A Lecture Presentation in Powerpoint Exploring Economics by Robert L. Sexton

A Lecture Presentation
in PowerPoint
to accompany
Exploring Economics
Second Edition
by Robert L. Sexton
Copyright © 2002 Thomson Learning, Inc.
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Printed in the United States of America
ISBN 0030342333
Copyright © 2002 by Thomson Learning, Inc.

Chapter 6
Consumer Choice and Welfare

6.1 Consumer Behaviour
 Individuals take action in response to
recognized opportunities to advance their
goals.
 This assumption that individuals act to
advance their goals—known as the rule of
rational choice—merely implies that
whatever individuals do is done with a
purpose.

6.1 Consumer Behavior
 In economics we assume that each
individual seeks to maximize his or her
own well-being or satisfaction.
 Economists developed the concept of

utility to allow them to study the
relative levels of satisfaction that
consumers get from the consumption of
goods and services.

 Utility varies from individual to
individual depending on specific
preferences.
 Therefore, it is not possible to compare the
relative satisfactions of different persons.
 Total utility is the total amount of
satisfaction derived from the consumption
of a certain number of units of a good or
service.

 Marginal utility is the additional satisfaction
generated by the last unit of a good that is
consumed.
 Total utility increases with additional
consumption.
 The incremental satisfaction—the
marginal utility—that results from the
consumption of additional units tends to
decline as consumption increases.

 This law of diminishing marginal utility
 means that each successive unit of a good

that is consumed generates less additional
satisfaction than did the previous unit.

Q TU MU
1 40
2 85 45
3 120 35
4 140 20
5 150 10
6 157 7
7 160 3
8 160 0
9 155 -5
10 145 -10

Q TU MU
1 40
2 85 45
3 120 35
4 140 20
5 150 10
6 157 7
7 160 3
8 160 0
9 155 -5
10 145 -10

Q TU MU
1 40
2 85 45
3 120 35
4 140 20
5 150 10
6 157 7
7 160 3
8 160 0
9 155 -5
10 145 -10

Exhibit 1: Total and Marginal
Utility
20 40
Marginal
(per pizza slice)
15 30
Marginal Utility
Total Utility
utility Total
utility
10 20
5 10
0 1 2 3 4 0 1 2 3 4
Quantity of Pizza Slices Quantity of Pizza Slices
(per hour) (per hour)

 It follows from the law of diminishing

marginal utility that as a person uses
more and more units of a good to satisfy
a given want, the intensity of the want,
and the utility derived from further
satisfying that want, diminishes.

6.2 The Consumer’s Choice
 Consumers try to add to their total
utility, so when the marginal utility
generated by the purchase of additional
units of one good drops too low,
 it can become rational for the consumer
to purchase other goods rather than to
purchase more of the first good.

 A rational consumer will avoid making
purchases of any one good beyond the
point at which other goods will yield
greater satisfaction for the amount
spent.
 Marginal utility is an important

concept in understanding and
predicting consumer behaviour.

The Consumer’s Choice
 Equilibrium of the Consumer:
 Single Commodity: The consumer is in

equilibrium
 when the MU of good x is equated to its
market price (Px).
 MUx = Px

 By comparing the marginal utilities
generated by units of the goods that he
or she desires as well as their prices, a
rational consumer seeks the
combination of goods that
maximizes his or her satisfaction.

 When the optimum, utility-maximizing

level of each good has been purchased,
consumers are said to have reached
the point of consumer equilibrium.

 In order to reach consumer equilibrium,
consumers must allocate their income in
such a way that the ratio of the
marginal utility to the price of the good
is equal for all goods purchased.
 When this goal is realized, one cedi’s
worth of additional banana will yield the
same marginal utility as one cedi’s worth
of additional bread or apples or movie
tickets or soap.
 Given a fixed budget, if the marginal
utilities per cedi spent on additional
units of two goods are not the same,
 the consumer can increase total
satisfaction by buying more of a
good with a higher marginal utility
per cedi and less of another good with a
lower marginal utility per cedi

 Consumers will continue to alter their
purchases to increase their satisfaction until
the ratio of the marginal utility to the
price of each good is equal for all goods
purchased.
 The law of demand—buying more of a good

as its price is reduced—reflects consumer
equilibrium where goods are subject to the
law of diminishing marginal utility.
 Derivation of Equilibrium:
 Multiple Commodities: If there are
more commodities, the condition for the
equilibrium of the consumer is
 that the ratios of the MU of the

individual commodities to their
prices must be equal


 A lower price for a good increases its

marginal utility or satisfaction per
cedi, leading to an increase in the
quantity of that good demanded.

6.3 Consumer and Producer Surplus
 How much a consumer is willing to pay versus
how much the consumer actually pays for the
product
 If it happens that what a consumer actually
pays for a good is usually less than what she is
willing to pay,
 The monetary difference between what the
consumer is willing to pay and what the
consumer actually pays is called consumer
surplus.
 Consumer surplus is shown graphically
as the area under the demand curve
(willingness to pay for the units
consumed) and above the market
price (what must be paid for those
units).

Exhibit 1: Consumer Surplus
a
Price
Demand
0
Q

Quantity
Exhibit 2: Consumer Surplus for
Iced Kenkey
Price of Iced Kenkey (per
¢4
Consumer surplus =
¢3 + ¢1 = ¢ 4
¢3
glass)
¢2
¢1
Market price
¢1
¢ .50 DICED KENKEY
0 1 2 3
Quantity of Iced Kenkey (by
Copyright © 2002 by Thomson Learning, Inc. glass)
 An increase in supply will lower the price
and increase your consumer surplus for
each of the units you were already
consuming.
 A supply increase will also increase
consumer surplus from increased
purchases at the lower price.
 Conversely, a decrease in supply will
increase the price and lower the amount
of consumer surplus.
Exhibit 3: The Impact of an Increase
in Supply on Consumer Surplus
Gain in consumer surplus
A from fall in price
S0
S1
B
Price
P0
C
P1
D
0
Q0 Q1
Quantity
 Producer surplus is the difference
between what a producer is paid for a
good and the seller’s cost for producing
each unit of the good.
 Because some units can be produced
at a cost that is lower than the market
price, the seller receives a surplus, or
net benefit, from producing those units.

 Producer surplus for a particular unit is
the difference between the market price
and the seller’s cost of producing that
unit.
 Total producer surplus is shown
graphically as the area under the
market price (what was paid for those
units) and above the supply curve (the
total cost, or sum of marginal costs, of
producing those units).
Exhibit 4: Producer Surplus
Supply
¢5
Price
¢1
Market
4 ¢2 Price
¢3
3
2
1
0
1 2 3 4 5
Quantity
 A higher market price due to an
increase in demand will increase total
producer surplus.
 Part of the added surplus is due to a
higher price for the quantity already
being produced.
 Part is due to the expansion of output
made profitable by the higher price.

Exhibit 5: The Impact of an Increase
in Demand on Producer Surplus
S
P1 New Market
Addition to
producer surplus
Price
Price
P0 Old Market
Old
producer Price
surplus
0 Q0 Q1
Quantity
 With the tools of consumer and producer
surplus, we can better analyze the
total gains from exchange.
 The demand curve represents a

collection of maximum prices that
consumers are willing and able to pay
for additional quantities of a good or
service.

 The supply curve represents a collection
of minimum prices that suppliers
require to be willing to supply
additional quantities of that good or
service.
 At the market equilibrium, consumers
receive consumer surplus and
producers receive producer surplus.
 Both benefit from trading every unit up to
the market equilibrium output.
 Once the equilibrium output is reached
at the equilibrium price, all of the
mutually beneficial trade opportunities
between the suppliers and the
demanders will have taken place.
 The sum of consumer and producer
surplus is maximized.

 The total welfare gain to the economy
from trade in a good is the sum of the
consumer and producer surplus
created.
 Consumers benefit from additional
amounts of consumer surplus and
producers benefit from additional
amounts of producer surplus.

 Improvements in welfare come from
additions to both consumer and
producer surplus.
 In competitive markets, where there are
large numbers of buyers and sellers at
the market equilibrium price and
quantity, the net gains to society are as
large as possible.

Exhibit 6: Consumer and Producer Surplus
S
$8
7
6 CS
5 CS
Price
CS
4
PS
3 PS PS
2
D
1
0 1 2 3 4

Quantity
6.4 The Welfare Effects of Taxes
and Price Controls
 We can use consumer and producer
surplus to measure the welfare effects
of various government programs, such
as taxes and price controls.

Exhibit 1: The Supply and Demand
of a Tax
Supply
PB Tax
Revenue Tax
Price
T  Q1
PS
Demand
Q1 Q0
Copyright © 2002 by Thomson Learning, Inc. Quantity
and Price Controls
 Welfare effects refer to the gains and
losses associated with government
intervention.
 After a tax is imposed, consumers pay a
higher price and lose the corresponding
amount of consumer surplus as a result.
 Producers receive a lower price after tax
and lose the corresponding amount of
producer surplus as a result.

and Price Controls
 The government gains the amount of
the tax revenue generated, which is
transferred to others in society.
 The net loss to society, or deadweight
loss, of a tax is the difference
between the lost consumer and
producer surplus and the tax
revenue generated, represented
graphically as the deadweight loss
triangle.
Exhibit 2: Welfare Effects of a Tax
Deadweight S
a Loss
PB
Price
b c
TAX
P0 e
d
PS
f
D
0
Q1 Q0
and Price Controls
 The deadweight loss of a tax occurs
because the tax reduces the quantity
exchanged (sold and bought) below the
original output level (Q0), reducing the
size of the total surplus realized from
trade.
 The tax distorts market incentives.
 The price to buyers is higher than before the
tax, so they consume less, and producers
produce less.
and Price Controls
 This leads to deadweight loss, or
market inefficiencies—the waste
associated with not producing the efficient
output.
 The size of the deadweight loss from a
tax, as well as how the burdens are
shared between buyers and sellers,
depends on the elasticities of supply
and demand.

and Price Controls
 Other things equal, the less elastic the
demand curve, the smaller the
deadweight loss.
 Similarly, the less elastic the supply
curve, the smaller the deadweight loss.
 However, if either the supply or demand
curves become more elastic, the
deadweight loss will be larger because
a given tax will reduce the quantity
exchanged by a greater amount.
and Price Controls
 That is, the more elastic the curves are,
the greater the change in output and the
larger the deadweight loss.

Exhibit 3: Elasticity and Deadweight
Loss
Deadweight loss
is relatively
small. S
¢0.50 Tax
Price
D
0
Q1 Q0
Quantity
Loss
S
Deadweight loss
is relatively small.
Price
¢.50 Tax
D
0
Q1 Q0
Quantity
Loss
Deadweight loss
S
is relatively large.
Price
¢.50 Tax
0
Q1 Q0
Quantity
and Price Controls
 Elasticity differences can help us understand
tax policy.
 Those goods that are heavily taxed often have
a relatively inelastic demand curve in the short
run.
 This means that the burden falls mainly on the
buyer.
 It also means that the deadweight loss to
society is smaller than if the demand curve
was more elastic.

and Price Controls
 We can see the welfare effects of a
price ceiling by observing the change in
consumer and producer surplus from
the implementation of the price ceiling.
 Consumers can now buy at a lower

price, but cannot buy as much as
before (since suppliers will not supply
as much).

and Price Controls
 Producers lose producer surplus from
the lower imposed ceiling price.
 The net loss is the resulting deadweight

loss triangle, just as with a tax.

Exhibit 4: Welfare Effects of a Price
Ceiling
a Deadweight S
P1 Loss
b c
Price
P0 e
d Price Ceiling
PMAX f
0 Q1 Q0
Copyright © 2002 by Thomson Learning, Inc. Quantity
and Price Controls
 We can also use consumer and producer
surplus to see the welfare effects of a price
floor, where the government buys up the
surplus.
 Consumers lose consumer surplus due to

the higher price floor. and must also pay
taxes to pay for the buying and storing of the
unsold (to consumers) output.

and Price Controls
 Producers gain producer surplus
from the higher prices and greater
output (since the government buys up
what is not sold on the market).
 On net, there is a deadweight loss from

the price floor.

Exhibit 5: Agricultural Price
Supports
P S
B C Price
¢4 Floor
Price of Cocoa
Surplus the
¢3 government
must absorb
A D D
0
QD Q QS
Quantity of Cocoa
Exhibit 6: Welfare Effects of a Price Floor
When Government Buys the Surplus
Deadweight Loss
(c + f + g + h + I) S
a
P1
b d
Price
c h
P0
f
e g i D
0
Q1 Q0 QS
Quantity

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A Lecture Presentation in Powerpoint Exploring Economics by Robert L. Sexton

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A Lecture Presentation

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

 Economists developed the concept of

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

 This law of diminishing marginal utility

 means that each successive unit of a good

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

 It follows from the law of diminishing

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

 Marginal utility is an important

Copyright © 2002 by Thomson Learning, Inc.

 Single Commodity: The consumer is in

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

 When the optimum, utility-maximizing

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

 The law of demand—buying more of a good

 that the ratios of the MU of the

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

 A lower price for a good increases its

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

 The demand curve represents a

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

Copyright © 2002 by Thomson Learning, Inc.

 Consumers can now buy at a lower

Copyright © 2002 by Thomson Learning, Inc.

 The net loss is the resulting deadweight

Copyright © 2002 by Thomson Learning, Inc.

 Consumers lose consumer surplus due to

Copyright © 2002 by Thomson Learning, Inc.

 On net, there is a deadweight loss from

Copyright © 2002 by Thomson Learning, Inc.

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