Consumer Choice Consumer Behavior Law of Demand Reviewed

Consumer Choice Consumer Behavior

Law of Demand Reviewed Common Sense ◦ High Price discourages customers from buying ◦ Low Price encourages customers to buy Consumer Behavior is reflected in the Demand Curve

The Income Effect The change in the price of a product will have effects on…. ◦ Consumer’s real income ◦ The quantity demanded of that product When the price of a good declines, people will have more money to spend My son’s allowance: $20 per week ◦ He drinks 8 Monsters a week at $2. 50 ◦ If price of monsters were to decrease to $2. 00 He would have $4. 00 Extra! He can either purchase more Monsters or other goods

Substitution Effect This is the impact that a change in product’s price has on its relative expensiveness and on the quantity demanded ◦ When price of a product falls, that product is now cheaper relative to other products ◦ If Monster falls from $2. 50 to $2. 00, it becomes a better buy ◦ Lower price induces my son to substitute Monsters for other caffeinated drinks He will buy More of it

Law of Diminishing Marginal Utility Mankiw’s Priniciple #3: Rational People Think at the Margin ◦ Margin—an incremental adjustment ◦ What is the benefit of the next item consumed? ◦ What is the cost of the next item consumed? Utility ◦ Want satisfying power Marginal Utility is the extra satisfaction that a person derives from an additional consumption of one more item

Example: Diminishing Marginal Utiity Tacos Consumed Per Meal Total Utility Derived “Utils” Marginal Utility “Utils” 0 0 1 10 10 2 18 8 3 24 6 4 28 4 5 30 2 6 30 0 7 28 -2

Total Utility 35 30 30 28 25 30 28 24 20 18 Total Utility 15 10 10 5 0 1 0 2 3 12 4 5 6 7 8 MARGINAL UTILITY 10 8 6 4 MARGINAL UTILITY 2 0 -2 -4 0 2 4 6 8

Vending Machines Soda Machines Newspaper Box

Indifference Curve Analysis Consumer behavior and equilibrium is based on: ◦ Budget Lines ◦ Indifference Curves

Budget Line Technical Constraint Schedule or curve that shows various combinations of two products a consumer can purchase with specific income

Budget Line: Combinations of Monster and Snickers Bars (Income of $20) Monsters $2. 50 per Snickers $1. 00 per Total Expenditure 8 0 $20 (=$20+0) 6 5 $20 (=$15+$5) 4 10 $20 (=$10+$10) 2 15 $20 (=$5+$15) 0 20 $20 (=0+$20)

Budget Line Budget LIne: Monsters and Snickers with $20 9 8 Monsters 7 6 5 4 3 2 1 0 0 5 10 15 20 25 Snickers

Budget Line Two (2) things can cause the budget line to shift ◦ Income Changes Increase in income will shift the curve to the left ◦ Price Changes Decreases in the price of both items will shift the curve to the left Change in price relative to the other will cause change in slope

Indifference Curves Subjective An indifference curve shows all the combinations of two products (A and B) that will yield the same total satisfaction or total utility to a consumer

Indifference Schedule Combination Monsters Snickers j 12 2 k 6 4 l 4 6 m 3 8

Indifference Curve Schedule Snickers j Monsters

Indifference Curve Characteristics Convex to origin Slope at each point measures Marginal Rate of Substitution ◦ Rate at which consumer will substitute one good for the other in order to remain equally satisfied. ◦ As the amount of Monsters increases, its marginal utility decreases ◦ As the amount of Snickers decreases, its marginal utility increases

A Group of Indifference Curves

Indifference Map Curves farther from origin indicate higher levels of total utility Curves closer to origin represent less total utility

Indifference Curves and Budget Constraints The best combination is the point where the indifference curve and the budget line are tangent.

Indifference Curves and Budget Constraints

Deriving a Demand Curve from the Indifference Curve Demand is the quantity of a good that a person will buy at various prices.

Deriving a Demand Curve from the Indifference Curve n By varying the price of one of the goods while holding the price of other constant, the points of tangency will change. This gives alternative price/quantity combinations.

Deriving a Demand Curve from the Indifference Curve

Concluding Remarks Does everyone think this way? As Mankiw points out: No Consumer behavior is a model

Revenues and Profits A brief overview

Revenue Total Income from sales

Revenue S P D Q REVENUE = PRICE X QUANTITY

Costs Fixed Costs ◦ Incurred no matter what the output is RENT VEHICLES EQUIPMENT Variable Costs ◦ Costs which vary per with output LABOR UTILITIES FUEL CONSUMPTION

TOTAL COSTS TOTAL COST = FIXED + VARIABLE

ACCOUNTING PROFIT Very Simple ◦ PROFIT = Revenue – Total Cost

Economic Profit Takes into account Explicit Costs (like an accountant) Also takes into account Implicit Costs ◦ Opportunity Cost

Economic Profit vs Accounting Profit Economist Accountant Economic Profit Accounting Profit Implicit Costs Explicit Costs

Opportunity Cost A firm’s implicit costs are the opportunity costs of using its self-owned, self employed resources. To the firm, opportunity costs are the money payments that self employed resources could have earned in their best alternative use

Economic Profit Example You are earning $22, 000 per year as a salesperson at the Gap You decide to open up your own store! You have saved up $20, 000 in CDs that were paying 5% per year ◦ Use that $20 K as a down-payment/initial investment on your new store ◦ New store’s lease is $5 K per year ◦ You hire clerk to help out and give her $18 K annually

End of Your 1 st Year! Total Sales Revenue $120, 000 Cost of Tee Shirts $40, 000 Clerk Salary $18, 000 Utilities $5, 000 Total Explicit Costs $63, 000 Accounting Profit $57, 000 Looks Good…. . right? ?

Your Economic Profit? ? Accounting Profit $57, 000 Foregone Interest $1, 000 Foregone Lease $5, 000 Foregone Wages $22, 000 Foregone Entrepreneurial Income* $5, 000 Total Implicit Costs $33, 000 Economic Profit $24, 000

Economic Profit Economic Profit is not a cost, because it is a return in excess of the normal profit that is required to retain the entrepreneur Even if the Economic Profit is zero, the entrepreneur is still covering all explicit and implicit costs, including a normal profit. In our example, as long as accounting profit is $33, 000 or more, you will continue to operate

Questions? ?