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Economics 2

Lecture 14: Consumer Equilibrium

choosing between goods
substitution and income effects
consumer surplus

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Choosing Between Goods

At each step, a utility maximizing consumer will purchase the good that provides the most marginal utility per dollar. The consumer should continue to purchase each good until the marginal utility received from the last dollar spent on each good is the same.

The consumer's equilibrium:

  MU of good X       MU of good Y        MU of good Z
---------------- = ---------------- =  ---------------- = . . . 
Price of good X    Price of good Y     Price of good Z

A change in the price of one good will disturb the consumer's equilibrium. The ratio of MU per dollar of expenditure will no longer be equal. Suppose in the the cake, coffee, and water example, that the price of cake falls to $1. The ratios of MU per dollar of expenditure are no longer equal. The consumer should reallocate her budget among the goods.

Substitution and Income Effects

A price change, say, a price decrease, has two effects on the consumer's decision process:

1. substitution effect - other goods become relatively more expensive so consumers buy more of the less expensive good (get more MU/$) and less of the more expensive good
2. income effect - the good purchased prior to the price change now costs less so the consumer can buy more of all normal goods

Consumer Surplus

consumer surplus

the difference between what a consumer is willing to pay and the market price of the good

The demand curve measures the value an individual places on each unit of the good. The height of the demand curve shows the amount she is willing to pay for an additional unit of the good. That is, the height of the demand curve measures the consumer's marginal willingness to pay. Since the benefits a person receives from consuming a good are equal to what they are willing to pay for it, the height of the demand curve also measures the consumer's marginal benefit from consuming the good.

Consumers, though, typically pay less for a good or service than they would be willing to pay. This difference between what the consumer is willing to pay and the price they actually pay is called consumer surplus.

Graphically, consumer surplus is the area below the demand curve above the market price.

David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building voice: (717) 771-4115 fax: (717) 771-4062 e-mail: web: www.yk.psu.edu/~dxl31