Individual Choice

1. Individual Choice 1. Rational (about costs) same cost - greater benefit same benefit - least cost 2. Utility the pleasure people get from doing or consuming something

2. Total Utility vs Marginal Utility Which is more valuable water or diamonds? “Why are you going out? Are your friends more important to you than me?” Some things have High Total Utility, but Smaller Marginal Utility

3. Diminishing Marginal Utility • After some point, the marginal utility received from each additional unit of a good decreases with each additional unit consumed • As additional units are consumed, marginal utility decreases, but total utility continues to increase • When total utility is at a maximum, marginal utility is zero • Beyond this point, total utility decreases and marginal utility is negative

4. Total Utility Curve Marginal Utility Curve The total utility curve is bowed downward Utility Utility The marginal utility curve is downward sloping and graphed at the halfway point 70 14 60 12 50 10 40 8 30 6 4 20 2 10 Q Q 0 1 2 3 4 5 6 7 8 1 2 3 4 5 6 7 8 –2

5. MUB MUN MUA PB PN PA Maximizing Utility until… = = . . . = Choices are based on comparisons of MU per $ spent on each good until choices are equal.

6. Two Goods Available Marginal Utility per $ Domestic $1 MU Imported $2 MU With Constraint Number Bought Domestic MU/$ Imported MU/$ 24 20 18 16 12 6 4 10 8 7 6 5 4 3 ____ ____ 1 2 3 4 5 6 7 ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ Without Income Constraint? With $12?

7. Consumer Demand Why the Demand Curve slopes down One Reason: Substitution Effect At a lower price consumers can switch to the cheaper good, substituting the cheaper for the more expensive.

8. Consumer Demand Why the Demand Curves slopes down A Second Reason: Income Effect A lower price of a good will increase purchasing power of the consumer. They can buy more than before.

9. Consumer Demand Why the Demand Curves slopes down A Third Reason: Diminishing Utility Consumers get less satisfaction as they buy more of a good. For the consumer to buy more the price must be reduced.

10. John’sdemand curvefor frozen pizza MB1 MB2 MB3 Price = $2.50 MB4 d = MB < < < MB4 MB3 MB2 MB1 because < < < MU4 MU3 MU2 MU1 The Pizza Demand Curve • The demand for frozen pizzas reflects the law of diminishing marginal utility. Price • Because marginal utility (MU) falls with increased consumption, so does a consumer’s maximum willingness to pay -- marginal benefit (MB). $3.50 $3.00 $2.50 • A consumer will purchase untilMB =Price. . . $2.00 so at $2.50 they would purchase 3 frozen pizzas and receive a consumer surplus shown by the shaded area (above the price line and below the demand curve). Frozen pizzasper week 1 2 4 3

11. Wage Rates and Labor Supply Wage The higher the wage, the higher the marginal utility of the goods you can get for the wage S $10.00 This gives an upward sloping supply curve $8.50 $8.00 Hours per week 20 21 26

12. Applying the Theory of Choice to the Real World • The assumptions underlying the theory of rational decision making place limits on the use of the theory • Those assumptions are: Decision making is costless Tastes are given Individuals maximize utility • Behavioral economists question all three assumptions

13. Decision making is costless • The costs of deciding among hundreds of possible choices may lead us to do some things that seem irrational • Most people may use bounded rationality which is rationality based on rules of thumb • “You get what you pay for” is the implication that high price equals high quality • “Follow the leader” leads to focal point equilibria in which a set of goods is consumed because they have become focal points to which people have gravitated

14. Tastes are given • Implicit in the theory of rational choice is that utility functions are given, not shaped by society • Tastes are often significantly influenced by society • Conspicuous consumption is the consumption of goods not for one’s direct pleasure, but to show off to others • “Given tastes” is the assumption on which an economic analysis is conducted

15. What to buy with $60? Maximizing Satisfaction Utility-Price Rule MUa/Pa MUb/Pb vs

16. If Mr. Smith thinks the last dollar spent on shirts yields less satisfaction than the last dollar spent on cola, and Smith is a utility-maximizing consumer, he should a. decrease his spending on cola. b. decrease his spending on cola and increase his spending on shirts. c. increase his spending on shirts. d. increase his spending on cola and decrease his spending on shirts. “I like ice cream, but after eating homemade ice cream last night, I want to have something else for dessert today.” This statement most clearly reflects a. the budget constraint. b. consumer irrationality. c. the second law of demand: Price elasticity increases with time. d. the law of diminishing marginal utility. If the price of gasoline goes up, and Dan now buys fewer candy bars because he has to spend more on gas, this would best be explained by a. the substitution effect. b. the income effect. c. the highly elastic demand for gasoline. d. weight watchers effect.