ECONOMICS
poorva
cm07_utility_econprofit.pptxMicroeconomics
Tuesday
July 2, 2019
CM07
Outline
Consumer choice theory
How consumers maximize their utility
1 and 2 goods, with and without budget constraints
Interest, Rent, and Profit
Relationship between bond prices and bond yields
Present value calculations
Economic rents, profits
Microeconomics
Consumer Choice and Utility Maximization
Outline
Review and Definitions
Utils & Utility
Total Utility (TU) , marginal utility (MU)
The Law of Diminishing Marginal Utility
Maximizing utility with 1 good
Maximizing utility with 1 good + budget constraint
Maximizing utility with 2 goods + budget constraint
Outline
Review and Definitions
Utils & Utility
Total Utility (TU) , marginal utility (MU)
The Law of Diminishing Marginal Utility
Maximizing utility with 1 good
Maximizing utility with 1 good + budget constraint
Maximizing utility with 2 goods + budget constraint
Utility Schedule
Utility: measure of satisfaction
Total Utility (TU): total satisfaction of consuming good(s)
Consuming 0 units 0 utils
Consuming 4 units 30 utils
Marginal utility is the additional utility obtained from consuming an additional unit (i.e., MU = ΔTU/ ΔQ)
Law of Diminishing Marginal Utility
The marginal utility gained by consuming equal successive units will decline as more is consumed.
MU can be positive, zero, or negative ( disutility ! )
Maximizing Utility with One Good
For each additional quantity consumed, total utility increases…up to a point…
9th Unit TU=45
Utility is maximized with the 9th unit
Is there consumption beyond the 9th unit?
Maximizing Utility with One Good
Utility is maximized with the 9th unit
No additional utility gained by consuming 10 units.
Marginal utility of consuming the 9th unit = 1
Marginal utility of consuming the 10th unit = 0
There is no additional benefit from consuming the 10th unit, therefore total utility is maximized by consuming only 9 units.
Comparing Total Utility and
Marginal Utility
Maximizing Utility with 1 Good + Budget
If money is no object, then total utility is maximized after consuming the 9th unit.
Suppose you have a budget of $12, and the price of each unit is $1.
Utility Maximized at 9 units.
$3 left over
Maximizing Utility with 2 Goods + Budget
Good X:
Good Y:
Maximizing Utility with 2 Goods + Budget
Price of Good X = $1/unit
Price of Good Y = $2/unit
Budget = $12
What quantity of these two goods will maximize total utility?
Assumptions:
Distinct units
Unspent $ no utility
Maximizing Utility with Good X
If you are only consuming good X, then
Max quantity = 12 units (budget constraint)
Max utility @ 9 units 45 utils
Maximizing Utility with Good Y
If you are only consuming good Y, then
Max quantity = 6 units (budget constraint)
Max utility @ 6 units = 78 utils
So we have two bundles…
Bundle 1. Consume only X and no Y 45 utils
Bundle 2. Consume no X and only Y 78 utils
But there are other possible bundles…
Maximizing utility with two goods
Consuming one additional unit of Y – must give up 2 units of X
Consuming one additional unit of X, must give up ½ units of Y
UTILITY MAXIMISATION RULE
Utility Maximization Rule
For two goods, total utility is maximized when:
Utility Maximization Rule (3 goods)
Utility Maximization Rule (N goods)
Apples to Apples
Suppose MU of consuming Fuji apples is 4, and the MU of consuming Braeburn apples is 12; and the price of of Fuji apples is $1/kg and the price of Braeburn apples is $3/kg
Is utility being maximized?
Apples to Apples
Suppose MU of consuming Fuji apples is 4, and the MU of consuming Braeburn apples is 12; and the price of of Fuji apples is $1/kg and the price of Braeburn apples is $3/kg
Is utility being maximized?
YES
Now suppose consumers prefer Fuji apples more than they used to, such that the marginal utility of consuming Fuji apples increases from 4 to 5.
What should consumers do to maximize utility?
Now suppose consumers prefer Fuji apples more than they used to, such that the marginal utility of consuming Fuji apples increases from 4 to 5.
What should consumers do to maximize utility?
They should consume more Fuji apples, and fewer Braeburn apples
Consuming more Fuji apples will decrease the marginal utility of Fuji apples….
Consuming fewer Braeburn apples will increase the marginal utility of Braeburn apples…
…until utility is maximized:
The Law of Diminishing Law of Marginal Utility is consistent with the Law of Demand…
Increased preference for a good requires that more of that good is consumed (i.e., increased demand).
A change in the price of a good will require more or less of that good to be consumed (depending on whether they are substitutes or complements).
A consumer is consuming two goods, X and Y. The marginal utility of X is 200, and the marginal utility of Y is 100; the price of good X is $4 per unit and the price of good Y is $2 per unit.
Utility is maximized because:
If the price of good X increases to $10, what should the consumer do to maximize utility?
If the price of good X increases, then the consumer should consume more Y (which will decrease the MUy), and fewer X (which will increase MUx) until MUx/Px = MUy/Py - that is, until total utility is maximized.
Microeconomics
Interest, Rent and Profit
Interest
The market for loanable funds exists because there are :
SAVERS and SPENDERS
SAVERS
Have a surplus of funds
Not able or willing to identify profitable investments
Willing to supply more funds when return is higher
SAVERS
Have a surplus of funds
Not able or willing to identify profitable investments
Willing to supply more funds when return is higher
SAVERS
Have a surplus of funds
Not able or willing to identify profitable investments
Willing to supply more funds when return is higher
SPENDERS
Have a shortage of funds
Are able and willing to identify and capitalize on profitable investments
Demand more funds at lower prices
Market for Loanable Funds
Equilibrium price in the loanable funds market…
Interest Rate
Bonds
Debt Security
Common source for loanable funds
Government, Corporate, Municipal
Treasury Bills
Face value
Discounted
Zero-coupon
Treasury Bills
Face value: $1000
Yield: 2.593%
Discounted: $974.73
Treasury Bills
Face value: $1000
Yield: 2.593%
Discounted: $974.73
Question: suppose next month the yield increases to 4.593% - does this make your bond worth more, or worth less?
Treasury Bills
Face value: $1000
Yield: 2.593%
Discounted: $974.73
Question: suppose next month the yield increases to 4.593% - does this make your bond worth more, or worth less?
LESS
$956.09
Bond Prices and Yields: Inverse Relationship
Present Value
The present value of future income is equal to the future income discounted by the interest rate.
Price of $1000 face value discount bonds with various yields and time to maturity
Present Value Derivations
Exercise
Suppose the interest rate is 10% and you have the opportunity to invest in a project (ie., make a loan) that is guaranteed to pay $1000 income per year for the next 3 years.
What is the most that you would invest?
Exercise (answer)
Suppose the interest rate is 10% and you have the opportunity to invest in a project (ie., make a loan) that is guaranteed to pay $1000 income per year for the next 3 years; what is the present value of this project?
So you would be willing to invest no more than $2,486.85
Factors that affect interest rates
Term
Risk
Transaction Costs
Expected Interest Rate in the future
Term and Bond Yields
Interest rates on bonds with different times to maturity
Risk and Bond Yields
Risk and Bond Yields
Factors that affect interest rates
Risk: a higher risk of default will increase the rate of interest
In 2017 the yield on AA Bond was 3.91%
In 2017 the yield on BBB Bond was 5.77% higher risk of default
Term: generally the longer the term, the higher the interest rate
In 2017 the interest rate on a 30-year US Treasury was 2.86%
In 2017 the interest rate on a 3-month US Treasury was 1.02%
Transaction Costs: higher costs generally increase the interest rate
Nominal versus Real Interest
Nominal Interest Rate (i) = Real Interest (r) + Expected Inflation
Inflation erodes purchasing power, so in real terms investments have a lower rate of return when inflation is expected.
real = nominal - Expected Inflation
If the price level is expected to be 2% higher next year, and you own a bond that pays 3%, then the real interest rate is 1% (3%-2%)
Fisher Effect
Expectations about higher prices (inflation) lead to
higher nominal interest rates, ceteris paribus
Economic History Lesson
In the 19th Century, people complained that grain prices were too high and blamed the higher prices on higher land rents, and advocated for the government to lower land rents to fix the problem.
Yet, the economist David Ricardo explained that the supply of land was fixed, and that higher demand for grain was increasing demand for land. Thus higher land rents were caused by higher grain prices, not the other way around.
Profit
Accounting profit, Economic profit, and Normal profit
TOTAL REVENUE = PRICE x QUANTITY
Accounting PROFIT = TOTAL REVENUE - TOTAL COST (explicit)
Explicit cost: incurred when a monetary payment is made.
Implicit cost: incurred as a result of a firm using its resources
Economic PROFIT = Total Revenue – Total Cost (explicit + implicit)
Example
Bayside Coffee Shop : First Year of Operation
Fixed costs = $28000
espresso machine, coffee grinder, water filter
Variable costs = $22000
water, cups, coffee, utilities, part-time help
Total cost = Fixed costs + Variable costs = $50000
Bayside Coffee Shop
First Year of Operation
Sold 14800 cups of coffee for an average price of $5/each
Total revenue (TR) = P x Q = $5 x 14800 = $74000
Total cost (TC) = fixed costs + variable costs = $50000
Profit = TR – TC = $74000 – $50000 = $24000
…but what about economic profit?
Bayside Coffee Shop
First Year of Operation
Total revenue (TR) = $74000
Total cost (TC) = $50000
Profit = $24000 this is accounting profit
The owner of the coffee shop is also the owner of the building, so fortunately she pays no rent. Yet, if she rented out the building instead of using it for the coffee shop, she could get $2000 per month in rent.
Bayside Coffee Shop
First Year of Operation
Total revenue (TR) = $74000
Total cost (TC) =
Explicit cost: $50000
Implicit cost: $24000
Accounting profit = $24000 (i.e., 74000 – 50000)
Economic profit = $0 normal profit
Zero Economic Profit
Also known as “normal profit”
Is always less than or equal to accounting profit
Firms can earn a positive accounting profit and, at the same time, have a zero (or a negative) economic profit.
For example: earning a normal profit for the owner of Bayview Coffee Shop means that the firm is doing as well as the next best alternative, that is, renting out the building.
Thank you!
QTYTUMUMU/PQTYTUMUMU/P
00000000
1999118189
21788234168
32477348147
43066460126
53555570105
6394467884
7423378463
8442288842
9451199021
104500109000
1144-1-11188-2-1
1242-2-21284-4-2
TU
X
=42TU
Y
=0
TOTAL UTILITY = 42 + 0 = 42
GOOD X: $1 per unitGOOD Y: $2 per unit
QTYTUMUMU/PQTYTUMUMU/P
00000000
1999118189
21788234168
32477348147
43066460126
53555570105
6394467884
7423378463
8442288842
9451199021
104500109000
1144-1-11188-2-1
1242-2-21284-4-2
TU
X
=0TU
Y
=78
TOTAL UTILITY = 0 + 78 = 78
GOOD X: $1 per unitGOOD Y: $2 per unit
QTYTUMUMU/PQTYTUMUMU/P
00000000
1999118189
21788234168
32477348147
43066460126
53555570105
6394467884
7423378463
8442288842
9451199021
104500109000
1144-1-11188-2-1
1242-2-21284-4-2
TU
X
=17TU
Y
=70
TOTAL UTILITY = 17 + 70 = 87
GOOD X: $1 per unitGOOD Y: $2 per unit
QTYTUMUMU/PQTYTUMUMU/P
00000000
1999118189
21788234168
32477348147
43066460126
53555570105
6394467884
7423378463
8442288842
9451199021
104500109000
1144-1-11188-2-1
1242-2-21284-4-2
TU
X
=30TU
Y
=60
TOTAL UTILITY = 30 + 60 = 90
GOOD X: $1 per unitGOOD Y: $2 per unit
QTYTUMUMU/PQTYTUMUMU/P
00000000
1999118189
21788234168
32477348147
43066460126
53555570105
6394467884
7423378463
8442288842
9451199021
104500109000
1144-1-11188-2-1
1242-2-21284-4-2
TU
X
=39TU
Y
=48
TOTAL UTILITY = 39 + 48 = 87
GOOD X: $1 per unitGOOD Y: $2 per unit
QTYTUMUMU/PQTYTUMUMU/P
00000000
1999118189
21788234168
32477348147
43066460126
53555570105
6394467884
7423378463
8442288842
9451199021
104500109000
1144-1-11188-2-1
1242-2-21284-4-2
TU
X
=44TU
Y
=34
TOTAL UTILITY = 44 + 34 = 78
GOOD X: $1 per unitGOOD Y: $2 per unit
QTYTUMUMU/PQTYTUMUMU/P
00000000
1999118189
21788234168
32477348147
43066460126
53555570105
6394467884
7423378463
8442288842
9451199021
104500109000
1144-1-11188-2-1
1242-2-21284-4-2
TU
X
=45TU
Y
=18
TOTAL UTILITY = 45 + 18 = 63
GOOD X: $1 per unitGOOD Y: $2 per unit
TUXYX,YXY
067804
258785
449066
638747
827828
10163018
12042-20
MU / PQTY
