ECONOMICS

What does it mean to me?

Part V:

•

Law of Diminishing Marginal Utility

•

Price Ceilings & Price Floors

•

Blackmarkets

The LAW of DIMINISHING MARGINAL UTILITY

In what kind of machines are newspapers sold?

Why don’t we sell Coca Cola in machines similar to those we use to sell newspapers?

REASON: The value of a 2nd newspaper diminishes fast…..unlike the value of Coca-Cola.

People use this information to make appropriate machines.

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).

This law operates ALWAYS with respect to time.

How much do you make?

-----> $1000 ???

Day? Week? Month? Year?

The period of time in which you make $1000 will make a difference in the amount of money you have to spend.

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.

The relationship between an individual’s 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.

Candy Total Utility 0 1 0 10 2 3 4 5 6 7 18 24 28 30 30 28 Marginal Utility 10 8 6 4 2 0 -2

Total Utility 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

.

Candy Total Utility 0 1 0 10 2 3 4 5 6 7 18 24 28 30 30 28 Marginal Utility 10 8 6 4 2 0 -2

Marginal Utility 10 8 6 4 2 0

1 2 3 4 5 6 7

Units consumed ** Marginal utility

reflects the change in total utility

.

Total Utility 30 20 Marginal Utility 10 8 6 4 10 2 0

1 2 3 4 5 6 7

Units consumed 0

1 2 3 4 5 6 7

Units consumed

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

Total Utility 30 20 Marginal Utility 10 8 6 4 10 2 0

1 2 3 4 5 6 7

0

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: a) 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

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?

The answer is to determine the

Marginal Utility per dollar .

The equation we will use is: MU x Mu y P x P y

Calculate Debbie’s MU per dollar for coke 3 4 5 Q coke 0 1 2 U coke 0 15 25 31 34 36 MU per/coke MU $ 15 10 6 3 2 3.75

2.5

1.5

.75

.5

The price per coke is $4

3 4 5 Q coke 0 1 2 Calculate Debbie’s MU per dollar for Chips/pound.

U coke 0 15 25 31 34 36 MU per/coke 15 10 6 3 2

The price per pound of chips is $2.

MU $ 3.75

2.5

1.5

.75

.5

7 8 9 10 3 4 5 6 Q coke 0 1 2 U coke 0 11.5

21.4

29.8

36.8

42.5

47 50.5

53.2

55.2

56.7

MU per/coke 11.5

9.9

8.4

7 5.7

4.5

3.5

2.7

2 1.5

MU $ 5.75

4.95

4.2

3,5 2.85

2.25

1.75

1.35

1.00

.75

3 4 5 Q coke 0 1 2 Calculate Debbie’s MU per dollar for coke U coke 0 15 25 31 34 36 MU per/coke 15 10 6 3 2

Debbie’s optimal consumption is

6 pounds 2 cokes MU $ 3.75

2.5

1.5

.75

.5

and of chips because she consumes these amounts, her MU per dollar is 2.

7 8 9 10 3 4 5 6 Q coke 0 1 2 U coke 0 11.5

21.4

29.8

36.8

42.5

47 50.5

53.2

55.2

56.7

MU per/coke 11.5

9.9

8.4

7 5.7

4.5

3.5

2.7

2 1.5

MU $ 5.75

4.95

4.2

3,5 2.85

2.25

1.75

1.35

1.00

.75

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) 10 8 6 4 2 0

1 2 3 4 5 6

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.

Quantity of Coke

NOTE: (Slope of the line is -2)

Changes in income shifts the budget line.

Quantity 10 of chips 8 (pounds) 6 4 2 0

1 2 3 4 5 6

Quantity of Coke

Now, let’s apply the Law of Marginal Utility to artificial pricing systems such as those applied by governments.

What happens when prices are “fixed” by the government?

Let’s look at a graph which shows the average consumption of beer in the United States.

PRICE CEILINGS & PRICE FLOORS (Consumer Surplus & Producer Surplus)

In this example, the average beers consumed per week is 6 at an average price of $2.50.

$4 $3 $2 E S $1 D 0 1 2 3 4 5 6 7 G e Beers per week

This chart illustrates the effects upon people if they were forced to go from G e to zero.

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 $4 $3 $2 $1 SURPLUS.

E S D 0 1 2 3 4 5 6 7 G e Beers per week

The 9th beer is worth to people what it is worth to people.

It is different for everybody.

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 G e Beers per week

The colored area is the total value to society $4 $3 of the cost $2 of 6 beers.

$1 Consumer Surplus Producer Surplus E S D 0 1 2 3 4 5 6 7 G e Beers per week

What if government mandate limited the maximum number of beers one could drink to 4 per week?

Four beers is not enough (too little, $4 Government Mandated Supply S inefficient) ….This is called $3 $2 E DEADWEIGHT loss.

$1 D 0 1 2 3 4 5 6 7 G e Beers per week

What if government mandate limited the maximum price of a beer to $1.00?

$4 However, suppliers would not want to produce as much beer.

S $3 E Consumers would want to buy more beer.

$2 $1 0 1 2 3 4 5 6 7 G e week D 10 Beers per

Producers will not want to produce for low prices.

If government limited the maximum price of a beer to $1.00, it would create a shortage.

$4 $3 $2 E S shortage $1 D 0 1 2 3 4 5 6 7 G e Beers per week

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.

Politically popular ideas include: --$ minimums on inputs (wages).

--$ maximums on outputs (prices).

When POLITICS vs. ECONOMICS => Politics always wins

A price ceiling keeps the market from reaching equilibrium.

The government mandating the maximum price of a beer is called a PRICE CEILING .

$4 S $3 E $2 shortage $1 D 0 1 2 3 4 5 6 7 G e Beers per week

The shortage created from the price ceiling will result in increased demand.

S $4 $3 E $2 shortage $1 D 0 1 2 3 4 5 6 7 G e X Beers per week

The increased demand and a willingness to pay higher prices will result in a BLACK MARKET for beer.

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 0 1 2 3 4 5 6 7 G e D Labor

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) $5 $4 $3 $2 Creating a SURPLUS of labor.

$1 SURPLUS E 0 1 2 3 4 5 6 7 G e S D Labor

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 .

Typically, the government jumps in during a surplus, buys the surplus….

and the surplus rots.

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?”

ANSWER: The 18th Amendment created a shortage of alcohol for consumption 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 S D 0 1 2 3 4 5 6 7 G e Beers per week

QUESTION 2: Using economic principles, explain the impact of government mandates on the supply and demand of the illegal marijuana market.

ANSWER: In 1937, the government reduced the availability of marijuana to zero by making it illegal. This created a shortage in the market.

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 S D 0 1 2 3 4 5 6 7 G e Marijuana use

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?

ANSWER: President Nixon initiated a price ceiling of $1.60.

REMEMBER: Producers will not want to produce for low prices.

S Consequently, a shortage existed because gas companies were taking a loss. This resulted in long lines and gas stations running out of fuel.

$4 $3 E shortage $2 $1 D 0 1 2 3 4 5 6 7 G e Gallons of Gas

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?

ANSWER: The government would reduce the supply of cigarettes to zero by making it illegal. This will create a shortage in the market.

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 S D 0 1 2 3 4 5 6 7 G e Cigarette use

ANSWER: The opportunity costs would include:

•

Lower environmental costs

•

Cleaner air

•

Lower costs for health care

•

Healthier population

•

Higher unemployment for lost jobs

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.

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.

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 0 1 2 3 4 5 6 7 G e S D Drug use

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?

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 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.

$D $C $B $A E shortage D 0 a b c d e f g G e Kilowatts

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