Microeconomics

Lecture 9
 Review of the Previous
Lecture
 Practical Application of the Consumer
Choice Concepts
– Theoretical Review
– Examples
 Revealed Preference Theory
 Topics Under Discussion

 Marginal Utility
– Diminishing Marginal Utility
– Marginal Utility and Consumer Choice
 Cost-of-Living Indexes
 Marginal Utility and
Consumer Choice
 Marginal utility

– measures the additional satisfaction

obtained from consuming one
additional unit of a good.
 Marginal Utility and
Consumer Choice
 Marginal Utility: An Example
– The marginal utility derived from increasing from
0 to 1 units of food might be 9
– Increasing from 1 to 2 might be 7
– Increasing from 2 to 3 might be 5
 Observation: Marginal utility is diminishing
 Marginal Utility and
Consumer Choice
 Diminishing Marginal Utility

– The principle of diminishing marginal utility

states that as more and more of a good is
consumed, consuming additional amounts
will yield smaller and smaller additions to
utility.
 Relationship of Total and
Marginal Utility
 Diminishing Marginal Utility: An Example
Quantity of a Total Marginal
Good Consumed Utility Utility
0 0
1 4 4
2 7 3
2
3 9
1
4 10 0
5 10
Relationship of Total and
Marginal Utility
Utility

10 TU
1

Total utility of consuming

a certain amount is equal
3
to the sum of the marginal
5
utilities up to the point

Total utility increases at a

decreasing rate
4

0 1 2 3 4 5 Quantity
Relationship of Total and
Marginal Utility

Marginal Utility
The fact that total utility
5 increases at a decreasing rate
is shown by negative slope of
4 marginal utility curve
3
2
1
MU

0 1 2 3 4 5 Quantity
 Marginal Utility and
Consumer Choice
 Marginal Utility and the Indifference Curve
– If consumption moves along an
indifference curve, the additional utility
derived from an increase in the
consumption of one good, food (F), must
balance the loss of utility from the
decrease in the consumption in the other
good, clothing (C).
 Marginal Utility and
Consumer Choice
 Formally:
0 = MUF (ΔF) + MUC (ΔC)
 Rearranging:

- (ΔC/ ΔF) = MUF / MUC

 Marginal Utility and
Consumer Choice
 C / F   MU F / MU C
Because:
 C / F   MRS of F for C

MRS  MUF/MUC
 Marginal Utility and
Consumer Choice
 When consumers maximize satisfaction
the:
MRS  PF/PC
 Since the MRS is also equal to the ratio of the
marginal utilities of consuming F and C, it follows that:

MUF/MUC  PF/PC
 Marginal Utility and
Consumer Choice
 Which gives the equation for utility
maximization:

MU F / PF  MU C / PC
 Marginal Utility and
Consumer Choice
 Total utility is maximized when the budget
is allocated so that the marginal utility per
dollar of expenditure is the same for each
good.

 This is referred to as the equal marginal

principle.
 Marginal Utility and
Consumer Choice
 Gasoline Rationing

– In 1974 and again in 1979, the government

imposed price controls on gasoline.

– This resulted in shortages and gasoline

was rationed.
 Marginal Utility and
Consumer Choice
 Gasoline Rationing

– Non-price rationing is an alternative to market

rationing.

– Under one form everyone has an equal chance to

purchase a rationed good.

– Gasoline is rationed by long lines at the gas pumps.

 Marginal Utility and
Consumer Choice
 Rationing hurts some by limiting the
amount of gasoline they can buy.

 This can be seen in the following model.

 It applies to a woman with an annual

income of $20,000.
 Marginal Utility and
Consumer Choice
Spending
on other
goods ($) 20,000 A With a limit of
2,000 gallons,
18,000
D the consumer moves
C to a lower
15,000 indifference curve
(lower level of utility).

U1

U2

B
Gasoline
2,000 5,000 20,000 (gallons per year)
 Cost-of-Living Indexes

 The CPI is calculated each year as the

ratio of the cost of a typical bundle of
consumer goods and services today in
comparison to the cost during a base
period.
 Cost-of-Living Indexes
 Example
– Two sisters, Raheela and Sarah, have
identical preferences.
– Sarah began college in 1987 with a $500
discretionary budget.
– In 1997, Raheela started college and her
parents promised her a budget that was
equivalent in purchasing power.
 Cost-of-Living Indexes
1987 (Sarah) 1997(Raheela)

Price of books $20/book $100/book

Number of books 15 6

Price of food $2.00/lb $2.20/lb

Pounds of food 100 300

Expenditure $500 $1,260

 Cost-of-Living Indexes
 Sarah’ Expenditure
$500=100 lbs of food x $2.00/lb +15 books x $20/book

 Raheela’ Expenditure for Equal Utility

$1,260=300 lbs of food x $2.20/lb +6 books x $100/book
 Cost-of-Living Indexes
 The ideal cost-of-living adjustment for
Raheela is $760.

 The ideal cost-of-living index is

$1,260/$500 = 2.52 or 252.

 This implies a 152% increase in the cost

of living.
 Cost-of-Living Indexes
Books
(per quarter)
For Raheela to achieve
the same level of utility as
U1 Sarah, with the higher
25 prices, her budget must
be sufficient to allow her
20 to consume the bundle
shown by point B.
A
15

10
B

5
l2
l1 Food
0 50 100 200 250 300 350 400 450 500 550 600 (lb./quarter)
 Cost-of-Living Indexes

 The ideal cost of living index represents

the cost of attaining a given level of utility
at current (1997) prices relative to the
cost of attaining the same utility at base
(1987) prices.
 Cost-of-Living Indexes

 To do this on an economy-wide basis

would entail large amounts of information.

 Price indexes, like the CPI, use a fixed

consumption bundle in the base period.
Called a Laspeyres price index
 Cost-of-Living Indexes
 The Laspeyres index tells us:
– The amount of money at current year
prices that an individual requires to
purchase the bundle of goods and
services that was chosen in the base year
divided by the cost of purchasing the
same bundle at base year prices.
 Cost-of-Living Indexes
 Calculating Raheela’s Laspeyres cost of
living index
– Setting the quantities of goods in 1997
equal to what were bought by her
sister, but setting their prices at their
1997 levels result in an expenditure of
$1,720 (100 x 2.20 + 15 x $100)
 Cost-of-Living Indexes
 Her cost of living adjustment would now
be $1,220.

 The Laspeyres index is:

$1,720/$500 = 344.

 This overstates the true cost-of-living

increase.
 Cost-of-Living Indexes
Books
(per quarter)
Using the Laspeyres
index results in the
U1 budget line shifting
25 up from I2 to I3.

20

A
15

10
B
l3
5
l2
l1 Food
0 50 100 200 250 300 350 400 450 500 550 600 (lb./quarter)
 Cost-of-Living Indexes

 What Do You Think?

– Does the Laspeyres index always

overstate the true cost-of-living index?
 Cost-of-Living Indexes
 Yes!
– The Laspeyres index assumes that
consumers do not alter their
consumption patterns as prices
change.
 Cost-of-Living Indexes
 Yes!
– By increasing purchases of those items
that have become relatively cheaper, and
decreasing purchases of the relatively
more expensive items consumers can
achieve the same level of utility without
having to consume the same bundle of
goods.
 Cost-of-Living Indexes
 The Paasche Index
– Calculates the amount of money at
current-year prices that an individual
requires to purchase a current bundle of
goods and services divided by the cost
of purchasing the same bundle in the
base year.
 Cost-of-Living Indexes
 Comparing the Two Indexes

– Suppose:

– Two goods: Food (F) and Clothing (C)

 Cost-of-Living Indexes
 Comparing the Two Indexes

– Let:

• PFt & PCt be current year prices

• PFb & PCb be base year prices

• Ft & Ct be current year quantities

• Fb & Cb be base year quantities

 Cost-of-Living Indexes
 Comparing the Two Indexes

– Both indexes involve ratios that involve today’s current

year prices, PFt and PCt.

– However, the Laspeyres index relies on base year

consumption, Fb and Cb.

– Whereas, the Paasche index relies on today’s current

consumption, Ft and Ct .
 Cost-of-Living Indexes
 Then a comparison of the Laspeyres and
Paasche indexes gives the following
equations:
PFt Fb + PCt Cb
LI =
PFb Fb + PCb Cb
PFt Ft + PCt Ct
PI =
PFb Ft + PCb Ct
 Cost-of-Living Indexes
 Comparing the Two Indexes

– Sarah (1990)

• Cost of base-year bundle at current prices equals

$1,720 (100 lbs x $2.20/lb + 15 books x $100/book)

• Cost of same bundle at base year prices is $500

(100 lbs x $2.00/lb + 15 books x $20/book)
 Cost-of-Living Indexes
 Comparing the Two Indexes

– Sarah (1990)

$1,720
LI   344
$500
 Cost-of-Living Indexes
 Comparing the Two Indexes

– Sarah (1990)

• Cost of buying current year bundle at current year

prices is $1,260 (300 lbs x $2.20/lb + 6 books x
$100/book)

• Cost of the same bundle at base year prices is $720

(300 lbs x $2/lb + 6 books x $20/book)
Cost-of-Living Indexes
 Comparing the Two Indexes

– Sarah (1990)

$1,260
PI   175
$ 720
 Cost-of-Living Indexes
 The Paasche index will understate the
cost of living because it assumes that the
individual will buy the current year bundle
in the base year.
 Summary

 Marginal Utility
– Diminishing Marginal Utility
– Marginal Utility and Consumer Choice
 Cost-of-Living Indexes
 Upcoming Topics

 Individual Demand
– Effect of Price Change
– Effect of Income Change
– Income and Substitution Effect
Microeconomics

Lecture 9