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Microeconomics Lecture Gap Sheets - way

Lecture
Recap L1 5 – Utility and Demand

PPF1

X
What drives Demand ?

Price What constitutes Demand ?

Y Budget Line
Scarcity
Choices
Tradeoff

Demand Curve
X

Quantity

Part 1 – Household Budget & Consumption Possibilities

Consumption
Possibility Pizza Coke
1.1 Consumption Possibilities A 0 10
B 1 8
C 2 6
Budget Constraints
Make _________
________________ D 3 4

Constraints on Consumption _____________ E 4 2
F 5 0

Consumption possibilities

Constrained by 1) Income 2) Prices of Goods

1.2 Budget Line Consumption Possibilities

Coke
To construct a budget line 10
A Income $30

3 variables B
Pizza $6 each
Coke $3 each
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1) Income C
2) Px 6
D
3) Py 4
E
2

Budget line equation _________________________________ F

1 2 3 4 5 Pizza

A budget line shows the limits of consumption possibilities and the income is __________ spent. w

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 Microeconomics Lecture Gap Sheets - way
1.3 Relative Price

Slope of Budget Line Consumption Possibilities

Coke
• To get 1 more pizza ($6), need to give up ______ coke 10
A Income $30
Pizza $6 each

opportunity cost of a pizza = ___________________ B
Coke $3 each
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C
• Slope of budget line = ___________________ 6
D
4
• Opportunity cost of a pizza slope of the budget line … [1] 2
E

(pizza on the x-axis) F

1 2 3 4 5 Pizza

Relative Price
• Relative price of a pizza in terms of coke = ______________________
• Relative price is price of one good divided by the price of the other good

• Relative price of pizza Opportunity cost of pizza … [2]

Relative price of a pizza opportunity cost of a pizza slope of budget line

_____________________________________
Consumption Possibilities
1.4 Real Income Coke
A Income $30
10
• Real income of coke = B
Pizza $6 each
Coke $3 each
8
C
• Real income of pizza = 6
D
4
• _______________ quantity of a good that can be purchased E
2
F
• Point at which the budget line ________________ the X and Y axis. 1 2 3 4 5 Pizza

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1.5 Price Change
Income = $30 Price Change
Ppizza = $6 Qpizza = 5 Ppizza falls
Coke
Pcoke = $3 Qcoke = 10
Budget line rotates ______
10
Budget line becomes ______

Real income ______
Price Fall
Relative price ______
Ppizza falls from $6 to $3
Opportunity cost _______

Qpizza = $30 / $3 = 10 (Qpizza increases from 5 to 10)
 Real income = 10

Relative price = Ppizza/Pcoke = $3/$3 = 1 (reduces from 2 to 1)

Price Rise
Ppizza rises from $6 to $12

Qpizza = $30 / $12 = 2.5

Real income = 2.5
2.5 5 10
Ppizza rise Pizza

Budget line rotates ________

Budget line becomes _______

Real income _____

Relative price _____

Opportunity cost ______
(Qpizza decreases from 5 to 2.5)

Relative price = Ppizza / Pcoke = $12/$3 = 4 (increases from 2 to 4)

Therefore, when prices changes

Real income and relative price (opportunity cost) ___________

Budget line rotates inwards/outwards

Q: When Px double & Py double, what happens to the relative price of X & Y, & the slope of the budget line? __________

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 Microeconomics Lecture Gap Sheets - way
1.6 Income Change
A) Income increased to $42
Y-intercept = $42 / $3 = 14 Income
X-intercept = $42 / $6 = 7 Income Change
Budget line ________
Coke 14

Real income _______

10 X & Y intercepts ___

Slope
6
R.P. of X & Y
B) Income reduced to $18 $30
Opp cost of X & Y
Y-intercept = $18 / $3 = 6
X-intercept = $18 / $6 = 3 3 5 7
Pizza

Income

Budget line ___________

Real income __________

X & Y intercepts ______

Slope

R.P. of X & Y

Opp cost of X & Y

Therefore, when income changes

Budget line parallel shift, real income ________ , X & Y intercepts _________

Slope of the budget line ______________________

Relative price of X and Y ______________________

Opportunity cost of X and Y ______________________
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 Microeconomics Lecture Gap Sheets - way

Part 2 – Utility

2.1 Concept of Utility Decreasing Marginal Utility

More expensive Cost much less

Prefer Gucci (Preferences)

why
Higher _____________________
Higher _______
• Consume 1st candy bar - Certain utility (eg 100 utils)

• Utility
The satisfaction or benefits derived from consuming a good • Consume the 2nd candy bar – certain utility (eg 80 utils)
– The incremental utility of 80 from the 2nd candy bar is the Marginal Utility
– The 2nd candy bar gives a lower utility than the 1st
Decreasing Marginal Utility
– Total Utility – 100 utils + 80 utils = 180 utils

• Consume the 3rd candy bar – certain utility (eg 60 utils)

2.2 Marginal Utility and Total Utility

A) Marginal utility
o Marginal utility is the ____________ utility that results from a one-unit increase in the quantity of a good consumed

o The 1st glass of beer give you a certain level of satisfaction, eg a 30 utils of utility
The 2nd glass of beer will give you a level of satisfaction that is ________ than that of the 1st glass, eg 18 utils
The 3rd glass of beer will give you a level of satisfaction that is ________ than that of the 2nd glass, eg 14 utils

B) Law of Diminishing Marginal Utility

o The marginal utility ______________ as the quantity of good consumed increases Marginal Utility
30

Units of Utility
Marginal utility (incremental
utility from the 2nd glass of beer)
18

14

10
6 No of glass (beer)

1 2 3 4 6
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Total Utility
C) Total Utility 62

52 10
o As you consumed more, the total utility ______________ 48
14

Units of Utility
o Total utility is the total benefit from the quantity of good consumed 18
30

Can the level of satisfaction or the incremental utility becomes negative ?

30
Or can total utility decreases as more goods are consumed ?

As you consume more and more glasses of beer
you … No of glass (beer)

Negative Marginal Utility

MU
• Consume 1st candy bar - Certain utility (eg 100 utils)
• Consume the 2nd candy bar – certain utility (eg 80 utils)
• Consume the 3rd candy bar – certain utility (eg 60 utils)
• Consume the 4th candy bar – certain utility (eg 30 utils)
• Consume the 5th candy bar – certain utility (eg 5 utils)
• Consume the 6th candy bar – becomes negative satisfaction (eg – 20 utils)

Marginal Utility
30
TU
Units of Utility

18

14

10
6 No of glass (beer)

1 2 3 4 6 7 8
-7
6
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 Microeconomics Lecture Gap Sheets - way
Part 3 – Maximising Utility
3.1 Utility Maximisation Combination, Optimal Consumption or Consumer Equilibrium
• Choose the consumption possibility that maximizes total utility.

Good A Good B
High Utility Low Utility
High MU Low MU
Buying a 2nd piece
Which one ?

Buy ______ A Buy _______ B

But what if A is very expensive B is relatively much cheaper

So ? Buy more or less A ? Buy less or more B ?

Consider MUA/ PA MUB /PB High Utility Low Utility

$3,000 $30
Consumer Equilibrium
Total utility is maximised when _________________________________

Spend all income and equalise the marginal utility per dollar
• Total utility is maximised when (or consumer equilibrium)
MUA/ PA = MUB /PB And spend all available income (or budget)
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Point B
Pizza Coke
MUpizza/ Ppizza > MUcoke /Pcoke Quantity MU MU/P Quantity MU MU/P
B 1 48 8 8 18 6

Consumption Possibilities
Coke
A
10
B
8
C
6
D
4
E
2
F

1 2 3 4 5 Pizza

Point D
MUpizza/ Ppizza < MUcoke /Pcoke
Pizza Coke
Quantity MU MU/P Quantity MU MU/P
D 3 30 5 4 24 8

Consumption Possibilities
Coke
A
10
B
8
C
6
D
4
E
2
F

1 2 3 4 5 Pizza
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Past Exam Question

Utility Maximisation / Optimal Consumption Example

Jessy's marginal utility of watching movies and marginal utility of eating out each month in utils are represented in the following table.

Total Utility Total Utility from

Movies/Month from Movies Eating Out/Month Eating Out
1 60 1 150
2 110 2 290
3 130 3 410
4 135 4 510

She spends $100 every month for entertainment, the price per movie is $10 and price per eating out is $20. What is Jessy's optimal combination of movies
and eating out?
Movies Eating Out
Qty TU MU MU/P Qty TU MU MU/P
1 60 1 150
2 110 2 290
3 130 3 410
4 135 4 510

What if budget increases to $110 (or budget = $110), what is Jessy’s optimal consumption combination ?

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3.2 Deriving Utility Maximization (or Cosumer Equilibrium) Using the MU/P Graph

Marginal Utility Per Dollar Curve

Marginal Utility Per Dollar Curve Marginal Utility Per Dollar Curve Coke
Pizza Coke MU/P
MU/P MU/P

MUpizza / Ppizza MUcoke / Pcoke

MUcoke / Pcoke

0 1 2 3 4 5 Qty 0 2 4 6 8 10 Qty 10 8 6 4 2 0 Qty

Marginal Utility Per Dollar Curve

Pizza and Coke

MU/P MUcoke / Pcoke

MUpizza / Ppizza

Coke 10 8 6 4 2 0 Qty
Pizza 0 1 2 3 4 5

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 Microeconomics Lecture Gap Sheets - way
Part 4 – Effect of Price and Income Change

4.1 Price Change - Marginal Utility Theory Predicts Law of Demand

Pizza Demand Curve

Price

Qty (Pizza)

Coke Demand Curve

Price

Qty (Coke)

4.2 Price Change - Marginal Utility Theory Predicts A Change in the Price of Substitute Changes the Demand for the Good

4.3 Income Change - Marginal Utility Theory Predicts A Change in the Income Changes the Demand for the Good
• When income increases :
– the demand for a normal good increases
– the demand for an inferior good decreases.
• Maximum utility occurs where the marginal utility per dollar spend on all goods are equal
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 Revision Question 4 Microeconomics Lecture Gap Sheets - way

Refer to the following table which shows the total utility of John when he consumes various quantities of pizza and movie:

Given that his weekly allowance is $24, all of which he spends on pizza and movie rentals, whose prices are $6 per slice and $3 per rental, respectively. If
slices of pizza and movie rentals are available only in whole-number amounts, list all possible combinations of the two goods that John can purchase each
week with his allowance. Further, determine his optimal consumption combination of the two products.

Pizzas/week Utils/week from Movie Utils/week from

pizza
0 0
1 20
2 38
3 54
4 68
5 80
6 90
7 98
8 104
rentals/week rentals
0 0
1 40
2 46
3 50
4 54
5 56
6 57
7 58
8 59

Combination Pizza Movie TU

1
2
3
4
5

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 Past Exam Question Microeconomics Lecture Gap Sheets - way

The table below shows May Xuan's utility from ice cream and chocolate bars.
The price of ice cream is $5 per tub and a box of chocolate is $10. Using the utility-maximizing rule, what is May Xuan’s optimal consumption combination of ice
cream and chocolate if her budget for these two goods is $35?
Ice Cream
Quantity Total utility
1 95
2 180
3 255
4 320
5 375
6 420
Chocolate
Quantity Total utility
1 170
2 320
3 450
4 560
5 650
6 720

Ice Cream Chocolate

Qty TU MU MU/P Qty TU MU MU/P
1 95 1 170
2 180 2 320
3 255 3 450
4 320 4 560
5 375 5 650
6 420 6 720

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 Powerpoint Tutorial Questions Microeconomics Lecture Gap Sheets - way

Q1 The law of diminishing marginal utility suggests that _________________.

(A) total utility will begin to fall.
(B) additional units of consumption will add less to total utility.
(C) total utility will begin to rise.
(D) most consumers will limit their consumption even when they earn high incomes.

Q2 Which of the following is NOT an assumption of marginal utility theory?

(A) A consumer derives utility from the goods consumed.
(B) Each additional unit of consumption yields additional utility.
(C) Consumers maximise their total utility.
(D) As more of a good is consumed, the decrease in the marginal utility from the good means that the total utility from the good decreases also.

Q3 The marginal utility of consuming the third cupcake is __________.

(A) three times the average utility of the three cupcakes.
(B) three cupcakes times the price of a cupcake.
(C) the total utility of three cupcakes divided by three.
(D) the change in total utility between the third cupcake and the second cupcake.

Q4 Tom was invited to a buffet lunch. The fact that the fourth plate that Tom ate generated more satisfaction than the fifth plate is an example of ____________.
(A) increasing marginal utility.
(B) diminishing marginal utility.
(C) diminishing total utility.
(D) the "paradox of value".

Q5 A measure of the satisfaction you receive from all the coffee that you consume is your ________.
(A) marginal utility of coffee.
(B) marginal utility per dollar spent on coffee.
(C) total utility from coffee.
(D) most marginal utility per dollar spent on coffee when you are in your consumer equilibrium.

Q6 State if the following statements are true or false. Explain your answer.
(a) As a person consumes more and more slices of pizza, the marginal utility of each extra slice increases.
(b) An increase in a person’s income shifts his/her budget line rightward and changes its slope.

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Q7 The table below shows Lisa's marginal utility for pizza and marginal utility for DVDs.

Quantity of Marginal utility from Quantity of Marginal utility from

DVDs DVDs
1 150
2 120
3 100
4 90
5 60
6 40
pizza pizza
1 200
2 180
3 150
4 120
5 100
6 60

(a) From the table, what can you conclude about Lisa’s marginal utility as she increases her consumption of both items?
(b) If the price of a pizza is $10, the price of a DVD is $5, and Lisa has $40 to spend on the two goods. Using the concept of MU/P, determine the combination of
pizza(s) and DVDs Lisa will consume in order to maximize her utility?

Q8 The table below shows Mary's total and marginal utilities from comedy videos.

Total utility Marginal utility Total utility Marginal utility

Quantity/Week
(Comedy videos) (Comedy videos) (Detective Novels) (Detective Novels)
0 0 - 0 -
1 250 ____ 100 100
2 ____ 180 280 180
3 580 ____ 330 50
4 700 ____ 370 40

(a) Fill in the missing cells for both total and marginal utility. Explain Mary’s utility when she increases her consumption of comedy videos beyond 4 (FOUR)
comedy videos per week?
(b) If the price of a pizza (?) is $10, the price of a DVD (?) is $5, and Mary has $40 to spend on the two goods. Using the concept of MU/P, determine the
combination of pizza(s) (?) and DVDs Mary will consume in order to maximize her utility?

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 Microeconomics Lecture Gap Sheets - way
Lecture 5 Summary
Consumption Possibilities Utility :
Two ways of showing Law of Diminishing Marginal Utility

Price change Income change

Px down
Rotates outward (flatter) Income down
// shift inward a) TU curve : rate of increase of TU is declining
Px up
Rotates inward (steeper) Income up
// shift outward b) MU curve : MU is declining

Px
Py 3 variables
Income
Example 2 – Changes in Consumption
Possibilities Qy Budget Lines
Slope of budget line Income Increase (*) I1
-Relative price = Px/Py Px
Py
Increase (*)
Decrease
Py1

(= Qy / Qx)
Io
Pyo

Income

I1 Io Qx
Price and income change Position of I1/Px1 is uncertain
Px1 Pxo

- Relative strength of change If income less than Px If income more than Px

3 Utility Maximisation or Consumer Equilibrium

The utility-maximizing combination is called a

Product 1 Product 2
consumer equilibrium Qty TU MU MU/P Qty TU MU MU/P
Total utility is maximized when:
MUm/Pm = MUs/Ps
and spend all income

If MUS/PS > MUM/PM.
spend more on S

If MUS/PS < MUM/PM.
spend more on M

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