beers for a pizza. Fred would therefore make die substitution. Moreover, a further utilit) gain is possible in this new situadon by substituting another two beers for a pizza. Heie the gain in utility from consuming these two additional beers is 11 utils, while that lost from consuming one less pizza is only 7 utils. He therefore makes a net gain of 4 utils (11-7) by making die Mvitch. However, condnued substitution of beer for pizza would now yield a loss of total utility: While 2 utils can be gained from consuming another tAVo beers, they are more than offset by the necessary sacrifice of 8 utils from a foregone pizza. Fred would therefore stay put Hence, udlity maximizadon again leads him to consume three pizzas and four beers: No matter where Fred starts, he uldmately consumes so that the marginal utility per dollar spent on the two goods is equal.

To present the reason a bit more abstractly, suppose that the marginal utility per dollar spent on beer exceeds the marginal utility per dollar spent on pizza. In this case, formula (1) above no longer holds and Fred could increase his totad udlity by spending a dollar more on beer and a dollar less on pizza. Total udlity rises because the udlity gained from consuming an extra dollars worth of beer exceeds that lost from consuming a dollars worth less of pizza. Moreover, further utility gains will remain possible until equadon (1) again holds. In summary, whenever the equality in (1) is not satisfied, Fred can increase his utihty b) reshuffling his purchases in favor of the good whose marginal utility per dollar spent is the greatest.

The result in (1) can also be cross multiplied and rearranged as:

goods:

pizza

beer

pizza

beer

In other words, the consumer is not in equilibrium unless the rado oftwo goods marginal utilides equals the ratio of their prices. Hence, because pizza is twice as expensive as beer, we know that in equilibrium the ratio of marginal utilides of pizza to beer is two to one. Formula (2) can also be generalized to:

MU/ MIL

where "A and B are any uvo goods. , the result in (1) can also be further extended to a world of many goods (A, B, C, D ....). Thus, when the consumer maximizes utility, his marginal udhty per dollar spent on each good is identical, regardless of the number of

Suppose now in (4) that tiie price of good A,i - falls. How would the consumer respond? Cleady,! the marginal udlit)- per dollar spent on good A would] rise relauve to the other goods B, C. D, etc. For exanf pie, a hahing of would mean a doubling of th marghial udlity per dollar spent on A. This means the consumer will want to buy more A to maximize hj total utilit). Doing so, however, will lower the margin al udlity of good A because of dimini.shing margii; udlity. Eventually, as the consumer substitutes inti good A the equality expressed in (4) will be ag established. But here is the important point: Burir more of good A when its price falls means that demand curve for good A slopes downward. Heiic the law of demand can be derived from the propc dons that (a) con.sumers maximize utilits and that ( marginal udlity diminishes.

Having derived this result, we must cauul you in three respects. First, because fractions of gc such as cars are not allowed, it may not always be ] sible to exactly equate (MU/P) for all goods. In case, the consumer will try to come as close as ble. True to our purpose of concentrating upon essendals, we will ignore this complication herea Second, our simple derivadon of marginal udhty i not permit complements and makes subsdtutesi most other goods. Third, while the assumptioni diminishing marginal udlity pernuts the derivadc downward sloping demand curves, it is not requij for generaung such curves. All these ]iinitadons corrected in more advanced treatments.

PRIORITIES

We have just seen that die quandr\ of beer pizza that Fred wishes to consume depends upon prices. Let the price of beer fall and Fred will consume more beer; let the piice of pizza rise and! will want to consume less pizza. As it is with beerJ pizza, so it is with everMhing else. We ob.ser\e in theJ world that people subsdiute into goods - oi even a.C ties such as murder and cheadng - as the cost paid just in money) declines. In other words, ecouort believe in utility theoi7 because real world beharic the theory. If real world beliaAior was inconsistent J the theory, the theory should be rejected, not theojj vation or the real world.

A dieory favored by psychologists which not appear to stand die test of obserraiion is die n«

that people make their decisions according to priorities. According to this view one first seeks to satisR- certain basic priorities (and horrors needs!) such as for food e,. (Priority #1), clothing (#2), .shelter (#3), aEfecdon (#4),

t,. ... color television (#289). ... trash compactor (M71) and so forth. Even if it is true that at observed prices people buy a good deal of food before spending a penny on anything else, just change the price of color television enough and watch them substitute. Almost as n as you do, they will falsify the priority dieory by

buying more color televisions and less quantity or qual ity of food. Since, in the real world, we observe substitution with falling price, we reject the nouon that people meet ceitain basic needs, prioriues or requirements before moving onto the next highest item on a mental list WTrether they .will want a Hide more of one good and a litde less of another depends upon price. Accordingly, economists do not use the word prioritie.s except to inform psychologists that their whole approach is fatally flawed.

WARM-UP QUESTIONS FOR SECTION II

A. Demand means; (a) the amount of a good which people buv (b) the amount of a good which people sell (c) both (a) and (b) (d) the various amounts of a good which people would be willing to buy at various prices (e) die amount of a good sold at the current price.

B. A demand curve .shows: (a) the quantity of a good that people will buy at various prices (b) the price people would pay for various quantities of a good (c) both (a) and (b) (d) the incomes of people (e) al! of the above.

C. The law of demand implies: (a) people should be thrift) (b) that demand curves slope down (c) that only price influences the quantitx of a good that people wil! buy (d) that it is illegal to buy too much of certain goods (e) consumers think only of themselves.

D. The market demand curve represents: (a) the demand of everyone buying in a particular store

(b) the amounts of a good that will be bought in a particular store at various prices (c) the horizontal summation of the demands of all releant individuals (d) die most an indi\idual wUl pay for a good (ej all of these.

E. An increase in demand means: (a) the added vmits of a good purchased when the price falls (b) the added units of a good purchased when the price rises

(c) a leftward shift of the demand curve (d) diat people are willing both to buy more at every price and to pay a higher price for everv quantin.

F. Which of tlie following ivould not cause a change in demand? (a) a decrease in price (b) an increase in income (c) a change in tastes (d) a change in the prices of related goods.

G. Superior goods are: (a) another name for normal goods (b) goods Avhose demand curves shift rightward as income rises (c) the opposite of inferior goods (d) all of the above (e) none of the above.

H. If X and are substitmes: (a) an increase in die price of x will increase the demand for (b) an increase in the price of will increase the demand curve for X (c) an increase in the price of x will decrease the demand cvuve for (d) an increase in the price of x will cause a movenieut along the demand curve of (e) bodi (a) and (b).

I. Marginal utility is: (a) the total amount of isfacdon from consuming a good (b) the total faction derived from consuming all goods (c) change in total satisfaction derived from consun one more unit of a particular good (d) always tive.

J. In equilibrium: (a) the ratio of the margjj utilities of two goods equals that of their prices (b) \ ratio of the marginal utilit) of good x divided price equals the ratio of the marginal utility of db ed by its price (c) people consume so as to maxii their total utility given their limited incomes (d); the above except (c) (e) all of the above except ((j

K. The total udlity derived from con.suming a ticular quandty of apples can be found by: (a) ming the marginal udlides of each apple consun (b) multiplying together the marginal udlities of < apple consumed (c) multiplying the marginal of the last apple consumed b) the number of appi! consumed (d) multiplying the marginal udlity of i last apple consumed by the price of apples (e) non of the above.

L. A consumer surplus arises because: (a) sumers waste some of the commodities they purcha (b) consumers value some of their purchases mc than the price they have to pay (c) consumers some of their purchases less than the price they ha to pay (d) consumers buy more of some commodit than they siricdy need (e) both (a) and (d).

M. If the marginal utility per dollar spent on exceeds that of "B," the consumer will tend to: (a shift out of "A" and into B (b) need to consultj teaching assistant (c) enjoy a utilit) maximum (<j buy more of both "A" and "B" (e) buy more A"*-

N. Which of the following is necessarily a con<3 tion for a utility maximum? (a) the consvmier speiio his entire income (b) the marginal utilit) of the !a unit, purchased is identical for all goods (c) the raiic of the marginal utility of good X to good Y is the same as the ratio of their prices (d) all of the above but (b) (e) none of the above.

O. When a consumer maximizes utilitv on a fixef budget, he consumes to the point at which: (a) is the same for all goods (b) marginal utilit) is ncga tive (c) marginal utilitv is the same for all good.-!] (d) marginal utility is zero for all goods (e) ni:u-