Answers to Questions for Review

1.       (Law of Diminishing Marginal Utility) Some restaurants offer “all you can eat” meals.
How is this practice related to diminishing marginal utility? What restrictions must the
restaurant impose on the customer in order to make a profit?

The marginal utility derived from each additional plate of food will diminish as you become
full. The marginal utility will continue to decrease until it reaches zero or becomes
negative. Food shows diminishing marginal utility after a certain amount has been
consumed. The restaurant must require that the consumer not take food home in a doggy
bag and that the consumer not share the meal with others at the table.

2.         (Law of Diminishing Marginal Utility) Complete each of the following sentences:

        a.    Your tastes determine the _____________ you derive from consuming a particular
good.

        b.   _______________ utility is the change in ________________ utility resulting from a
_______________ change in the consumption of a good.

        c.   As long as the marginal utility is positive, total utility is

____________________________.

        d.   The law of diminishing marginal utility states that as an individual consumes more of a
good during a given time period, other things constant, total utility
________________________.

a.       Utility

b.       Marginal; total; one-unit

c.       Rising

d.       Increases by smaller amounts

  3.   (Marginal Utility) Is it possible for marginal utility to be negative while total utility is
positive? If yes, under what circumstances is it possible?

          Yes, it is possible. Total utility rises as long as marginal utility is positive. When total
utility starts to drop, marginal utility becomes negative. Total utility is still positive as long
as the negative marginal utilities are not sizable enough to completely offset the positive
marginal utilities on earlier units of consumption.
4.      (Utility-Maximizing Conditions) For a particular consumer, the marginal utility of cookies
equals the marginal utility of candy. If the price of a cookie is less than the price of candy, is
the consumer in equilibrium? Why or why not? If not, what should the consumer do to
attain equilibrium?

          Using a numerical example, the marginal utility of a cookie is 10 and the marginal utility
of candy is 10.  The price of a cookie is 5, but the price of candy is 10. To be in equilibrium,
the following equality  (MUcookie / pcookie) = (MUcandy / pcandy) should hold.  However, in this
example, the (MUcookie / pcookie) > (MUcandy / pcandy) because (10 / 5) > (10 / 10).

          The consumer is not in equilibrium since the marginal utility per dollar spent on cookies
(2) is larger than the marginal utility per dollar spent on candy (1). According to the law of
diminishing marginal utility, the rational consumer would reduce consumption of candy
and increase consumption of cookies.

  5.   (Utility-Maximizing Conditions) Suppose that marginal utility of Good X  = 100, the price
of X is $10 per unit, and the price of Y is $5. Assuming that the consumer is in equilibrium and
is consuming both X and Y, what must the marginal utility of Y be?

          For the per dollar marginal utilities to be equal, the marginal utility of Y should be 50
(100/10 = X/50). Note that the key assumption is that the consumer is in equilibrium.

  6.   (Utility-Maximizing Conditions) Suppose that the price of X is twice as high as the price of
Y. You are a utility maximizer who allocates your budget between those two goods. What
must be true about the equilibrium relationship between the marginal utility levels of the
last unit of each good consumed? What must be true about the equilibrium relationship
between the marginal utility levels of the last dollar spent on each good?

          Assuming utility maximization, the marginal utility level for the last unit of the higher-
priced good (X) must be twice as high as the marginal utility level of  good (Y). The marginal
utility levels of the last dollar spent on each good will also be equal; otherwise, shifting a dollar
from one good to the other will increase total utility.

  7.   (Consumer Surplus) The height of the demand curve at a given quantity reflects the
marginal valuation of the last unit of that good consumed. For a normal good, an increase in
income will shift the demand curve to the right and therefore increase its height at any
quantity. Does this mean that consumers get greater marginal utility from each unit of this
good than they did before? Explain.

        Marginal valuation is the dollar value of the marginal utility derived from consuming a unit
of the good—it is not the marginal utility itself. A shift in the demand curve does not necessarily
mean that there is a shift in the marginal utilities. In this case, the increased income has
changed the dollar value of the marginal utilities—it generates a greater willingness to pay for
each unit, so the demand curve shifts up to the right. Marginal utility, however, is determined by
consumer tastes, which have not changed.

  8.   (Consumer Surplus) Suppose that a good is in perfectly elastic supply at a price of $5. The
market demand curve for this good is linear, with zero quantity demanded at a price of $25.
If the slope of this linear demand curve is –0.25, draw a supply and demand graph to
illustrate the consumer surplus that occurs when the market is in equilibrium.

The slope of the demand curve is p/qd (see the Appendix to Chapter 1 for a review of
slope). Therefore, with a slope of 0.25, a $1 drop in the price generates a 4-unit increase in
the quantity demanded. The demand curve intersects the vertical axis at $25 and the
horizontal axis at 100 units. A $20 drop in price from $25 increases the quantity demanded
from zero to 80 units at $5. The consumer surplus equals the shaded area shown in the
following graph.

9.      (CaseStudy: The Marginal Value of Free Medical Care) Medicare recipients pay a
monthly premium for coverage, must meet an annual deductible, and have a copayment for
doctor’s office visits. There is no coverage for prescription medications. What impact would an
increase in the monthly premium have on their consumer surplus? What would be the impact of a
reduction in their copayments? What would be the impact on the quantity demanded and
consumer surplus if Medicare started providing coverage for prescription medications?

          Increased monthly premiums would reduce consumer surplus. Reduced copayments would
increase consumer surplus. Coverage for prescription medications would lead to an increase in
quantity demanded and increased consumer surplus.

10.     (Role of Time in Demand) In many amusement parks, you pay an admission fee to the park
but you do not need to pay for individual rides. How do people choose which rides to go on?
          The rides are allocated on the basis of the time costs incurred while standing in line
waiting for the ride. Those who really prefer a particular ride or those who have abundant
time available will be willing to wait longer. Those with little time available may elect to
ride other less crowded but also less thrilling rides.

11.    (CaseStudy: Water, Water Everywhere) What is the diamonds–water paradox, and how is it
explained?  Use the same reasoning to explain why bottled water costs so much more than tap
water.

        Diamonds are expensive; water is cheap.  Water is essential for life; diamonds are not a
necessity of life.  Why is the price of something as useful as water so much lower than
something of such limited use as diamonds?  Certainly the total utility of water exceeds the
total utility of diamonds.  However, the market value of a good is based on marginal utility,
the amount consumers are willing to pay for an additional unit of the good.  Diamonds are
scarce. Thus, the marginal utility of diamonds is high. Water is abundant, thus, water is
cheap.  

          Bottled water costs more than tap water because bottled water is scarce, consumers value
the convenience of bottled water when away from home, and they do not consider them perfect
substitutes. Consumers believe that the additional benefits of bottled water offset the additional
costs.

Answers to Problems and Exercises

12.    (Utility Maximization) The following tables illustrate Eileen’s utilities from watching
first-run movies in a theater and from renting movies from a video store. Suppose that
she has a monthly entertainment budget of $36, each movie in a theater costs $6, and
each video rental costs $3.
  

            Movies in a Theater

Q        TU           MU        MU/P
0           0           ——          ———
1         200          ——          ———
2         290          ——          ———
3         370          ——          ———
4         440          ——          ———
5            500              ——             ———
6            550              ——             ———
7            590              ——             ———
–            —                ——          ——   
      Movies from a Video Store
Q        TU           MU         MU/P
0           0            ——         ————
1         250          ——         ————
2         295          ——         ————
3         335          ——         ————
4         370          ——         ————
5         400          ——         ————
6         425          ——         ————
 

a.       Complete the tables.

b.       Do these tables show that Eileen’s preferences obey the law of diminishing marginal utility?
Explain your answer.

        c.   How much of each good will Eileen consume in equilibrium?

        d.   Suppose the prices of both types of movies drop to $1 while Eileen’s entertainment
budget shrinks to $10. How much of each good will she consume in equilibrium?

        a.    MU(t): —; 200; 90; 80; 70; 60; 50; 40

                   MU(t)/$6:  —; 33.3; 15.0; 13.33; 11.67; 10.0; 8.33; 6.67

                   MU(v):  —; 250; 45; 40; 35; 30; 25; 20

                   MU(v)/$3:  —; 83.33; 15.0; 13.33; 11.67; 10.0; 8.33; 6.67

          b.   Yes, for both goods. For both theater movies and video rentals, marginal utility drops
as consumption rises, starting with the second movie.
          c.     Four theater movies plus four video rentals. Each has a per dollar MU of 11.67 at
that consumption level, and total spending equals $36 ($24 on theater movies and $12 on video
rentals).

          d.   Seven theater movies and three video rentals. Each has a per dollar MU of 40 at that
consumption level, and total spending equals $10 ($7 on theater movies and $3 on video
rentals).