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LAW OF DIMINISHING MARGINAL RETURNS: A principle stating that as more and more of a variable input is combined with a fixed input in short-run production, the marginal product of the variable input eventually declines. This is THE economic principle underlying the analysis of short-run production for a firm. Among a host of other things, it offers an explanation for the upward-sloping market supply curve. How does the law of diminishing marginal returns help us understand supply? The law of supply and the upward-sloping supply curve indicate that a firm needs to receive higher prices to produce and sell larger quantities. Why do they need higher prices?
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                           RULE OF CONSUMER EQUILIBRIUM: A condition of consumer equilibrium and utility maximization stating that the marginal utility-price ratios for all goods are equal. This rule is a handy way of checking for consumer equilibrium and utility maximization. If the rule is not satisfied, then consumer equilibrium and utility maximization are not achieved. The rule of consumer equilibrium is satisfied when a consumer selects a combination of goods that maximizes utility. With utility maximization, a consumer cannot increase utility by consuming more of one good and less of another. This occurs because the marginal utility-price ratio for each good is the same. In other words, consumers generate the same amount of utility from the last dollar spent on each good.A Handy FormulaThe following equation summarizes the rule of consumer equilibrium for two goods (ingenuously labeled good 1 and good 2). While this equation is only for two goods, in principle, it applies to any number of goods.marginal utility of good 1
price of good 1 | = | marginal utility of good 2
price of good 2 |
Working a Few Numbers| Pretzels and Sundaes |  |
The rule of consumer equilibrium can be illustrated using this table summarizing Duncan Thurly's snack consumption of two goods, Max Mulroney's Pretzel-on-a-Stick and Hot Momma Fudge Bananarama Ice Cream Sundae.The left half of the table summarizes the utility numbers for Duncan's pretzel consumption. As Duncan consumes pretzels, up to 6, his total utility rises to a peak of 36 utils before declining. His marginal utility for pretzel consumption begins at 12 utils for the first pretzel, then declines (according to the law of diminishing marginal utility) until reaching -2 utils for the seventh one. The utility story for Duncan's hot fudge sundae consumption in the right half of the table follows a similar pattern, albeit with different numbers. Duncan's total utility reaches a maximum of 60 utils for consuming 5 hot fudge sundaes. His marginal utility begins at 20 utils for the first hot fudge sundae then declines to -8 utils for the seventh (also following the law of diminishing marginal utility). Now suppose that the price of Hot Momma Fudge Bananarama Ice Cream Sundaes is $4, the price of a Max Mulroney's Pretzel-on-a-Stick is $2, and Duncan has $20 of income. Under these circumstances Duncan maximizes utility by consuming 4 pretzels and 3 hot fudge sundaes. Click the [Utility Max] to highlight this combination. Given that the marginal utility of Duncan's Third hot fudge sundae is 12 utils and the price is $4, the marginal utility-price ratio for hot fudge sundaes is three to one. Duncan gets 3 utils of satisfaction for the last $1 spent on sundaes. marginal utility of hot fudge sundaes
price of hot fudge sundaes | = | 12 utils
$4 | = | 3 utils per dollar |
Given that the marginal utility of Duncan's Fourth pretzel is 6 utils and the price is $2, the marginal utility-price ratio for Max Mulroney's Pretzel-on-a-Stick is also three to one. Duncan gets 3 utils of satisfaction for the last $1 spent on pretzels.marginal utility of pretzels
price of pretzels | = | 6 utils
$2 | = | 3 utils per dollar |
While this combination of pretzels and hot fudge sundaes might be an unhealthy diet, at least Duncan has satisfied the rule of consumer equilibrium. The last dollar spent on each good generates the same utility. And because Duncan cannot increase his total utility by consuming more of one good and less of another, he has also achieved utility maximization.Breaking the RuleIf the rule of consumer equilibrium is not satisfied, then utility is not maximized and can be increased by changing the combination of goods consumed. Suppose, for example, that Duncan decides to forego the third hot fudge sundae, and the 12 utils of satisfaction that it generates, to consume more pretzels. The $4 hot fudge sundae price can be used to purchase two additional pretzels.In this case, Duncan consumes 2 hot fudge sundaes and 6 pretzels. Considering the law of diminishing marginal utility, the marginal utility of pretzels decreases from 6 utils to 2 utils. Working in the reverse direction, the marginal utility of hot fudge sundaes increases from 12 utils to 16 utils. The new marginal utility-price ratio for hot fudge sundaes increases to 4 utils per dollar, based on the $4 price and the 16 utils of satisfaction. marginal utility of hot fudge sundaes
price of hot fudge sundaes | = | 16 utils
$4 | = | 4 utils per dollar |
The new marginal utility-price ratio for pretzels decreases to 1 util per dollar, based on the $2 price and the 2 utils of satisfaction.marginal utility of hot pretzels
price of pretzels | = | 2 utils
$2 | = | 1 util per dollar |
This situation is not good. Duncan is better off with 3 sundaes and 4 pretzels than with 2 sundaes and 6 pretzels. He is not satisfying the rule of consuming equilibrium. A quick check of the utility numbers in the table above also indicates that Duncan has less utility. The combination of 3 sundaes (with 48 utils) and 4 pretzels (with 36 utils) generates a total utility of 84 utils. The combination of 2 sundaes (with 36 utils) and 6 pretzels (with 42 utils) generates a total utility of 78 utils. If Duncan does not satisfy the rule of consumer equilibrium then his utility is not maximized.
Recommended Citation:RULE OF CONSUMER EQUILIBRIUM, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: April 27, 2024].
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