus—but cheap. Diamonds are less valuable than water—have a smaller consumer surplus—but are expensive. animation 9160335_CH07_p149-168.qxp 160 6/22/09 8:59 AM Page 160 CHAPTER 7 Utility and Demand Temperature: An Analogy Utility is similar to temperature. Both are abstract concepts, and both have units of measurement that are arbitrary. You can’t observe temperature. You can observe water turning to steam if it is hot enough or turning to ice if it is cold enough. And you can construct an instrument—a thermometer—that can help you to predict when such changes will occur. We call the scale on the thermometer temperature and we call the units of temperature degrees. But these degree units are arbitrary. We can use Celsius units or Fahrenheit units or some other units. The concept of utility helps us to make predictions about consumption choices in much the same way that the concept of temperature helps us to make predictions about physical phenomena. Admittedly, marginal utility theory does not enable us to predict how buying plans change with the same precision that a thermometer enables us to predict when water will turn to ice or steam. But the theory provides important insights into buying plans and has some powerful implications. It helps us to understand why people buy more of a good or service when its price falls and why people buy more of most goods when their incomes increase. It also resolves the paradox of value. We’re going to end this chapter by looking at some new ways of studying individual economic choices and consumer behavior. Review Quiz ◆ 1 2 3 4 5 When the price of a good falls and the prices of other goods and a consumer’s income remain the same, what happens to the consumption of the good whose price has fallen and to the consumption of other goods? Elaborate on your answer to the previous question by using demand curves. For which good does demand change and for which good does the quantity demanded change? If a consumer’s income increases and if all goods are normal goods, how does the quantity bought of each good change? What is the paradox of value and how is the paradox resolved? What are the similarities between utility and temperature? Work Study Plan 7.2 and get instant feedback. Maximizing Utility in Markets for Recorded Music Downloads Versus Discs In 2007, Americans spent $10 billion on recorded music, down from $14 billion in 2000. But the combined quantity of discs and downloads bought increased from 1 billion in 2000 to 1.8 billion in 2007 and the average price of a unit of recorded music fell from $14 to $5.50. The average price fell because the mix of formats bought changed dramatically. In 2000, we bought 1 billion CDs; in 2007, we bought only 0.5 billion CDs and downloaded 1.3 billion music files. Figure 1 shows the longer history of the changing formats of recorded music. The music that we buy isn’t just one good—it is several goods. Singles and albums are different goods; downloads and discs are different goods; and downloads to a computer and downloads to a cell phone are different goods. There are five major categories (excluding DVDs and cassettes) and the table shows the quantities of each that we bought in 2007. Singles Albums Format (millions in 2007) Disc Download Mobile 3 800 400 500 40 – Source of data: Recording Industry Association of America. Most people buy all their music in digital form, but many still buy physical CDs and some people buy both downloads and CDs. We get utility from the singles and albums that we buy, and the more songs and albums we have, the more utility we get. But our marginal utility from songs and albums decreases as the quantity that we own increases. We also get utility from convenience. A song that we can buy with a mouse click and play with the spin of a wheel is more convenient both to buy and to use than a song on a CD. The convenience of songs downloaded over the Internet means that, song for song, we get more utility from songs in this format than we get from physical CDs. But most albums are still played at home on a CD player. So for most people, a physical CD is a more convenient medium for delivering an album. Album 9160335_CH07_p149-168.qxp 6/22/09 8:59 AM Page 161 P redictions of Marginal Utility Theory 1,000 In the 1970s, recorded music came on vinyl discs. Cassettes gradually replaced vinyl, then compact discs gradually replaced cassettes, and today, digital files downloaded to computers and mobile devices are replacing physical CDs. Downloads Compact discs 800 600 Units (millions per year) 161 Casettes 400 Vinyl discs 200 0 1975 1980 1985 1990 1995 2000 2005 2010 Year Figure 1 Changing Formats of Recorded Music for album, people on average get more utility from a CD than from a download. When we decide how many singles and albums to download and how many to buy on CD, we compare the marginal utility per dollar from each type of music in each format. We make the marginal utility per dollar from each type of music in each format equal, as the equations below show. The market for single downloads has created an enormous consumer surplus. The table shows that the quantity of single downloads demanded at 99 cents each was 800 million in 2007, and the quantity of singles on a disc demanded at $4.75 a disc was 3 million in 2007. If we assume that $4.75 is the most that anyone would pay for a single download (probably an underestimate), the demand curve for single downloads is that shown in Fig. 2. With the price of a single download at $0.99, consumer surplus (the area of the green triangle) is $1.5 billion. Price (dollars per single) Source of data: www.swivel.com. 5.00 4.75 Consumer surplus from single downloads 4.00 3.00 2.00 0.99 D 0 200 400 600 800 1,000 Quantity (millions of singles per year) Figure 2 The Demand for Single Downloads MUsingle downloads Psingle downloads = MUalbum downloads Palbum downloads = MUphysical singles Pphysical singles = MUphysical albums Pphysical albums = MUmobile Pmobile MUsingle downloads $0.99 = MUalbum downloads $10 = MUphysical singles $4.75 = MUphysical albums $15 = MUmobile $2.50 9160335_CH07_p149-168.qxp 6/22/09 8:59 AM Page 162 READING BETWEEN THE LINES A Paradox of Value: Paramedics and Hockey Players Salaries, Strong Recruitment Ease Area Paramedic Shortage April 4, 2008 To curb a critical shortage, fire departments across the Washington region have pursued paramedics like star athletes in recent years, enticing them with signing bonuses, handsome salaries and the promise of fast-track career paths. Montgomery County hired a marketing expert and launched a national recruiting drive, reaching out in particular to women and minorities. Fairfax County offered top starting salaries, now totaling about $57,000—as much as 50 percent higher than some other local jurisdictions, though Fairfax paramedics generally work longer hours. ... Copyright 2008 The Washington Post. Reprinted with permission. Further reproduction prohibited. Ducks Give Perry $26.6 Million Deal July 2, 2008 The Ducks’ first free-agent signing might also be their last, their biggest and their most expected. Within the first hour of the NHL’s free agency period, Corey Perry signed a five-year, $26.625 million contract that will keep the 23-year-old in Anaheim until 2013. Both parties had expressed an interest in completing the deal for several months but it wasn’t possible until Tuesday, when the Ducks had enough room for long-term contracts under the salary cap. “I really wanted to stay in Anaheim,” Perry said. “It’s home now and I didn’t want to leave here. It’s a great place to play hockey and it just shows how well the organization is run.” Including an $8 million signing bonus spread over its duration, the contract will pay Perry $4.5 million in 2008–09, then $6.5 million, $5.375 million, $5.375 million and $4.875 million, respectively, over the final four years. ... Copyright 2005 The Daily News of Los Angeles. Reprinted with permission. Further reproduction prohibited. Essence of the Stories ■ 162 In Washington, the starting salary for a paramedic is $57,000 per year. ■ Corey Perry has a 5-year contract with the Anaheim Ducks that will earn him $26.6 million. 6/22/09 8:59 AM Page 163 Economic Analysis ■ If resources are used efficiently, the marginal utility per dollar from the services of a paramedic, MUP/PP, equals the marginal utility per dollar from the services of a hockey player, MUH/PH. That is, MUH MUP = . PP PH ■ A paramedic in Washington earns $57,000 a year, but the national average paramedic wage is $27,000 a year. ■ If we put these numbers into the above formula, we get 57 Consumer surplus = $3 billion 50 40 SP 27 Corey Perry earns $26.6 million over 5 years, or $5.32 million a year on average. ■ Wage rate (thousands of dollars per year) 9160335_CH07_p149-168.qxp MUP $27,000 = MUH $5,320,000 . 20 DP 10 0 100 200 Quantity (thousands of paramedics) Figure 1 The value of paramedics MUH = 197. MUP ■ ■ ■ ■ ■ Is the marginal utility from Corey Perry’s services really 197 times that from the paramedic’s services? The answer is no. A paramedic might serve about 8 people a day, or perhaps 2,000 in a year; a hockey player like Corey Perry serves millions of people a year. If a paramedic serves 2,000 people a year, then the price of a paramedic’s service per customer served is $27,000/2,000, which equals $13.50. Wage rate (millions of dollars per year) Equivalently, ■ Figure 1 shows the market for paramedics. The equilibrium quantity is 200,000 workers, and the average wage rate is $27,000 a year. ■ Figure 2 shows the market for professional hockey players. The equilibrium quantity is 500 players and the 6.0 Consumer surplus = $1.5 billion 4.0 2.0 If Corey Perry serves 1,000,000 people a year, then the price of Corey Perry’s service per customer served is $5,320,000/1,000,000, which equals $5.32. Using these prices of the services per customer, a paramedic is worth 2.5 times as much as a hockey player—the marginal utility from the services of a paramedic is 2.5 times that from a hockey player. SH 8.0 DH 0 750 1,500 Quantity (hockey players) Figure 2 The value of hockey players average wage rate is $4,000,000 a year. (Corey Perry earns more than the average player.) ■ Not only is the marginal utility from a paramedic greater than that from a hockey player, but paramedics also create a greater consumer surplus. 163 9160335_CH07_p149-168.qxp 164 6/22/09 8:59 AM Page 164 CHAPTER 7 Utility and Demand SUMMARY ◆ Key Points Predictions of Marginal Utility Theory (pp. 155–161) ■ Maximizing Utility (pp. 150–154) ■ ■ ■ ■ A household’s preferences can be described by a utility schedule that lists the total utility and marginal utility derived from various quantities of goods and services consumed. The principle of diminishing marginal utility is that the marginal utility from a good or service decreases as consumption of the good or service increases. Total utility is maximized when all the available income is spent and when the marginal utility per dollar from all goods is equal. If the marginal utility per dollar for good A exceeds that for good B, total utility increases if the quantity purchased of good A increases and the quantity purchased of good B decreases. ■ ■ ■ ■ ■ Marginal utility theory predicts the law of demand. That is, other things remaining the same, the higher the price of a good, the smaller is the quantity demanded of that good. Marginal utility theory also predicts that, other things remaining the same, the larger the consumer’s income, the larger is the quantity demanded of a normal good. Marginal utility theory resolves the paradox of value. Total value is total utility or consumer surplus. But price is related to marginal utility. Water, which we consume in large amounts, has a high total utility and a large consumer surplus, but the price of water is low and the marginal utility from water is low. Diamonds, which we buy in small quantities, have a low total utility and a small consumer surplus, but the price of a diamond is high and the marginal utility from diamonds is high. Key Figures Figure 7.1 Figure 7.2 Total Utility and Marginal Utility, 151 A Fall in the Price of a Movie, 156 Figure 7.3 Figure 7.4 Figure 7.5 A Rise in the Price of Soda, 157 The Effects of a Rise in Income, 158 The Paradox of Value, 159 Key Terms Consumer equilibrium, 152 Diminishing marginal utility, 151 Marginal utility, 150 Marginal utility per dollar, 152 Total utility, 150 Utility, 150 9160335_CH07_p149-168.qxp 6/22/09 8:59 AM Page 165 Problems and Applications PROBLEMS and APPLICATIONS 165 ◆ Work problems 1–10 in Chapter 7 Study Plan and get instant feedback. Work problems 11–21 as Homework, a Quiz, or a Test if assigned by your instructor. 1. Max enjoys windsurfing and snorkeling. The table shows the total utility he gets from each activity. Hours per day Total utility from windsurfing Total utility from snorkeling 1 120 40 2 220 76 3 300 106 4 360 128 5 396 140 6 412 150 7 422 158 a. Find Max’s marginal utility from windsurfing at each number of hours per day. b. Find Max’s marginal utility from snorkeling at each number of hours per day. c. Do Max’s marginal utility from windsurfing and from snorkeling obey the principle of diminishing marginal utility? d. Which does Max enjoy more: his 6th hour of windsurfing or his 6th hour of snorkeling? 2. Max in problem 1 has $35 a day to spend, and he can spend as much time as he likes on his leisure pursuits. Windsurfing equipment rents for $10 an hour, and snorkeling equipment rents for $5 an hour. a. Make a table that shows the various combinations of hours spent windsurfing and snorkeling that Max can afford. b. In your table, add two columns and list Max’s marginal utility per dollar from windsurfing and from snorkeling. c. How long does Max spend windsurfing and how long does he spend snorkeling to maximize his total utility? d. If compared to c, Max spent a dollar more on windsurfing and a dollar less on snorkeling, by how much would his total utility change? e. If compared to c, Max spent a dollar less on windsurfing and a dollar more on snorkeling, by how much would his total utility change? f. Explain why, if Max equalized the marginal utility per hour from windsurfing and from snorkeling, he would not maximize his utility. 3. Max in problems 1 and 2 is offered a special deal on windsurfing equipment: a rental rate of $5 an hour. His income remains at $35 a day and the rental price of snorkeling equipment remains at $5 an hour. a. Make a table that shows the new combinations of hours spent windsurfing and snorkeling that Max can afford. b. In your table, list Max’s marginal utilities per dollar from windsurfing and snorkeling. c. How many hours does Max now spend windsurfing and how many hours does he spend snorkeling? 4. Given the information about Max in problems 1, 2, and 3, a. Find two points on Max’s demand curve for rented windsurfing equipment. b. Draw Max’s demand curve for rented windsurfing equipment. c. Is Max’s demand for renting windsurfing equipment elastic or inelastic? 5. Max, with the utility schedules in problem 1, gets an increase in income from $35 to $55 a day. Windsurfing equipment rents for $10 an hour, and snorkeling equipment rents for $5 an hour. Show the effect of the increase in Max’s income on Max’s demand curve for a. Rented windsurfing equipment, and explain whether, for Max, windsurfing equipment is a normal good or an inferior good. b. Rented snorkeling equipment, and explain whether, for Max, snorkeling equipment is a normal good or an inferior good. 6. Schools Get a Lesson in Lunch Line Economics Sharp rises in the cost of milk, grain, and fresh fruits and vegetables are hitting cafeterias across the country, forcing cash-strapped schools to raise prices or pinch pennies by serving more economical dishes. … Fairfax schools, for instance, serve oranges—14 cents each—instead of grapes, which are a quarter a serving. The Washington Post, April 14, 2008 Assume that a Fairfax school has a $14 daily fruit budget. a. How many oranges a day can the school afford to serve if it serves no grapes? 9160335_CH07_p149-168.qxp 166 6/22/09 8:59 AM Page 166 CHAPTER 7 Utility and Demand b. How many servings of grapes can the school afford each day if it serves no oranges? c. If the school provides 50 oranges a day and maximizes utility, how many servings of grapes does it provide? d. If the marginal utility from an orange is 14 units of utility, what is the marginal utility from a serving of grapes? 7. Can Money Buy Happiness? “Whoever said money can’t buy happiness isn’t spending it right.”... You know that there must be some connection between money and happiness. If there weren’t, you’d be less likely to stay late at work (or even come in at all). … “Once you get basic human needs met, a lot more money doesn’t make a lot more happiness.” … Going from earning less than $20,000 a year to making more than $50,000 makes you twice as likely to be happy, yet the payoff for then surpassing $90,000 is slight. CNN, July 18, 2006 a. What does the fundamental assumption of marginal utility theory suggest about the connection between money and happiness? b. Explain why this article is consistent with marginal utility theory. 8. Eating Away the Innings in Baseball’s Cheap Seats Baseball and gluttony, two of America’s favorite pastimes, are merging in a controversial trend taking hold at Major League Baseball stadiums across the nation: all-you-can-eat seats. … Some fans try to “set personal records” during their first game in the section. By their second or third time in such seats … they eat like they normally would at a game. USA Today, March 6, 2008 a. What conflict might exist between utilitymaximization and setting “personal records” for eating? b. What does the fact that fans eat less at subsequent games indicate about what happens to the marginal utility from ballpark food as the quantity consumed increases? c. How can setting personal records for eating be reconciled with marginal utility theory? d. Which ideas of behavioral economics are consistent with the information in the news clip? 9. Compared to Other Liquids, Gasoline is Cheap Think a $4 gallon of gas is expensive? Consider the prices of these other fluids that people buy every day without complaint. … Gatorade, 20 oz @ $1.59 = $10.17 per gallon … Wite-Out, 7 oz @ $1.39 = $25.42 per gallon … HP Ink Cartridge, 16 ml @ $18 = $4,294.58 per gallon The New York Times, May 27, 2008 a. What does marginal utility theory predict about the marginal utility per dollar from gasoline, Gatorade, Wite-Out, and printer ink? b. What do the prices per gallon reported in this news clip tell you about the marginal utility from a gallon of gasoline, Gatorade, WiteOut, and printer ink? c. What do the prices per unit reported in this news clip tell you about the marginal utility from a gallon of gasoline, a 20 oz bottle of Gatorade, a 7 oz bottle of Wite-Out, and a cartridge of printer ink? d. How can the paradox of value be used to explain why the fluids listed in the news clip might be less valuable than gasoline, yet far more expensive? 10. Exclusive Status: It’s in The Bag; $52,500 Purses. 24 Worldwide. 1 in Washington. Forget your Coach purse. Put away your Kate Spade. Even Hermes’s famous Birkin bag seems positively discount. The Louis Vuitton Tribute Patchwork is this summer’s ultimate status bag, ringing in at $52,500. And it is arriving in Washington. … The company … [is] offering only five for sale in North America and 24 worldwide. … The Washington Post, August 21, 2007 a. Use marginal utility theory to explain the facts reported in the news clip. b. If Louis Vuitton offered 500 Tribute Patchwork bags in North America and 2,400 worldwide, what do you predict would happen to the price that buyers would be willing to pay and what would happen to the consumer surplus? c. If the Tribute Patchwork bag is copied and thousands are sold illegally, what do you predict would happen to the price that buyers would be willing to pay for a genuine bag and what would happen to the consumer surplus? 9160335_CH07_p149-168.qxp 6/22/09 8:59 AM Page 167 Problems and Applications 11. Cindy enjoys golf and tennis. The table shows the marginal utility she gets from each activity. Hours per month Marginal utility from golf Marginal utility from tennis 1 80 40 2 60 36 3 40 30 4 30 20 5 20 10 6 10 5 7 6 2 Cindy has $70 a month to spend, and she can spend as much time as she likes on her leisure pursuits. The price of an hour of golf is $10, and the price of an hour of tennis is $5. a. Make a table that shows the various combinations of hours spent playing golf and tennis that Cindy can afford. b. In your table, add two columns and list Cindy’s marginal utility per dollar from golf and from tennis. c. How long does Cindy spend playing golf and how long does she spend playing tennis to maximize her utility? d. Compared to c, if Cindy spent a dollar more on golf and a dollar less on tennis, by how much would her total utility change? e. Compared to c, if Cindy spent a dollar less on golf and a dollar more on tennis, by how much would her total utility change? f. Explain why, if Cindy equalized the marginal utility per hour of golf and tennis, she would not maximize her utility. 12. Cindy’s tennis club raises its price of an hour of tennis to $10. The price of golf and Cindy’s income remain the same. a. Make a table that shows the combinations of hours spent playing golf and tennis that Cindy can now afford. b. In your table, list Cindy’s marginal utility per dollar from golf and from tennis. c. How many hours does Cindy now spend playing golf and how many hours does she spend playing tennis? 13. Given the information in problems 11 and 12, a. Find two points on Cindy’s demand curve for tennis. 167 b. Draw Cindy’s demand curve for tennis. c. Is Cindy’s demand for tennis elastic or inelastic? d. Explain how Cindy’s demand for golf changed when the price of an hour of tennis increased. e. What is Cindy’s cross elasticity of demand for golf with respect to the price of tennis? f. Are tennis and golf substitutes or complements for Cindy? 14. Cindy, with the utility schedules in problem 11, loses her math tutoring job and her income falls to $35 a month. With golf at $10 an hour and tennis at $5 an hour, how does the decrease in Cindy’s income change her demand for a. Golf, and explain whether, for Cindy, golf is a normal good or an inferior good. b. Tennis, and explain whether, for Cindy, tennis is a normal good or an inferior good. 15. Cindy in problem 11 takes a Club Med vacation, the cost of which includes unlimited sports activities. With no extra charge for golf and tennis, Cindy allocates a total of 4 hours a day to these activities. a. How many hours does Cindy play golf and how many hours does she play tennis? b. What is Cindy’s marginal utility from golf and from tennis? c. Why does Cindy equalize the marginal utilities rather than the marginal utility per dollar from golf and from tennis? 16. Ben spends $50 a year on 2 bunches of flowers and $50 a year on 10,000 gallons of tap water. Ben is maximizing utility and his marginal utility from water is 0.5 unit per gallon. a. Are flowers or water more valuable to Ben? b. Explain how Ben’s expenditure on flowers and water illustrates the paradox of value. 17. Blu-Ray Format Expected to Dominate, but When? Blu-ray stomped HD DVD to become the standard format for high-definition movie discs, but years may pass before it can claim victory over the good old DVD. … “The group that bought $2,000, 40-inch TVs are the ones that will lead the charge. … Everyone else will come along when the price comes down.”… Blu-ray machine prices are starting to drop. Wal-Mart Stores Inc. began stocking a $298 Magnavox model. … 9160335_CH07_p149-168.qxp 168 6/22/09 8:59 AM Page 168 CHAPTER 7 Utility and Demand That’s cheaper than most alternatives but a hefty price hike from a typical $50 DVD player. CNN, June 2, 2008 a. What does marginal utility theory predict about the marginal utility from a Magnavox Blu-ray machine compared to the marginal utility from a typical DVD player? b. What will have to happen to the marginal utility from a Blu-ray machine before it is able to “claim victory over the good old DVD”? 18. Five Signs You Have Too Much Money Some people think bottled water is a fool’s drink. I’m not among them, but when a bottle of water costs $38, it’s hard not to see their point. The drink of choice these days among image-conscious status seekers and high-end teetotalers in L.A. is Bling H2O… it’s not the water that accounts for the cost. … Much of the $38 is due to the “limited edition” bottle decked out in Swarovski crystals. CNN, January 17, 2006 a. Assuming that the price of a bottle of Bling H2O is $38 in all the major cities in the United States, what might its popularity in Los Angeles reveal about consumers’ incomes or consumers’ preferences in Los Angeles relative to other U.S. cities? b. Why might the marginal utility from a bottle of Bling H2O decrease more rapidly than the marginal utility from ordinary bottled water? 19. How To Buy Happiness. Cheap Sure, in any given country at any given point in time, the rich tend to be a bit happier than the poor. But across-the-board increases in living standards don’t seem to make people any happier. Disposable income for the average American has grown about 80% since 1972, but the percentage describing themselves as “very happy” (roughly a third) has barely budged over the years. … As living standards increase, most of us respond by raising our own standards. Things that once seemed luxuries now seem necessities. … As a result, we’re working harder than ever to buy stuff that satisfies us less and less. CNN, October 1, 2004 a. According to this news clip, how do widespread increases in living standards influence total utility? b. What does the news clip imply about how the total utility from consumption changes over time? c. What does the news clip imply about how the marginal utility from consumption changes over time? 20. Putting a Price on Human Life What’s a healthy human life worth? According to Stanford and University of Pennsylvania Researchers, about $129,000. Using Medicare records on treatment costs for kidney dialysis as a benchmark, the authors tried to pinpoint the threshold beyond which ensuring another “quality” year of life was no longer financially worthwhile. The study comes amid debate over whether Medicare should start rationing health care on a cost-effectiveness basis. … Time, June 9, 2008 a. Why might it be necessary for Medicare to ration health care according to treatment that is “financially worthwhile” as opposed to providing as much treatment as is needed by a patient, regardless of costs? b. What conflict might exist between a person’s valuation of his or her own life and the rest of society’s valuation of that person’s life? c. How does the potential conflict between self-interest and the social interest complicate setting a financial threshold for Medicare treatments? 21. Study Reading Between the Lines (pp. 162–163). a. If a wave of natural disasters put paramedics in the news and a large number of people decide to try to get jobs as paramedics, what happens to i. The marginal utility of the services of a paramedic? ii. Consumer surplus in the market for the services of paramedics? b. If television advertising revenues during hockey games double, what happens to i. The marginal utility of the services of a hockey player? ii. Consumer surplus in the market for the services of hockey players? ...
View Full Document

This note was uploaded on 02/07/2010 for the course ECON 251 taught by Professor Blanchard during the Fall '08 term at Purdue University-West Lafayette.

Ask a homework question - tutors are online