Law of Diminishing Marginal Utility

1
ECONOMICS
What does it mean to me?

• Part V
• Law of Diminishing Marginal Utility
• Price Ceilings Price Floors
• Blackmarkets

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The LAW of DIMINISHING MARGINAL UTILITY
3
In what kind of machines are newspapers sold?
4
Why dont we sell Coca-Cola in machines similar
to those we use to sell newspapers?
5
REASON
The value of a 2nd newspaper diminishes
fast..unlike the value of Coca-Cola. People use
this information to make appropriate machines.
6
This is called the LAW of DIMINISHING MARGINAL
UTILITY The value given to the amount of
gratification derived from something will
decrease with each additional unit of that item.
TOTAL UTILITY is the total amount of satisfaction
a person gets from consuming a specific quantity
(such as 20 units).
7
This law operates ALWAYS with respect to
time. How much do you make?
-----gt 1000 ???
Week?
Month?
Year?
Day?
The period of time in which you make 1000 will
make a difference in the amount of money you have
to spend.
8
What day would be most likely for newspapers be
stolen from the machines?
The answer is Sunday because that is coupon day.
However, people can still get TOO MANY coupons,
so the law still applies.
9
The relationship between an individuals
consumption bundle and the total amount of
utility is called the UTILITY FUNCTION. The
utility function differs for each person. We will
measure Utility in hypothetical units called
UTILS.
10
Total Utility
Marginal Utility 10 8 6 4 2 0 -2
Candy 0 1 2 3 4 5 6 7
Total Utility 0 10 18 24 28 30 30 28
30 20 10 0
1 2 3 4 5 6 7
Units consumed
As more of a product is consumed, total utility
increases at a diminishing rate, reaches a
maximum, and then declines.
11
Marginal Utility
Marginal Utility 10 8 6 4 2 0 -2
Candy 0 1 2 3 4 5 6 7
Total Utility 0 10 18 24 28 30 30 28
10 8 6 4 2 0
1 2 3 4 5 6 7
Units consumed
Marginal utility reflects the change in total
utility.
12
Marginal Utility
Total Utility
10 8 6 4 2 0
30 20 10 0
1 2 3 4 5 6 7
1 2 3 4 5 6 7
Units consumed
Units consumed

• 1) When MU is zero in graph b, total utility in
  graph a is
• also zero b) neither rising nor falling c)
  negative
• d) rising, but at a declining rate

13
Marginal Utility
Total Utility
10 8 6 4 2 0
30 20 10 0
1 2 3 4 5 6 7
1 2 3 4 5 6 7
Units consumed
Units consumed

• 2) Suppose the person represented here
  experienced a diminished taste for candy. As a
  result
• TU curve would get steeper b) MU curve gets
  flatter
• c) TU MU would shift downward d) MU curve (not
  TU) would collapse to horizontal axis

14
Debbie makes 20 and cokes are 2 and chips are
4 a pound. How does Debbie decide HOW MUCH to
consume based on the fact that the more cokes she
consumes, the fewer chips she can purchase?
15
The answer is to determine the Marginal Utility
per dollar.
The equation we will use is MUx Muy Px
Py
____ ____
16
Calculate Debbies MU per dollar for coke
Qcoke Ucoke MUper/coke MU 0 0 1 15 2 25 3 31
4 34 5 36
15 10 6 3 2
3.75
2.5
1.5
.75
.5
The price per coke is 4
17
Calculate Debbies MU per dollar for Chips/pound.
Qcoke Ucoke MUper/coke MU 0 0 1 11.5 2 21.4 3
29.8 4 36.8 5 42.5 6 47 7 50.5 8 53.2 9 55.2 10 5
6.7
Qcoke Ucoke MUper/coke MU 0 0 1 15 2 25 3 31
4 34 5 36
5.75 4.95 4.2 3,5 2.85 2.25 1.75 1.35 1.00 .75
11.5 9.9 8.4 7 5.7 4.5 3.5 2.7 2 1.5
15 10 6 3 2
3.75
2.5
1.5
.75
.5
The price per pound of chips is 2.
18
Calculate Debbies MU per dollar for coke
Qcoke Ucoke MUper/coke MU 0 0 1 11.5 2 21.4 3
29.8 4 36.8 5 42.5 6 47 7 50.5 8 53.2 9 55.2 10 5
6.7
Qcoke Ucoke MUper/coke MU 0 0 1 15 2 25 3 31
4 34 5 36
5.75 4.95 4.2 3,5 2.85 2.25 1.75 1.35 1.00 .75
11.5 9.9 8.4 7 5.7 4.5 3.5 2.7 2 1.5
15 10 6 3 2
3.75
2.5
1.5
.75
.5
Debbies optimal consumption is 2 cokes and 6
pounds of chips because she consumes these
amounts, her MU per dollar is 2.
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Optimum Consumption and the Budget Line
Assume that Debbie earns 20. Coke is 4 a can
and chips are 2 a pound.
Quantity of chips (pounds)
The budget line represents all the possible
combinations of coke and chips Debbie can
purchase. If Debbie wants to consume 1 more coke,
she must give up 2 pounds of chips.
10 8 6 4 2 0
1 2 3 4 5 6
Quantity of Coke
NOTE (Slope of the line is -2)
20
Changes in income shifts the budget line.
Quantity of chips (pounds)
10 8 6 4 2 0
1 2 3 4 5 6
Quantity of Coke
21
Now, lets apply the Law of Marginal Utility to
artificial pricing systems such as those applied
by governments.
22
What happens when prices are fixed by the
government?
Lets look at a graph which shows the average
consumption of beer in the United States.
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PRICE CEILINGS PRICE FLOORS (Consumer Surplus
Producer Surplus)
24
S
In this example, the average beers consumed per
week is 6
4 3 2 1
E
at an average price of 2.50.
D
0 1 2 3 4 5 6 7
Beers per week
Ge
25
This chart illustrates the effects upon people if
they were forced to go from Ge to zero.
S
You might be willing to pay 4 for your first
beer, but price is 2.50 ..now you are 1.50
better off. This is called CONSUMER SURPLUS.
4 3 2 1
E
D
0 1 2 3 4 5 6 7
Beers per week
Ge
26
The 9th beer is worth to people what it is worth
to people. It is different for everybody.
27
S
From the suppliers standpoint, they could supply
at a lower price but they CAN get more. This is
called PRODUCER SURPLUS.
4 3 2 1
E
D
0 1 2 3 4 5 6 7
Beers per week
Ge
28
The colored area is the total value to society of
the cost of 6 beers.
S
4 3 2 1
Consumer Surplus
E
Producer Surplus
D
0 1 2 3 4 5 6 7
Beers per week
Ge
29
What if government mandate limited the maximum
number of beers one could drink to 4 per week?
Government Mandated Supply
S
Four beers is not enough (too little,
inefficient) .This is called DEADWEIGHT loss.
4 3 2 1
E
D
0 1 2 3 4 5 6 7
Beers per week
Ge
30
What if government mandate limited the maximum
price of a beer to 1.00?
However, suppliers would not want to produce as
much beer.
S
4 3 2 1
E
Consumers would want to buy more beer.
D
0 1 2 3 4 5 6 7
10
Beers per week
Ge
31
Producers will not want to produce for low prices.
S
If government limited the maximum price of a
beer to 1.00, it would create a shortage.
4 3 2 1
E
shortage
D
0 1 2 3 4 5 6 7
Beers per week
Ge
32
The legal maximum price that can be charged is
called a PRICE CEILING. A legal minimum price
that can be charged is called a PRICE FLOOR.
Price ceilings and floors keep markets from
reaching equilibrium.
33
Politically popular ideas include -- minimums
on inputs (wages). -- maximums on outputs
(prices).
When POLITICS vs. ECONOMICS gt Politics always
wins
34
A price ceiling keeps the market from reaching
equilibrium.
The government mandating the maximum price of a
beer is called a PRICE CEILING.
S
4 3 2 1
E
shortage
D
0 1 2 3 4 5 6 7
Beers per week
Ge
35
The shortage created from the price ceiling will
result in increased demand.
S
4 3 2 1
E
shortage
D
0 1 2 3 4 5 6 7
X
Beers per week
Ge
36
The increased demand and a willingness to pay
higher prices will result in a BLACK MARKET for
beer.
37
When the government mandates a the minimum price
of something, it is called a PRICE FLOOR.
S
The minimum wage is an example of a price floor.
5 4 3 2 1
E
D
Labor
0 1 2 3 4 5 6 7
Ge
38
The minimum wage increases the number of people
who want to work (supply of labor). . .
. . . And decreases the number of businesses who
want to hire (demand for labor)
S
5 4 3 2 1
SURPLUS
E
Creating a SURPLUS of labor.
D
Labor
0 1 2 3 4 5 6 7
Ge
39
CONCLUSION
A price floor stops the market from reaching
equilibrium and creates a surplus. A price
ceiling stops the market from reaching
equilibrium and creates a shortage.
40
Typically, the government jumps in during a
surplus, buys the surplus.
and the surplus rots.
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QUESTION 1
Using economic principles and the impact of
government mandate, why was the 18th Amendment to
the U.S. Constitution considered the great
experiment that failed?
42
ANSWER The 18th Amendment created a shortage of
alcohol for consumption
S
When the price of alcohol increased under black
market conditions, this initiated the development
of the syndicate and the notoriety of such
underworld figures as Al Capone.
5 4 3 2 1
E
D
0 1 2 3 4 5 6 7
Beers per week
Ge
43
QUESTION 2
Using economic principles, explain the impact of
government mandates on the supply and demand of
the illegal marijuana market.
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ANSWER In 1937, the government reduced the
availability of marijuana to zero by making it
illegal.
This created a shortage in the market.
S
Because people have been willing to pay a high
price for the product, black market conditions
have existed since the shortage was created.
300 250 200 150 100 50
E
D
0 1 2 3 4 5 6 7
Marijuana use
Ge
45
QUESTION 3
In 1973, President Nixon froze gasoline prices
after the OPEC cartel created a shortage in the
United States. What impact did this have on the
market economy at that time?
46
ANSWER President Nixon initiated a price ceiling
of 1.60.
REMEMBER Producers will not want to produce for
low prices.
S
4 3 2 1
Consequently, a shortage existed because gas
companies were taking a loss. This resulted in
long lines and gas stations running out of fuel.
E
shortage
D
0 1 2 3 4 5 6 7
Gallons of Gas
Ge
47
QUESTION 4
Using economic principles and the impact of
government mandate, explain what would happen if
cigarette smoking were made illegal. What would
be the opportunity cost of making cigarettes
illegal?
48
ANSWER The government would reduce the supply
of cigarettes to zero by making it illegal.
This will create a shortage in the market.
S
Because some people will be willing to pay a
high price for the product, black market
conditions will exist and the price of cigarettes
will increase.
10 8 6 4 2
E
D
0 1 2 3 4 5 6 7
Cigarette use
Ge
49

• ANSWER The opportunity costs would include
• Lower environmental costs
• Cleaner air
• Lower costs for health care
• Healthier population
• Higher unemployment for lost jobs

50
Question 5
Many experts contend that the Food and Drug
Administration (FDA) directly creates the high
price of prescription drugs. Do you agree?
Why or why not? Explain your answer.
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ANSWER The FDA, a government regulatory agency,
reduces the supply of certain drugs by making
them unavailable to certain people through the
use of prescriptions.
This results in a limited market.
S
Because doctors prescribe drugs for illness and
the patient requests good health, they pay the
higher price created by the government.
100 80 60 40 20
E
D
0 1 2 3 4 5 6 7
Drug use
Ge
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Question 6
In May 2001, President Bush visited with Governor
Gray of California to discuss the energy crisis
in that state. It will take 10 years to build
the power plants necessary to provide the
electricity needed to support the population and
costs will skyrocket as demand exceeds supply.
Governor Gray is requesting that President Bush
place a federal price ceiling on the cost of
energy. Why did President Bush refuse?
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ANSWER President Bush realizes that a price
ceiling will result in a shortage of electricity.
REMEMBER Producers will not want to produce for
low prices.
S
D C B A
Limiting the price that power companies can
charge for electricity will cause them to lose
money, not produce efficiently, and result in a
shortage of power.
E
shortage
D
0 a b c d e f g
Kilowatts
Ge
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THE END
Sources Economics, by Krugman, Wells. Economics,
by McConnell, Brue Economics, by Mankiw
Compiled by Virginia Meachum Economics Teacher,
Coral Springs High School, Florida