2IntroductionSome economists suggest that governments should ban credit cards because the use of credit cards makes consumers more satisfied until they receive their credit-card bills.As a result, banning credit cards would make people better off.In this chapter, you will learn how economists study the way people make choices intended to maximize their levels of satisfaction.
3Learning ObjectivesDistinguish between total utility and marginal utilityDiscuss why marginal utility first rises but ultimately tends to decline as a person consumes more of a good or serviceExplain why an individual’s optimal choice of how much to consume of each good or service entails equalizing the marginal utility per dollar spent across all goods and services
4Learning Objectives (cont'd) Describe the substitution effect of a price change on the quantity demanded of a good or serviceUnderstand how the real-income effect of a price change affects the quantity demanded of a good or service
5Chapter Outline Utility Theory Graphical Analysis Diminishing Marginal UtilityOptimizing Consumption ChoicesHow a Price Change Affects Consumer OptimumThe Demand Curve RevisitedBehavioral Economics and Consumer Choice Theory
6Did You Know That ...The human brain does its intelligent computing with 100,000,000,000 neurons?Evidence indicates that all this computing power makes the human brain at least 10,000 times more intelligent than the most artificially constructed supercomputers.In this chapter we discuss what is called utility analysis.
7Utility Theory Utility Utility Analysis The want-satisfying power of a good or serviceUtility AnalysisThe analysis of consumer decision making based on utility maximization
8Utility Theory (cont’d) A representative unit by which utility is measuredDeveloped by philosopher Jeremy Bentham; the school of thought is called utilitarianism
9Utility Theory (cont'd) Marginal UtilityThe change in total utility due to a one-unit change in the quantity of a good or service consumedMarginal utility =Change in total utilityChange in number of units consumed
10Figure Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (a)
11Figure 20-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panels (b) and (c)Total utility ismaximized...…where marginalutility equals zero.
12Utility Theory (cont'd) ObservationsMarginal utility falls as more is consumedMarginal utility equals zero when total utility is at its maximum
13Diminishing Marginal Utility The principle that as more of any good or service is consumed, its extra benefit declinesIncreases in total utility from consumption of a good or service become smaller and smaller as more is consumed during a given time period.
14Example: Newspaper Vending Machines versus Candy Vending Machines Newspaper machines do not prevent people from taking more than one paper. Why not dispense candy the same way?The answer is found in the concept of diminishing marginal utility.Can you think of a circumstance under which a substantial number of newspaper purchasers might be inclined to take more than one newspaper from a vending machine?
15Optimizing Consumption Choices Consumer OptimumA choice of a set of goods and services that maximizes the level of satisfaction for each consumer, subject to limited income
16Table Total and Marginal Utility from Consuming Music Album Downloads and Cappuccinos on an Income of $26
17Table Total and Marginal Utility from Consuming Music Album Downloads and Cappuccinos on an Income of $26 (cont'd)
18Optimizing Consumption Choices (cont’d) A consumer’s money income should be allocated so that the last dollar spent on each good purchased yields the same amount of marginal utility (when all income is spent), because this rule yields the largest possible total utility
20Optimizing Consumption Choices (cont'd) A little mathThe rule of equal marginal utilities per dollar spentA consumer maximizes personal satisfaction when allocating money income in such a way that the last dollars spent on good A, good B, good C, and so on, yield equal amounts of marginal utility
21Optimizing Consumption Choices (cont'd) A little mathThe rule of equal marginal utilities per dollar spentMU of good APrice of good A=MU of good BPrice of good BMU of good ZPrice of good Z...
22Example: Does Consuming More Expensive Items Make People Happier? Economist Antonio Rangel conducted an experiment in which he offered to let people taste wines.The experiment with wines revealed that people derive greater satisfaction from consuming the good when they believe that it has a higher explicit price.This means that when consumers choose to pay higher prices, they derive additional satisfaction.22
23Why Not … make consumers happier by requiring them to purchase the quantities the government chooses?If the government required individuals to reallocate their incomes to purchase more of certain items, then the marginal utilities from consuming those items would decline.Also, consumers would have less remaining income available to purchase other items, so the marginal utilities of buying those items would rise.So, the consumers would be less satisfied as their marginal utility per dollar spent would no longer be equal.23
24How a Price Change Affects Consumer Optimum Recall from Table 20-1 Income = $26Qd = 4MUdPd36.55== 7.3Qs = 2MUsPs223
25How a Price Change Affects Consumer Optimum (cont'd) Assume Price of Music Falls to $4Qd = 4MUdPd36.54== 9.125Qs = 2MUsPs223= 7.3
26How a Price Change Affects Consumer Optimum (cont'd) Assume Price of Music Falls to $4ResultBuy more downloads and MUd fallsNowMUdPd>MUsPs
27How a Price Change Affects Consumer Optimum (cont'd) Consumption decisions are summarized in the law of demandThe amount purchased is inversely related to priceA consumer’s response to a price changeAt higher consumption rate, marginal utility falls
28Figure 20-2 Digital Music Download Prices and Marginal Utility
29How a Price Change Affects Consumer Optimum (cont'd) The Substitution EffectThe tendency of people to substitute cheaper commodities for more expensive commodities
30How a Price Change Affects Consumer Optimum (cont'd) The Principle of SubstitutionConsumers and producers shift away from goods and resources that become priced relatively higher in favor of goods and resources that are now priced relatively lower
31How a Price Change Affects Consumer Optimum (cont'd) Purchasing PowerThe value of money for buying goods and servicesIf your money income stays the same but the price of one good that you are buying goes up, your effective purchasing power falls, not vice versa
32How a Price Change Affects Consumer Optimum (cont'd) Real-Income EffectThe change in people’s purchasing power that occurs when, other things being constant, the price of one good that they purchase changesWhen that price goes up (down), real income, or purchasing power, falls (increases)
33How a Price Change Affects Consumer Optimum (cont'd) What do you think?Which would usually have more of an impact on your purchases—the substitution effect or the real-income effect?
34The Demand Curve Revisited QuestionHow is the demand curve derived?AnswerBy assuming income, tastes, expectations, and the price of related goods are not changing as the price of the good changes
35The Demand Curve Revisited (cont'd) Marginal utility, total utility, and the diamond-water paradoxDiamonds are not essential to life but relatively expensiveWater is essential to life but relatively cheap.Total utility of water exceeds that of diamonds but marginal utility determines the price
37Behavioral Economics and Consumer Choice Theory Does behavioral economics better predict consumer choices?The bounded rationality assumptionHowever, people do not be have as if they are rational. If the rationality assumption does not apply to actual behavior, behavioralists argue that utility-based consumer choice theory cannot, either.
38Behavioral Economics and Consumer Choice Theory (cont’d) Consumer choice theory alive and wellIn spite of the doubts expressed by proponents of behavioral economics, most economists continue to apply the assumption that people behave as if they act rationally with an aim to maximize utilityThese economists continue to utilize utility theory because of a fundamental strength of this approach: It yields clear-cut predictions regarding consumer choices
39You Are There: Signing Up for “Free” Trial Offers with TrialPay TrialPay offer items at no explicit charge and instead its customers have to agree to sign up for a trial offer for a product of another firm, such as a “free” trial membership with the movie service Netflix.TrialPay ensures that the marginal utility per dollar spent will be high enough to make a trial membership part of the consumer optimum for its customers.
40Issues & Applications: Is the Utility from Using Credit Cards Really Negative? Behavioral economists argue that a consumer’s rationality is bounded, meaning that people often are unable to assess all aspects of choices that they confront.Some economists suggest the utility from credit card use is negative on net because the positive utility that consumers derive from using credit cards to obtain immediate use of an item is overwhelmed by a utility decrease from having to give up other items when they pay their credit-card bill.
41Summary Discussion of Learning Objectives Total utility versus marginal utilityTotal utility is total satisfaction from consumptionMarginal utility is the additional satisfaction from consuming an additional unitLaw of diminishing marginal utilityMarginal utility ultimately declines as a person consumes more and more of a good or service
42Summary Discussion of Learning Objectives (cont'd) The consumer optimumOccurs when the marginal utility per dollar spent on the last unit consumed is equalizedThe substitution effect of a price changeA person will substitute among goods by buying less of a good when its price increases
43Summary Discussion of Learning Objectives (cont'd) The real-income effect of a price changeA price change affects the purchasing power of an individual’s available income
44Appendix F: On Being Indifferent What does it mean to be indifferent?It usually means that you don’t care one way or the other about something—you are equally disposed to either of two alternatives44
45Figure F-1 Combinations That Yield Equal Levels of Satisfaction
46Appendix F: Properties of Indifference Curves Downward (negative) slopeCurvaturenot a straight lineconvex with respect to the origin46
47Figure F-2 Indifference Curves: Impossibility of an Upward Slope
48Figure F-3 Implications of a Straight-Line Indifference Curve
49Appendix F: The Marginal Rate of Substitution The marginal rate of substitution is equal to the change in the quantity of one good that just offsets a one-unit change in the consumption of another good, such that total satisfaction remains constant49
50Table F-1 Calculating the Marginal Rate of Substitution
51Appendix F: The Indifference Map A set of indifference curvesA higher indifference curve represents the possibility of higher rates of consumption of both goodsA higher indifference curve is preferred to a lower one because more is preferred to less51
55Appendix F: Consumer Optimum Revisited Consumers will try to attain the highest level of total utility possible, given their budget constraintsGraphically, it is the tangency point between the highest indifference curve and budget constraint55
57Appendix F: Deriving the Demand Curve QuestionWhat happens when the price of one good changes, holding both the price of another good and income constant?AnswerThe budget line rotates, resulting in a new optimum pointThe demand curve slopes downward57