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Econ 2005: Chapter 6 - Utility

by: LaurieWestog

Econ 2005: Chapter 6 - Utility ECON 2005

Virginia Tech
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About this Document

These notes cover the majority of what the professor went over in class on chapter 6. It includes the topics of utility, budget lines, and utility maximization.
Principles of Economics
Steve Trost
Class Notes




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This 7 page Class Notes was uploaded by LaurieWestog on Monday February 22, 2016. The Class Notes belongs to ECON 2005 at Virginia Polytechnic Institute and State University taught by Steve Trost in Spring 2016. Since its upload, it has received 41 views. For similar materials see Principles of Economics in Economcs at Virginia Polytechnic Institute and State University.


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Date Created: 02/22/16
Econ 2005 - Chapter 6: Utility Q: Why do soda machines only dispense one can but newspaper machines allow you to take all of the newspapers? A: As we consume more of something, the less we enjoy it. So we don’t need all the newspapers because we wouldn’t derive any enjoyment from taking more than one newspaper. Consumer Choice and Demand Utility – The level of satisfaction or happiness a consumer derives from the consumption of a good or service. It is the basis of choice for economists.  The goal of consumers is to maximize utility o Individuals maximize utility in many different manners  If we could measure utility, it would be in utils o There is nothing in the theory that says different people who consume the same good must derive the same number of utils from it, meaning people can enjoy the same good but get different levels of utility from it Marginal Utility (MU) – the additional satisfaction gained by the consumption or use of one or more unity of something, ceteris paribus Total Utility (TU) – the total amount of satisfaction obtained from consumption of a good or service. Formulas: MU = TU/Q TU= MU Law of Diminishing Marginal Utility (LDMU): The more of any good or service a person consumes per period, the less satisfaction (utility) generated by consuming each additional (marginal) unit of the same good, ceteris paribus OR the more you consume of a good, the less utility you get # of TVs MU Total Utilityout of each 1 100 100 additional unit 2 50 150 consumer all else equal 3 30 180 4 10 190 5 5 195 Example of LDMU: 6 0 195 7 -5 190 TVs gotten for birthday Marginal Utility 2 Total Utility Side Note: A group of people called “utilitarians” tried to develop a way to measure utility. They wanted to develop a system of allocation that would allocate society’s scarce goods and services to those who would derive the most utility from consuming these goods and services. However, a market system does not allocate goods and services to those who want them most. Market systems do not maximize total social utility. Possible exceptions of LDMU  Drugs – the more you take, the more you want; develops an addiction  Cracker Jacks – “the more you eat, the more you want” which is direct opposition of LDMU The Budget Line (aka the budget constraint) Budget Constraint – The limits imposed on household choice by income, wealth, and product prices (aka budget line) Choice Set (aka opportunity set) - All combinations of goods that a household can afford (i.e. all bundles of good that lie inside or on the budget constraint. 3  The budget line depicts all possible combinations of goods that a consumer can afford.  Information on household income and wealth, together with information on product prices, makes it possible to distinguish the combinations of goods and services from those that are affordable and from those are not. Example: Jazz Club Visits vs. Thai Meals Income = 1000 Price of Jazz Club: $5 Price of Thai Food: $10 The set of combinations of goods you can afford is called the “opportunity set” or “choice set” Budget Constraint Equation: PxX + PyY = I Px: price of good x X: quantity of good x consumed Py: price of good y Y: quantity of good y consumed I: household income Budget Lines: 4 As prices change, the budget line “rotates” in our out GoodY $12=I/Py $4=I/Py $6=I/Px GoodX As income rises but prices do not change, the line shifts out. Good Y $20 =I/Py $12 =I/Py $6=I/Px $10 =I/Px Good X Real Income Real Income - set of opportunities to purchase real goods and services available to a household as determined by prices and money income  Real income rises when money income rises and prices stay the same OR if prices fall and income stays the same 5  Or when you can buy more stuff  Budget constraints change when prices rise or fall. Real income rises when the choice set gets bigger.  When prices or income change the choice set changes. Utility Maximization  Consumers want to maximize utility. They have to within their budget set but achieve highest level of utility.  To maximize combination of utility, consumers must spend all money. LDMU and Consumption  The combination of the LDMU and consumption ensures that the last dollar spent on a good or service yields the same utility across all goods OR the consumer will set the per dollar marginal utility to be the same across all goods and service aka “get the bang for their buck” Utility – Maximizing Rule  Consumers spread out their expenditures until the following conditions hold: MUx MUy 1) Px = Py 2) Allincomemustbespent 6 MUx MUy If Px > Py the consumer is always better off by buying more of good x and less of good y. NOTE: THIS ONLY WORKS IF YOU KNOW THE PRICES. MUx > MUy does not tell us much. 7


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