12 Elasticity AP Microeconomics II B Theory of Consumer Choice 1 Explain the concept of price elasticity of demand understanding that it involves responsiveness of quantity demanded to a change in price along a given demand curve ID: 463556
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Slide1
IB Economics:1.2 ElasticityAP Microeconomics:II. B. Theory of Consumer ChoiceSlide2
1. Explain the concept of price elasticity of demand, understanding that it involves responsiveness of quantity demanded to a change in price, along a given demand curve.
Elasticity
refers to the responsiveness of one economic variable, such as quantity demanded, to a change in another variable, such as price
.Price elasticity of demand (PED) shows the relationship between price and quantity demanded and provides a precise calculation of the effect of a change in price on quantity demanded
.
Loosely speaking,
PED
measures the price-sensitivity of buyers’ demand. Slide3
2. Calculate PED using the following equation.
PED = percentage
change in quantity demanded /percentage change in price
(Q2 – Q1) / Q1
PED = (P2 – P1) / P1
Price elasticity of demand
=
Percentage change in
Q
d
Percentage change in
P
end value – start value
start value
x 100%Slide4
3. State that the PED value is treated as if it were positive although its mathematical value is usually negative.
Along a
D
curve, P and Q move in opposite directions, which would make price elasticity negative.
We will drop the minus sign and report
all price elasticity's
as positive numbers.
0
P
Q
D
Q
2
P
2
P
1
Q
1Slide5
3. State that the PED value is treated as if it were positive although its mathematical value is usually negative.
The
PED is negative because of the inverse relationship between price and quantity. Since the
law of demand applies to nearly all good and services, we typically ignore the negative sign and express PED
as an
absolute value.
This enables us to analyze positive numbers when comparing the elasticity's of different goods. Slide6
4. Explain, using diagrams and PED values, the concepts of price elastic demand, price inelastic demand, unit elastic demand, perfectly elastic demand and perfectly inelastic demand.
The degree of response of quantity demanded to a change in price can vary considerably. The
key benchmark for measuring elasticity is whether changes are greater or less than proportionate
.PED can be:Less than one, which means PED is inelastic.
Greater than one, which is
elastic.
Equal to one,
unit elastic.
Zero (0), which is
perfectly inelastic.Infinite (∞), which is
perfectly elastic.Slide7
Q
1
P
1
D
“Perfectly inelastic demand”
(one extreme case)
P
Q
P
2
P
falls by 10%
Q
changes
by 0%
0
0%
10%
= 0
Price elasticity
of demand
=
% change in
Q
% change in
P
=
Consumers’
price sensitivity:
D
curve:
Elasticity:
vertical
0
0Slide8
D
“Inelastic demand”
P
Q
Q
1
P
1
Q
2
P
2
Q
rises less than 10%
0
< 10%
10%
< 1
Price elasticity
of demand
=
% change in
Q
% change in
P
=
P
falls by 10%
Consumers’
price sensitivity:
D
curve:
Elasticity:
relatively steep
relatively low
< 1Slide9
D
“Unit elastic demand”
P
Q
Q
1
P
1
Q
2
P
2
Q
rises by 10%
0
10%
10%
= 1
Price elasticity
of demand
=
% change in
Q
% change in
P
=
P
falls by 10%
Consumers’
price sensitivity:
Elasticity:
intermediate
1
D
curve:
intermediate slopeSlide10
D
“Elastic demand”
P
Q
Q
1
P
1
Q
2
P
2
Q
rises more than 10%
0
> 10%
10%
> 1
Price elasticity
of demand
=
% change in
Q
% change in
P
=
P
falls by 10%
Consumers’
price sensitivity:
D
curve:
Elasticity:
relatively flat
relatively high
> 1Slide11
D
“Perfectly elastic demand”
(the other extreme)
P
Q
P
1
Q
1
P
changes by 0%
Q
changes
by any %
0
any %
0%
= infinity
Q
2
P
2
=
Consumers’
price sensitivity:
D
curve:
Elasticity:
infinity
horizontal
extreme
Price elasticity
of demand
=
% change in
Q
% change in
P
=Slide12
5. Explain the determinants of PED, including the number and closeness of substitutes, the degree of necessity, time and the proportion of income spent on the good.
Determinants of PED
There are several reasons why consumers may respond elastically or inelastically to a price change, including the following, which can be summarized using the acronym
SPLAT:S – SubstitutesP – Proportion of income
L – Luxury or necessity
A – Addictive or not
T – Time to respondSlide13
5. Explain the determinants of PED, including the number and closeness of substitutes, the degree of necessity, time and the proportion of income spent on the good.
The number and ‘closeness’ of substitutes
A unique and desirable product, such as an important work of art, is likely to exhibit an inelastic demand with respect to price - perhaps approaching zero. However, a very common product which is available everywhere many have may alternative outlets, and PED may approach infinity.The proportion of consumer income which is spent on the good
The PED for a daily newspaper is likely to be much lower than that for a new car, given that, at least in the short run, less income is spent on newspapers.The degree of necessity of the good
A necessity like bread will be demanded inelastically with respect to price, whereas a luxury, such a holiday to the Caribbean, may be demanded elastically.
Slide14
5. Explain the determinants of PED, including the number and closeness of substitutes, the degree of necessity, time and the proportion of income spent on the good.
Whether the good is addictive
Consumers are relatively insensitive to changes in the price of habitually demanded products, such cigarettes. The time to respondImmediately following a change in price, it is unlikely that consumers will adjust their consumption by
very much. It is difficult to identify suitable substitutes for
a good that has increased in price in the short run, but in the long run new options can be identified and consumers can further reduce their consumption of the more expensive good. Slide15
5. Explain the
determinants of PED, including the number and closeness of substitutes, the degree of necessity, time and the proportion of income spent on the good.
Determinates
of PED
Elastic
Inelastic
Substitutes
Lots
Few
Proportion of income
High percent of incomeLow percent of incomeLuxury or NecessityLuxury Necessity
Addictive or not
Not Addictive Addictive Time to respondLong RunShort RunSlide16
6. Calculate PED
between two designated points on a demand curve using the PED
equation above.
Introduction to Price Elasticity of Demand – calculating PED using data from a demand diagramSlide17
7. Explain why PED varies along a straight line demand curve
and is not represented by the slope
of the demand curve.
Graphically, relative price elasticity's of demand can be compared by examine the
slopes
of demand curves drawn on the same axes.
The
steeper
the slope
of demand of a good, the less elastic the demand for that good. The more nearly horizontal the slope, the more elastic the demand. The relative slope of demand curves on the same axis indicates the relative elasticity's of demand for the goods they represent. Goods for which demand is highly elastic reflects their elasticity in the flat slope of the demand curve, while goods for which demand is relatively inelastic show demand curves closer to vertical. Slide18
Elasticity of a Linear Demand Curve
0
The
slope
of a linear demand curve is constant,
but its
elasticity
is not.
P
Q
$30
20
10
$0
0
20
40
60
200%
40%
= 5.0
E
=
67%
67%
= 1.0
E
=
40%
200%
= 0.2
E
=Slide19
8. Examine the role of PED for firms in making decisions regarding price changes and their effect on
total revenue.
For a firm producing at a quantity and price combination along in the
inelastic range of its demand curve can always benefit by reducing its output and increasing its price, since consumers will be relatively unresponsive
to the higher prices and
total revenues
will therefore increase.
However, if a firm is producing at an output and price combination along the elastic
range of its demand curve, the firm may benefit from lowering its price since consumers are relatively price
sensitive and the percentage increase in quantity sold will exceed the percentage decrease in price, improving the firm’s total revenue. Slide20
Price Elasticity and Total Revenue
If demand is elastic, then
price elasticity of demand > 1 % change in QD
> % change in PThe fall in revenue from lower
QD
is greater
than the increase in revenue from higher
P
, so revenue falls.
(Inverse relationship between Price and total revenue)
Total Revenue
=
P x Q
Price elasticity of demand
=
Percentage change in
Q
Percentage change in
P
0Slide21
Price Elasticity and Total RevenueElastic demand
(elasticity = 1.8)
P
Q
D
$200
12
If
P
= $200,
Q
= 12 and revenue = $2400.
When
D
is elastic,
a price increase
causes revenue to fall.
0
$250
8
If
P
= $250,
Q
= 8 and
revenue = $2000.
lost revenue due to lower
Q
increased revenue due to higher
P
Deman
d
for your websitesSlide22
Price Elasticity and Total Revenue
If demand is inelastic, then
price elasticity of demand < 1 % change in
QD < % change in P
The fall in revenue from lower
QD
is smaller
than the increase in revenue from higher
P
, so revenue rises.
(A direct relationship between price and total revenue)
Price elasticity of demand
=
Percentage change in
Q
Percentage change in
P
0Slide23
Price Elasticity and Total Revenue
Now, demand is inelastic: elasticity = 0.82
P
Q
D
$200
12
If
P
= $200,
Q
= 12 and revenue = $2400.
$250
10
If
P
= $250,
Q
= 10 and
revenue = $2500.
When
D
is inelastic,
a price increase
causes revenue to rise.
0
lost revenue due to lower
Q
increased revenue due to higher
P
Deman
d
for your websitesSlide24
Total Revenue and PED
Price Elasticity of Demand and the Total Revenue TestSlide25
Price DiscriminationDiscrimination is the practice of treating people differently based on some characteristic, such as race or gender. Price discrimination
is the business practice of selling the same good at different prices to different buyers.
The characteristic used in price discrimination is willingness to pay (WTP): A firm can increase profit by charging a higher price to buyers with higher WTP.Slide26
Price discriminationPrice discrimination can only occur if certain conditions are
met:
The firm must be able to identify different market segments, such as domestic users and industrial users.Different segments must have
different price elasticity's (PEDs).
Markets must be kept separate
, either by time, physical distance and nature of use, such as Microsoft Office ‘Schools’ edition which is only available to educational institutions, at a lower price.
There must be
no seepage between the two markets,
which means that a consumer cannot purchase at the low price in the elastic sub-market, and then re-sell to other consumers in the inelastic sub-market, at a higher price.
The firm must have some degree of monopoly power.
Slide27
Price discriminationSlide28
9. Explain why the PED for many primary commodities is relatively low and the PED for manufactured products
is relatively high.
The price elasticity of demand
for many primary products is relatively price inelastic
. They are often necessities and have few close substitutes.
The
PED
for primary commodities
is relatively low due to the fact that they have very few substitutes whereas manufactured products
have a relatively high PED because of the existence of many substitutes. For example, the PED for cow leather (primary commodity) is relatively lower than a genuine cow leather shoe (manufactured product). The reason being there is no or very few substitutes for leather as a raw material for producing shoes. However, leather shoes may have many substitutes in the form of sheep leather and other types of artificial leather shoes available in the market.Slide29
9. Explain why the PED for many primary commodities is relatively low and the PED for manufactured products is relatively high.
The prices of many primary commodities have shown two noticeable characteristics:
They often exhibit a downward trend over time
They are prone to fluctuationsHow does economic theory explain this?
Downward trend in their prices?
The downward trend in commodity prices is due to changes in the long-term conditions of supply and demand.
Supply factors
An increase in the supply of the commodities due to improvements in the technology e.g. development and use of fertilizers and pesticides.
An increase in government subsidy or increases in production quotasDemand factors Many commodities are necessities and have a low income elasticity of demand. Consequently as the consuming nations experience increases in their incomes their demand for commodities grows but at a proportionately smaller rate. The demand curve has shifted to the right over time but by a small amount. If alternatives to the commodities are found then the demand curve may even decrease and shift to the left.Slide30
9. Explain why the PED for many primary commodities is relatively low and the PED for manufactured products is relatively high.
Why are commodity prices inclined to fluctuate?
There are a number of explanation why the prices of primary commodities especially agricultural primary commodities.Supply Shocks Agricultural prices are prone to unplanned changes in supply because of weather conditions. Shocks such as these will cause the market supply curve to make shifts to the left and right depending upon the weather conditions.
Low Price elasticity of demand
The price elasticity of demand for many primary products is relatively price inelastic. They are often
necessities
and have
few close substitutes.Slide31
10. Examine the significance of PED for government in relation to indirect taxes.
PED and the burden of tax
The relative burden, or incidence, of an
indirect tax is determined by the price elasticity of
demand
(
PED) of the consumer in response to a price rise. If the consumer is unresponsive, and PED is
inelastic
, the burden will fall mainly on the consumer. However, if the consumer is
responsive
to the price rise, and PED is elastic, the burden will fall mainly on the firm.Slide32
10. Examine the significance of PED
for government in relation to
indirect taxes.Slide33
11. Explain the concept of price elasticity of supply, understanding that it involves responsiveness of quantity supplied to a change in price along a given supply curve.
Price elasticity of supply (PES)
measures the responsiveness of quantity supplied to a change in price. It is necessary for a firm to know how quickly, and effectively, it can respond to changing market conditions, especially to price changes. Slide34
S
11. Explain the concept of
price elasticity of supply
, understanding that it involves responsiveness of quantity supplied to a change in price along a given supply curve.
P
Q
0
Supply often becomes
less elastic
as
Q
rises,
due to capacity limits.
$15
525
12
500
$3
100
4
200
elasticity > 1
elasticity < 1Slide35
12. Calculate PES using the following equation. PES= percentage change in quantity supplied/ percentage change in price
Price elasticity of supply
measures how much
Qs
responds to a change in
P
.
PES = (QS2 – QS1)/ QS1
(P2 – P1) / P1
Price elasticity of supply
=
Percentage change in
Q
s
Percentage change in
PSlide36
13. Explain, using diagrams and PES values, the concepts of elastic supply, inelastic supply, unit elastic supply, perfectly elastic supply and perfectly inelastic supply.
Possible range of values
:
PES > 1:
Supply is
elastic
PES = 1:
Supply is
unit elastic
PES < 1: Supply is inelastic PES = 0: if the supply curve is vertical, and there is no response to prices (Perfectly Inelastic) PES = infinity: if the supply curve is horizontal (Perfectly Elastic)Slide37
S
“Perfectly inelastic”
(one extreme)
P
Q
Q
1
P
1
P
2
Q
changes
by 0%
0
0%
10%
= 0
Price elasticity
of supply
=
% change in
Q
% change in
P
=
P
rises by 10%
Sellers’
price sensitivity:
S
curve:
Elasticity:
vertical
0
0Slide38
S
“Inelastic”
P
Q
Q
1
P
1
Q
2
P
2
Q
rises less than 10%
0
< 10%
10%
< 1
Price elasticity
of supply
=
% change in
Q
% change in
P
=
P
rises by 10%
Sellers’
price sensitivity:
S
curve:
Elasticity:
relatively steep
relatively low
< 1Slide39
S
“Unit elastic”
P
Q
Q
1
P
1
Q
2
P
2
Q
rises
by 10%
0
10%
10%
= 1
Price elasticity
of supply
=
% change in
Q
% change in
P
=
P
rises by 10%
Sellers’
price sensitivity:
S
curve:
Elasticity:
intermediate slope
intermediate
= 1Slide40
S
“Elastic”
P
Q
Q
1
P
1
Q
2
P
2
Q
rises more than 10%
0
> 10%
10%
> 1
Price elasticity
of supply
=
% change in
Q
% change in
P
=
P
rises by 10%
Sellers’
price sensitivity:
S
curve:
Elasticity:
relatively flat
relatively high
> 1Slide41
S
“Perfectly elastic”
(the other extreme)
P
Q
P
1
Q
1
P
changes by 0%
Q
changes
by any %
0
any %
0%
= infinity
Price elasticity
of supply
=
% change in
Q
% change in
P
=
Q
2
P
2
=
Sellers’
price sensitivity:
S
curve:
Elasticity:
horizontal
extreme
infinitySlide42
14. Explain the determinants of PES, including time, mobility of factors of production, unused capacity and ability to store stocks.
The more easily sellers can change the quantity they produce, the greater the price elasticity of supply.
(Manufactured or Service
vs
Primary products)
For many goods, price elasticity of supply is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market.
(Time Frame)
Amount of excess capacity, the greater the excess capacity the more elastic supply will be and the
less
the excess capacity the less elastic. (excess capacity)Availability of substitutes in production, the more substitutes the more elastic and the less substitutes the less elastic. (substitutes)
Ease of storage
: if it is easy to store production, the more elastic supply response to increases in demandSlide43
14. Explain the determinants
of PES, including time, mobility of factors of production, unused capacity and ability to store stocks.
Determinants
of PES
Elastic
Inelastic
Manufactured or Service VS Primary products
Manufactured or Service
Primary productsTime FrameLong RunShort RunExcess capacity
Yes
NoSubstitutesManyFewEase of storageNon Perishable Perishable Slide44
15. Explain why the PES for primary commodities
is relatively low and the PES for manufactured products
is relatively high.
Low-tech manufactured goods and low-skilled services have a relatively
elastic supply
.
Producer can easily hire more workers and acquire more raw materials and capital resources to meet increases in demand or cut inputs for falling demand, thus they are
highly responsive
to changes in prices.
Primary commodities
that are land-intensive in production exhibit immobility of the factors of production. It is time-consuming and costly to bring into production primary commodities to meet rising demand, or to take them out of production in response to falling prices. Thus they are relatively inelastic. Slide45
16. Explain the concept of income elasticity of demand, understanding that it involves responsiveness of demand (and hence a shifting demand curve) to a change in income.
(YED)
The
Income elasticity of demand measures the response of
Q
d
to a change in consumer income
.
Recall:
An increase in income causes an increase in demand for a normal
good. Hence, for normal goods, income elasticity > 0. (Positive)For inferior goods, income elasticity < 0. (Negative) Recall also that a change in income is a determinate of Demand, thus a change in income can cause a shift of the demand curve. Slide46
17. Calculate YED using the following equation
YED = percentage change in quantity demanded / percentage change in income
YED =
percentage change in quantity demanded / percentage change in
income
(
Y= Income)
YED = (Qd2-Qd1) / Qd1
(Y2-Y1) / Y1
Income elasticity of demand
=
Percent change in
Q
d
Percent change in incomeSlide47
18. Show that normal goods have a positive
value of YED
and inferior goods have a negative
value of YED.
Normal goods:
an increase in income leads to an increase in consumption, demand shifts to the right. Thus YED is positive for normal goods.
Inferior goods:
Income elasticity is actually negative for inferior goods, the demand curve shifts left as income rises. As income rises, the proportion spent on cheap goods will reduce as now they can afford to buy more expensive goodsSlide48
18. Show that normal goods have a positive value of YED and inferior goods have a negative value of YED.Slide49
19. Distinguish, with reference to YED, between necessity
(income inelastic) goods and luxury
(income elastic) goods.
Necessities have an income elasticity of demand
of between 0 and +1. Demand rises with income, but less than proportionately.
Often
this is because we have a limited need to consume additional quantities of
necessary goods
as our real living standards rise.
The class examples of this would be the demand for fresh vegetables, toothpaste and newspapers.
Demand is not very sensitive at all to fluctuations in income in this sense total market demand is relatively stable following changes in the wider economic (business) cycle. Slide50
19. Distinguish, with reference to YED, between necessity (income inelastic) goods and
luxury
(income elastic) goods.
Luxuries on the other hand are said to have an income elasticity of demand
> +1. (Demand rises more than proportionate to a change in income).
Luxuries
are items we can (and often do) manage to do without during periods of below average income and falling consumer confidence.
When incomes are rising strongly and consumers have the confidence to go ahead with “big-ticket” items of spending, so the demand for
luxury goods
will grow. Slide51
The Engle’s curve shows the relationship between income and quantity or consumption.Slide52
19. Distinguish, with reference to YED, between necessity (income inelastic) goods and luxury (income elastic) goods.Slide53
19. Distinguish, with reference to YED, between necessity (income inelastic) goods and luxury (income elastic) goods.Slide54
YED Slide55
20. Examine the implications for producers and for the economy of a relatively low YED for primary products, a relatively higher
YED
for manufactured products and an even higher YED
for services
Significance
of income elasticity for
sectorial
change
(
primary> secondary > tertiary) as economic growth occurs
As economies grow (and move from primary to secondary to tertiary production)Firms will plan on producing fewer inferior goodsProduction and purchasing of capital goods and other factors can be plannedProduction for exports can be planned as new markets open and closePrimary sector is generally income inelasticJust because a person's income changes does not mean he will buy more tomatoesHowever, secondary and tertiary sectors tend to be income elastic; a change in income will have a big impact on quantity demanded of cars, or the demand for personal massagesSlide56
21. Explain the concept of cross price elasticity of demand, understanding that it involves responsiveness of demand for one good (and hence a shifting demand curve) to a change in the price of another good.
(XED)
Cross Price Elasticity of demand
measures the responsiveness of demand for a product to a change in the price of other related products. We normally focus on the links between changes in the prices of substitutes and
complements
.Slide57
21. Explain the concept of cross price elasticity of demand, understanding that it involves responsiveness of demand for one good (and hence a shifting demand curve) to a change in the price of another good. (XED)Slide58
22. Calculate XED using the following equation.
XED = percentage change in quantity demanded of good x/ percentage change in price of good y
(X = Cross between two goods)
XED = (Qb2 – Qb1) / Qb1
(Pa2 – Pa1) / Pa1
Cross-price elast.
of demand
=
% change in
Q
d
for good 1
% change in price of good 2Slide59
23. Show that substitute goods have a positive value of XED
and complementary goods
have a negative value of XED.
The main use of cross price elasticity
concerns changes in the prices of substitutes and complements.
With
substitute
goods such as brands of cereal, an increase in the price of one good will lead to an increase in demand for the rival product. The cross price elasticity for two substitutes will be
positive. With goods that are in
complementary demand such as the demand for DVD players and DVD’s, when there is a fall in the price of DVD players we expect to see more DVD players bought, leading to an expansion in market demand for DVD’s. This is a negative relationship. When there is no relationship (Independent) between two products, the cross price elasticity of demand is zero.Slide60
23. Show that substitute goods have a positive value of XED
and complementary goods
have a negative value of XED.Slide61
Complements or substitutes? Slide62
24. Explain that the (absolute) value of XED depends on the closeness
of the relationship between two goods.
The
stronger the relationship between two products, the higher is the co-efficient of cross-price elasticity of demand. When there is a strong complementary relationship between two products, the cross-price elasticity will be highly negative. An example might be games consoles and software games
For
example, if the
X
ED
is +2 the goods are
close substitutes.
If the XED is +.02 the goods are weak substitutes. If the XED is zero the goods are independent. Slide63
24. Explain that the (absolute) value of XED depends on the closeness
of the relationship between two goods.Slide64
24. Explain that the (absolute) value of XED depends on the closeness
of the relationship between two goods.Slide65
24. Explain that the (absolute) value of XED depends on the closeness
of the relationship between two goods.Slide66
25. Examine the implications of XED for businesses if prices of substitutes or complements change.
Why does a firm want to know XED?
Knowing the
XED of its own and other related products enables the firm to map out its market.
Mapping
allows a firm to
calculate how many rivals it has,
and how close they are as competitors.
It also allows the firm to
measure how important its complementary products are to its own products.This knowledge allows the firm to
develop strategies to reduce its exposure to the risks associated with price changes by other firms, such as a rise in the price of a complement or a fall in the price of a substitute.Slide67
AP Microeconomics:II. B. Theory of Consumer ChoiceSlide68
26. Define total and marginal utility
Total utility
is simply a measure of the total satisfaction of wants and needs obtained from the consumption or use of a good or service
.Marginal utility is the additional utility, or extra satisfaction of wants and needs, obtained from the consumption or use of an additional unit of a good or service
.
Marginal utility is specified as
:
marginal utility = change in total
utility
change in quantitySlide69
27. Explain The Law of Diminishing Marginal Utility
The law of diminishing marginal utility
states that marginal utility, or the extra utility obtained from consuming a good, decreases as the quantity consumed increases.
In essence, each additional good consumed is less satisfying than the previous one. This
law is particularly important for insight into market demand and the
law of demand.Slide70
28. Describe how the consumer decides what to purchase using the utility maximization rule.
The process or goal of obtaining the highest level of utility from the consumption of goods or services
.
So how does the consumer decide what to purchase? Unfortunately everything has a price and consumers only have so much money to spend.
Consequently
consumers try to spend the limited money they have on what will give them the greatest amount of satisfaction.
The
decision rule for
utility maximization is to purchase those items that give the greatest marginal utility per dollar and are affordable or within the budget. Slide71
29. Explain the marginal utility-price ratios.
The ratio of the marginal utility obtained from consuming a good to the price of the good.
This ratio is particularly important in determining consumer equilibrium, which is reached when the marginal utility-price ratios are the same for all goods.
Equality between all marginal utility-price ratios is the rule of consumer equilibrium which is satisfied with utility maximization.
The
marginal utility-price ratio
indicates the satisfaction derived from the last dollar spent on a good.
A
consumer maximizes utility be equating the marginal utility-price ratio
for each good purchased and consumed. If
the ratios are not equal, then utility can be increased by changing the combination of goods consumed.A generic marginal utility-price ratio looks like this: marginal utility of a generic good price of a generic goodSlide72
2012 AP® MICROECONOMICS FREE-RESPONSE QUESTIONS
2. Theresa consumes both bagels and toy cars.
(a) The table above shows Theresa’s marginal utility from bagels and toy cars.(i) What is her total utility from purchasing three toy cars?
(ii) Theresa’s weekly income is $11, the price of a bagel is $2, and the price of a toy car is $1.
What quantity
of bagels and toy cars will maximize Theresa’s utility if she spends her entire weekly
income on
bagels and toy cars? Explain your answer using marginal analysis.
Quantity of
Bagels
Marginal Utilityfrom Bagels (utils)Quantity ofToy CarsMarginal Utility fromToy Cars (utils)
1
81102728363
6454454536
362Slide73
Videos:Economics: Understanding Utility Theory
Economics: Finding Consumer EquilibriumSlide74
30. Explain the DIAMOND-WATER PARADOX
Why does water that is essential to sustain life cost so much less than
diamonds that are atheistically pleasing, but are relatively unnecessary? Recall that price reflects the scarcity of a good.
Overall, the supply of water is relatively abundant while the supply of
diamonds
is relatively limited.
Thus
the price we pay for water
is low compared to the price of diamonds.
Is it logical for someone who is maximizing his utility to purchase both water and diamonds? When deciding what to purchase we compare the marginal utility divided by the price. With lots of water consumption, the total utility of water is very large but the marginal utility of the last gallon consumed is relatively low. Few diamonds are purchased so while the marginal utility is very large, say the diamond ring you just purchased for your future spouse, the total utility is low since few diamonds are purchased.Slide75
30. Explain the DIAMOND-WATER PARADOX