utility and demand chapter 7. 2 after studying this chapter you will be able to explain what limits...
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Utility and Demand
CHAPTER7
2
After studying this chapter you will be able to
Explain what limits a household’s consumption choices
Describe preferences using the concept of utility and distinguish between total utility and marginal utility
Explain the marginal utility theory of consumer choice
Use marginal utility theory to predict the effects of changing prices and incomes
Use marginal utility theory to prove the law of demand
Explain the paradox of value
3
Approaches to Consumer Utility
• Marginal Utility approachBased on cardinal numbers
• Indifference Curve approachBased on ordinal numbers
The Household’s Budget
Consumption Possibilities
A household’s consumption possibilities are constrained by its income and the prices of the goods and services it buys.
A household has a given amount of income to spend and cannot influence the prices of the goods and services it buys.
A household’s budget line describes the limits to a household’s consumption choices.
The Household’s Budget
Relative Price
A relative price is the price of one good divided by the price of another good.
The price of a movie is $6 and the price of soda is $3 a six-pack.
So the relative price of a movie is $6 per movie divided by $3 per six-pack, which equals 2 six-packs per movie.
The Household’s Budget
Real Income
A household’s real income is the household’s income expressed as the quantity of goods that the household can afford to buy.
Expressed in terms of soda, Lisa’s real income is 10 six-packs—the maximum quantity of six-packs that she can buy.
Lisa’s real income equals her money income ($30) divided by the price of a six-pack ($3).
Preferences and Utility
Preferences
A household’s preferences determine the benefits or satisfaction a person receives consuming a good or service.
The benefit or satisfaction from consuming a good or service is called utility.
Total Utility
Total utility is the total benefit a person gets from the consumption of goods. Generally, more consumption gives more utility.
Preferences and Utility
Table 7.1 on page 157 provides an example of total utility schedule.
Figure 7.2(a) shows a total utility curve.
Total utility increases with the consumption of a good.
Preferences and Utility
Marginal Utility
Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed.
As the quantity consumed of a good increases, the marginal utility from consuming it decreases.
We call this decrease in marginal utility as the quantity of the good consumed increases the principle of diminishing marginal utility.
Law of Diminishing Marginal Utility
As a person consumes additional units of a commodity, at some point,the additional satisfaction(marginal utility) will diminish.
Preferences and Utility
Figure 7.2(b) illustrates diminishing marginal utility.
Utility is analogous to temperature.
Both are abstract concepts and both are measured in arbitrary units.
Law of Diminishing Marginal Utility
• Utility defined• Subjective nature• Difficult to quantify
Total and Marginal Utility
Hamburgersconsumedper meal
TotalUtility
Marginalutility(2)
01234567
010182428303028
10 8 6 4 2 0 -2
0 1 2 3 4 5 6 7
Units consumed per meal
Units consumed per meal
30
20
10
To
tal
Uti
lity
(u
tils
)M
arg
ina
l U
tili
ty (
uti
ls)
10 8 6 4 2 0 -2
TU
MU 1 2 3 4 5 6 7
Maximizing Utility
The key assumption of marginal utility theory is that the household chooses the consumption possibility that maximizes total utility.
The Utility-Maximizing Choice
We can find the utility-maximizing choice by looking at the total utility that arises from each affordable combination.
Table 7.2 (page 158) shows an example of the utility-maximizing combination, which is called a consumer equilibrium.
Maximizing Utility
Equalizing Marginal Utility per Dollar
Using marginal analysis, a consumer’s total utility is maximized by following the rule:
Spend all available income and equalize the marginal utility per dollar for all goods.
The marginal utility per dollar is the marginal utility from a good divided by its price.
Utility Maximizing Rule
The consumer’s money incomeshould be allocated so that thelast dollar spent on each productpurchased yields the same amountof extra (marginal) utility
Algebraic Restatement of theUtility Maximization Rule
MU of product A MU of product B
Price of A Price of B=
First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2
Unit ofUnit ofproductproduct
Product A: Price = $1 Product B: Price = $2
Marginalutility,utils
Marginalutility per
dollar(MU/price)
MarginalMarginalutility,utility,utilsutils
MarginalMarginalutility perutility per
dollardollar(MU/price)(MU/price)
Marginal Utility and the Demand CurveMarginal Utility and the Demand Curve
Deriving the Demand CurveDeriving the Demand Curve• Preferences or tastes• Money Income• Prices of other goods
Create a demand schedule from theCreate a demand schedule from thepurchase decisions as the price ofpurchase decisions as the price ofthe product is varied ....the product is varied ....
Price per unit of B Quantity Demanded
$2 4 1 6
THE LAW OF DEMAND
Substitution Effect
–The change in quantity demanded resulting from a change in relative price
Income Effect
–The change in quantity demanded resulting from a change in price due to the change in real income
THE LAW OF DEMAND
Total Effect
–The change in quantity demanded resulting from a change in price
THE LAW OF DEMAND
Total Substitution Income Effect Effect Effect
Price of Good X Decreases
Type Subst Income TotalGood Effect Effect Effect
Normal + + +
Inferior + - +
Giffen + - - Giffen good is the only exception to the law of demand.
Efficiency, Price, and Value
Consumer Efficiency and Consumer Surplus
–When consumers maximize their utility, they are using resources efficiently. –And the marginal benefit from a good or service is the maximum price the consumer is willing to pay for an extra unit of that good or service when his or her utility is maximized.
Applications and DiscussionApplications and Discussion
Transfers and GiftsDiamond-Water ParadoxDiamond-Water Paradox
Efficiency, Price, and Value
–Value and Consumer Surplus–The supply of water is perfectly elastic, so the quantity of water consumed is large and the consumer surplus from water is large.
–In contrast, the supply of diamonds in perfectly inelastic, so the price is high and the consumer surplus from diamonds is small.