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Understand consumer choices by translating wants into demand using the Law of Diminishing Marginal Utility. Learn to allocate income for optimal utility and the Rational Spending Rule. Make informed decisions based on utility-maximizing principles.
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Chapter 5 Consumer choices The Benefit Side of Demand
Recall: The Law of Demand • People do less of what they want to do as the cost of doing it rises • The benefit of an activity equals the highest price we’d be willing to pay to pursue it (i.e., the reservation price). • As the cost of an activity rises and exceeds the reservation price, less of the activity will be pursued.
The difference among needs, wants and demand • Needs: minimum requirement to stay alive • Wants: • “tastes” or “preferences” • quality of life • living standard • satisfaction • Demand: • Willingness • Ability
Translating Wants into Demand • Measuring Wants: The Concept of Utility • Utility • The satisfaction people derive from their consumption activities • Assumption • People allocate their income to maximize their satisfaction or total utility
Utility • Total utility: • Total satisfaction from consuming a certain amount of goods and services • Average utility: • Average satisfaction from consuming each unit of goods and services • AU = TU / Q • Marginal utility: • Additional utility from consuming one additional unit of goods and services • MU = change in TU / change in Q
Sarah’s Total Utility from Ice Cream Consumption Figure 5.2, p.130 Based on table 5.1, p.129
Diminishing Marginal Utility Figure 5.3, p. 131 Based on Table 5.2, p.130
Key Points • TU first increases then max out and starts to decrease • TU increases at a slower pace • TU is maximized when MU=0 • MU is decreasing but positive when TU is increasing • MU is decreasing and negative when TU is decreasing • MU = 0 when TU is maximized
Decision Rule • The goal: max TU • Decision rule: • Increase Q as long as MU > 0 • consume up to Q when MU = 0
In the example • Did not consider cost • One product: no trade-off introduce cost include other products --to represent consumption bundle --to show trade-off
Translating Wants into Demand • The Law of Diminishing Marginal Utility • The tendency for the additional utility gained from consuming an additional unit of a good to diminish as consumption increases beyond some point
Translating Wants into Demand • Allocating a fixed income between two goods • Assume • Two goods: Chocolate and vanilla ice cream • Price of chocolate equals $2/pint • Price of vanilla equals $1/pint • Sarah’s budget = $400/yr • Currently Sarah is consuming 200 pints of vanilla and 100 pints of chocolate • Question • Is Sarah maximizing her total utility?
Marginal Utility Curves for Two Flavors of Ice Cream (II) Figure 5.5, p. 133
Translating Wants into Demand • At 200 vanilla and 100 chocolate • Marginal utility vanilla/P • $12/1 = 12 utils/$ • Marginal utility chocolate/P • 16/2 = 8 utils/$ • MU/P for vanilla not equal to MU/P for chocolate • MU/P for vanilla higher than MU/P for chocolate • Increase Q for vanilla to reduce MU for V • Decrease Q for chocolate to increase MU for Ch Until MU/P for vanilla = MU/P for chocolate
Optimal Consumption Figure 5.6, p.134
Translating Wants into Demand • The Rational Spending Rule • Spending should be allocated across goods so that the marginal utility per dollar is the same for each good.
Translating Wants into Demand • The Rational Spending Rule • How is the rational spending rule related to the cost-benefit principle? • How should Sarah respond to a reduction in the price of chocolate ice cream?
Translating Wants into Demand • Assume • Budget = $400 • PC = $2 & PV = $1 • QC= 75 & QV = 250
Translating Wants into Demand • Assume • Price of chocolate falls to $1