The Economics of Consumers

Study Questions

n 1. What are the kinds of goods consumers spend their income on?

n 2. What is diminishing marginal utility?

n 3. How do consumers maximize utility over several products?

n 4. What is the difference between an inelastic demand and an elastic demand?

n 5. What is the main factor affecting supply?

n 6. Why would retailers prefer taxes to be levied on inelastic goods rather than elastic goods?

Income Earners

n Owners of land resources – rent

n Owners of labor – wages/salary

n Owners of financial capital –interest

¨ Owners of capital goods – return on investment

n Entrepreneurs – profit, if successful

What do we do with our Income?

n Pay taxes.

n Save some.

n Spend the rest.

Consumer Spending

n Durable goods

n Nondurable goods

n Services

Utility

n This is the amount of satisfaction, usefulness or pleasure we get from consuming a specific item at one particular time.

¨ subjective; intensely personal and situational

¨ we use our value system to assign utility

Utility

n Marginal utility – the added utility we will get out of consuming one more of a good.

¨ Marginal cost – the added cost of obtaining one more of a good.

n Total utility – the sum of all the utility we obtain when we consume a series of a good.

Diminishing Marginal Utility

n As you consume more and more of a good, your marginal utility decreases.

n As your marginal utility decreases, you become less interested in consuming another unit of the good.

¨ When MU falls below MC, you will decide to stop consuming more units of this good

Figure 3-1. Diminishing Marginal Utility

Demand and Diminishing MU

n If the sales person wants us to buy more of his goods, he must offer it to us at a lower price.

¨ the added units are less valuable to us due to diminishing MU, so we will buy them only if they come at a lower price (MC is decreased).

Comparing Value to Price

n Consumers choose from many products.

n The next item a consumer should by is the one with the highest MU per dollar (MU/P) spent. This increases TU the greatest.

n The consumer maximizes TU when the next choices all have the same MU/P.

Consumer Equilibrium

n This is the state where the consumer has purchased all goods that have high MU/P and all remaining possibilities have the same MU/P ratio.

n The consumer is indifferent to all these choices.

¨ The consumer has maximized total utility.

Upsetting Consumer Equilibrium

n Start: MU/P for Good A equals MU/P for Good B

¨ Let MU for good A rise and the consumer will prefer more of good A.

¨ Let MU for good A fall and the consumer will prefer more of good B.

¨ Let P for good A rise and the consumer will prefer more of good B.

¨ Let P for good A fall and the consumer will prefer more of good A.

Upsetting Consumer Equilibrium

n Advertising:

¨ tries to get us to increase our MU for its good.

¨ notifies us when P of its good is lower.

¨ both will upset consumer equilibrium.

¨ and we will buy more of the advertised good.

Elasticity of Demand

n If price falls, we buy more, and vice versa.

n How much more?

¨ How intense is our response to a price change?

Elasticity of Demand

n Elastic demand:

¨ A small price decrease generates a big increase in quantity demanded.

¨ A small price increase generates a big decrease in quantity demanded.

n Inelastic demand:

¨ A big price decrease generates only a small increase in quantity demanded.

¨ A big price increase generates only a small decrease in quantity demanded.

Characteristics of Goods with Elastic Demand

n Substitutes readily available

n Big price tag compared to our income

n We don’t need to buy it right now

Characteristics of Goods with Inelastic Demand

n No substitutes available

n Small price tag compared to our income

n We need to buy it right now

Measuring Elasticity

n Percent change method:

¨ %change = (change) x 100/(original number)

n Calculate the percent change in quantity.

n Calculate the percent change in price.

n Now calculate elasticity:

¨ Elasticity = (%change in Q)/(%change in P)

Measuring Elasticity

¨ Elasticity = (%change in Q)/(%change in P)

n If elasticity > 1, demand is elastic.

n If elasticity < 1, demand is inelastic.

n If elasticity = 1, demand is unitary.

Figure 3-2. Demand Curve Elasticity

n Steep demand curves are inelastic

¨ Small change in Q in response to a big change in P

n Shallow (nearly flat) demand curves are elastic

¨ Large change in Q in response to a small change in P

Uses of Elasticity

n Elastic demand?

¨ Lower prices, and sales grow rapidly.

n New customer base

n Sales revenue increases

¨ Keep price increases as quiet as possible.

n Inelastic demand?

¨ Raise prices and sales fall off insignificantly.

n Sales revenues rise

n Costs decrease and profits rise

¨ Offer lower prices only as a “loss leader”.

n Lure more customers into the store

Elasticity of Supply

n Suppliers want to sell more if price rises.

n Time is the determinant:

¨ Zero time to respond? Zero increase in quantity supplied (extremely inelastic)

¨ A short time to respond? Small increase in quantity supplied (inelastic)

¨ A long time to respond? Large increase in quantity supplied (elastic)

Taxes and Elasticity

n Burden of a Tax

¨ the product does not pay the tax

¨ people pay the tax

n consumers?

n producers/sellers?

¨ who carries the burden of a tax?

n Inelastic Goods;

¨ add a tax

¨ seller increases P by the amount of the tax

¨ inelastic response; consumers cut back only a little

¨ seller takes the tax out of increased sales revenues

¨ buyer carries most of the burden of the tax

n Elastic Goods;

¨ add a tax

¨ seller increases P by the amount of the tax

¨ elastic response; consumers cut back by a large amount

¨ sales revenue decreases; seller takes the tax out of profits

¨ seller carries most of the burden of the tax