CHAPTER 5 CONSUMER CHOICE AND UTILITY MAXIMIZATION

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

CHAPTER 5 CONSUMER CHOICE AND UTILITY MAXIMIZATION