ECON 101 MIDTERM 2

Agenda

Chapter 8: Utility and Demand Chapter 9: Possibilities, Preferences, and Choices Chapter 11: Output and Costs

Chapter 8

Definitions:• Utility: The benefit that a person gets from

the consumption of a good or service • Total Utility: The total benefit that a person

gets from the consumption of a good/service • Marginal Utility: The change in total utility

that results from a one-unit increase in the quantity of good consumed.

Meet Billy

Total and Marginal Utility

Hair Gel T-Shirts

Quantity (per month)

Total Utility Marginal Utility

Quantity (per month)

Total Utility Marginal Utility

0 0 0 0

1 20 20 1 14 14

2 36 16 2 26 12

3 50 14 3 36 10

4 62 12 4 44 8

5 72 10 5 51 7

6 80 8 6 57 6

Diminishing Marginal Utility

Diminishing Marginal Utility

Marginal Utility Rule

A consumer’s total utility is maximized by following the rule:

• Spend all available income • Equalize the marginal utility per dollar for all

goods

Exercise

Billy makes $40 a month. Hair gel costs $10 per bottle and T-shirts are $5 each.

a) How many units of each product should Billy buy to maximize his total utility?

b) Suppose that the price of T-shirts doubles to $10 what is the new consumer equilibrium?

c) Suppose that hair gel sells for $10, and T-shirts $10, and Billy gets a raise and is now making $60 a month. What is his consumer equilibrium?

Hair Gel T-Shirts

Quantity (per month)

Total Utility Marginal Utility

Quantity (per month)

Total Utility Marginal Utility

0 0 0 0

1 20 20 1 14 14

2 36 16 2 26 12

3 50 14 3 36 10

4 62 12 4 44 8

5 72 10 5 51 7

6 80 8 6 57 6

What have we learned

True or False(1) If the marginal utilities from consuming two

goods are not equal, the consumer cannot be in equilibrium.

(2) When the price of a good increases, the marginal utility from the consumption of that good decreases.

Paradox of Value

• Water is cheap but essential but diamonds are very expensive and mostly unnecessary

• Resolving the Paradox: distinguish between total utility and marginal utility

• Consumer Surplus

Remember Billy

Chapter 9

Budget Line: limits to a household’s consumption choices

Divisible Goods: goods that can be bought in any quantity desired

Budget Equation: Expenditure = Income

Budget Equation

Real Income: a household’s income expressed as a quantity of goods that the household can afford to buy

Relative price: the ratio of the price of one good or service to the price of another good or service; is an opportunity cost

Change in Price or Income

• Change in prices: changes the slope of the budget line

• Change in income: shifts the budget line but does not change its slope

Indifference Curve

Indifference Curve: shows combinations of goods among which a consumer is indifferent

• The consumer is indifferent between the combinations indicated by any two points on one indifference curve

• Any point above an indifference curve is preferred to any point along the same indifference curve; any point on the curve is preferred to any point below it

Marginal Rate of Substitution

Marginal rate of substitution: the rate at which a person will give up good y to get an additional unit of good x and at the same time remain indifferent (stay on the same indifference curve)

• Steep IC = high marginal rate of substitution • Flat IC = low marginal rate of substitutionKey Assumption: • Diminishing marginal rate of substitution

Predicting Consumer Choices

Best Affordable choice• The point on the budget line and on the highest

attainable indifference curvePrice Effect• The effect of a change in the price on the

quantity of a good consumed Income Effect• The effect of a change in income on buying plans

Substitution and Income Effects

Price effect can be divided into two parts:• Substitution effect: the effect of a change in

price on the quantity bought when the consumer remains indifferent between the current situation and the new one

• Income effect

Chapter 11

Short run: time frame in which the quantity of at least one factor of production is fixed

Long run: time frame in which the quantities of all factors of production can be varied

Total product: maximum output that a given quantity of labour can produce

Marginal product: increase in total product that results from a one-unit increase in the quantity of labour employed

Average product: (Total product)/(Quantity of labour employed)

Short-Run Cost

Total Cost: cost of all the factors of production a firm uses

Total fixed cost: cost of the firm’s fixed factors Total variable cost: cost of the firm’s variable

factorsTotal cost = Total fixed cost + Total variable costMarginal cost = (Increase in total cost)/(Increase

in Output)

Short-Run Cost

Average Fixed cost: total fixed cost per unit of output

Average variable cost: total variable cost per unit of output

Average total cost: total cost per unit of output

ExerciseBilly opens his own Hair Gel company and the total

product schedule is:

a) Draw the Total product curve, Average product curve, Marginal product curve

Labour (workers per month) Output (bottles per month)

0 0

1 1

2 3

3 6

4 12

5 17

6 20

Exercise: Short Run

Billy hires workers at $200 per month. He also has fixed costs of $200 a month.

a) Calculate the total cost, total variable cost, and total fixed cost at each output.

b) Sketch the short-run total cost curves. c) Calculate the average total cost, average fixed cost,

and marginal cost of each output.d) Describe the effect of an increase in fixed costs.e) Describe the effect of an increase in variable costs.

Exercise: Long Run

Billy opens a second plant and the output produced by each worker increases by 100%. The total fixed cost of operation each plant is $200 a month. Each worker is paid $200 a month.

a) Draw the ATC curves for both plants.b) Identify the LRAC curve.

GOOD LUCK!