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Part Two: Microeconomics of Product Markets. CHAPTER 5 CONSUMER CHOICE AND UTILITY MAXIMIZATION. In this chapter you will learn:. 5.1 About total utility, marginal utility, and the law of diminishing marginal utility

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CHAPTER 5 CONSUMER CHOICE AND UTILITY MAXIMIZATION

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Part Two: Microeconomics

of Product Markets

CHAPTER 5 CONSUMER CHOICE AND UTILITY MAXIMIZATION


In this chapter you will learn:

5.1About total utility, marginal utility, and the law of diminishing marginal utility

5.2How rational consumers compare marginal utility-to-price ratios for products in purchasing combinations of products that maximize their utility

5.3How a demand curve can be derived by observing the outcomes of price changes in the utility-maximization model

5.4How the utility-maximization model helps highlight the income and substitution effects of a price change

Chapter 5


Law of Diminishing Marginal Utility

  • Gains in satisfaction decline as additional units are consumed

  • Terminology

    • utility is want-satisfying power

  • Total Utility and Marginal Utility

    • total utility: total amount of satisfaction

    • marginal utility:extra satisfaction from consuming one more unit

      graphically examined....

Chapter 5.1


Tacos

Consumed

Total

Utility

Marginal

Utility

0

1

2

3

4

5

6

7

0

10

18

24

28

30

30

28

Figure 5-1Total and Marginal Utility

Chapter 5.1


Total and Marginal Utility

Tacos

Consumed

Total

Utility

Marginal

Utility

0

1

2

3

4

5

6

7

0

10

18

24

28

30

30

28

10

Chapter 5.1


Total and Marginal Utility

Tacos

Consumed

Total

Utility

Marginal

Utility

0

1

2

3

4

5

6

7

0

10

18

24

28

30

30

28

10

8

6

4

2

0

Diminishing Marginal Utility

-2

Chapter 5.1


Marginal Utility and Demand

  • If marginal utility falls rapidly for each successive unit…

  • It will take a considerable drop in price to cause an increase in quantity demanded…

  • So demand is fairly…

  • INELASTIC

Chapter 5.1


Theory of Consumer Choice

A Typical Consumer…

  • Exhibits rational behaviour

  • Knows clear-cut preferences

  • Is subject to a budget constraint

  • Responds to price changes

Chapter 5.2


Utility-Maximizing Rule

  • The consumer’s money income should be allocated so that the last dollar spent on each product purchased yields the same amount of extra (marginal) utility

Chapter 5.2


Numerical Example

  • First, put the marginal utilities into a per-dollar-spent basis

  • Decision-making process: at each step, spend where the marginal utility per dollar is highest

  • Table 5-1

Chapter 5.2


7

9

6

8

6

5

4

3

3

2

Table 5-1

10

12

8

10

Chapter 5.2


1

1

1

1

Table 5-2Sequence of Purchases to Achieve Consumer Equilibrium

$2

1

$3

What will the consumer buy first?

And next?

$2

1

$3

$10

2

4

Chapter 5.2


Utility Maximization

  • At each step, spend where MU/$ is highest

  • In general, if MU/$ is unequal, spending should be allocated

    • away from the good where MU/$ is low

    • toward the good where MU/$ is high

Chapter 5.2


Algebraic Restatement

MU of product B

MU of product A

=

Price of A

Price of B

Chapter 5.2


Utility Maximization and the Demand Curve

Deriving the Demand Curve

  • What if the price of Product B falls to $1?

Chapter 5.3


7

18

6

16

12

5

4

6

3

4

Table 5-1

10

24

8

20

Chapter 5.3


$1

1

$1

1

$1

1

$1

1

$1

1

$1

1

$1

1

$1

1

1

$1

1

4

$10

6

Decision Making Process

Chapter 5.3


Utility Maximization and the Demand Curve

  • When pProduct B = $2

    • the quantity demanded is 4

  • When pProduct B = $1

    • the quantity demanded is 6

Chapter 5.3


Figure 5-2Deriving an Individual Demand Curve

price

D

Product B

$2

Price

Quantity demanded

$1

6

$1

$2

4

4

6

quantity demanded

Chapter 5.3


Utility Maximization and the Demand Curve

  • Substitution Effect

    • when the price of Product B falls, there is a substitution of now cheaper B

  • Income Effect

    • increase in real income increases consumption of both A & B

Chapter 5.3


Applications and Extensions

  • DVDs and DVD Players

  • The Diamond-Water Paradox

  • The Value of Time

  • Cash and Non-Cash Gifts

Chapter 5.4


Chapter Summary

  • 5.1 The Law of Diminishing Marginal Utility

  • 5.2 Theory of Consumer Choice

    • Marginal Utility per Dollar

  • 5.3 Utility Maximization and the Demand Curve

    • Income and Substitution Effects

  • 5.4 Applications and Extensions

Chapter 5


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