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Learning Objectives. Distinguish between total utility and marginal utility Discuss why marginal utility at first rises but ultimately tends to decline as a person consumes more of a good or service

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Learning objectives l.jpg
Learning Objectives

  • Distinguish between total utility and marginal utility

  • Discuss why marginal utility at first rises but ultimately tends to decline as a person consumes more of a good or service

  • Explain why an individual’s optimal choice of how much to consume of each good or service entails equalizing the marginal utility per dollar spent across all goods and services

Chapter 21 - Consumer Choice


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Learning Objectives

  • Describe the substitution effect of a price change on the quantity demanded of a good or service

  • Understand how the real-income effect of a price change affects the quantity demanded a good or service

  • Evaluate why the price of diamonds is so much higher than the price of water even though people cannot survive long without water

Chapter 21 - Consumer Choice


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Did You Know That...

  • There has been a proliferation of choices at U.S. grocery stores, which now stock an average of 40,000 items?

  • One way of deriving the law of demand involves an analysis of the logic of consumer choice in a world of limited resources?

  • In this chapter we discuss what is called utility analysis.

Chapter 21 - Consumer Choice


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Utility Theory

  • Utility

    • The want-satisfying power of a good or service

  • Utility Analysis

    • The analysis of consumer decision making based on utility maximization

  • Util

    • A representative unit by which utility is measured

Chapter 21 - Consumer Choice


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Change in total utility

Marginal utility =

Change in number of units consumed

Utility Theory

  • Marginal Utility

    • The change in total utility due to a one-unit change in the quantity of a good or service consumed

Chapter 21 - Consumer Choice


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Graphical Analysis

  • We can appreciate total and marginal utility by using graphical analysis.

Chapter 21 - Consumer Choice


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Total and Marginal Utility of Downloading and Listening to Digital Music Albums

Chapter 21 - Consumer Choice


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Total and Marginal Utility of Downloading and Listening to Digital Music Albums

Chapter 21 - Consumer Choice


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Total and Marginal Utility of Downloading and Listening to Digital Music Albums

Chapter 21 - Consumer Choice


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Total and Marginal Utility of Downloading and Listening to Digital Music Albums

Total utility is

maximized...

…where marginal

utility equals zero.

Chapter 21 - Consumer Choice


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Graphical Analysis

  • Observations

    • Marginal utility falls as more is consumed.

    • Marginal utility equals zero when total utility is at its maximum.

Chapter 21 - Consumer Choice


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The High Cost of Certain Sources of Negative Marginal Utility

  • Conventional wisdom says that it is impossible to put a price tag on happiness.

  • Economists usually attempt to attach dollar values to economic goods.

  • What is the amount of compensation required for economic “bads?”

Chapter 21 - Consumer Choice


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Diminishing Marginal Utility

  • Diminishing Marginal Utility

    • The principle that as more of any good or service is consumed, its extra benefit declines

    • Increases in total utility from consumption of a good or service become smaller and smaller as more is consumed during a given time period.

Chapter 21 - Consumer Choice


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Newspaper Vending Machines versus Candy Vending Machines

  • How many people take more than one paper from the vending machine?

  • Why not dispense candy the same way?

  • The answer is found in the concept of diminishing marginal utility.

Chapter 21 - Consumer Choice


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Optimizing Consumption Choices

  • Consumer Optimum

    • A choice of a set of goods and services that maximizes the level of satisfaction for each consumer, subject to limited income

Chapter 21 - Consumer Choice


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Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26

Chapter 21 - Consumer Choice


Total and marginal utility from consuming music album downloads and sandwiches on an income of 2617 l.jpg
Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26

Chapter 21 - Consumer Choice


Total and marginal utility from consuming music album downloads and sandwiches on an income of 2618 l.jpg
Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26

Chapter 21 - Consumer Choice


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Optimizing Consumption Choices Downloads and Sandwiches on an Income of $26

  • A consumer’s money income should be allocated so that the last dollar spent on each good purchased yields the same amount of marginal utility (when all income is spent), because this rule yields the largest possible total utility.

Chapter 21 - Consumer Choice


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Optimizing Consumption Downloads and Sandwiches on an Income of $26Choices

  • A little math

    • The rule of equal marginal utilities per dollar spent

      • A consumer maximizes personal satisfaction when allocating money income in such a way that the last dollars spent on good A, good B, good C, and so on, yield equal amounts of marginal utility.

Chapter 21 - Consumer Choice


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MU Downloads and Sandwiches on an Income of $26 of good A

MU of good B

MU of good Z

=

=

...

=

Price of good A

Price of good B

Price of good Z

Optimizing Consumption Choices

  • A little math

    • The rule of equal marginal utilities per dollar spent

Chapter 21 - Consumer Choice


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MU Downloads and Sandwiches on an Income of $26d

36.5

Qd = 4

= 7.3

=

Pd

5

MUs

22

Qs = 2

= 7.3

=

Ps

3

How a Price Change Affects Consumer Optimum

Recall from Table 20-1 Income = $26

Chapter 21 - Consumer Choice


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Assume Price of Music Falls to $4 Downloads and Sandwiches on an Income of $26

MUd

36.5

Qd = 4

= 9.125

=

Pd

4

MUs

22

Qs = 2

= 7.3

=

Ps

3

How a Price Change Affects Consumer Optimum

Chapter 21 - Consumer Choice


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Assume Price of Music Falls to $4 Downloads and Sandwiches on an Income of $26

Now

>

Result

Buy more downloads and MUd falls

MUd

MUs

Pd

Ps

How a Price Change Affects Consumer Optimum

Chapter 21 - Consumer Choice


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How a Price Change Affects Consumer Optimum Downloads and Sandwiches on an Income of $26

  • Consumption decisions are summarized in the law of demand

    • The amount purchased is inversely related to price.

  • A consumer’s response to a price change

    • At higher consumption rate, marginal utility falls.

Chapter 21 - Consumer Choice


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Digital Music Download Prices and Marginal Utility Downloads and Sandwiches on an Income of $26

Chapter 21 - Consumer Choice


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How a Price Change Affects Consumer Optimum Downloads and Sandwiches on an Income of $26

  • The Substitution Effect

    • The tendency of people to substitute cheaper commodities for more expensive commodities

Chapter 21 - Consumer Choice


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How a Price Change Affects Consumer Optimum Downloads and Sandwiches on an Income of $26

  • The Principle of Substitution

    • Consumers and producers shift away from goods and resources that become priced relatively higher in favor of goods and resources that are now priced relatively lower.

Chapter 21 - Consumer Choice


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How a Price Change Affects Consumer Optimum Downloads and Sandwiches on an Income of $26

  • Purchasing Power

    • The value of money for buying goods and services

Chapter 21 - Consumer Choice


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How a Price Change Affects Consumer Optimum Downloads and Sandwiches on an Income of $26

  • Real-Income Effect

    • The change in people’s purchasing power that occurs when, other things being constant, the price of one good that they purchase changes

    • When that price goes up (down), real income, or purchasing power, falls (increases).

Chapter 21 - Consumer Choice


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The Demand Curve Revisited Downloads and Sandwiches on an Income of $26

  • Question

    • How is the demand curve derived?

  • Answer

    • By presuming income, tastes, expectations, and the price of related goods are not changing as the price of the good changes

Chapter 21 - Consumer Choice


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The Demand Curve Downloads and Sandwiches on an Income of $26Revisited

  • Marginal utility, total utility, and the diamond-water paradox

    • Water is essential to life but cheap.

    • Diamonds are not essential to life but expensive.

Chapter 21 - Consumer Choice


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The Diamond-Water Paradox Downloads and Sandwiches on an Income of $26

Chapter 21 - Consumer Choice


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The Upside of Taking Off from Downloads and Sandwiches on an Income of $26a Less Convenient Airport

  • According to the principle of substitution, people shift away from consuming items that become priced relatively higher in favor of items that are now priced relatively lower.

  • In recent years, the principle of substitution has applied to the services offered by several major airports.

  • Many consumers of air travel are choosing to drive some distance before they depart to their ultimate destinations by plane.

Chapter 21 - Consumer Choice


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The Upside of Taking Off from Downloads and Sandwiches on an Income of $26a Less Convenient Airport

  • Weighing relative marginal utilities and prices

  • Opting to avoid hassles that reduce marginal utility

  • Responding to price changes

Chapter 21 - Consumer Choice


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Selected Substitute Airport Pairs in the United States Downloads and Sandwiches on an Income of $26

Chapter 21 - Consumer Choice


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Summary Discussion Downloads and Sandwiches on an Income of $26of Learning Objectives

  • Total utility versus marginal utility

    • Total utility is total satisfaction from consumption.

    • Marginal utility is the additional satisfaction from consuming an additional unit.

  • Law of diminishing marginal utility

    • Marginal utility ultimately declines as a person consumes more and more of a good or service.

Chapter 21 - Consumer Choice


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Summary Discussion Downloads and Sandwiches on an Income of $26of Learning Objectives

  • The consumer optimum

    • Occurs when the marginal utility per dollar spent on the last unit consumed is equalized

  • The substitution effect of a price change

    • A person will substitute among goods by buying less of a good when its price increases.

Chapter 21 - Consumer Choice


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Summary Discussion Downloads and Sandwiches on an Income of $26of Learning Objectives

  • The real-income effect of a price change

    • A price change affects the purchasing power of an individual’s available income.

  • Why the price of diamonds exceeds the price of water even though people cannot long survive without water

    • Marginal utility, not total utility, determines how much people are willing to pay.

Chapter 21 - Consumer Choice


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