Principles of Economics
Principles of Economics

Principles of Economics

Lead Author(s): Stephen Buckles

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Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

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Only available with supplementary resources at additional cost

Only available with supplementary resources at additional cost

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Pricing

Average price of textbook across most common format

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Up to 40-60% more affordable

Lifetime access on any device

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

$130

Hardcover print text only

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

$175

Hardcover print text only

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

$140

Hardcover print text only

Always up-to-date content, constantly revised by community of professors

Constantly revised and updated by a community of professors with the latest content

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

In-book Interactivity

Includes embedded multi-media files and integrated software to enhance visual presentation of concepts directly in textbook

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

Customizable

Ability to revise, adjust and adapt content to meet needs of course and instructor

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

All-in-one Platform

Access to additional questions, test banks, and slides available within one platform

Top Hat

Stephen Buckles, Principles of Economics, Only One Edition needed

Cengage

N. Gregory Mankiw, Principles of Economics, 8th Edition

Pearson

Case, Fair, Oster, Principles of Economics, 12th Edition

McGraw-Hill

McConnell, Brue, Flynn, Principles of Microeconomics, 7th Edition

About this textbook

Lead Authors

Stephen Buckles, Ph.DVanderbilt University

Stephen Buckles is a Senior Lecturer at Vanderbilt University, where he also received his Ph.D. in Economics. Buckles has been the recipient of numerous awards, including Madison Sarratt Prize for Excellence in Undergraduate Teaching (Vanderbilt, 2008), Kenneth G. Elzinga Distinguished Teaching Award (Southern Economic Association, 2006), and the Dean’s Award for Excellence in Teaching (Vanderbilt, 2007). His course pack, which this text is based on, has been used by thousands of students and engages the concepts of active learning.

PJ Glandon, PhDKenyon College

PJ Glandon joined Kenyon College as an Associate Professor of Economics after completing his Ph.D. at Vanderbilt University.

Contributing Authors

Benjamin ComptonUniversity of Tennessee

Caleb StroupDavidson College

Chris CotterOberlin College

Cynthia BenelliUniversity of California

Daniel ZuchengoDenver University

Dave BrownPennsylvania State University

John SwintonGeorgia College

Michael MathesProvidence College

Li FengTexas State University

Mariane WanamakerUniversity of Tennessee

Rita MadarassySanta Clara University

Ralph SonenshineAmerican University

Zara LiaqatUniversity of Waterloo

Susan CarterUnited States Military Academy

Julie HeathUniversity of Cincinatti

Explore this textbook

Read the fully unlocked textbook below, and if you’re interested in learning more, get in touch to see how you can use this textbook in your course today.

Chapter 6: Behind Demand

Figure 6.1: One small example of an action all of us do every single day. [1]​​

Crème de la Crème: The Future of Pet Furniture [1]

When Chase Stehr adopted a Westie puppy and went looking for dog accessories that would complement his modern décor, he came up short. “I was looking for dog bowls and a dog bed to fit 

Figure 6.2: Kitten rests on a cat tower. [2]​

the modern, minimalist look of my condo. I found there were very few options out there.” So Mr. Stehr founded Ultra Modern Pet, a company that provides chic, modern pet accessories for the discerning owner, featuring a “Zulu Hut” pet house ($270), a “dogPacer” treadmill ($470), and cat tree in the shape of a giant stiletto pump ($725).

- Brie Witherspoon for The Huffington Post, December 19, 2016 

Why are scarce resources used in this manner? Isn't this a waste of resources when we have so many social and economic problems around the world?

6.1 Objectives

After reading and working through this chapter, you will be able to:

  • Use fundamental economic logic to explain the nature of demand curves.
  • Explain the relationship between marginal utility and prices.
  • Use an economic model to describe rational consumer behavior in maximizing satisfaction.
  • Explain why demand curves are downward-sloping.
  • Explain why an absolute necessity might have a very low marginal utility relative to other goods and services, and something that is a luxury might have a very high marginal utility.
  • An absolute necessity can be most easily modeled as having a very high utility at low levels of consumption. 

Enhancing our abilities to use supply and demand to understand the effects of economic policy and changes in cost and tastes is an important part of the goals of any economics course. In this chapter, we expand our understanding of how to derive a relationship that explains consumers' behavior. We will use that analysis to  understand economic efficiency better. We will also use that analysis to improve our understanding of changes in markets and how changes in prices signal changes in costs and consumer tastes.

6.2 Consumer Satisfaction

Why do you spend money on iPods? Films? Concerts? Books? Food?

You probably answered something along the lines of "because I will enjoy the experience” or "it will make me happy.” Or in the case of food, "because I have to eat in order to live.”

Most of us purchase goods and services because we believe we will be better off if we do so. We buy food because we are hungry and if we eat we will feel better (and live longer). We go to a movie because we expect to get more enjoyment from the movie than we will get from staying home and watching television or studying, or whatever it is that we would have been doing. In other words, we go to a movie because we expect that its value is greater than the value of our opportunity cost.

6.3 What is Utility?

Economics uses the concept of utility to represent satisfaction gained from consuming a good or service or participating in an activity. Although neuroscientists and psychologists are trying, utility and satisfaction received from consuming a good cannot yet actually be measured or quantified. However, we can use the concept to understand the behavior of consumers. Most of us derive utility (satisfaction) from going to a movie or from eating a good meal. In fact, that is why we engage in these activities.

Figure 6.3: Total utility and the number of movies seen per week.​

Assume that the amount of satisfaction or utility from going to the movies is as presented in the following table:

Table 6.1: Total utility and the number of movies seen per week. ​

We can see that going to one movie a week brings 12 “units of satisfaction,” while going to 4 movies in a week gives us 39 units of satisfaction. In general, the more of something we consume, the more satisfaction we get from it. So an economist will say that she received a great amount of utility from that movie (if she's being exact) instead of simply saying, "Wasn't that a great movie?"

Figure 6.4: An artist's depiction of Georg Emanuel Opiz Der Völler. [3]​

Figure 6.3 shows that the total utility gained from films increases as one increases the number of films seen each week. Notice that the vertical axis measures total utility, but does not specify in what units. While the units of measure are abstract, the concept is not and is, in fact, very simple—the more you consume of something, the more satisfaction you get.

A related concept is that of marginal utility. Marginal utility is the change in total utility that one gets from consuming one more unit of a good. Based on Table 6.1, the total utility of seeing one movie in a week is the total satisfaction gained from going to the movies – 12 units of happiness – and the total utility from seeing two movies is 22 units. Marginal utility is the addition to satisfaction of attending one more movie per week, so the marginal utility of the second movie is 10 units of satisfaction. As can be seen from the table, while total utility increases as the number of movies per week increases, the marginal utility of each additional movie decreases.

Table 6.2: As the number of movies watched per week increases, marginal utility decreases.​​

Question 6.01

Question 6.01

What do you think will happen to marginal utility (that is, the additional satisfaction gained from consuming each additional good) as one consumes more of a good?

Hover here to see the hint for Question 6.01
Click here to see the answer to Question 6.01

6.4 Why Does Marginal Utility Diminish as We Consume More of a Good?

The concept of diminishing marginal utility is an empirical one. Consider the manner in which your total satisfaction increases as you increase your consumption of a good. Eventually, if you are normal, the additional utility you get from consuming one more unit of a good will begin to diminish. Perhaps not right away, but it will eventually.

If I am really hungry, an apple in the middle of the afternoon will really be nice. A second apple would also be good, but probably not as good as the first. A third? Well, yes, I might enjoy it, but nowhere near as much as the first. And in fact, it might even make me unhappy. In that case, I certainly would not want that third apple.

The first few movies provide a great deal of enjoyment. But after going to three movies in a week, at least for most of us, the fourth will be a little less satisfying when compared to the enjoyment gained from each of the first three. Maybe for you, the additional satisfaction doesn’t diminish until you are going to ten movies a week. But eventually, the additional utility will begin to diminish. That doesn’t say that you don’t enjoy the eleventh movie, it just says that you enjoy it less than you enjoyed the first or second or third movie.




















Figure 6.5: Marginal utility and the number of movies.

Question 6.02

Question 6.02

Explain why the marginal utility of water may be quite high at low levels of consumption, but eventually diminish as you increase your consumption.

Hover here to see the hint for Question 6.02.
Click here to see the answer to Question 6.02.

Graphing Question 6.01

6.5 How Do Consumers Maximize Satisfaction?

Consumers purchase goods to provide satisfaction. Economists assume that most consumers are rational in spending their incomes and that they try to maximize their total satisfaction. It makes sense. If you have choices about what to buy, you are most likely to choose the good or activity that satisfies you the most. For example, if two goods cost the same and buying one more of one good provides more satisfaction than buying one more of the other, a rational consumer will be better off if she buys one more of the good providing the greater additional satisfaction. Or in economic terms, she will buy the good with the greater marginal utility.

Question 6.03

Question 6.03

How does diminishing marginal utility affect the decision about how much of a good to purchase compared to another good at the same price?

Hover here to see the hint for Question 6.03.
Click here to see the answer to Question 6.03.

Question 6.04

Question 6.04

How does a consumer maximize satisfaction when goods have different prices?

Hover here to see the hint for Question 6.04.
Click here to see the answer to Question 6.04.

Question 6.05

The marginal utility from drinking one more glass of water is likely to be ______________ the marginal utility from going to one more movie.

A

The same as

B

Greater than

C

Less than

D

Declining until it is just greater than


Figure 6.6: An assortment of plums and apples. [4]​

Assume for the moment that there are only two goods and you are spending all your income on these two goods. For example, suppose you are spending $7 a week on fruit. Apples cost $1 apiece and plums cost $.25. You are consuming 5 apples and 8 plums (($1 x 5) + ($.25 x 8) = $7) per week. And suppose that you enjoy each apple twice as much as you enjoy each plum. In other words, each apple gives you two units of satisfaction and each plum gives you one unit of satisfaction. Suppose you give up an apple. In terms of the prices of the fruit, you could buy 4 plums instead. But let’s look at the utility you would get from this trade. The loss of one apple means your utility decreases by two units, and the addition of four plums increases your utility by four units. You gain two units of satisfaction with this decision.

Now to the really challenging part of the logic. As you change how many apples and plums you buy, the marginal utilities of each change. As you consume more plums, the marginal utility of plums will begin to decline. Why? Remember diminishing marginal utility? The more of a good you consume, the less satisfaction you get from each additional unit. Think of that relationship in reverse. What do you think would happen if you start consuming less of a good? If you consume less, the marginal utility will increase. In this case, consuming more plums results in diminishing marginal utility of plums, while the simultaneous decrease in consumption of apples increases the marginal utility of apples. If this sounds like a balancing act, it is.

Figure 6.7: Maximum utility is achieved when the ratio of marginal utilities equals the ratio of prices. [5]​

One good’s marginal utility is increasing and the other good’s marginal utility is decreasing—where should we stop? Remember that apples were four times more expensive than plums. If you were going to pay four times as much for something, does it make sense that you should get four times as much satisfaction from it? So, once apples provide four times as much marginal utility as a plum, you will stop switching from apples to plums. In other words, the ratio of the marginal utilities will end up being equal to the ratio of the prices.

With a little algebra (multiply both sides by the marginal utility of plums and divide both sides by the price of apples), this is the same thing as:

or another way of saying the same thing:

What this expression really means is that if a consumer is maximizing well-being, given prices and income, the marginal utility of the last dollar spent on apples will be just equal to the last dollar spent on plums. Understanding why this is true is a fundamental use of marginal analysis – an economic way of thinking at its best. Think of what the result would be if this equality was not true. What if you were consuming apples and plums such that the marginal utility of another apple were 10 and the marginal utility of another plum were 4? Remember that the price of an apple is $1 and the price of a plum is $0.25. This means that you get 10 units of satisfaction from spending another dollar on an apple, and you get 16 units of satisfaction from consuming another plum. What would you do? Since you get more “bang for your buck” – literally – from buying another plum, you would buy more plums. Of course, this means that you’re also buying fewer apples. Buying more plums means their marginal utility falls, and buying fewer apples means their marginal utility increases. You would keep switching from apples to plums until you get an equal bang for your buck. This result is crucial to understanding why the law of demand is true.

This marginal analysis will also help us understand other topics, such as how rational businesses and workers should make decisions and how government policy should be made.

At this point, you are probably thinking that you have never bought anything this way—by explicitly thinking about how much additional satisfaction you get from each good and comparing it to both its price and the ratio for other goods. The thought of doing so probably leaves you exhausted. The reality is that no one consciously makes these calculations when they’re at the store, deciding on apples or plums. But here’s the amazing part: we all act as if that’s exactly what we’re doing. We may not have these ratios at the front of our minds, but we behave as if we are doing these calculations.

Question 6.06

Assume Anna is consuming two goods, movies and books, and at her current level of consumption, the marginal utility of the last movie is 60 and the marginal utility of the last book is 30. The price of a movie is $12 and the price of a book is $4. In order to maximise her utility, what should Anna do?

A

Increase her consumption of both movies and books

B

Decrease her consumption of both movies and books

C

Do nothing—she’s maximizing her utility

D

Decrease her consumption of movies and increase her consumption of books

E

Increase her consumption of movies and decrease her consumption of books


Question 6.07

A consumer is maximizing her satisfaction and currently consuming three goods. If her tastes change so that the marginal utility she gains from movies increases, what will happen to her consumption of the other two goods – hamburgers and football games?

A

Her consumption will increase because the ratio of their marginal utilities to their prices is now greater than the ratio of the marginal utility of movies to the price of a movie.

B

Her consumption will increase because the ratio of their marginal utilities to their prices is now less than the ratio of the marginal utility of movies to the price of a movie.

C

Her consumption will decrease because the ratio of their marginal utilities to their prices is now less than the ratio of the marginal utility of movies to the price of a movie.

D

Her consumption will decrease because the ratio of their marginal utilities to their prices is now greater than the ratio of the marginal utility of movies to the price of a movie.


Question 6.08

If David buys more coffee and less ice cream, the ______________ of coffee will ______________ , and the ___ of ice cream will ______________.

A

Marginal utility; fall; marginal utility; rise

B

Marginal utility; rise; marginal utility; fall

C

Total utility; fall; marginal utility; rise

D

Marginal utility; rise; total utility; rise

Question 6.09

Question 6.09

Are marginal utilities of all goods equal to all other marginal utilities if consumers are maximizing their satisfaction? Explain why or why not.

Hover here to see the hint for Question 6.09.
Click here to see the answer to Question 6.09.

Graphing Question 6.02

6.6 A Downward-Sloping Demand Curve

In the analysis above, we assumed that the prices of the two goods, apples and plums, did not change. But what happens when the price of one of the goods changes? Let’s revisit our apples and plums example. Remember that you are only consuming apples and plums, the current price of apples is $1 and the price of plums is $.25, and you are maximizing your satisfaction. That means each dollar spent on apples brings you the same satisfaction as a dollar spent on plums. If you are maximizing your satisfaction, you must be getting four times as much enjoyment from an apple as from a plum. But now, suppose that the price of plums increases to $1.

Question 6.10

Question 6.10

Assume that you are only consuming apples and plums and you are maximizing your utility. The price of apples is $1 each and the price of plums is $.25 each. Describe what will happen to the utility-maximizing choice if the price of plums increases to $1.

Hover here to see the hint for Question 6.10.
Click here to see the answer to Question 6.10.

Let’s step back and look at what has happened. As the price of plums increased from $0.25 to $1, the number of plums purchased decreased. You decreased your purchase of plums because, at the new, higher price, they were not giving you as much satisfaction as apples per dollar spent. So when the price of plums increases, you purchase more apples and fewer plums because that is what maximizes your utility. Another way to look at this is that as your consumption (quantity) of plums increases, each plum brings you less and less satisfaction. Therefore, each additional plum is worth less to you – you value each one less; therefore, you would only buy additional plums if the price fell the more you purchased. Does this relationship sound familiar? This negative relationship between the quantity and price (or value) is the demand relationship.

Question 6.11

Question 6.11

Describe in your own words what the relationship is between prices and marginal utilities when a consumer is considering how much to consume.

Hover here to see the hint for Question 6.11.
Click here to see the answer for Question 6.11.


Question 6.12

Assuming a fixed budget, when the price good X increases, consumers will adjust their consumption patterns in a way that the marginal utilities of all other goods will _________.

A

Increase

B

Decrease

C

Not change

D

Decrease, but the marginal utility of good X will increase.

E

Increase, but the marginal utility of the higher priced good will decrease.


Question 6.13

If a good is provided for free, it is likely to have a marginal utility that is relatively ______________ and be ______________ the marginal utility that could be gained from consuming some other good which must be paid for.

A

High; less than

B

High; greater than

C

Low; less than

D

Low; greater than

E

Unknown; equal to

6.7 Income and Substitution Effects

Returning to our apples/plums example, we explained the downward-sloping demand curve by pointing out that as the price of plums increased, you would adjust you optimal purchase of plums by buying fewer of them because their marginal utility per dollar falls. The opposite, of course, is happening with apples, as you increase your purchases of apples, substituting them for the more-expensive plums.

Figure 6.8: When goods decrease in price, you are able to purchase a greater amount for the same amount of money. [6]​

But there’s something else that happens when the price of a good changes that affects our decision of how much to buy. Assume that you are buying 5 apples (for $1 each) and 4 plums (for $.25 each).  This purchase costs you $7. What happens when the price of plums increases to $1 each?  If you were to buy the same quantities as before, it would cost you $9. But you don’t have $9; you have $7. So you can’t continue to buy the same quantities as before. In terms of your buying power, it’s like you lost income. You really didn’t, of course – you still have the same $7 in your pocket – but the amount that your income can buy has decreased. As the price of plums increased, your real income decreased. Real income represents the amount of goods and services that you can purchase, taking price changes (or purchasing power) into account.

When the price of plums increases, you cannot buy as many plums as you did before because your real income falls. But this drop in real income means that you have less to spend on all goods and services, not just the good whose price increased. If plums are normal goods, the decrease in real income (caused by the increase in the price of plums) will decrease the amount you are willing and able to buy. You also may choose to buy fewer apples (if apples are a normal good) when the price of plums increases—and remember, nothing happened to the price of apples.

Table 6.3: This table summarizes the differences between income and substitution effects.​​

How important is the effect of a change in real income on how much you buy? It depends upon the portion of income you spend on the good with the increasing price. If the expenditure is a large portion of income, then the change in real income will be large. If the expenditure is small, then there will not be much of an effect on income. Which would have a greater income effect, an increase in your rent or an increase in the price of chewing gum?

The income effect of the increase in rent should be much larger. Who really cares about the effects of a change in the price of chewing gum? But most of us spend much more (relative to income) on rent and therefore are much more sensitive to changes in the levels of rent than a change in the price of chewing gum. Our real income would fall and be noticed.

6.7.1. Putting the Income and Substitution Effects Together

It is the substitution effect and the income effect together that explain the downward-sloping demand curve for normal goods. As the price of a good increases, consumers switch away from it toward other, relatively cheaper goods. And the increase in the price of the good reduces real income, meaning that consumers buy less of all normal goods. You should recognize that a similar process happens when the price of a good decreases. Consumers will buy more of this good, substituting away from relatively more expensive goods (price decreases, quantity increases). And a decrease in the price means that real income rises, so consumers can buy more of all normal goods (again, price decreases, quantity increases).

Question 6.14

Question 6.14

Is it possible for an inferior good to violate the law of demand?

Hover here to see the hint for Question 6.14.
Click here to see the answer to Question 6.14.

Question 6.15

If the price of a normal good increases, the income effect ______________ the quantity demanded of that good.

A

Increases

B

Decreases


Question 6.16

If the price of a normal good decreases, the substitution effect ______________ the quantity demanded of that good.

A

Increases

B

Decreases


Question 6.17

If the price of a good changes, why does an income effect exist?

A

You need income to purchase the good

B

Diminishing marginal utility exists

C

The price change causes a change in real income

D

People prefer larger incomes


Question 6.18

Assuming a good is a normal good, a decrease in price will lead to a substitution effect that does what?

A

Along with the income effect, increases quantity

B

Increases quantity while the income effect decreases quantity

C

Decreases quantity while the income effect increases quantity

D

Along with the income effect, decreases quantity

6.8 Consumer Surplus

In the preceding analysis, we found that rational consumers will purchase more of a good or service as long as the marginal benefit is greater than the price of the good, that is, the marginal cost for the consumer acquiring it. We will expand consumption right up to the point where the additional benefits are just equal to the additional costs. That concept may mislead us when we are comparing the total benefits consumers receive from the wide variety of goods and services we consume.

Question 6.19

Question 6.19

How does consumption benefit consumers if the marginal cost just equals the marginal benefit?

Hover here to see the hint for Question 6.19.
Click here to see the answer to Question 6.19.

Suppose a typical buyer’s demand schedule and curve are shown in Table 6.4 and Figure 6.9.

Table 6.4: Price and quantity demanded of apples​.​


Figure 6.9: Demand curve of apples in a week​

Suppose the market price for apples is 50 cents. Our consumer is willing to pay $3.00 for the first apple but only has to pay 50 cents. This difference of $2.50 is called consumer surplus for the first apple purchased. For the second apple, the consumer is willing to pay $2.00. Again, the market price is only 50 cents, so this consumer benefits by $1.50 from purchasing the second apple. How many apples will this consumer purchase? Five apples? The fifth apple costs the same as the others—50 cents—but the consumer is only willing to pay 25 cents, so the fifth apple will not be purchased. Will the consumer buy four apples? The price is 50 cents, and that’s exactly equal to how much the consumer is willing to pay. Our demand curve tells us that the fourth apple is the last apple that will provide us with benefits greater than what we have to give up. So, we buy it.

The consumer’s total consumer surplus is the total value of all of the goods purchased minus what is actually paid (in this case, 50 cents). The consumer surplus of the first apple is $2.50 ($3.00 - $.50); the second, $1.50 ($2.00 - $ .50); the third, $.50 ($1.00 - $.50); and the fourth, 0 ($.50 - $.50). So the total consumer surplus is the sum of these: $2.50 + $1.50 + $0.50 + $0 = $4.50. By purchasing four apples, this consumer has a benefit of $4.50 over the cost of purchasing the apples.

Figure 6.10: The demand for apples and a market price​

 We know how to compute consumer surplus mathematically. What does it look like on our graph of the demand curve? On the individual demand curve, the consumer surplus at each level of consumption will be the area above the price paid and under the demand curve. This area (in Figure 6.11) represents the prices this particular consumer is willing to pay above what she has to pay. Market demand curves show the same concept, except the area represents what all consumers are willing to pay above the going market price.

Figure 6.11: Demand of apples and consumer surplus​


Question 6.20

Using the graph, if the price of an ice cream cone is $2.00, consumer surplus will equal ______.

question description
A

2

B

3

C

4

D

5


Question 6.21

Using the graph, if the price of an ice cream cone is $1, consumer surplus will equal ______.

question description
A

2

B

4

C

6

D

8


Question 6.22

Using the graph, if the price increases from $1 to $1.50, consumer surplus will decrease by _____.

question description
A

$1.50

B

$2.50

C

$3.50

D

$4.50

Graphing Question 6.03

​Graphing Question 6.04

​Graphing Question 6.05

6.9 The Paradox of Value

The price of water is quite low. In fact, it is free in restaurants, in hallways, and at drinking fountains on the street. Yet it obviously has great value.
Diamonds are expensive, but they are not really necessary. At least, they are not nearly as necessary as water. Why is something that is a luxury so much more expensive than something that is essential to life? The explanation of the difference in the values of the two resources can be found in the explanation of consumer surplus.

Question 6.23

Question 6.23

Given that water is essential to life and diamonds are not, why are diamonds so much more expensive than water (in most parts of the world)?

Hover here to see the hint for Question 6.23.
Click here to see the answer to Question 6.23.

Figure 6.12: The markets in water and in diamonds​

The supply of water, relative to the demand for water, is such that the equilibrium price of water is low. Given the relatively large supply, consumers are not willing to pay very much for the last glass of water. However, the value of the first glass of water is extremely high. And the total value that consumers gain from consumption of water as measured by consumer surplus is quite high.

 The supply of diamonds is such that the equilibrium price of diamonds is quite high. Equilibrium prices are shown relative to the demand in Figure 6.12. However, the value (consumer surplus) enjoyed from water is very large and is represented by the darkened triangular areas in Figure 6.13. The consumer surplus from diamonds is really very small. 

Figure 6.13: The markets in water and in diamonds​​

It is not just the price of a good that determines the consumer surplus. It is how much we as consumers value a good, and one of the ways that shows up is in the elasticity of the demand for the good.

The concept will become important to us in evaluating taxes, and government production and regulations. The value of current consumption and future consumption is not just the price we are paying now, but what we would be willing to pay if we are consuming less or more of a specific good or service.

Key determinants of the size of the consumer surplus include where a market is on its demand curve and how steep that demand curve is. Given a demand curve, the greater the quantity demanded, the greater will be the area under the demand curve above the price consumers have to pay. The steeper that demand curve, the greater the amount of consumer surplus. This says that with relatively flat demand curves people are not willing to pay significantly greater prices without reducing their quantities demanded a good deal. With steep demand curves, an increase in price does not reduce the quantity demanded by very much. 

Question 6.24

Fred just ate a hamburger and received total utility of 15 from consuming it. If he eats another one, which of the following will be true?

A

His total utility will likely stay at 15

B

His total utility will likely decrease

C

His total utility will likely increase

Question 6.25

Grace likes eating pizza and going to the movies. If she has $120 to spend in a month, and pizza and movies each cost $10, she decides to eat 5 pizzas and see 7 movies. If the price of movies increases to $12 what is likely to happen?

A

Both the substitution and income effects would predict that she will consume fewer pizzas and movies

B

Both the substitution and income effects would predict that she will consume more of pizzas and movies

C

The substitution effect would predict that she consumes fewer pizzas and more movies; and the income effect would predict that she would consume more of both

D

The substitution effect would predict that she consumes more pizzas and fewer movies; the income effect would predict that she would consume fewer of both

Question 6.26

If the price of a hot dog is $2 and your willingness to pay is $3, then your consumer surplus is _____.

A

$1

B

$2

C

$3

D

$5

Question 6.27

Question 6.27

Who suffers the greater loss of consumer surplus when the price increases: those with elastic demands or those with inelastic demands?

Hover here to see the hint for Question 6.27.
Click here to see the answer to Question 6.27.

Question 6.28

Suppose that the price of a pizza is $10 and the price of a video game is $30. Currently, Aaron is consuming such that the ratio of his marginal utility of pizza to marginal utility of video games is ¼. If he wants to maximize his utility, what should he do?

A

Buy more pizzas and fewer video games

B

Buy more pizzas and more video games

C

Buy fewer pizzas and video games

D

Buy fewer pizzas and more video games

6.10 Summary

In this chapter, we have expanded our understanding of how we derive the relationship that explains consumers’ behavior. We will use that analysis to understand economic efficiency better. We also will use that analysis to better understand changes in markets and how prices signal changes in costs and consumer tastes.

  • Utility is the amount of satisfaction one gains from consuming a good or service or participating in an activity.
  • Marginal utility is the increase in total utility gained from consuming one more unit of a good or service.
  • As one consumes more of a good or service, the amount of utility one gains from consuming one more unit will eventually begin to diminish.
  • If consumers are maximizing their satisfaction, given their tastes and incomes, the marginal utility per dollar spent on each good will be equal to the marginal utility of each dollar spent on every other good. (The marginal utility of each good divided by the good’s price will be equal to that of all other goods.)
  • The law of demand is true primarily because as a price increases, consumers will substitute other goods in order to increase their satisfaction.
  • The quantity demanded of a good is inversely related to the price of the good due to this substitution effect, but also the income effect.
  • Consumer surplus is the amount of satisfaction gained from consuming a good or service. It is represented by the amount consumers are willing to pay for each unit of a good or service minus the amount they actually have to pay.

6.11 Key Concepts

Utility
  Marginal utility
  Diminishing marginal utility
Maximizing satisfaction
Marginal analysis 
Downward-sloping demand curves
  Substitution effects
  Income effects
Consumer surplus
Paradox of value

6.12 Glossary

Consumer surplus: The difference between the total value to the consumer of consuming a specific amount of a good and the amount the consumer must pay for that amount of the good.

Law of diminishing marginal utility: As a consumer purchases more of a good in a specific time period, the additional satisfaction enjoyed from the additional unit of the good will diminish.

Marginal analysis: A consumer will maximize his or her total well-being if the last dollar spent on each good provide the same marginal (additional) utility.

Marginal utility: The change in total utility or satisfaction resulting from consuming one more unit of a good or service.

Real income: Income adjusted for price changes. A measure of the amount of goods and services one can purchase.

Total utility: The total amount of satisfaction enjoyed from consuming a specific amount of a good or service.

Utility: The satisfaction gained from consuming a good or service.





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Answer Keys

Answer to Question 6.01

The more of something you consume, the less satisfaction another unit will bring you. Sometimes you consume so much of something, that consuming one more will actually lower your overall satisfaction – eating too much pizza, for example!

Click here to return to Question 6.01.












Answer to Question 6.02

If you are very thirsty, then that first glass of water will bring you a great deal of satisfaction and happiness. The second glass might continue to increase your satisfaction but probably will not taste as good as that first glass. By the time you get to the fourth glass, you may be struggling to get it down, and the fifth glass might actually cause you distress.

Click here to return to Question 6.02.













Answer to Question 6.03

Because of the law of diminishing marginal utility, the marginal utility of the good purchased will eventually begin to diminish as more and more is purchased. If the marginal utility of the purchased good falls below the marginal utility of other possible purchases that have the same price, the buyer will not buy additional units of the first good, and will instead buy more of the other goods that now have a relatively higher marginal utility.

However, not all goods cost the same amount. See if you can work out the logic when prices differ.

Click here to return to Question 6.03.











Answer to Question 6.04

If two goods cost the same, it’s pretty straightforward to compare marginal utilities. But what if they do not cost the same? It’s not accurate to only think of how much marginal utility you get for different goods if their prices are different. For example, you would probably get a higher marginal utility from a new car than a pizza, but a new car has a much higher price than a pizza, so comparing one more car to one more pizza is not comparing “like” things. You need some way of creating a common point of comparison between two goods that have different prices. Thinking of how much utility you would get per dollar spent on each good makes the comparison of cars and pizzas possible.

Click here to return to Question 6.04.










Answer to Question 6.09

No. It is the ratio of marginal utilities to prices that are equal. For most people, the marginal utility of an additional Mercedes will be greater than that of an additional plum. But a Mercedes costs much more than a plum, so we need to take into account how much it costs to achieve the additional utility from each. When a dollar “buys” the same amount of satisfaction from each good, then there will be no further incentive to change your buying choices.

Click here to return to Question 6.09.












Answer to Question 6.10

With the new prices, if you give up one apple, you will now get one plum, (not four, as before).  Since the marginal utility of an apple is four times the marginal utility of a plum at the old level of consumption, but the price is now equal to that of a plum, you can increase your satisfaction by increasing your consumption of apples (which also means that your consumption of plums will decrease).  Looked at another way, if apples cost the same as plums, you will maximize your satisfaction when the marginal utility of apples is equal to that of plums.  Again, as you increase your consumption of apples, you will experience diminishing marginal utility.  As you decrease your consumption of plums, the marginal utility of plums will increase.

Click here to return to Question 6.10.











Answer to Question 6.11

Your summary should be similar to the following marginal analysis. If consumers want to maximize total satisfaction, they will consume goods so that the marginal utility per dollar spent on each good is equal. If a consumer can gain more satisfaction by spending an additional dollar on cereal than he can on spending that dollar on fruit, he will give up the fruit and buy the cereal. 

But, as he changes his spending patterns, the additional satisfaction gained from more cereal will begin to diminish.  And since less fruit is consumed, the additional satisfaction gained from the fruit will now be higher than before. (Be sure that you can explain why one marginal utility increases and the other decreases.) He will continue switching until the marginal utility gained from spending another dollar on cereal is just equal to the marginal utility gained from spending another dollar on fruit.

This is an important process. The logic is fundamental to the development of an economic way of thinking. Work on this concept until you can explain it – forward and backward – or at least in a variety of circumstances.

Click here to return to Question 6.11.









Answer to Question 6.14

Remember the definition of an inferior good—one that you want less of as your income increases (and more of when your income decreases). In the case of a normal good, the income and substitution effect work in the same direction: as price falls, quantity increases, and vice versa. In the case of an inferior good, the income and substitution effects work in opposite directions. A price decrease works the same as before – you will substitute toward the now-cheaper good, increasing the quantity that you buy. And a price decrease still increases real income. The difference is that when your real income increases and you are consuming an inferior good, you will buy less of it than before. In this case, the income effect leads to a decrease in quantity when the price falls.

Theoretically, if the income effect is quite large – larger than the substitution effect – a price decrease could actually cause the amount you wish to purchase to decrease, leading to a positively-sloped demand curve. This is extremely rare, and some economists question whether it could happen at all.  This is called a Giffen good, and it was speculated that it could occur with an inferior good that makes up a large portion of a person's consumption, and therefore spending.  One paper suggested that there is evidence that this happens with rice in China.

Click here to return to Question 6.14.








Answer to Question 6.19

The reason that consumers benefit is that the marginal cost is not equal to the marginal benefit for every unit consumed. It is likely that for the first unit of consumption, a consumer is willing to pay a relatively high price. Given diminishing marginal utility and the resulting law of demand, a consumer will be willing to pay less for a second unit and even less for the third. As long as the price consumers are willing to pay (representing the marginal benefit) is greater than the price the consumers have to pay (representing the marginal cost), consumers will increase consumption and be better off from doing so.

Click here to return to Question 6.19.











Answer to Question 6.23

Water is much more plentiful than diamonds are, so although diamonds are not a necessity, the supply of them is much less than the supply of water.

Click here to return to Question 6.23.















Answer to Question 6.27

Those with elastic demand. Because they are more sensitive to price changes, they will reduce their consumption by more than those with an inelastic demand.

Click here to return to Question 6.27.















Image Credits

[1] Image courtesy of Erik Scheel in the Public Domain.

[2] Image courtesy of notoneko in the Public Domain.

[3] Image courtesy of Beurret & Bailly in the Public Domain.

[4] Image courtesy of SP2Zsolt in the Public Domain.

[5] Image courtesy of maxmann in the Public Domain.

[6] Image courtesy of Alan Cleaver under CC BY-SA 3.0.

The total amount of satisfaction enjoyed from consuming a specific amount of a good or service.
The change in total utility or satisfaction resulting from consuming one more unit of a good or service.
Think of a personal example and how much satisfaction you get from consuming the first unit as opposed to the 10th unit.
As a consumer purchases more of a good in a specific time period, the additional satisfaction enjoyed from the additional unit of the good will diminish.
Even though it is essential to life, water is no different than any other good as far as diminishing utility is concerned.
Think of getting “bang for your buck”.
Again, think of getting “bang for your buck”.
A consumer will maximize total well-being if the last dollar spent on each good provides the same marginal (additional) utility as the last dollar spent on every other good.
Think per dollar spent, not just marginal utility.
Think about the numeric trade-offs in terms of prices--if plums become more expensive, then the tradeoff between plums and apples has changed. What does that do to the amount of satisfaction you would expect from each at this new price ratio?
Don’t just think of how much of something you want; also think of how much you can afford.
Income adjusted for price changes. A measure of the amount of goods and services one can purchase.
Think of what an inferior good is and how the income and substitution effects of a price change are different.
At what unit does marginal cost equal marginal benefit?
The difference between the total value to the consumer of consuming a specific amount of a good and the amount the consumer must pay for that amount of the good. For each unit purchased, the consumer surplus is the price the consumer is willing to pay minus the price the consumer actually has to pay.
Remember that there are two things that determine price.
How responsive are you to price changes when demand is elastic vs. inelastic?