Thus marginal analysis for consumption decisions involves comparing the

Thus marginal analysis for consumption decisions

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include the budget constraint. Thus, marginal analysis for consumption decisions involves comparing the marginal utility per dollar spent on each good and selecting that consumption bundle in which the marginal utility per dollar is the same for all goods. Entertainment Food Budget line Income/price of food = 20 Income/price of entertainment = 5 C D A B 364 C H A P T E R 1 0 THE RATIONAL CONSUMER
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Tip #4. The substitution and income effects are challenging concepts for students. Most students have to work hard to achieve an understanding of these concepts. Tip #5. The substitution effect considers the effect of a change in the price of a good onthe consumption of that good. To see this effect using the marginal analysis, look at how theprice change affects the marginal utility per dollar spent on the good. For example, if theprice of good X increases, this causes the MUX/PXto decrease since the denominator is nowlarger and the numerator has not changed. For the individual to equate the marginal utilityper dollar spent on all goods in their consumption bundle, they need to decrease their con-sumption of good X while increasing their consumption of the other goods in the bundle.The effect of this is to increase the marginal utility the individual receives from consuminggood X (recall the principle of diminishing marginal utility): as the individual consumesfewer units of good X, the last unit consumed provides greater marginal utility and thereforethe MUX/PXincreases. As the individual consumes more of the other goods, their marginalutility from the last unit consumed decreases, causing the MUY/PYto fall. This process willcontinue until the marginal utility per dollar spent on all the goods in the consumption bun-dle are equal to one another.Tip #6.The income effect considers the effect of a change in the price of a good on the con-sumer’s ability to command goods and services. The income effect therefore considers theimpact of a change in the price of a good on the consumer’s purchasing power. This is espe-cially relevant for a good that represents a substantial expenditure relative to the consumer’sincome. Thus, if the price of a good increases and this good makes up a substantial part of theconsumer’s budgetary expenditure, the consumer experiences a decrease in their purchasingpower, and this will result in a change in the quantity of the goods they demand.If the good is a normal good, both the substitution and the income effects will lead theconsumer to consume less of the good.If the good is an inferior good, the substitution effect will lead the consumer to consumeless of the good while the income effect will cause the consumer to consume more of thegood. Typically, the substitution effect is stronger than the income effect, and the con-sumer’s overall consumption of the good will fall as its price rises. C H A P T E R 1 0 THE RATIONAL CONSUMER 365 WORKED PROBLEMS
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