IB ECONOMICS:
1.2 ELASTICITY
AP MICROECONOMICS:
II. B. THEORY OF CONSUMER CHOICE
1. Explain the concept of price elasticity of demand, understanding that it involves
responsiveness of quantity demanded to a change in price, along a given demand
curve.
Elasticity refers to the responsiveness of one economic
variable, such as quantity demanded, to a change in
another variable, such as price.
Price elasticity of demand (PED) shows the relationship
between price and quantity demanded and provides a
precise calculation of the effect of a change in price on
quantity demanded.
Loosely speaking, PED measures the pricesensitivity of buyers’ demand.
2. Calculate PED using the following equation.
PED = percentage change in quantity demanded /percentage change in price
Price elasticity
of demand
Percentage change in Qd
=
Percentage change in P
end value – start value
x 100%
start value
(Q2 – Q1) / Q1
PED = (P2 – P1) / P1
3. State that the PED value is treated as if it were positive
although its mathematical value is usually negative.
Along a D curve, P and Q
move in opposite directions,
which would make price
elasticity negative.
We will drop the minus sign
and report
all price elasticity's
as positive numbers.
P
P2
P1
D
Q2
Q1
Q
3. State that the PED value is treated as if it were positive
although its mathematical value is usually negative.
The PED is negative because of the inverse
relationship between price and quantity.
Since the law of demand applies to nearly all
good and services, we typically ignore the
negative sign and express PED as an absolute
value.
This enables us to analyze positive numbers when
comparing the elasticity's of different goods.
4. Explain, using diagrams and PED values, the concepts of price elastic demand,
price inelastic demand, unit elastic demand, perfectly elastic demand and
perfectly inelastic demand.
The degree of response of quantity demanded to a
change in price can vary considerably. The key
benchmark for measuring elasticity is whether changes
are greater or less than proportionate.
PED can be:
 Less than one, which means PED is inelastic.
 Greater than one, which is elastic.
 Equal to one, unit elastic.
 Zero (0), which is perfectly inelastic.
 Infinite (∞), which is perfectly elastic.
“Perfectly inelastic demand” (one extreme case)
% change in Q
Price elasticity
=
=
of demand
% change in P
P
D curve:
vertical
10%
=0
D
P1
Consumers’
price sensitivity:
0
Elasticity:
0
0%
P2
P falls
by 10%
Q1
Q changes
by 0%
Q
“Inelastic demand”
< 10%
% change in Q
Price elasticity
<1
=
=
of demand
10%
% change in P
P
D curve:
relatively steep
P1
Consumers’
price sensitivity:
relatively low
Elasticity:
<1
P2
D
P falls
by 10%
Q1 Q2
Q rises less
than 10%
Q
“Unit elastic demand”
% change in Q
Price elasticity
=
=
of demand
% change in P
10%
=1
P
D curve:
intermediate slope
P1
Consumers’
price sensitivity:
intermediate
Elasticity:
1
10%
P2
P falls
by 10%
D
Q1
Q2
Q
Q rises by 10%
“Elastic demand”
> 10%
% change in Q
Price elasticity
>1
=
=
of demand
10%
% change in P
P
D curve:
relatively flat
P1
Consumers’
price sensitivity:
relatively high
Elasticity:
>1
P2
P falls
by 10%
D
Q1
Q2
Q rises more
than 10%
Q
“Perfectly elastic demand” (the other extreme)
any %
% change in Q
Price elasticity
= infinity
=
=
of demand
0%
% change in P
P
D curve:
horizontal
Consumers’
price sensitivity:
extreme
Elasticity:
infinity
D
P2 = P1
P changes
by 0%
Q1
Q2
Q changes
by any %
Q
5. Explain the determinants of PED, including the number and closeness of
substitutes, the degree of necessity, time and the proportion of income spent on the
good.
Determinants of PED
There are several reasons why consumers may respond
elastically or inelastically to a price change, including
the following, which can be summarized using the
acronym SPLAT:
 S – Substitutes
 P – Proportion of income
 L – Luxury or necessity
 A – Addictive or not
 T – Time to respond
5. Explain the determinants of PED, including the number and
closeness of substitutes, the degree of necessity, time and the
proportion of income spent on the good.
The number and ‘closeness’ of substitutes
A unique and desirable product, such as an important work of art, is
likely to exhibit an inelastic demand with respect to price - perhaps
approaching zero. However, a very common product which is
available everywhere many have may alternative outlets, and PED
may approach infinity.
 The proportion of consumer income which is spent on the
good
The PED for a daily newspaper is likely to be much lower than that
for a new car, given that, at least in the short run, less income is spent
on newspapers.
 The degree of necessity of the good
A necessity like bread will be demanded inelastically with respect to
price, whereas a luxury, such a holiday to the Caribbean, may be
demanded elastically.

5. Explain the determinants of PED, including the number and
closeness of substitutes, the degree of necessity, time and the
proportion of income spent on the good.
Whether the good is addictive
Consumers are relatively insensitive to changes in the price
of habitually demanded products, such cigarettes.
 The time to respond
Immediately following a change in price, it is unlikely that
consumers will adjust their consumption by very much.
It is difficult to identify suitable substitutes for a good that
has increased in price in the short run, but in the long run
new options can be identified and consumers can further
reduce their consumption of the more expensive good.

5. Explain the determinants of PED, including the number and closeness of substitutes, the
degree of necessity, time and the proportion of income spent on the good.
Determinates of PED Elastic
Inelastic
Substitutes
Lots
Few
Proportion of income
High percent of income Low percent of income
Luxury or Necessity
Luxury
Necessity
Addictive or not
Not Addictive
Addictive
Time to respond
Long Run
Short Run
6. Calculate PED between two designated points on a
demand curve using the PED equation above.
Introduction to Price Elasticity of Demand – calculating
PED using data from a demand diagram
7. Explain why PED varies along a straight line demand curve and
is not represented by the slope of the demand curve.
Graphically, relative price elasticity's of demand can be
compared by examine the slopes of demand curves drawn
on the same axes.
The steeper the slope of demand of a good, the less elastic
the demand for that good. The more nearly horizontal the
slope, the more elastic the demand.
The relative slope of demand curves on the same axis
indicates the relative elasticity's of demand for the goods
they represent.
Goods for which demand is highly elastic reflects their
elasticity in the flat slope of the demand curve, while goods
for which demand is relatively inelastic show demand curves
closer to vertical.
Elasticity of a Linear Demand Curve
P
200%
E =
= 5.0
40%
$30
67%
E =
= 1.0
67%
20
40%
E =
= 0.2
200%
10
$0
0
20
40
60
Q
The slope
of a linear
demand
curve is
constant,
but its
elasticity
is not.
8. Examine the role of PED for firms in making decisions
regarding price changes and their effect on total revenue.
For a firm producing at a quantity and price combination
along in the inelastic range of its demand curve can always
benefit by reducing its output and increasing its price, since
consumers will be relatively unresponsive to the higher
prices and total revenues will therefore increase.
However, if a firm is producing at an output and price
combination along the elastic range of its demand curve, the
firm may benefit from lowering its price since consumers are
relatively price sensitive and the percentage increase in
quantity sold will exceed the percentage decrease in price,
improving the firm’s total revenue.
Price Elasticity and Total Revenue
Price elasticity
=
of demand
Percentage change in Q
Percentage change in P
Total Revenue = P x Q


If demand is elastic, then
price elasticity of demand > 1
% change in QD > % change in P
The fall in revenue from lower QD is greater
than the increase in revenue from higher P,
so revenue falls. (Inverse relationship between
Price and total revenue)
Price Elasticity and Total Revenue
Elastic demand
(elasticity = 1.8)
If P = $200,
Q = 12 and
revenue = $2400.
If P = $250,
Q = 8 and
revenue = $2000.
P
$250
increased
Demand for
revenue due
your websiteslost
to higher P
revenue
due to
lower Q
$200
When D is elastic,
a price increase
causes revenue to fall.
D
8
12
Q
Price Elasticity and Total Revenue
Price elasticity
=
of demand


Percentage change in Q
Percentage change in P
If demand is inelastic, then
price elasticity of demand < 1
% change in QD < % change in P
The fall in revenue from lower QD is smaller
than the increase in revenue from higher P,
so revenue rises. (A direct relationship
between price and total revenue)
Price Elasticity and Total Revenue
Now, demand is
inelastic:
elasticity = 0.82
If P = $200,
Q = 12 and
revenue = $2400.
If P = $250,
Q = 10 and
revenue = $2500.
P
$250
increased
Demand for
revenue
due
your websites
lost
to higher P
revenue
due to
lower Q
$200
When D is inelastic,
a price increase
causes revenue to rise.
D
10
12
Q
Total Revenue
and PED
Price Elasticity of Demand and the Total
Revenue Test
Price Discrimination



Discrimination is the practice of treating people
differently based on some characteristic, such as
race or gender.
Price discrimination is the business practice of
selling the same good at different prices to
different buyers.
The characteristic used in price discrimination
is willingness to pay (WTP):
A
firm can increase profit by charging a higher price to
buyers with higher WTP.
Price discrimination
Price discrimination can only occur if certain conditions are
met:
 The firm must be able to identify different market segments,
such as domestic users and industrial users.
 Different segments must have different price elasticity's (PEDs).
 Markets must be kept separate, either by time, physical
distance and nature of use, such as Microsoft Office ‘Schools’
edition which is only available to educational institutions, at a
lower price.
 There must be no seepage between the two markets, which
means that a consumer cannot purchase at the low price in the
elastic sub-market, and then re-sell to other consumers in the
inelastic sub-market, at a higher price.
 The firm must have some degree of monopoly power.
Price discrimination
9. Explain why the PED for many primary commodities is relatively
low and the PED for manufactured products is relatively high.
The price elasticity of demand for many primary products is
relatively price inelastic. They are often necessities and have few
close substitutes.
The PED for primary commodities is relatively low due to the fact
that they have very few substitutes whereas manufactured products
have a relatively high PED because of the existence of many
substitutes.
For example, the PED for cow leather (primary commodity) is
relatively lower than a genuine cow leather shoe (manufactured
product).
The reason being there is no or very few substitutes for leather as a
raw material for producing shoes.
However, leather shoes may have many substitutes in the form of
sheep leather and other types of artificial leather shoes available
in the market.
9. Explain why the PED for many primary commodities is relatively
low and the PED for manufactured products is relatively high.
The prices of many primary commodities have shown two noticeable characteristics:
1.
They often exhibit a downward trend over time
2.
They are prone to fluctuations
How does economic theory explain this?



Downward trend in their prices?
The downward trend in commodity prices is due to changes in the long-term conditions of supply and
demand.
Supply factors

An increase in the supply of the commodities due to improvements in the technology e.g.
development and use of fertilizers and pesticides.

An increase in government subsidy or increases in production quotas
Demand factors

Many commodities are necessities and have a low income elasticity of demand. Consequently as
the consuming nations experience increases in their incomes their demand for commodities grows
but at a proportionately smaller rate. The demand curve has shifted to the right over time but by
a small amount. If alternatives to the commodities are found then the demand curve may even
decrease and shift to the left.
9. Explain why the PED for many primary commodities is relatively
low and the PED for manufactured products is relatively high.
Why are commodity prices inclined to fluctuate?
There are a number of explanation why the prices of
primary commodities especially agricultural primary
commodities.
 Supply Shocks
Agricultural prices are prone to unplanned changes in
supply because of weather conditions. Shocks such as
these will cause the market supply curve to make shifts to
the left and right depending upon the weather conditions.
 Low Price elasticity of demand
The price elasticity of demand for many primary products
is relatively price inelastic. They are often necessities and
have few close substitutes.
10. Examine the significance of PED for government in
relation to indirect taxes.
PED and the burden of tax
The relative burden, or incidence, of an indirect
tax is determined by the price elasticity of
demand (PED) of the consumer in response to a
price rise. If the consumer is unresponsive, and
PED is inelastic, the burden will fall mainly on the
consumer. However, if the consumer is responsive
to the price rise, and PED is elastic, the burden
will fall mainly on the firm.
10. Examine the significance of PED for government in relation
to indirect taxes.
11. Explain the concept of price elasticity of supply, understanding that it
involves responsiveness of quantity supplied to a change in price along a given
supply curve.
Price elasticity of supply (PES) measures the
responsiveness of quantity supplied to a
change in price.
It is necessary for a firm to know how quickly,
and effectively, it can respond to changing
market conditions, especially to price
changes.
11. Explain the concept of price elasticity of supply, understanding that it
involves responsiveness of quantity supplied to a change in price along a given
supply curve.
P
S
Supply often
becomes
less elastic
as Q rises,
due to
capacity
limits.
elasticity
<1
$15
12
elasticity
>1
4
$3
100 200
Q
500 525
12. Calculate PES using the following equation.
PES= percentage change in quantity supplied/ percentage change in price
Price elasticity
of supply
Percentage change in Qs
=
Percentage change in P
Price elasticity of supply measures how much Qs
responds to a change in P.
PES = (QS2 – QS1)/ QS1
(P2 – P1) / P1
13. Explain, using diagrams and PES values, the concepts of elastic supply,
inelastic supply, unit elastic supply, perfectly elastic supply and perfectly inelastic
supply.
Possible range of values:
PES > 1: Supply is elastic
PES = 1: Supply is unit elastic
PES < 1: Supply is inelastic
PES = 0: if the supply curve is vertical, and
there is no response to prices (Perfectly
Inelastic)
PES = infinity: if the supply curve is horizontal
(Perfectly Elastic)
“Perfectly inelastic” (one extreme)
0%
% change in Q
Price elasticity
=
=
of supply
% change in P
P
S curve:
vertical
S
P2
Sellers’
price sensitivity:
0
Elasticity:
0
10%
=0
P1
P rises
by 10%
Q1
Q changes
by 0%
Q
“Inelastic”
< 10%
% change in Q
Price elasticity
<1
=
=
of supply
10%
% change in P
P
S curve:
relatively steep
S
P2
Sellers’
price sensitivity:
relatively low
Elasticity:
<1
P1
P rises
by 10%
Q1 Q2
Q rises less
than 10%
Q
“Unit elastic”
% change in Q
Price elasticity
=
=
of supply
% change in P
10%
=1
P
S curve:
intermediate slope
S
P2
Sellers’
price sensitivity:
intermediate
Elasticity:
=1
10%
P1
P rises
by 10%
Q1
Q2
Q rises
by 10%
Q
“Elastic”
> 10%
% change in Q
Price elasticity
>1
=
=
of supply
10%
% change in P
P
S curve:
relatively flat
S
P2
Sellers’
price sensitivity:
relatively high
Elasticity:
>1
P1
P rises
by 10%
Q1
Q2
Q rises more
than 10%
Q
“Perfectly elastic” (the other extreme)
any %
% change in Q
Price elasticity
= infinity
=
=
of supply
0%
% change in P
P
S curve:
horizontal
Sellers’
price sensitivity:
extreme
Elasticity:
infinity
S
P2 = P1
P changes
by 0%
Q1
Q2
Q changes
by any %
Q
14. Explain the determinants of PES, including time, mobility of
factors of production, unused capacity and ability to store stocks.
 The more easily sellers can change the quantity they produce, the
greater the price elasticity of supply.
(Manufactured or Service vs Primary products)
 For many goods, price elasticity of supply is greater in the long run
than in the short run, because firms can build new factories, or new
firms may be able to enter the market. (Time Frame)
 Amount of excess capacity, the greater the excess capacity the
more elastic supply will be and the less the excess capacity the
less elastic. (excess capacity)
 Availability of substitutes in production, the more substitutes the
more elastic and the less substitutes the less elastic. (substitutes)
 Ease of storage: if it is easy to store production, the more elastic
supply response to increases in demand
14. Explain the determinants of PES, including time, mobility of factors
of production, unused capacity and ability to store stocks.
Determinants of PES
Elastic
Inelastic
Manufactured or
Service VS Primary
products
Manufactured or
Service
Primary products
Time Frame
Long Run
Short Run
Excess capacity
Yes
No
Substitutes
Many
Few
Ease of storage
Non Perishable
Perishable
15. Explain why the PES for primary commodities is relatively low
and the PES for manufactured products is relatively high.
Low-tech manufactured goods and low-skilled services have a
relatively elastic supply.
Producer can easily hire more workers and acquire more raw
materials and capital resources to meet increases in demand or
cut inputs for falling demand, thus they are highly responsive to
changes in prices.
Primary commodities that are land-intensive in production
exhibit immobility of the factors of production.
It is time-consuming and costly to bring into production primary
commodities to meet rising demand, or to take them out of
production in response to falling prices.
Thus they are relatively inelastic.
16. Explain the concept of income elasticity of demand, understanding that it
involves responsiveness of demand (and hence a shifting demand curve) to a
change in income. (YED)
The Income elasticity of demand measures the
response of Qd to a change in consumer income.
Recall: An increase in income causes an increase in demand
for a normal good.

Hence, for normal goods, income elasticity > 0. (Positive)

For inferior goods, income elasticity < 0. (Negative)
Recall also that a change in income is a determinate of
Demand, thus a change in income can cause a shift of the
demand curve.
17. Calculate YED using the following equation
YED = percentage change in quantity demanded / percentage change in income
YED = percentage change in quantity demanded / percentage change in income
(Y= Income)
YED = (Qd2-Qd1) / Qd1
(Y2-Y1) / Y1
Percent change in Qd
Income elasticity
=
of demand
Percent change in income
18. Show that normal goods have a positive value of YED and
inferior goods have a negative value of YED.


Normal goods: an increase in income leads to an
increase in consumption, demand shifts to the right.
Thus YED is positive for normal goods.
Inferior goods: Income elasticity is actually negative
for inferior goods, the demand curve shifts left as
income rises. As income rises, the proportion spent on
cheap goods will reduce as now they can afford to
buy more expensive goods
18. Show that normal goods have a positive value of YED and
inferior goods have a negative value of YED.
19. Distinguish, with reference to YED, between necessity
(income inelastic) goods and luxury (income elastic) goods.
Necessities have an income elasticity of demand of between 0
and +1. Demand rises with income, but less than proportionately.
Often this is because we have a limited need to consume additional
quantities of necessary goods as our real living standards rise.
The class examples of this would be the demand for fresh
vegetables, toothpaste and newspapers.
Demand is not very sensitive at all to fluctuations in income in this
sense total market demand is relatively stable following changes in
the wider economic (business) cycle.
19. Distinguish, with reference to YED, between necessity
(income inelastic) goods and luxury (income elastic) goods.
Luxuries on the other hand are said to have an income elasticity
of demand > +1. (Demand rises more than proportionate to a
change in income).
Luxuries are items we can (and often do) manage to do without
during periods of below average income and falling consumer
confidence.
When incomes are rising strongly and consumers have the
confidence to go ahead with “big-ticket” items of spending, so
the demand for luxury goods will grow.
The Engle’s curve shows the relationship
between income and quantity or consumption.
19. Distinguish, with reference to YED, between necessity
(income inelastic) goods and luxury (income elastic) goods.
19. Distinguish, with reference to YED, between necessity
(income inelastic) goods and luxury (income elastic) goods.
YED
20. Examine the implications for producers and for the economy of a
relatively low YED for primary products, a relatively higher YED for
manufactured products and an even higher YED for services
Significance of income elasticity for sectorial change
(primary> secondary > tertiary) as economic growth occurs
 As economies grow (and move from primary to secondary to tertiary
production)






Firms will plan on producing fewer inferior goods
Production and purchasing of capital goods and other factors can be
planned
Production for exports can be planned as new markets open and close
Primary sector is generally income inelastic
Just because a person's income changes does not mean he will buy
more tomatoes
However, secondary and tertiary sectors tend to be income elastic; a
change in income will have a big impact on quantity demanded of
cars, or the demand for personal massages
21. Explain the concept of cross price elasticity of demand, understanding that it
involves responsiveness of demand for one good (and hence a shifting demand
curve) to a change in the price of another good. (XED)
Cross Price Elasticity of demand measures the
responsiveness of demand for a product to a change in
the price of other related products. We normally focus
on the links between changes in the prices of substitutes
and complements.
21. Explain the concept of cross price elasticity of demand, understanding that it
involves responsiveness of demand for one good (and hence a shifting demand
curve) to a change in the price of another good. (XED)
22. Calculate XED using the following equation.
XED = percentage change in quantity demanded of good x/ percentage change in price of
good y
% change in Qd for good 1
Cross-price elast.
=
of demand
% change in price of good 2
(X = Cross between two goods)
XED = (Qb2 – Qb1) / Qb1
(Pa2 – Pa1) / Pa1
23. Show that substitute goods have a positive value of XED and
complementary goods have a negative value of XED.
The main use of cross price elasticity concerns changes in
the prices of substitutes and complements.
With substitute goods such as brands of cereal, an increase
in the price of one good will lead to an increase in demand
for the rival product. The cross price elasticity for two
substitutes will be positive.
With goods that are in complementary demand such as the
demand for DVD players and DVD’s, when there is a fall in
the price of DVD players we expect to see more DVD
players bought, leading to an expansion in market demand
for DVD’s. This is a negative relationship.
When there is no relationship (Independent) between two
products, the cross price elasticity of demand is zero.
23. Show that substitute goods have a positive value of XED
and complementary goods have a negative value of XED.
Complements or substitutes?
24. Explain that the (absolute) value of XED depends on
the closeness of the relationship between two goods.
The stronger the relationship between two products, the
higher is the co-efficient of cross-price elasticity of
demand.
When there is a strong complementary relationship
between two products, the cross-price elasticity will be
highly negative. An example might be games consoles
and software games
 For example, if the XED is +2 the goods are close
substitutes.
 If the XED is +.02 the goods are weak substitutes.
 If the XED is zero the goods are independent.
24. Explain that the (absolute) value of XED depends on the
closeness of the relationship between two goods.
24. Explain that the (absolute) value of XED depends on the
closeness of the relationship between two goods.
24. Explain that the (absolute) value of XED depends on the
closeness of the relationship between two goods.
25. Examine the implications of XED for businesses if
prices of substitutes or complements change.
Why does a firm want to know XED?
Knowing the XED of its own and other related products
enables the firm to map out its market.
Mapping allows a firm to calculate how many rivals it has,
and how close they are as competitors.
It also allows the firm to measure how important its
complementary products are to its own products.
This knowledge allows the firm to develop strategies to
reduce its exposure to the risks associated with price
changes by other firms, such as a rise in the price of a
complement or a fall in the price of a substitute.
AP Microeconomics:
II. B. Theory of Consumer Choice
26. Define total and marginal utility
Total utility is simply a measure of the total satisfaction
of wants and needs obtained from the consumption or
use of a good or service.
Marginal utility is the additional utility, or extra
satisfaction of wants and needs, obtained from the
consumption or use of an additional unit of a good or
service.
Marginal utility is specified as:
marginal utility =
change in total utility
change in quantity
27. Explain The Law of Diminishing Marginal Utility
The law of diminishing
marginal utility states that
marginal utility, or the extra
utility obtained from consuming
a good, decreases as the
quantity consumed increases.
In essence, each additional good
consumed is less satisfying than
the previous one.
This law is particularly important
for insight into market demand
and the law of demand.
28. Describe how the consumer decides what to
purchase using the utility maximization rule.
The process or goal of obtaining the highest level of
utility from the consumption of goods or services.
So how does the consumer decide what to purchase?
Unfortunately everything has a price and consumers
only have so much money to spend.
Consequently consumers try to spend the limited money
they have on what will give them the greatest amount of
satisfaction.
The decision rule for utility maximization is to purchase
those items that give the greatest marginal utility per
dollar and are affordable or within the budget.
29. Explain the marginal utility-price ratios.
The ratio of the marginal utility obtained from consuming a good to the price of
the good.
This ratio is particularly important in determining consumer equilibrium, which is
reached when the marginal utility-price ratios are the same for all goods.
Equality between all marginal utility-price ratios is the rule of consumer
equilibrium which is satisfied with utility maximization.
The marginal utility-price ratio indicates the satisfaction derived from the last
dollar spent on a good.
A consumer maximizes utility be equating the marginal utility-price ratio for each
good purchased and consumed.
If the ratios are not equal, then utility can be increased by changing the
combination of goods consumed.
A generic marginal utility-price ratio looks like this:
marginal utility of a generic good
price of a generic good
2012 AP® MICROECONOMICS FREE-RESPONSE QUESTIONS
2. Theresa consumes both bagels
and toy cars.
(a) The table above shows Theresa’s
marginal utility from bagels and toy
cars.
(i) What is her total utility from
purchasing three toy cars?
(ii) Theresa’s weekly income is
$11, the price of a bagel is $2,
and the price of a toy car is $1.
What quantity of bagels and toy
cars will maximize Theresa’s utility if
she spends her entire weekly income
on bagels and toy cars? Explain
your answer using marginal analysis.
Quantity
of
Bagels
Marginal
Utility
from
Bagels
(utils)
Quantity
of
Toy Cars
Marginal
Utility
from
Toy Cars
(utils)
1
8
1
10
2
7
2
8
3
6
3
6
4
5
4
4
5
4
5
3
6
3
6
2
Videos:
Economics: Understanding Utility Theory
Economics: Finding Consumer Equilibrium
30. Explain the DIAMOND-WATER PARADOX
Why does water that is essential to sustain life cost so much less than
diamonds that are atheistically pleasing, but are relatively unnecessary?
Recall that price reflects the scarcity of a good.
Overall, the supply of water is relatively abundant while the supply of
diamonds is relatively limited.
Thus the price we pay for water is low compared to the price of
diamonds.
Is it logical for someone who is maximizing his utility to purchase both
water and diamonds?
When deciding what to purchase we compare the marginal utility divided
by the price.
With lots of water consumption, the total utility of water is very large but
the marginal utility of the last gallon consumed is relatively low.
Few diamonds are purchased so while the marginal utility is very large,
say the diamond ring you just purchased for your future spouse, the total
utility is low since few diamonds are purchased.
30. Explain the DIAMOND-WATER PARADOX