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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

Part Two: Microeconomics

of Product Markets

CHAPTER 5 CONSUMER CHOICE AND UTILITY MAXIMIZATION


In this chapter you will learn

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

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


Figure 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

Figure 5-1Total and Marginal Utility

Chapter 5.1


Chapter 5 consumer choice and utility maximization

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


Chapter 5 consumer choice and utility maximization

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

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

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

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

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


Chapter 5 consumer choice and utility maximization

7

9

6

8

6

5

4

3

3

2

Table 5-1

10

12

8

10

Chapter 5.2


Table 5 2 sequence of purchases to achieve consumer equilibrium

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

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

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

Utility Maximization and the Demand Curve

Deriving the Demand Curve

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

Chapter 5.3


Chapter 5 consumer choice and utility maximization

7

18

6

16

12

5

4

6

3

4

Table 5-1

10

24

8

20

Chapter 5.3


Decision making process

$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 curve1

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 2 deriving an individual demand curve

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 curve2

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

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

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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