CHAPTERS 8 Utility and Demand

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CHAPTERS 8 Utility and Demand

Marginal Utility Theory
The purpose of marginal utility theory is to explain an individual householdâ€™s demand. Marginal utility theory predicts that individual demand curves slope downward. Therefore, market demand curves must also slope downward.

Household Consumption Choices
Two factors determine a householdâ€™s consumption choices: Its budget constraint (how much money it has to spend and the prices of each good or service it buys) Its preferences (how much it likes each good relative to others)

Budget Constraint A householdâ€™s consumption choices are constrained by its income and by the prices of the goods and services it buys. The limits to a householdâ€™s consumption choices are described by its budget constraint or sometimes called its budget line.

Example - Lisaâ€™s Consumption Possibilities
Lisa has \$30 per month to spend on movies and soda. Movies cost \$6 each. If she spends her entire budget on movies, she can see 5 per month. Soda costs \$3 per six-pack. If she spends her entire budget on soda, she can drink 10 six-packs a month.

Consumption Possibilities
Movies (\$6) Soda (\$3) Expenditure Expenditure Possibility Q (dollars) Q (dollars) a b c d e f

Consumption Possibilities
a 10 b 8 c Soda (six-packs per month) 6 d 4 e 2 f Movies (per month)

Consumption Possibilities
a 10 b Each point on line exhausts the entire \$30 budget 8 c Soda (six-packs per month) 6 d 4 e 2 f Movies (per month)

Consumption Possibilities
a 10 Affordable b 8 Unaffordable c Soda (six-packs per month) 6 d 4 e 2 f Movies (per month)

Preferences The combination of goods and services a person chooses to consume from the available choices on the budget line is determined by their likes and dislikes â€” their preferences. The satisfaction a person gets from consumption is called utility.

Lisaâ€™s Preferences How Lisa spends her \$30 per month depends on her preferences for movies and soda. Each additional movie or soda she consumes increases her total utility.

Utility Is an Abstract Concept
We cannot directly observe values for utility. However, each of us knows what we like and what we dislike. We will consume more of the goods and services we like and less of those we dislike.

Total Utility Total utility is the total benefit or satisfaction that a person gets from the consumption of goods and services. Total utility depends on the level of consumption â€” more consumption generally increases total utility.

Lisaâ€™s Total Utility The more movies Lisa sees each month, the greater her total utility from movies. The more soda Lisa drinks each month, the greater her total utility from soda.

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

Total Utility and Marginal Utility
Movies Quantity Total utility Marginal utility 1 50 2 88 -

Total Utility and Marginal Utility
Movies Quantity Total utility Marginal utility 1 50 2 88 - 50

Total Utility and Marginal Utility
Movies Quantity Total utility Marginal utility 1 50 2 88 - 50 38

Total Utility and Marginal Utility
Movies Quantity Total utility Marginal utility 1 50 2 88 - 50 38 33

Total Utility and Marginal Utility
Movies Quantity Total utility Marginal utility 1 50 2 88 - 50 38 33 29

Total Utility and Marginal Utility
Movies Quantity Total utility Marginal utility 1 50 2 88 - 50 38 33 29 25

Total Utility and Marginal Utility
Movies Quantity Total utility Marginal utility 1 50 2 88 - 50 38 33 29 25 21

Total Utility and Marginal Utility
Movies Quantity Total utility Marginal utility 1 50 2 88 - 50 38 33 29 25 21 18

Total Utility and Marginal Utility
Movies Quantity Total utility Marginal utility 1 50 2 88 - 50 38 33 29 25 21 18 15

Total Utility and Marginal Utility
Movies Quantity Total utility Marginal utility 1 50 2 88 - 50 38 33 29 25 21 18 15 12

Total Utility and Marginal Utility
Movies Quantity Total utility Marginal utility 1 50 2 88 - 50 38 33 29 25 21 18 15 12 9

Diminishing Marginal Utility
As consumption of a good or service increases, the incremental (or marginal) satisfaction we get from consuming one more unit decreases. This decrease is called the principle of diminishing marginal utility.

Total Utility and Marginal Utility
200 Units of utility Units of utility 150 100 50 50 Quantity (movies per month) Quantity (movies per month)

Total Utility and Marginal Utility
200 Total utility Units of utility Units of utility 150 100 50 50 Quantity (movies per month) Quantity (movies per month)

Total Utility and Marginal Utility
200 Total utility Units of utility Units of utility 150 100 Increasing total utility... 50 50 50 Quantity (movies per month) Quantity (movies per month)

Total Utility and Marginal Utility
200 Total utility Units of utility Units of utility 150 100 Increasing total utility... â€¦and diminishing marginal utility 50 50 50 38 Quantity (movies per month) Quantity (movies per month)

Total Utility and Marginal Utility
200 Total utility Units of utility Units of utility 150 100 Increasing total utility... â€¦and diminishing marginal utility 50 50 50 38 33 Quantity (movies per month) Quantity (movies per month)

Total Utility and Marginal Utility
200 Total utility Units of utility Units of utility 150 100 Increasing total utility... â€¦and diminishing marginal utility 50 50 50 38 33 29 Quantity (movies per month) Quantity (movies per month)

Total Utility and Marginal Utility
200 Total utility Units of utility Units of utility 150 100 Increasing total utility... â€¦and diminishing marginal utility 50 50 50 38 33 29 25 Quantity (movies per month) Quantity (movies per month)

Total Utility and Marginal Utility
200 Total utility Units of utility Units of utility 150 100 Increasing total utility... â€¦and diminishing marginal utility 50 50 Marginal utility 50 38 33 29 25 Quantity (movies per month) Quantity (movies per month)

Total Utility and Marginal Utility
Soda Quantity Total utility Marginal utility -

Total Utility and Marginal Utility
Soda Quantity Total utility Marginal utility - 75

Total Utility and Marginal Utility
Soda Quantity Total utility Marginal utility - 75 42

Total Utility and Marginal Utility
Soda Quantity Total utility Marginal utility - 75 42 36

Total Utility and Marginal Utility
Soda Quantity Total utility Marginal utility - 75 42 36 28

Total Utility and Marginal Utility
Soda Quantity Total utility Marginal utility - 75 42 36 28 25

Total Utility and Marginal Utility
Soda Quantity Total utility Marginal utility - 75 42 36 28 25 19

Total Utility and Marginal Utility
Soda Quantity Total utility Marginal utility - 75 42 36 28 25 19 18

Total Utility and Marginal Utility
Soda Quantity Total utility Marginal utility - 75 42 36 28 25 19 18 17

Total Utility and Marginal Utility
Soda Quantity Total utility Marginal utility - 75 42 36 28 25 19 18 17 16

Total Utility and Marginal Utility
Soda Quantity Total utility Marginal utility - 75 42 36 28 25 19 18 17 16 15

Maximizing Utility A householdâ€™s income and the prices it faces limit the total utility it can obtain. We assume that households consume the quantities of goods and services that maximize total utility. People must make hard choices because wants exceed resources.

The Utility-maximizing Choice
A consumer equilibrium is a situation in which a consumer has allocated his or her income in the way that, given the prices of goods and services, maximizes his or her total utility.

Lisa's Affordable Combinations
Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per month a b c d e f

Lisa's Affordable Combinations
Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per month a b c d e f

Lisa's Affordable Combinations
Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per month a b c d e f

Lisa's Affordable Combinations
Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per month a b c d e f

Lisa's Affordable Combinations
Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per month a b c d e f

Lisa's Affordable Combinations
Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per month a b c d e f

Lisa's Affordable Combinations
Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per month a b c d e f

Lisa's Affordable Combinations
Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per month a b c d e f

Equalizing Marginal Utility Per Dollar Spent
The allocation that maximizes total utility will also make the marginal utility per dollar spent on each good equal for all goods. The marginal utility per dollar spent is the marginal utility obtained from the last unit of a good consumed divided by the price of the good.

Maximizing Total Utility
Total utility is maximized when all the consumerâ€™s income is spent and when the marginal utility per dollar spent is equal for all goods. If all income is not spent, utility could be improved by spending more. Therefore, the consumer will spend all income.

Lisa Maximizes Utility
She spends all her income and MUmovies/ Pmovies = MUsoda/ Psoda Equivalently: MUmovies/MUsoda = Pmovies/ Psoda

Equalizing Marginal Utilities Per Dollar Spent
Movies (\$6 each) Soda (\$3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent a b c d e f

Equalizing Marginal Utilities Per Dollar Spent
Movies (\$6 each) Soda (\$3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent a b c d e f

Equalizing Marginal Utilities Per Dollar Spent
Movies (\$6 each) Soda (\$3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent a b c d e f

Equalizing Marginal Utilities per Dollar Spent
Movies (\$6 each) Soda (\$3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent a b c d e f

Equalizing Marginal Utilities Per Dollar Spent
Movies (\$6 each) Soda (\$3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent a b c d e f

Equalizing Marginal Utilities Per Dollar Spent
Movies (\$6 each) Soda (\$3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent a b c d e f

Equalizing Marginal Utilities Per Dollar Spent
Movies (\$6 each) Soda (\$3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent a b c d e f

Equalizing Marginal Utilities Per Dollar Spent
Movies (\$6 each) Soda (\$3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent a b c d e f

Equalizing Marginal Utilities Per Dollar Spent
Movies (\$6 each) Soda (\$3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent a b c d e f

Equalizing Marginal Utilities Per Dollar Spent
Movies (\$6 each) Soda (\$3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent a b c d e f

Equalizing Marginal Utilities Per Dollar Spent
Movies (\$6 each) Soda (\$3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent a b c d e f

Equalizing Marginal Utilities Per Dollar Spent
Movies (\$6 each) Soda (\$3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent a b c d e f

Lisa Maximizes Utility
She spends all her income and MUmovies/ Pmovies = MUsoda/ Psoda (38/6) = (19/3) = 6.33 Equivalently: MUmovies/MUsoda = Pmovies/ Psoda (38/19) = (6/3) = 2

Why the Marginal Utility Rule Maximizes Total Utility Case I
If the ratio of marginal utility to price is higher for movies than for soda, Lisa can increase total utility by consuming less soda and more movies. If MUmovies/ Pmovies > MUsoda/ Psoda then the next movie provides more satisfaction per dollar than a soda.

Why the Marginal Utility Rule Maximizes Total Utility Case II
If the ratio of marginal utility to price is lower for movies than for soda, Lisa can increase total utility by consuming more soda and less movies. If MUmovies/ Pmovies < MUsoda/ Psoda then the next soda provides more satisfaction per dollar than a movie.

Equalizing Marginal Utilities Per Dollar Spent
16.00 12.00 Marginal utility per dollar spent (units of utility per dollar) 8.33 6.33 5.67 4.00 Movies Soda Possibility a b c d e f

Equalizing Marginal Utilities Per Dollar Spent
16.00 12.00 Marginal utility per dollar spent (units of utility per dollar) 8.33 6.33 5.67 4.00 MUm Pm Movies Soda Possibility a b c d e f

Equalizing Marginal Utilities Per Dollar Spent
MUs Ps 16.00 12.00 Marginal utility per dollar spent (units of utility per dollar) 8.33 6.33 5.67 4.00 MUm Pm Movies Soda Possibility a b c d e f

Equalizing Marginal Utilities Per Dollar Spent
MUs Ps 16.00 12.00 Marginal utility per dollar spent (units of utility per dollar) Maximum total utility Case II Utility gain from more soda and fewer movies 8.33 6.33 5.67 4.00 Case I Utility gain from more movies and less soda MUm Pm Movies Soda Possibility a b c d e f

Consuming Only Sodas 0 1 2 3 4 5 10 8 6 4 2 0 a b c d e f MUs Ps MUm
Marginal utility per dollar spent (units of utility per dollar) MUm Pm Movies Soda Possibility a b c d e f

Consuming Only Movies 0 1 2 3 4 5 10 8 6 4 2 0 a b c d e f MUm Pm MUs
Marginal utility per dollar spent (units of utility per dollar) MUs Ps Movies Soda Possibility a b c d e f

The Power of Marginal Analysis
The method we have used to maximize Lisaâ€™s utility is an example of marginal analysis. By comparing marginal gain with marginal loss, we can guarantee that total utility is maximized.

New Ways of Explaining Consumer Choices
Behavioral Economics Behavioral economics studies the ways in which limits on the human brainâ€™s ability to compute and implement rational decisions influence economic behaviorâ€”both the decisions that people make and the consequences of those decisions for the way markets work. There are three impediments to rational choice: Bounded rationality Bounded willpower Bounded self-interest

New Ways of Explaining Consumer Choices
Bounded Rationality Bounded rationality is rationality that is limited by the computing power of the human brain. Faced with uncertainty, consumers cannot rationally make choices and instead rely on other decision-making methods such as rules of thumb, listening to the views of others, or gut instinct.

New Ways of Explaining Consumer Choices
Bounded Willpower Bounded will-power is the less-than-perfect willpower that prevents us from making a decision that we know, at the time of implementing the decision, we will later regret.

New Ways of Explaining Consumer Choices
Bounded Self-Interest Bounded self-interest is the limited self-interest that sometimes results in suppressing our own interests to help others. Main applications are in finance where uncertainty is the key factor and savings where future is the key factor.

New Ways of Explaining Consumer Choices
One behavior observed by behavioral economists is more general and might affect your choices. The Endowment Effect The endowment effect is the tendency for people to value something more highly simply because they own it.

New Ways of Explaining Consumer Choices
Neuroeconomics Neuroeconomics is the study of the activity of the human brain when a person makes an economic decision. Different decisions appear to activate different areas of the brain. Some decisions are made In the pre-frontal cortex where memories are stored and data analyzed and where decisions might be deemed rational. In the hippocampus where memories of anxiety and fear are stored and where decisions might be deemed irrational.

New Ways of Explaining Consumer Choices
Controversy Should economics focus on explaining the decisions we observe or should it focus on what goes on inside peopleâ€™s heads? This is the controversy. For most economists, the goal of economics is to explain the decisions that we observe people make, and not to explain what goes on inside peopleâ€™s heads.

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