Central Carolina Technical College Consumer Behavior, Choice & Profit Questions ***Read each of the lectures and for question 1 answer the question and the

Central Carolina Technical College Consumer Behavior, Choice & Profit Questions ***Read each of the lectures and for question 1 answer the question and the follow up and for question 2 choose just ONE of the questions and answer it.***

Question 1

Before addressing this question, but sure to have read Lecture 5: Household Behavior and Consumer Choice

Instructions:

1. Provide an example of a product or service consumed by you or your household for which the principle of diminishing marginal utility applies.

2. Does marginal utility decrease quickly or slowly?

Question 2

Before addressing this question, but sure to have read Lecture 6: Defining Profit

Be sure that your example shows that you understand the idea of opportunity cost and how opportunity cost is related to economic profit. Also be sure that you provide a reason why the person or business in your example is earning positive or negative economic profit.

Instructions:

Answer only ONE of these:

A. Name a market or industry where most of the participants (e.g. owners, labor) earn positive economic profits (i.e. they are earning more than they could in their next best opportunity).

or

B. Name a market or industry where most of the participants earn negative economic profits (i.e. they are earning less than they could in their next best opportunity). Our preferences for different goods and services are determined by how satisfying we find
certain goods.
We use the concept of “utility” to talk about this satisfaction.
In economics, utility is simply the satisfaction gained from a good or service.
Question: Can we measure utility? That is, can we measure satisfaction?
Put yourself in the consumer position and think about it… Suppose that you just purchased and
drank a soda. How much satisfaction did you get from that soda? Can you measure this
satisfaction in some way?
I like to think about movies here, because it always gets people thinking about measuring
satisfaction. So, suppose that you and a friend just watched a movie together. Could you
measure the amount of utility that you derived from the movie?
How could you do it?
The utility or satisfaction that you gain from a good or service may be hard to quantify because
it’s a subjective measure.
One question we could ask is: what units should we use to quantify utility?
Should we use dollars or some other measure?
What is the common way of measuring the satisfaction that people get from movies?
It’s usually some sort of rating system, like the number of stars out of 5. This is a perfectly fine
way to measure (or quantify) utility.
It turns out that to examine choices and preferences we don’t have to worry about units. We can
use any measure or rating system that we like. However, if we’re interested in comparing
satisfaction between goods, or for a single good across consumers, we should use a consistent
measure. For example, if you and your friend wanted to compare your relative satisfaction from
watching a movie, you’d both want to use the same scale for easy comparison.
Most textbooks label arbitrary units of utility as “UTILS”. Keep in mind that this is very much
like stars or ratings.
2
At this point, one thing we do want to think about is the distinction between TOTAL UTILITY
and MARGINAL UTILITY.
Total Utility is the total satisfaction gained from all units consumed. Think about adding up all
the satisfaction you receive from different units of particular good, say slices of pizza that you
eat over the course of a dinner.
As consumers, our goal should be to maximize total utility, given our budget. That is, our goal
when buying things is to be as satisfied as we possibly can.
Marginal Utility is the additional or incremental satisfaction gained when one extra unit is
consumed. Think about the additional satisfaction that you receive when you eat the first slice
of pizza, or the second slice… or the tenth slice …
What should happen to total utility as you consume more of a good?
What should happen to marginal utility as you consume more of a good?
For each of the above questions, assume that all units are of the same quality. This is tough to
do for goods like movies, where there are clear differences in quality across units. Also assume
that the goods we’re talking about are good goods. That is, we’re talking about things that you
like.
Hopefully, you have come to the following conclusions:
1. Total Utility (total satisfaction) from the consumption of both goods should increase as the
number of units of a good consumed increases. That is, more is better than less.
Total Utility rises as we consume more of a good.
2. Marginal Utility (incremental satisfaction or the change in total utility for each one unit
change in the quantity of the good) should be as the number of units of a good consumed
increases. That is, each unit gives you satisfaction, but it gives you less satisfaction than the
previous unit.
Marginal utility decreases as we consume more of a particular good.
3
The principle of diminishing marginal utility states that the marginal utility of a good tends
to decline or diminish as more of the good is purchased over a given period.
In other words, each additional unit contributes less to total utility than the previous unit.
Notice that this principle is related to the concept of demand that we covered in chapter 4.
Recall that when we first introduced the idea of a DEMAND CURVE, we said that part of the
reason that demand curves were downward sloping was because of the law of diminishing
marginal utility.
P
Q
Recall that a demand curve reveals what we are willing and able
to purchase. We’re willing to pay more for the first units of a
good, because we’re not tired of it yet. But as we consume more
and more units of the good, our willingness to pay decreases –
the price we are willing to give up for unit #2 is less than the
price we were willing to pay for unit #1. Eventually, if we have
so much of the good, our willingness to pay might be zero – the
D curve intersects the horizontal axis.
Given this interpretation, how might we interpret the vertical intercept of a demand curve?
At too high of a price QD = 0 … the good costs too much. The price is higher than what we
are willing and able to pay, because we don’t get enough utility for it to be worth the high price.
Before we move on, here are a two more questions to consider about marginal utility:
Can the marginal utility from a particular unit of something be zero?
Can marginal utility be negative?
Hopefully you see that the answer to both of these questions is yes. It is possible to get zero
incremental satisfaction from something and it is certainly possible for an additional unit of
something to give you disutility (i.e. discomfort). Consider that tenth slice of pizza!
4
The Utility Maximizing Rule (also known as the “Equimarginal Principle”)
Applying the principle of diminishing marginal utility to a series of consumption choices allows
us to understand how to maximize total utility from our purchases.
Consider your monthly purchases of two goods: iTunes albums and Movies.
For this example, assume that the price of an album is $10, the price of a movie is $5, and your
monthly income of $65 is spent entirely on these two goods.
Note: We could draw a budget line with this information. A budget line is a graphical
representation of all the combinations of two goods that you can purchase. Each point on the
budget line represents a single combination that uses up a given amount of income.
albums
This budget line tells us all the
possible combinations of movies and
albums that we can purchase with
our limited $65 income.
6.5
6
5
4
3
2
1
1
3
5
7
9
11
13
movies
Notice that each point on the budget line costs exactly $65. The budget line is a nice way to
outline what we can purchase, given prices and our income.
Given the preferences of a particular consumer, it should seem reasonable that one of these
affordable combinations will provide more satisfaction than the others. For example, if your
preferences favor movies over music, you might derive the most utility from combinations
closer to the horizontal axis. Likewise, if you are more of a music person, you might get more
utility from combinations near the vertical axis.
5
The budget line shows us what we can afford, but it does not tell us which combination is the
best one to purchase (i.e. the combination that gives us the highest total utility). For that, we
need more information about preferences.
Suppose that we know the preferences of a particular consumer and have quantified the utility
that this person gets from movies and albums as shown in the total utility (TU) columns below.
If we wanted to find the best combination of these two goods, given the above prices and
income and these preferences, we could measure the total utility of each combination on the
budget line and choose the highest one.
# movies
0
TUM
0
#albums
0
TUA
0
1
20
1
50
2
38
2
85
3
53
3
110
4
65
4
130
5
75
5
145
6
83
6
155
7
90
7
161
To find the combination of two goods that yields the maximum utility, we could instead apply a
simple and intuitive rule:
The utility-maximizing combination of 2 or more goods is the combination where the marginal
utility per dollar spent is as close to equal as possible across the goods (and for which all
income is spent).
Note: Marginal utility per dollar is essentially “bang-for-the-buck”. For a particular unit of a
particular good, we can find the utility per dollar spent (bang-for-the-buck) by dividing the
marginal utility by the price of the good.
This rule is known as the “utility maximizing rule” or the “equimarginal principle”
In short, total utility is maximized when the marginal utility is equal across goods.
6
The intuition is that if we can compare the marginal utility for each dollar that we spend, and
always put our dollars towards the good that gives us the higher utility, we’ll maximize total
utility for all of our dollars. Combining this idea with the principle of diminishing marginal
benefits leads to the utility maximizing rule. Consider the idea that if the marginal utility per
dollar is higher for one good than the other, total utility can be increased by buying more of that
good and less of the other good.
As soon as the marginal utility per dollar is equal across the goods it stops being advantageous
to move dollars between goods… we can’t make total utility go up anymore.
When the marg U per dollar is equal across goods, then we can no longer increase total U by
moving dollars between goods we’re doing the best we can given prices and income.
We can see that we’re looking at this by looking at the movies and CD’s data again, but this
time calculating marginal utility and marginal utility per dollar.
# movies
0
TUM
0
MUM
–
MUM/$spent
–
#albums
0
TUA
0
MUA
–
MUA/$ spent
–
1
20
20
4
1
50
50
5
2
38
18
3.6
2
85
35
3.5
3
53
15
3
3
110
25
2.5
4
65
12
2.4
4
130
20
2.0
5
75
10
2
5
145
15
1.5
6
83
8
1.6
6
155
10
1.0
7
90
7
1.4
7
161
6
0.6
Notice that the utility-maximizing rule is satisfied at 5 movies and 4 albums (the marginal
utility per dollar is equal at 2). This combination provides more total utility than any other
combination on the budget line.
Do we use this rule in life? Yes, I think so. Perhaps not as explicitly as we’ve outlined it here.
But we do try different combinations of goods, and we tend to move our dollars towards those
goods that give us higher bang-for-the-buck. Eventually we find combinations that are the best
for us and so we tend to purchase those goods until prices change, or our preference change or
our budget (income) changes.
7
Practice questions:
1. Assume the price of pizza is $2.00 and the price of Beer is $1.00, and that at your current
levels of consumption, the Marginal Utility from pizza is 10 and the marginal utility from beer
is 6.
True or false: You can increase total utility by buying more beer and less pizza.
TRUE
marg U/ dollar beer = 6/1 = 6
marg U/ dollar pizza = 10/2 = 5
2. The price of steak is $7 per pound, and the price of chicken is $2 per pound. Your mother
currently receives a marginal utility of 14 from consuming steak this week and 6 from
consuming chicken this week. The marginal utility of chicken is therefore less than that of
steak. Does this imply that your mother should buy less chicken this week? Explain.
NO.
Marg u per dollar chicken = 6/2 = 3
marg u per dollar steak = 14/7 = 2
Therefore there is higher u per dollar from chicken
buy more chicken and less steak to
U
8
Another consumer decision that we can examine is the purchase of multiple units of a single
good. Since we’re not comparing goods with different prices, we can dispense with the
somewhat abstract idea utility and talk in terms of monetary value.
The dollar value (or monetary value) of total utility is defined as the TOTAL BENEFIT.
Total Benefit (TB) is the dollar value of the satisfaction realized from the consumption of a
given quantity of a good or service. Hence total benefit simply expresses total utility in
monetary terms.
Marginal benefit (MB) is the additional dollar benefit from the consumption of an additional
unit of a good or service. Hence marginal benefit simply puts marginal utility in monetary
terms. Marginal benefit is the change in total benefit for each one unit change in quantity.
Marginal benefit also represents the maximum willingness to pay for each unit of a good or
service.
Net Benefit (NB) is the difference between marginal benefits and marginal costs. If MB is
greater than MC, then net benefits are positive. IF MC is greater than MB, then net benefits are
negative.
Note: The principle of diminishing marginal utility is equivalent to the principle of diminishing
marginal benefits… incremental satisfaction tends to decrease as we consume more of
something.
An important point to recall about marginal benefit: Marginal benefit represents the most you
would be willing to pay (your “reservation price”) for a particular unit.
i.e. You will never pay more for a good than the dollar value of the satisfaction you gained
from the good. You won’t pay more than it is worth to you.
As long as NET BENEFITS (MB – MC) are positive, you gain from consuming the good.
Also recall that for a consumer, the marginal cost of a unit is the same as per unit price.
For a consumer, MC = PRICE
9
So we can say that “rational” consumers will purchase additional units of a good only if
marginal benefits are at least as large as marginal costs.
Because marginal benefits are diminishing, we can say that the optimal quantity of a good is
where marginal benefits are equal to marginal costs.
The optimal quantity of a single good is where MB = MC
Lets do an example to see this:
Eg: # of trips to King’s Dominion per year. Assume P = $30 per visit.
Assume that we know the monetary value of the
satisfaction gained from each trip to Kings Dominion, so
that we can list the TB for each number of trips.
Q
P
0
–
1
Total expenditure (P Q)
TB
MB
Net Ben
0
0
–
–
$30
$30
$75
$75
$45
2
$30
$60
$125
$50
$20
3
$30
$90
$160
$35
$5
4
$30
$120
$175
$15
-$15
How many trips to King’s Dominion do you take?
Here, the optimal quantity is 3 trips. This quantity maximizes your total net gain (recall that
total net gain to a consumer is called “consumer surplus”).
Why don’t you take the 4th trip?
Because for the 4th trip, MC > MB
Why don’t you stop after 2 trips?
Because we gain more net benefit by going again.
10
Let’s look at this decision graphically:
$
70
60
50
40
30
20
10
P = MC
MB
1
2
3
4
Q trips
We want to find the intersection of the MB curve and the MC curve. This intersection gives us
the optimal quantity of a single good to consume.
Notice that total net gains from 3 trips $70.
This is because total benefits are $160.00 (this is your max willingness to pay for those 3 trips),
and total cost (total amount paid) for 3 trips is $90.00
Total net benefits = total benefits – total costs = $160 – $90 = $70
11
Where is consumer surplus on the graph of MB vs. MC?
Graphically, CS is the area above the price (MC) line and below the demand curve (MB) line.
MB represents
what you are
willing to pay
CS graphically:
$
70
60
50
40
30
20
10
MC represents
what you actually
paid
CS
P = MC
MB
1
2
3
4
Q trips
12
Next we must recognize that there are some economic principles that apply to all
types of firms. Our job is to cover those now so that we can apply them in the
context of different levels of competition.
Ideas that apply to all types of firms, regardless of the level of competition they
face:
What we mean by “profit” (Lecture 6 part 1)
Production theory and diminishing marginal returns (Lecture 6 part 3)
How short run unit costs change as more output is produced (Lecture 7)
A general definition of profit is the difference between revenues and costs:
Profit = Revenue – Costs
Revenue is gross earnings from sales, and can be found as the product of price
and quantity.
Revenue = Price x Quantity
For example, if a firm sells 10,000 units of a good at $20 each, their revenues are:
Revenue = 10,000 x $20 = $200,000
We will discuss costs in a lot of detail soon, but generally speaking there are two
types of costs: Economic Costs and Accounting Costs
We will see that what we mean by “profit” depends on what we mean by “costs”.
Accountants and economists tend to look at the idea of costs differently.
Economic Costs are found as the monetary value of all inputs used over a given
period. This is the dollar amount that represents the value of all resources used to
produce the good or service.
2
Economic costs include both explicit and implicit costs and represent the full
opportunity costs of the resources used in production.
What are explicit costs?
Explicit costs are the cost of inputs for which there is an actual purchase or
transaction. These types of costs are commonly referred to as “expenses”
or “accounting costs”.
What are implicit costs?
Implicit costs are synonymous with opportunity costs and represent the
costs of non-purchased inputs. No actual transaction takes place for these
inputs, hence these costs must be estimated.
Examples of implicit (opportunity) costs associated with operating a business:
(a)
The opportunity cost of the business owner’s time. Labor hours
provided by a business owner carry an opportunity cost in terms of
the earnings he or she gives up by not working for someone else. If
the business owner gave up a job to operate their own business, we
could use those previous earnings as an estimate of this implicit cost.
Something to consider: How could we estimate the opportunity cost
of a business owner’s time if they did not have another job before
starting their own business?
(b)
The opportunity cost of the business owner’s funds. If you use some
of your own funds to operate your business, chances are that you
gave up some interest on those funds. This implicit cost would be
estimated as the rate of return that could have been earned by
investing your money elsewhere.
Hopefully you now recognize that while economists tend to think about both
explicit and implicit costs, accountants typically only consider explicit costs.
Accounting Costs include explicit costs (“expenses”) only
3
2 Definitions of Costs
Accounting costs = explicit costs
Economic costs = explicit costs + implicit costs
2 Definitions of Profit
Accounting Profit = Revenue – Accounting costs
Economic Profit = Revenue – Economic costs
Given these definitions, we can do some rearranging:
Economic Profit = Revenue – accounting costs – implicit costs
Hence,
Economic Profit = Accounting profit – implicit costs
Because economic costs are always at least as large as accounting costs, we can
conclude that accounting profits are always at least as large as economic profits.
Further, it seems likely that some implicit costs will exist for most businesses;
hence in most cases the following will be true:
Economic cost > Accounting cost
Economic profit < Accounting profit Something to consider: Is it possible for economic costs to be equal to accounting costs (and economic profit = accounting profit)? 4 An example of calculating costs and profit: Suppose that immediately after graduation Johnny has the following job choice: Option 1: Johnny can go to work for IBM. IBM makes Johnny an offer of $55,000 per year Option 2: Johnny can open his own beach wear shop in Key Largo. Based on his market analysis, he estimates that his salary will be $15,000 in his first year. Let’s suppose that Johnny chooses option 2 and to start his business he withdraws $20,000 of his own funds from an account that was earning 5% interest. After 1 year of operating his beach wear shop, Johnny has the following information on his books: Revenue earned $50,000 Costs of purchased inventory Labor expenses Rent expense $ 8,000 $15,000 $12,000 Calculate the following: a) b) c) d) Accounting costs Economic costs Accounting profit Economic profit Answers are on the next page… 5 Answers: a) Accounting costs... Purchase answer to see full attachment