HKALE Microeconomics

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HKALE Microeconomics

• Chapter 3 Consumer Demand(1)-The MUV Approach
  and Exchange

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Six Basic Postulates

1. Each individual desires more goods and has many
   goals.
2. For each individual, some goods are scare.
3. Postulate of substitution economic goods are
   substitutable, i.e. each person is willing to
   forsake some of a good to get more of other
   goods.

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Six Basic Postulates

• 4. Postulate of diminishing MUV the more of a
  good one has, the larger the TUV, but the lower
  the MUV of a unit.
• 5. Not all individuals have identical tastes and
  preferences.
• 6. Individuals are innovative but logically
  consistent in making choice.

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Use Value and Exchange Value

• Value can be referred to use value or
  exchange/market value.
• (Personal) use value (or value in use) of a unit
  of a good is defined as the maximum amount of
  another good which a person is willing to forgo
  in order to obtain it.
• Exchange value (or value in exchange) is defined
  as the amount of some other goods or money that a
  consumer has to pay for a given amount of a good
  in the market.

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Use Value Vs. Exchange Value

• The use value of a good is the maximum amount of
  other good one is willing to give up for
  obtaining that good.
• The exchange value of a good is, however, the
  amount of other good to be exchanged within a
  transaction.

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Use Value Vs. Exchange Value

• Use value is subjective.
• However, exchange value is an objective concept
  because it can be measured, e.g. an apple can be
  exchanged with two lemons in a transaction.

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Use Value Vs. Exchange Value

• The use value of a good depends on how people
  evaluate the good(i.e. individual preference) or
  is positively related to the number of its uses.
• However, the exchange value of a good depends on
  the demand for and the supply of the good, i.e.
  depending on the degree of scarcity.

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Use Value Vs. Exchange Value

• The use value of a good may be measured by the
  amount of money one is willing to sacrifice.
• The exchange value of a good, however, if
  measured in terms of money, is called money
  price if measured in terms of other good, it is
  called relative price.

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Use Value Vs. Exchange Value

• Paradox of value the use value of a good may not
  be in proportion to its exchange rate.
• Example water has high use value but low
  exchange value, while diamond has low use value
  but high exchange value.

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Value Vs. Cost Differences

• Value is the max. amount of other good one is
  willing to forgo for obtaining a good.
• Cost is the value of the highest-valued option
  forgone in making a decision.

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Value Vs. Cost Differences

• Value is a reflection of an individual's
  preference.
• Cost, however, as an ex-ante concept, is a
  constraint of behavior.

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Value Vs. Cost Differences

• The value of a free good may be positive while
  the cost of a free good, however, is zero.
• Value arises when people make personal valuation
  while cost arises because of scarcity.

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Value Vs. Cost Similarities

• They are measured in terms of other goods.
• They are expressed in terms of 'maximum' amount
  of other good.
• They can affect decision-making.

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Value Vs. Cost

• Cost and value are not necessarily related. In
  fact, cost and value are used to derive the
  decision-making process of individuals.
• Example a hair cut poorer than anticipated only
  reduces its value, but it does not raise its
  cost. The cost of the hair cut will rise if the
  time involved in getting it done, increases in
  value.

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Cost Vs. Price

• Cost is the highest-valued option forgone while
  price is the physical exchange rate of one good
  for another good.
• Cost arises because of scarcity, no choice hence
  results in no cost. However, price arises because
  of exchange, no exchange hence leads to no price.

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Cost Vs. Price

• Cost still exists in an one-man economy while
  price is absent in one-man economy because of no
  interpersonal exchange.

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TUV, AUV MUV

• Total use value (TUV) is the maximum total amount
  of another good that one is willing to pay for
  the entire quantity of a good.
• Average use value (AUV) is the total use value
  divided by the number of units (Q) of a good,
  i.e. TUV/Q
• Marginal use value (MUV) is the maximum amount of
  another good that a person is willing to pay for
  an extra unit of a good. MUV?TUV/?Qslope of TUV
  curve.

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TUV, AUV MUV Illustration
Q(1) MUV(2) ?(4)/ ?(1) AUV(3) (4)/(1) TUV(4) ?(2)
1 10 10.0 10
2 9 9.5 19
3 8 9.0 27
4 7 8.5 34
5 6 8.0 40
6 5 7.5 45
7 4 7.0 49
8 3 6.5 52
9 2 6.0 54
10 1 5.5 55
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TUV, AUV MUV Diagrams
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The Marginal Use Value Curve

• A MUV curve slopes downward indicating that as
  one's holdings of a good get larger, there is a
  decrease in one's marginal personal value for
  that good.
• The position or height of the whole curve varies
  positively with the wealth (or number of other
  goods) a person has it shifts upward for
  superior goods and downward for inferior goods.
• With different tastes or preferences, the MUV
  curves are not identical for everyone.

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Price, MUV Consumer's Equilibrium

• In making consumption, individuals will compare
  its cost (P) with expected benefits (MUV) of a
  good.
• If MUVgtP, it is beneficial to buy and thus
  bringing down MUV until decreasing MUVP.
• If, however, MUVltP, one will reduce his quantity
  demanded for avoiding loss, which brings up MUV
  until increasing MUVP.
• Hence, consumer's equilibrium is attained when
  PMUV (for the last/marginal unit transacted).

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Demand Curve and MUV Curve

• A consumer's MUV curve of a good can be regarded
  as an ordinary individual demand curve for that
  good because
• given the MUV curve, one maximizes his gain by
  equating his MUV with the market price.
• it tells how many units one consumes given any
  level of market prices.

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Price, Total Revenue, Average Revenue Marginal
Revenue

• Total revenue, TRPXQ
• Average revenue
• ARTR/Q
• Then, AR(PXQ)/Q
• Thus, ARP
• Marginal revenue, MR?TR/?Q

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Demand Curve Average Revenue (AR) Curve

• Demand curve reflects relationship between P Qd
  while AR curve reflects AR Qd(QsQt at
  equilibrium).
• As PMUV and PAR,
• ? PARMUV
• Hence, AR curveD curveMUV curve

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P, TR, AR MR Illustration
P(1) Q(2) TR(3) (1)x(2) AR (3)/(2) MR ?(3)/?(2)
10 1 10 10 10
9 2 18 9 8
8 3 24 8 6
7 4 28 7 4
6 5 30 6 2
5 6 30 5 0
4 7 28 4 -2
3 8 24 3 -4
2 9 18 2 -6
1 10 10 1 -8
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TR, AR MR Diagrams
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TR, AR MR Diagrams
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TR, AR MR Diagrams
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TR, AR MR Diagrams
TR reaches its maximum when MR0.
TR falls when MR falls
TR
TR rises when MR rises
MR
AR
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Finding TR from AR Curve

• TRrectangular area defined by drawing
  perpendicular lines from a particular price and
  the corresponding quantity to the demand/AR
  curve.

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Finding TR from MR Curve

• TRthe area under the MR curve and above the
  quantity axis.

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Finding TR from MR Curve

• TRthe area under the MR curve and above the
  quantity axis.

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Finding MR from TR Curve

• MRslope of the TR curve?TR/ ?Q.

P, AR, MR, TR
Slope of TR curve MR
TR1
E
TR
?TR
0 Q1
Q
?Q
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Finding AR from TR curve

• ARTR/Qslope of a ray from the origin to a point
  on TR, say point E.

P, AR,MR, TR
A ray from the origin to point E
TR1
E
TR
Slope of the ray AR
TR at point E
0 Q1
Q
Q at point E
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Why is Price Larger Than MR?

• Because a cut in price is made to sell more
  units, the extra revenue will be less than the
  price received on the extra unit sold.
• However, the new uniform price at which an extra
  unit is sold is lower on ALL the units formerly
  sold at the higher price.
• Reduction in revenue on the quantity previously
  sold at the higher price will offset part of (or
  possibly more than) the price received on the
  extra unit sold.

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Why is Price Larger Than MR?

• Thus, the net revenue increase or MR from selling
  one more at the new, lower price will always be
  less than the price received on that extra unit
  less by the amount of reduced revenue on all the
  units formerly salable at the old, higher price.
• With different pricing tactics, say price
  discrimination, MR could be equal to P.
• MR P2(Q2-Q1)-(P1-P2)Q1

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Relations Between TR, AR MR

• MR is less than AR(or P)

P Q MR
10 1 10
9 2 8
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Relations Between TR, AR MR

• MR is less than AR(or P)

P Q MR
10 1 10
9 2 8
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Relations Between TR, AR MR

• MR is less than AR(or P) an illustration

P Q TR AR MRP2(Q2-Q1)-(P1-P2)Q1
10 1 10 10 /
9 2 18 9 9(2-1)-(10-9)18
8 3 24 8 8(3-2)-(9-8)26
7 4 28 7 7(4-3)-(8-7)34
6 5 30 6 6(5-4)-(7-6)42
5 6 30 5 5(6-5)-(6-5)50
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Relations Between TR, AR MR

• The slope of MR curve is twice the slope of AR
  curve.

Remarks Point Amid-point of AR curve Area
BCP1area ACQ1
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TEV, AEV MEV

• (Total)Exchange value (TEV) of a specified
  quantity of a good is the actual amount of
  money(or some other goods) that one has to pay
  for that entire specific quantity.
• TEVPXQ
• TEVTotal revenue(TR)Total expenditure(TE)
  Total market value(TMV)

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TEV, AEV MEV

• Average exchange value(AEV) of a specified
  quantity of a good is the average revenue
  received by the seller, i.e. AEVARTEV/Q.
• Marginal exchange value(MEV) is the actual amount
  of money or some other goods one pays for an
  extra unit of the good, i.e. MEV?TEV/?Q.
• Under uniform pricing/single per-unit pricing
  arrangement, price refers to AEV or AR.

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Consumer's Surplus (CS)

• CS is the extra amount the consumer is willing to
  pay over and above what he or she actually pays,
  given quantity demanded.
• CSTUV-TEV for a given quantity
• CSMUV-P for an extra unit
• It is assumed that the CS is calculated under
  uniform pricing (or single per-unit pricing).

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Consumer's Surplus (CS)
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Consumer's Surplus (CS) An Illustration
P(1) MUV Q(2) TEV(3) (1)X(2) TUV(4) ?(1) CS(5) (4)-(3)
10 1 10 10 0
9 2 18 19 1
8 3 24 27 3
7 4 28 34 6
6 5 30 40 10
5 6 30 45 15
4 7 28 49 21
3 8 24 52 28
2 9 18 54 36
1 10 10 55 45
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Paradox of Value

• Adam Smith pointed out in his book, 'The Wealth
  of Nations', that the things (e.g. water) which
  have the greatest value in use frequently have
  little or no value in exchange and those (e.g.
  diamond) which have the greatest value in
  exchange frequently have little value in use.

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Resolving The Paradox of Value

• The paradox arises from confusing total and
  marginal use values with market values.
• The exchange value of a good is determined by its
  relative scarcity and its MUV, but not its TUV.
• The more scarce the good, the higher its MUV will
  be, thus demanding a higher price(or average
  exchange value) vice versa.
• While a good with higher TUV would bring a larger
  consumer's surplus and thus more benefit.

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Resolving The Paradox of Value
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Ways to Extract Consumer's Surplus(1)

• By all-or-nothing pricing tactic
• Consumers either purchase a good at a stipulated
  quantity at a given price, or not at all.
• The price under an all-or-nothing arrangement is
  set in accordance with the AUV of the last unit,
  i.e. PAUV.
• As the TUV of the good becomes the same as its
  TEV, CS is then fully exploited.

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Ways to Extract Consumer's Surplus(1)

• By all-or-nothing pricing (AONP) tactic

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Ways to Extract Consumer's Surplus(1)

• By all-or-nothing pricing (AONP) tactic

Remarks Under uniform pricing, consumer buys Q2
at P1(MUV) however, under AONP,he has to pay
P2(AUV) for Q2, or not at all. Thus, as area
ACP2area BCE, TUVTEV CS0.
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Ways to Extract Consumer's Surplus(2)

• By charging price with fees, e.g. membership fees
  or license fees, where the fee is set to extract
  all of the consumer's surplus.

Membership or license fee CS
P, MUV
Remark TEVarea 0P1EQ1 area
P1AE TUVarea 0AEQ1 As TEVTUV, CS0
A
P1
E
MUV
0 Q1 Q
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Ways to Extract Consumer's Surplus(3)

• By practicing 1st degree price discrimination
  charging the maximum amount the consumer is
  willing to pay for EACH unit, then PMUV.

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Why does Exchange Occur?

• It is commonly, but wrongly, believed that people
  trade because they have a surplus of some goods.
• In fact, trade or exchange occurs because
  participants find it mutually beneficial, because
  people place different marginal valuations on
  scarce goods.

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Assumptions behind the Simple Exchange Model

1. Private property rights exist.
2. Transaction costs are zero.
3. There is no production taken place, i.e. the
   stock of any good is fixed.

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Conditions for Conducting Mutually Beneficial
Exchange

• Trade occurs when participants have different
  marginal use value curves, even though they have
  the same initial endowment of a good.
• Trade is still possible even trading parties have
  the same MUV curves, if their initial endowments
  are different.

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Exchange without Production

• The individual with higher MUV will be the buyer
  while the one with lower MUV will act as the
  seller.
• The seller is willing to engage an exchange if
  the price he receives is higher than or equal to
  the forgone MUV.
• The buyer, however, will buy a unit only if what
  he actually pays (P) is lower than or equal to
  what he receives(MUV).

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Exchange without Production

• The actual trading price then lies between the
  different initial MUVs of the traders.
• The equilibrium price is indicated at where the
  two MUV curves intersect.
• Exchange brings the MUVs of a good to both
  parties to equality, and no further trade would
  be mutually desired.

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Exchange without Production

• Gains from exchange to the buyer
• Per unit gain MUV P
• Total gain TUV TEV
• Gains from exchange to the seller
• Per unit gain P MUV forgone
• Total gain TEV TUV forgone
• However, the distribution of gains from exchange
  depends on the bargaining power or pricing
  tactics of both trading parties.

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Exchange without Production

• If the buyer has higher bargaining power, he will
  enjoy most or all of the gains from trade by
  obtaining the lowest possible price.
• If, however, the seller has higher bargaining
  power, he will capture most or all of the gains
  from trade by requesting the highest possible
  price.
• As with normal shaped MUV curves, both parties
  share the gains from trade.

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Exchange without Production An Illustration
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Exchange without Production An Illustration
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Transaction Costs Exchange

• There are substantial costs of finding trade
  possibilities, or assessing the true
  characteristics or qualities of goods, and of
  negotiating exchange contracts and arranging for
  such legal protections as warranties.
• With the presence of transaction costs, the gain
  from trade to traders are thus reduced.
• As a maximizer, traders will seek ways to reduce
  transaction costs and maximize their gains from
  trade. And this could be done by employing
  middlemen and using money.

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Exchange with Transaction Costs and without
Middlemen
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Exchange with Transaction Costs and Middlemen
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Exchange with Transaction Costs and Middlemen

• Whenever the fees charged by middlemen for
  arranging and facilitating an exchange is lower
  than the transaction costs being borne by traders
  in conducting prepurchase search and production
  inspection, trade is still beneficial.
• In an open market, competition among middlemen
  reduces the spread between their buying and
  selling prices to one that just covers the costs
  of providing their services at the quality wanted
  by the consumers.