Consumer choices

The Benefit Side of Demand

Chapter 5

2

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.

3

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

4

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

5

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

6

Example:

Q TU AU MU

0 0 /

1 50 50

2 90 45

3 120 40

4 140 35

5 150 30

6 140 23

7

Sarah’s Total Utility from Ice Cream Consumption

Figure 5.2, p.130

Based on table 5.1, p.129

8

Diminishing Marginal UtilityFigure 5.3, p. 131

Based on Table 5.2, p.130

9

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

10

Decision Rule

The goal: max TUDecision rule:

– Increase Q as long as MU > 0

– consume up to Q when MU = 0

11

In the example

Did not consider costOne product: no trade-off

introduce cost

include other products --to represent consumption bundle

--to show trade-off

12

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

13

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?

14

Marginal Utility Curves for Two Flavors of Ice Cream (II)

Figure 5.5, p. 133

15

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

16

Optimal Consumption

Figure 5.6, p.134

17

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.

V

V

C

C

P

MU

P

MU

18

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?

19

Translating Wants into Demand

Assume – Budget = $400

– PC = $2 & PV = $1

– QC = 75 & QV = 250

1

10

P

MU

2

20

P

MU

V

V

C

C

20

Translating Wants into Demand

Assume – Price of chocolate falls to $1

1

10

P

MU

1

20

P

MU

V

V

C

C