EQUIMARGINAL PRINCIPLE: EQUAL MARGINAL UTILITIES PER DOLLAR FOR EVERY GOOD
We·now want to use utility theory to summer demand and to understand the Na man curves. We assume that each co·n”‘IT misses his or her utility, which means consumer chooses the most preferred goods from what is available. What are the implications of institution? Certainly I would not expect that I am buying brings exactly the same Jill~ma as the last pair of shoes I am buying, for ,much more per unit than eggs. A more Clumsily would be: If good A costs twice as me then buy good A only when its marge least twice as great as good B’s . This leads to the marginalize Will~” should arrange may consumption 50 philanthropically spent on each good is bringing me final utility, In such a situation, I am Fujiyama satisfaction or utility from my purchase.
Marginalization: The fundamental condition of maximum satisfaction or utility is the marginalize principle. It states that a consumer having a fixed income and facing given market prices of goods ,,:m achieve maximum satisfaction or utility when the marginal utility of the last dollar spent on each good is exactly the same as the marginal utility of the last dollar spent on any other good. Why must this condition hold? ,If anyone good gave more marginal utility per dollar, I would, increase my utility by taking Kinney away,from other goods and spending more on that good-until the lawful diminishing marginal utility drove its marginal utility per dollar down to equality with that of other goods. If any good gave less marginal utility per dollar than the common level, I would buy less of it until the marginal utility of the last dollar spent on it had risen back to the common level.” The common marginal utility per dollar of commodities in consumer equilibrium is ‘called the marginal utility of income. It measures the additional utility that would be gained if the consumer could enjoy an extra dollar’s worth of consumption. This fundamental condition of -consumer equilibrium can be written in terms of the marginal utilities (MILS) and prices (1\) of the differentiation in the following’ compact’ way:5
Why Demand Curves Slope Downward
Using-the fundamental rule for consumer behavior, wean easily see why demand curves slope downward . . For simplicity, hold the common marginal utility per dollar of income constant, Then increase the price of good 1.With no change in quantity’ consumed, the first ratio (i.e., Mu good lip) will be below the Maj per dollar of all other goods. The consumer will therefore have to readjust the consumption of good 1.The consumer will do this by (a) lowering the consumption of good I, (b) thereby raising the ‘MU ed good 1, until (c) at the new, reduced level of consumption of good I, the new marginal utility per dollar spent on good 1 is again equal to the MU per dollar spent on other goods. Higher price for:a good reduces the consumer’s desired consumption of that commodity; this shows why demand curves slope downward.
Leisure and the Optimal Allocation of Time
A Spanish toast to a friend wishes “health, wealth, and the time to enjoy them.” This saying aptly captures the idea that we must allocate our time budgets in much the same wayside do our dollar budgets. lime. is the great equalizer; for even the richest person has but 24 hours a day to “spend.” Let’s see how our earlier analysis of allocating scarce dollars applies to time.
Consider leisure, often defined as “time which one can spend as one pleases.” Leisure brings out our personal eccentricities. The seventeenth-century philosopher Francis Bacon’ held that the purest of human pleasures was gardening. The modern British statesman Winston Churchill wrote of his holiday: MI have had a delightful month building a cottage and
dictating a book: 200 bricks and 2000 words a day.” White\-er aftertastes, the principles of utility theory can apply well. Suppose that, after satisfying all your obligations, you have 3 hours a free time and can devote it to gardening, laying bricks, or writing history. What is the best way to allocate your Let’s ignore the possibility that time spent on” some of these activities might be an investment that will enhance your earning power in the future. Rather, assume that these are all pure consumption or utility-yielding pursuits. The principles of consumer choice suggest that you will make the best-use of your time when you equalize the marginal utilities of the last minute spent on each activity, To lake another example, suppose you want to maximize your knowledge in your courses but you have only a limited amount of time available. Should you study each for the same amount of time? Surely oenology may find that an equal study time for economics, history, and chemistry will not yield the same amount of knowledge in the last minute. If the last minute produces a greater marginal knowledge in chemistry than in history, you would raise yo total . knowledge by shifting additional minutes from history to chemists, and so on, until the last minute yields the same incremental knowledge in each subject. The same rule of maximum utility per hour can be applied to many different areas of life, including engaging in charitable activities, improving the environment, or losing weight. It is not merely a law of economics. It is a law of rational choice.
Consumers as wizard?
All this discussion mikes k sound as If consumers mathematical wizards who can mile Ecuadorians d Jinan utility to me ~ decimal place and sat complicated squadrons. T His unrelieved Sew Is definitely not what _ u- SUI’M In economics. We know that most decisions made In I routine and that people sometimes buy lemons or are bind by unscrupulous sales patches.What Is assumed In economics Is plat consumers are fairly concision In weirdie tan and actions-flat they do not flail around In unpredictable ways.maid.,. dissembles miserable by persistent errors of inducement or arithmetic. If most people act consistently most of the time. Toadding erratic chaps In buys behavior and generally choose Mar most preferred commodities, our scientific theory Idea reasonably cod approximation to the Curia.Curia. Warsaw, however, must be alert to situations Irradiation or inconsistent behemoth tends to crop up.
AN ALTERNATIVE APPROACH: SUBSTITUTION Effect AND INCOME EFFECT
The concept of marginal utility has helped explain the fundamental law of downward-sloping demand. But over the last few decades, economists have developed an alternative approach to the analysis of demand- one that makes no mention of marginal utility. This alternative approach uses “indifference curves,” which are explained in the appendix to this
chapter, to rigorously and consistently produce the major propositions about consumer behavior. 1 h. “approach also helps explain the factors that tend to make the responsiveness of quantity demanded to price-the price elasticity-of demand-large or small. Indifference analysis asks about the substitution effect and the income effect of a change in price. By
looking at these, we can see why the quantity demanded a good declines as its price rises.
The substitution effect is the most obvious factor for explaining downward-sloping demand curves. If the price of coffee goes up while other prices do not, then coffee has become relatively more expensive. When coffee becomes a more expensive beverage, less coffee and more tea or cola will be bought. Similarly. because sending electronic mail is cheaper and
quicker than sending letters through the regular mail, people are increasingly relying on electronic mail for correspondence. More generally, the substantiation effect says that when the price of a good rises, consumers will tend to substitute other goods for the more expensive good in order to satisfy their desires more inexpensively. “” Consumers, then, behave the way businesses do when the rise in price of an input causes firms to substitute low-priced inputs for high-priced inputs. By this process of substitution, businesses can produce a given amount of output at the-least-total cost. Similarly. when consumers substitute less expensive goods for more expensive ones, they are buying a given amount of satisfaction at less cost.
In addition, when your money income is fixed, a price increase jurist like a reduction in your “real income. (Rail incognito means the actual amount of goods and services that your money income can buy.) When a price rises and money incomes are fixed, consumers’ real incomes fall-because they cannot afford to buy the same quantity of goods as before. This produces the income effect, which denotes the impact of a price change on a good’s quantity demanded due to the effect of the interchange real incomes. Because a lower real income generally leads to lower consumption. the income effect will normally reinforce the substitution effect in making the demand curve downward-sloping. . To obtain a quantitative measure of the effect, we examine a good’s income elasticity. This term denotes the percentage change in quantity DE; sanded divided by the percentage change in income, holding other things, such as prices, constant. High income elasticities, such as those for airline travel or yachts, indicate that the demand for these goods rises rapidly as income increases. Low income elasticities, such as for food or cigarettes, denote a weak response of demand as income rises.
Income and substitution effects combine to determine the major characteristics of demand curves of different commodities. Under some circumstances the resulting demand curve is very price-elastic, as where the consumer has been spending a good deal on the commodity and ready substitutes are available. In this case both the income and the substitution.
effects are strong and the “quantity demanded responds strongly to a price increase. But consider a commodity like salt. which requires only a scallion of the consumer’s budget. Salt is not easily replaceable by other items and is.needed in small amounts to complement more important items. For salt. both income and Substitutions effects are small, and demand will tend tore price.
FROM INDIVIDUAL TO MARKET DEMAND.
Having analyzed the principles underlying a single ‘individual’s demand for coffee or electronic mail, we next examine how the entire market demand derives from the individual demand. Tu! demand curve for a good for the entire Marietta is obtained by summing up the quantities demanded by tonsure. Each consumer has a demand curve along which the quantity demanded can be plotted against the price; it generally slopes downward and to the right. If all consumers
were exactly alike in their demands and if there were. 1 million consumers, we could think of the market demand curve as a million fold enlargement of each consumer’s; demand curve. But people are not all exactly alike. Some have
high incomes, some low. Some greatly Desiree: others prefer cola. To obtain the total market curve, .•all we have to do is calculate the sum total of what all the different t:”summers will consume at any given price. We then plot that total amount as a point on the market demand curve. Or, if we like, we might construct a numerical demand table by summing the
quantities demanded by all individuals at each market price.
The market demand curve is the sum of individual demands at each price; Figure 5-2 ‘shows how to add individual dd demand curves horizontally to get the market DD demand curve.’
We know that changes in the price of coffee affect the quantity of coffee demanded. We know this from budget studies, from historical experience, and from examining our own behavior. We discussed briefly in Chapter 3 some of the important non price determinants of demand. We now review the earlier discussion in light of our analysis of consumer behavior.
An increase in income tends to increase the amount we are willing to buy of most goods. Nieces sites tend to be less responsive than most goods to income changes. while luxuries tend to be more responsive to income. And there are a few anomalous goods, known as inferior goods, for which purchases may shrink as incomes increase because people can
afford to replace them with other, more desirable goods. Soup bones, intercity bus travel, and used TVs are examples of inferior goods for many Americans today. . What does all this mean in terms of the demand curve? The demand curve shows how the quantity of a good demanded responds to a change in its own
FIGURE 5·1. Market Duodenum Derived from Individual Demands
price. But the demand is also affected by the prices of other goods, by consumer incomes, and by spew CIA influences. The demand curve was drawn on the assumption that these other’ things were held constant. But what if these other things change? Then the whole demand curve will shift to the right or to the left.
Figure 5-3 illustrates changes in factors affecting demand. Given people’s incomes and the prices for other goods, we can draw the demand curve for coffee as DD.Assume that price and quantity are at point A Suppose that incomes rise while. the prices of coffee and other goods are unchanged. Because coffee 0. a normal good with a positive income elasticity,people will increase their purchases of coffee. Hence the demand curve for coffee will shift to the right, to D’D’, with A’ indicating the new quantity em, extolled of toffee. If incomes should fall, then we expect a reduction in demand and in quay· This downward shift we illustrate by D”D”
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