Chapter 7 1 Marginal Utility The additional utility or satisfaction derived from consuming an additional unit of a good Law of Diminishing Marginal Utility Basic economic principle that as the consumption of a product increases the marginal utility derived from consuming more of it per unit of time will eventually decline Consumers decide what to buy and how much to buy based upon a lot of different factors that vary over time and circumstance The consumer must decide how to allocate scarce resources to obtain the largest benefit List Five key factors that dictate consumer behavior 1 Limited income necessitates choice 2 Consumers make decisions purposefully 3 One good can be substituted for another 4 Consumers must make decisions without perfect information but knowledge and past experience will help 5 The law of diminishing marginal utility applies As the rate of consumption increases the marginal utility gained from consuming additional units of a good will decline 2 Marginal benefit The maximum price a consumer will be willing to pay for an additional unit of a product It is the dollar value of the consumer s marginal utility from the additional unit and therefor it falls as consumption increases Substitution effect That part of an increase decrease in amount consumed that is the results of a good being cheaper more expensive in relation to other goods because of a reduction increase in price Income effect That part of an increase decrease in amount consumed that is the result of the consumer s real income being expanded contracted by a reduction rise in the price of a good A consumer s willingness to pay for a good is directly linked to the additional benefit received Since the consumer s marginal benefit falls as more units of the good are obtained the willingness to pay falls Hence the demand curve is downward sloping The substitution and income effects result from a change in the price of a good Together they reinforce the downward sloping shape of the demand curve 3 Price elasticity of demand The percentage change in the quantity of a product demanded divided by the percentage change in the price that caused the change in quantity The price elasticity of demand indicated how responsive consumers are to a change in a product s price Formula for price elasticity of demand Price elasticity of demand Percentage change in quantity demanded Percentage change in price When demand is inelastic which is greater the change in quantity demanded or the change in price Change in price When demand is elastic which is greater the change in quantity demanded or the change in price Change in quantity demanded Elastic A and Inelastic B Demand Curves 4 5 Primary factors determine elasticity of demand 1 Availability of substitutes More substitutes more elastic more responsive 2 Share of budget Greater share more elastic 3 Time More time more elastic When demand is inelastic and price rises total revenue will increase When demand is inelastic and price falls total revenue will decrease When demand is elastic and price rises total revenue will decrease When demand is elastic and price falls total revenue will increase When demand is inelastic which part of the equation is larger the change in quantity demanded or the change in price Change in price When demand is elastic which part of the equation is larger the change in quantity demanded or the change in price Change in quantity demanded Income elasticity The percentage change in the quantity of a product demanded divided by the percentage change in consumer income that caused the change in quantity demanded It measures the responsiveness of the demand for a good to a consumer s change in income Normal good A good that has a positive income elasticity so that as consumer income rises demand for the good rises too Inferior good A good that has a negative income elasticity so that as consumer income rises the demand for the good falls Formula for income elasticity Income elasticity Percentage change in quantity demanded Percentage change in income Two goods that are normal 1 Private education 2 New automobiles Two goods that are inferior 1 Margarine 2 Bus travel 6 Price elasticity of supply The percentage change in quantity supplied divided by the percentage change in the price that caused the change in quantity supplied Inelastic supply and Elastic supply curves Chapter 8 Explicit costs Payments by a firm to purchase the services of productive resources Implicit costs The opportunity costs associated with a firm s use of resources that it owns These costs do not involve a direct money payment Examples include wage income and interest forgone by the owner of a firm who also provides labor services and equity capital to the firm Total Cost The costs both explicit and implicit of all the resources used by the firm Total cost includes a normal rate of return for the firm s equity capital Opportunity cost of equity capital The rate of return that must be earned by investors to induce them to supply financial capital to the firm Economic profit The difference between the firm s total revenues and its total costs including both the explicit and implicit cost components Normal profit rate Zero economic profit providing just the competitive rate of return on the capital and labor of owners An above normal profit will draw more entry into the market whereas a below normal profit will lead to an exit of investors and capital Accounting profit The sales revenues minus the expenses of a firm over a designated time period usually one year Accounting profits typically make allowances for changes in the firm s inventories and depreciation of it assets No allowance is made however for the opportunity cost of the equity capital of the firm s owners or other implicit costs Why would a firm be content to stay in business if it s earning zero economic profit They indicate that the owners are receiving exactly the normal profit rate or the competitive market rate of return on their investment Example of an explicit cost Money wages interest and rental payments Example of an implicit cost Wage income and interest forgone by the owner of a firm who also provides labor services and equity to the firm 2 Short run A time period so short that a firm is unable to vary some of its factors of production The firm s plant size typically cannot be altered in the short run At least one input is fixed Long run A time period long enough to allow the firm to vary all of its
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