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Econ 200 Chapter 7 Notes

by: Drew Herring

Econ 200 Chapter 7 Notes ECON200

Marketplace > University of Maryland > Microeconomics > ECON200 > Econ 200 Chapter 7 Notes
Drew Herring

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These notes cover chapter 7 of the textbook. As always, I've defined key terms and concepts. For the difficult points, I list real-world examples to make them easier to understand.
Principles of Micro-Economics
Hossein Abbasi Alikamar
Class Notes
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This 4 page Class Notes was uploaded by Drew Herring on Monday October 10, 2016. The Class Notes belongs to ECON200 at University of Maryland taught by Hossein Abbasi Alikamar in Fall 2016. Since its upload, it has received 2 views. For similar materials see Principles of Micro-Economics in Microeconomics at University of Maryland.


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Date Created: 10/10/16
Chapter 7 Notes Consumer Behavior 7.0   Introduction How do people make decisions on how to spend their precious time and money? This  process is measured by Utility: The measure of satisfaction a person derives from something.  Things that you like increase your utility. For example, eating a Reese’s Cup or watching The  Office would greatly increase my utility, while eating tomato soup or reading a boring magazine  would decrease my utility. People make decisions by choosing to do the things that they think  will give them the most utility given the available options.  When you make decisions to bring the greatest possible utility to yourself, you are  engaging in Utility Maximization. Rational people who behave in order to reach utility  maximization are called Rational Utility­Maximizers. In rational decision making, you usually  have to make choices on achieving high utility in the short term versus the long term. Utility  varies from person to person and can therefore be difficult to predict or measure quantifiably. 7.1   Revealed Preference We can draw inferences about other people’s measures of utility through something  called Revealed Preference. Revealed Preference is the idea that people’s preferences can be  determined by observing their choices and behavior. If people were to observe me at a candy  store, for example, they would notice that Reese’s candy is my candy of choice. Thus, through  revealed preference, you can conclude that Reese’s candy brings me the greatest utility. However, once in a blue moon, I’ll take gummy worms over Reese’s Cups, because I  might be more in the mood for a sweet candy than a salty one. This means that gummy worms,  in that instance, will bring me more utility than Reese’s Cups will. Therefore, utility is a volatile  (easily changed) measurement. Ever heard the phrase “actions speak louder than words”? This is usually true when  measuring utility. Things that people actually do (as opposed to what they say) carry more  weight about what brings them utility. In order to think systematically about how people make  choices, economists construct a utility function. Utility Functions are formulas for calculating  the total utility that a particular person derives from consuming a combination of goods and  services. Utility functions are ways of quantitatively describing preferences. Bundles are unique  combinations of goods that a person could choose to consume. Too much of a good thing can be a bad thing, however. The change in total utility that  comes from consuming one additional unit of a good or service is called Marginal Utility (MU). If I kept eating Reese’s Cups, eventually, (like maybe the 30th or 40th one lol) I would get sick  of them. This means that instead of raising my utility, that candy would start to lower my utility.  This principle that the additional utility gained from consuming successive units of a good or  service tends to be smaller than the utility gained from the previous unit is called Diminishing  Marginal Utility. Products can have one of three effects on the consumer. It can increase utility,  meaning it results in a positive marginal utility. It can decrease utility, meaning it results in a  negative marginal utility. Lastly, it can keep utility exactly the same, meaning it has zero  marginal utility. Total and marginal utility can be displayed on a graph, as shown below. Pretend that this graph represents the total and marginal utility I receive when eating  Reese’s Cups. Total utility levels off at the 6th cup, and begins decreasing between the 7th and  8th cups. Total utility will usually have this parabolic shape: a steady increase, an apex where the curve levels off, and then a steady decrease. The marginal utility represents the change in utility. Notice how each successive cup  from 1 to 6 brings me progressively less and less utility, until it isn’t bringing me any at all.  Marginal utility is related to the slope (rate of change) of the total utility curve, kind of like the  derivative function in calculus. Marginal utility measures the resulting utility from each new cup  I eat. Look at how at the 7th cup, the marginal utility is zero. When the marginal utility of an  additional unit of a good is zero, you’ve maxed out the total utility you can get from consuming  that good. Also, notice how once my total utility starts to decrease, my marginal utility turns  negative. 7.2    Maximizing Utility Within Constraints In the real world, people attain utility as a combination of consuming many goods and  doing many activities. The combination of goods and services a consumer can consume is  represented by a Budget Constraint. The budget constraint graph is similar to a production  possibilities frontier, in that a consumer has to choose a possible combination of goods that his  resources will allow him to get. The most important point on a budget constraint graph is the  Optimal Combination, which is the point with the maximum possible utility. 7.3    Changes in Income When a person’s income increases, their budget constraint expands. This means that they  can purchase more bundles of goods/services. When a person’s income decreases, the reverse is  true. No matter the change in income, the slope of the budget constraint line will stay the  same. This is because the price ratio between different goods stays the same. 7.4     Changes in Prices Remember that normal goods are goods that are demanded more following an increase in  income, such as cell phones, TVs, or cars. Inferior goods are goods that see less demand  following an increase in income, such as ramen noodles or knock­off brands of food. Changes in the price of a good have two key effects. The first one is called the Income  Effect: the change in consumption that results from increased effective wealth due to lower  prices. This effect doesn’t necessarily mean that the consumer has an increase in his income. For  example, say I normally spend $25 a month on Reese’s Cups. If there was a 60% off sale on  Reese’s Cups, I would save $15 a month, or be $15 “richer” per month because of the sale.  Decreases in price cause the budget line to rotate (not shift) outward. This is because the Reese’s  Cup is the only good that is decreasing in price. My other candy of choice, the gummy worm, is  not decreasing in price. Therefore, the opportunity cost of buying a Reese’s Cup goes down. This increases the slope of the budget constraint. The essence of the income effect is that when goods  get cheaper, the consumer’s money can buy more. The second effect is the Substitution Effect: the change in consumption that results from a change in the relative price of goods. It is very similar to the income effect. In terms of the  previous example, it simply means I will substitute more Reese’s Cups for gummy worms, since  Reese’s became cheaper.  An exception to this rule occurs with products called Veblen Goods. These are goods  that actually increase in quantity demanded when price goes up. This is mostly true for flashy  goods such as expensive watches, handbags, or shoes. Some people get utility from having other  people notice their luxurious shoes or purses. The principle of veblen goods proves that utility  can be influenced by the perceptions of other people. 7.5     Utility and Status Utility is a mix of outside perceptions and inner preferences, both of which contribute to  decision making. Since utility can be related to status, and some people get lots of utility from  showing off how wealthy they are, they buy the best goods that show off their wealth. On the flip side Altruism describes a motive for an action in which a person’s utility increases simply  because someone else’s utility increases. In light of the principles of altruism and selfishness, we can infer that rational decision  making depends on more than goods and services. Revealed preferences show us that many  people get utility from doing things that really aren’t selfish at all. Reciprocity is the tendency to respond to another’s action with a similar action. It  involves doing good things for people who did good things for you. When you make an effort to  decrease someone else’s utility in response to being harmed, you are engaging in negative  reciprocity. A key principle of economics is the assumption that people attempt to maximize their  utility within the limitations of their resources.


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