Copyright © 2006 Pearson Education Canada Utility and Demand PART 3Households’ Choices 8 CHAPTER.

Copyright © 2006 Pearson Education Canada

Utility and Demand

PART 3 Households’ Choices

8CHAPTER


Objectives

After studying this chapter, you will 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

Explain the paradox of value


Household’s Budget

A household’s consumption choices are determined by:

Consumption possibilities

Preferences

Consumption Possibilities

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

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



Figure 7.1 shows a budget line.

The household can afford all the points on or below the budget line.

The household cannot afford the points beyond the budget line.



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 pop 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



A fall in the price of the good on the x-axis increases the affordable quantity of that good and decreases the slope of the budget line.

Figure 7.2(a) shows the rotation of a budget line after a change in the relative price of movies.



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 pop, 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).



An change in the household’s income brings a parallel shift of the budget line.

The slope of the budget line doesn’t change because the relative price doesn’t change.

Figure 7.2(b) shows how the budget line shifts when income changes.


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.



Table 7.1 provides an example of total utility schedule.

Figure 7.3(a) shows a total utility curve.

Total utility increases with the consumption of a good.



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.



Figure 7.3(b) illustrates diminishing marginal utility.


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 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 on all goods.

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

Copyright © 2006 Pearson Education Canada Utility and Demand PART 3Households’ Choices 8 CHAPTER.

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