CIA4U0 Analyzing Current Economic Issues

1. CIA4U0Analyzing Current Economic Issues Chapter 5: Applications of Demand & Supply Topic 3: Making Consumption Choices: Utility Theory P 102-105

2. Utility Theory • If your grade in a course was 49% how hard would you be willing work to get 51%? 80%? • If your mark was 84% how hard would you work to get an 85%? • What is the utility of a Coke?

3. Utility Theory • “Utility Theory” is officially known as “Marginal Utility Theory of Consumer Choice" • Advanced by economist Alfred Marshall (1842-1924) the father of demand and supply • Utility refers to the satisfaction or usefulness one gets from buying a product or service • Marginal simply means extra, as in the extra satisfaction that comes from buying 1 more of something we already have • In the end when we buy a product or service we pay according to the utility we feel we get from the product

4. Utility Theory • Reflect: • Going from 49% to 51% or 80% we would probably feel a great deal of satisfaction (utility) and would be willing to work hard (pay) to get it • If we already had 84%, getting 1 additional percent would probably not excite us too much, we then would say the “marginal utility” of that 1 extra percent is very low. • Utility is relative, person to person, situation to situation (Coke)

5. Utility Theory • Economists use an invented unit called “utils” to measure the satisfaction one gets from different products in different circumstances. • How many utils would you feel going from a pass to a fail? To an A? • How many utils would you feel after drinking that Coke on a freezing cold day? A boiling hot day?

6. Utility Theory • Consumers have a limited budget and are constantly trying to “get the most” out of their money • Using utils, we can actually figure out what combination of purchases and quantities will maximize our satisfaction in spending our budget • This state is called “consumer equilibrium”—the point at which one is getting the same amount of satisfaction per dollar for each item purchased

7. Utility Theory • Consumers have a limited budget and are constantly trying to “get the most” out of their money • Using utils, we can actually figure out what combination of purchases and quantities will maximize our satisfaction in spending our budget • This state is called “consumer equilibrium”—the point at which one is getting the same amount of satisfaction per dollar for each item purchased while staying within budget.

8. Utility Theory Applications of Utility Theory: • The Demand Curve • Utility Theory supports the belief that the demand curve slopes from high left to low right • The more we buy of a product, the less satisfaction we get from it (novelty wears off) • Since our level of satisfaction directly determines what we’re willing to spend, the more we buy the less we’re willing to pay.

9. Utility Theory Applications of Utility Theory: • Adam Smith’s Paradox (Diamonds vs. Water) • Why is a necessity to life valued less than a “useless” crystal? • Utility theory solved this mystery: • Diamonds are scarce and we only buy a small number over many years, making the marginal utility very high • Water is abundant and we drink it often; we get so little satisfaction that we often drink it only because we have to

10. Utility Theory Applications of Utility Theory: • Consumer Surplus • The idea that we get everything at a bargain • Vendors don’t sell things in cycles according to when our marginal utility goes up and down • Instead, they set a price that is lower than the highest price you would be willing to pay when your marginal utility is highest • This means consumers pay less than they would be willing to, but vendors get consistent sales in return

11. Utility Theory Homework: • P116 #5 • P117 #11 • P117 #13