FSU ECO 2023 - CHAPTER 7: CONSUMER CHOICE and ELASTICITY

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STUDY GUIDE for SECOND EXAM ECO2023 04 FALL 2011 Martha Evans Instructor Note This study guide is intended to be used as a tool to help you prepare for the test It is an outline representing the topics that have been emphasized in lecture the book and the slides for each section chapter It is NOT an exact representation of the way that questions will be phrased on the test CHAPTER 7 CONSUMER CHOICE and ELASTICITY 1 Consumer Choice Diminishing Marginal Utility Know the Law of Diminishing Marginal Utility and how it explains the downward slope of an individual s demand curve Law of diminishing marginal utility As the rate of consumption increases the marginal utility derived from consuming additional units of a good will decline The height of an individual s demand curve indicates the maximum price a consumer is willing to pay for a unit They pay less and less with each additional unit therefore describing the downward slope of their demand curve Examples in class eating slices of pizza or drinking pitchers of beer 2 Marginal Benefit Marginal Utility Understand these concepts and how they relate to the Demand Curve and how they affect consumer choice How do consumers maximize their total utility See page 150 MUA PA MUB PB Each consumer will maximize his her satisfaction by ensuring that the last dollar spent on each commodity yields an equal degree of marginal utility With the MUA PA MUB PB equation Satisfaction divided by price you want the highest ratio possible You will maximize your utility get the most bang for your buck when you make the ratios of the equation equal Example Burger B vs Coke C Price B 2 Price C 1 You have a 10 budget and decide to have 4 burgers and 2 cokes But when you finish the coke you still have burgers leftover and they no longer look appealing You would have had more utility with fewer burgers and another Coke Or let s say that you want 100 burgers Using the equation 100 2 would give you a ratio of 50 Wanting 65 cokes using the equation 65 1 you d get a ration of 65 65 is greater than 50 so you would get the most satisfaction having 65 cokes rather than 100 burgers For the MAXIMUM utility you would want 100 burgers 100 2 50 and 50 cokes 50 1 50 3 Substitution Effect Income Effect Define and be able to give specific examples Substitution Effect If a product s price falls the consumer will buy more of it and less of other now more expensive products Example If the price of beef rises you will buy more chicken Income effect As a product s price falls a consumer s real income rises and so induces the individual to buy more of both it and other goods Example Your rent decreases by 100 a month and you can now buy more of a number of other goods 1 4 Price Elasticity of Demand Understand this concept and be able to calculate using the midpoint formula see pages 153 and 154 What is the major determinant of elasticity The Price elasticity of demand indicates how responsive consumers are to a change in a product s price change in quantity demanded divided by change in price aka Q P Example P1 6 P2 10 Q1 90 Q2 70 Q 70 90 90 70 2 20 60 25 25 P 10 6 10 6 2 4 8 50 50 Elasticity coefficient Q P 25 50 50 or 50 The major determinant is the availability of substitutes When substitutes are available a rise in price may induce consumers to switch to another product The greater availability of substitutes the more elastic demand will be Another determinant is the share of total budget expended on a product As the share of the total budget spent on the product increases the more elastic demand will be If elasticity coefficient is 1 ignoring negative or positive then demand is elastic If elasticity coefficient is 1 ignoring negative or positive then demand is inelastic If elasticity coefficient 1 ignoring negative or positive then demand is unitary elastic very rare 5 Graphic Representation of Price Elasticity of Demand Use Exhibit 3 on page 155 to understand how perfectly elastic perfectly inelastic unit elastic relatively elastic and relatively inelastic demand curves look in a model of supply and demand Perfectly inelastic Relatively inelastic Unit Elastic Relatively elastic Perfectly elastic 2 6 Demand Elasticity and How Changes in Price Affect Total Consumer Expenditures or a Firm s Total Revenue Use Exhibit 7 on page 159 to be able to answer questions about the effects of various price elasticities on revenue and expenditures Price Elasticity of Demand Elastic Unit Elastic Inelastic Numerical elasticity coefficient Absolute value 1 to 1 0 to 1 Impact of raising price on total consumer expenditures or a firm s total revenue decrease unchanged increase total Impact of lowering price on consumer expenditures or a firm s total revenue increase unchanged decrease 7 Income Elasticity What is the concept of income elasticity of demand and how is it calculated What do the ideas of normal goods and inferior goods have to do with income elasticity of demand Indicates responsiveness of the demand of a product to a change in income change in quantity demanded divided by change in income Normal good positive income elasticity As income expands demand for normal goods will rise Steak Lobster Inferior good negative income elasticity As income expands demand for inferior goods will decline Ramen noodles boxed mac n cheese 8 Price Elasticity of Supply Be able to define and discuss why elasticity of supply varies with some goods and how this may change over time change in quantity supplied divided by change in price causing the supply response This measures the responsiveness of sellers to a change in price and is analogous to the price elasticity of demand Supply elasticities will be greater when suppliers have a longer time to respond to a price change If change in quantity is small relative to change in price supply is inelastic If change in quantity is large relative to change in price supply is elastic Example inelastic physician services Example elastic soda CHAPTER 8 COSTS and the SUPPLY of GOODS Role of the Firm As we discussed in class what is the primary obligation of the 1 business to its owners investors shareholders What does the term residual claimant mean How does being a residual claimant provide incentives to business owners The first obligation of a business is to maximize profits for their shareholders Residual claimants individuals who personally receive the excess if any of revenues over costs Residual claimants gain if the firm s costs are reduced or revenues


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FSU ECO 2023 - CHAPTER 7: CONSUMER CHOICE and ELASTICITY

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