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 implies that a consumer s marginal benefit and thus the height of their demand curve falls with the rate of consumption An individual s demand curve reflects the law of diminishing marginal utility Because marginal utility MU falls with increased consumption so does a consumer s maximum willingness to pay marginal benefit MB 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 1 3 Substitution Effect Income Effect Define and be able to give specific examples Substitution effect as a product s price falls the consumer will buy more of it and less of other now more expensive products Always negative for the seller Consumers always switch from spending on higher priced goods to lower priced ones as they attempt to maintain their living standard in face of rising prices Substitution effect is not confined only to consumer goods but manifests in other areas as well such as demand for labor and capital Example can sometimes be observed over the winter holiday season where in lean economic times discount retailers often hold up well 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 1 When an individual s income increases other things remaining the same that person will demand more goods and services thus increasing their consumption 2 With rise in income households shifts from coarse grains to finer grains add more butter to toasts in breakfast then add meat to larger number of meals per week adds health drinks move from colour TVs to plasma TVs move from unbranded apparel to branded apparel to calculate 4 Price Elasticity of Demand Understand this concept and be able using the midpoint formula see pages 153 and 154 What is the major determinant of elasticity Price elasticity reveals the responsiveness of the amount purchased to a change in price 2 Put more simply Determinant is how badly the consumer wants the good whether it satisfies a basic need and whether or not there are substitutes available 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 An increase in price results in no change in consumer purchases The vertical demand curve is mythical as the substitution and income effects prevent this from happening in the real world Relatively inelastic A increase in price results in a smaller reduction in sales The demand for cigarettes has been estimated to be highly inelastic Price Mythical Demand Curve Quantity Time Pric e Demand for Cigarettes Quantity Time Unitary Elastic The percent change in quantity demanded due to an increase in price is equal to the change in price A decreasing slope results Sales revenue price times quantity is constant Demand curve of unitary elasticity 3 Price Price Price Relatively elastic A increase in price results in a larger reduction in purchases When there are good substitutes for a product as with Granny Smith Apples the quantity purchased will be highly sensitive to changes in price Quantity Time Demand for Granny Smith Apples Quantity Perfectly elastic Consumers will buy all of a good i e Farmer Jones wheat at the market price but none will be sold above the market price Demand for Farmer Jones wheat Quantity Time 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 Elasticity coefficient absolute demand value Impact of a higher price on total consumer expenditures or a firm s total revenue Impact of a lower price on total consumer expenditures or a firm s total revenue 1 to decrease Elastic Unitary Elastic 1 unchanged increase unchanged 4 Inelastic 0 to 1 increase decrease and how 7 Income Elasticity What is the concept of income elasticity of demand is it calculated What do the ideas of normal goods and inferior goods have to do with income elasticity of demand Income elasticity indicates the responsiveness of a product s demand to a change in income Income Elasticity of demand change in quantity demanded change in income A normal good is a good with a positive income elasticity of demand As income expands the demand for normal goods will rise Goods with negative income elasticity are called inferior goods As income expands the demand for inferior goods will decline 8 Price Elasticity of Supply Be able to define and discuss why elasticity varies with some goods and how this may change over time of supply The price elasticity of supply is the percent change in quantity supplied divided by the percent change of the price causing the supply response analogous to the price elasticity of demand If the change in quantity is small relative to the change in price supply is inelastic If the change in quantity is large relative to the change in price is elastic However price elasticity of supply is positive because the quantity producers are willing to produce is directly related to price supply 5 Role of the Firm As we discussed in class what is the primary CHAPTER 8 COSTS and the SUPPLY of GOODS 1 obligation of the business to its owners investors shareholders What does the term residual claimant mean How does being a residual claimant provide incentives to business owners In a market economy firm owners are residual claimants They have
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