Utility and Demand

CHAPTER7

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After studying this chapter you will be able to

Explain what limits a household’s consumption choices

Describe preferences using the concept of utility and distinguish between total utility and marginal utility

Explain the marginal utility theory of consumer choice

Use marginal utility theory to predict the effects of changing prices and incomes

Use marginal utility theory to prove the law of demand

Explain the paradox of value

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Approaches to Consumer Utility

• Marginal Utility approachBased on cardinal numbers

• Indifference Curve approachBased on ordinal numbers

The Household’s Budget

Consumption Possibilities

A household’s consumption possibilities are constrained by its income and the prices of the goods and services it buys.

A household has a given amount of income to spend and cannot influence the prices of the goods and services it buys.

A household’s budget line describes the limits to a household’s consumption choices.

The Household’s Budget

Relative Price

A relative price is the price of one good divided by the price of another good.

The price of a movie is $6 and the price of soda is $3 a six-pack.

So the relative price of a movie is $6 per movie divided by $3 per six-pack, which equals 2 six-packs per movie.

The Household’s Budget

Real Income

A household’s real income is the household’s income expressed as the quantity of goods that the household can afford to buy.

Expressed in terms of soda, Lisa’s real income is 10 six-packs—the maximum quantity of six-packs that she can buy.

Lisa’s real income equals her money income ($30) divided by the price of a six-pack ($3).

Preferences and Utility

Preferences

A household’s preferences determine the benefits or satisfaction a person receives consuming a good or service.

The benefit or satisfaction from consuming a good or service is called utility.

Total Utility

Total utility is the total benefit a person gets from the consumption of goods. Generally, more consumption gives more utility.

Preferences and Utility

Table 7.1 on page 157 provides an example of total utility schedule.

Figure 7.2(a) shows a total utility curve.

Total utility increases with the consumption of a good.

Preferences and Utility

Marginal Utility

Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed.

As the quantity consumed of a good increases, the marginal utility from consuming it decreases.

We call this decrease in marginal utility as the quantity of the good consumed increases the principle of diminishing marginal utility.

Law of Diminishing Marginal Utility

As a person consumes additional units of a commodity, at some point,the additional satisfaction(marginal utility) will diminish.

Preferences and Utility

Figure 7.2(b) illustrates diminishing marginal utility.

Utility is analogous to temperature.

Both are abstract concepts and both are measured in arbitrary units.

Law of Diminishing Marginal Utility

• Utility defined• Subjective nature• Difficult to quantify

Total and Marginal Utility

Hamburgersconsumedper meal

TotalUtility

Marginalutility(2)

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Units consumed per meal

Units consumed per meal

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Maximizing Utility

The key assumption of marginal utility theory is that the household chooses the consumption possibility that maximizes total utility.

The Utility-Maximizing Choice

We can find the utility-maximizing choice by looking at the total utility that arises from each affordable combination.

Table 7.2 (page 158) shows an example of the utility-maximizing combination, which is called a consumer equilibrium.

Maximizing Utility

Equalizing Marginal Utility per Dollar

Using marginal analysis, a consumer’s total utility is maximized by following the rule:

Spend all available income and equalize the marginal utility per dollar for all goods.

The marginal utility per dollar is the marginal utility from a good divided by its price.

Utility Maximizing Rule

The consumer’s money incomeshould be allocated so that thelast dollar spent on each productpurchased yields the same amountof extra (marginal) utility

Algebraic Restatement of theUtility Maximization Rule

MU of product A MU of product B

Price of A Price of B=

First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2

Unit ofUnit ofproductproduct

Product A: Price = $1 Product B: Price = $2

Marginalutility,utils

Marginalutility per

dollar(MU/price)

MarginalMarginalutility,utility,utilsutils

MarginalMarginalutility perutility per

dollardollar(MU/price)(MU/price)

Marginal Utility and the Demand CurveMarginal Utility and the Demand Curve

Deriving the Demand CurveDeriving the Demand Curve• Preferences or tastes• Money Income• Prices of other goods

Create a demand schedule from theCreate a demand schedule from thepurchase decisions as the price ofpurchase decisions as the price ofthe product is varied ....the product is varied ....

Price per unit of B Quantity Demanded

$2 4 1 6

THE LAW OF DEMAND

Substitution Effect

–The change in quantity demanded resulting from a change in relative price

Income Effect

–The change in quantity demanded resulting from a change in price due to the change in real income

THE LAW OF DEMAND

Total Effect

–The change in quantity demanded resulting from a change in price

THE LAW OF DEMAND

Total Substitution Income Effect Effect Effect

Price of Good X Decreases

Type Subst Income TotalGood Effect Effect Effect

Normal + + +

Inferior + - +

Giffen + - - Giffen good is the only exception to the law of demand.

Efficiency, Price, and Value

Consumer Efficiency and Consumer Surplus

–When consumers maximize their utility, they are using resources efficiently. –And the marginal benefit from a good or service is the maximum price the consumer is willing to pay for an extra unit of that good or service when his or her utility is maximized.

Applications and DiscussionApplications and Discussion

Transfers and GiftsDiamond-Water ParadoxDiamond-Water Paradox

Efficiency, Price, and Value

–Value and Consumer Surplus–The supply of water is perfectly elastic, so the quantity of water consumed is large and the consumer surplus from water is large.

–In contrast, the supply of diamonds in perfectly inelastic, so the price is high and the consumer surplus from diamonds is small.