Consumer Choice and Demand Chapter 6 Consumer Choice and Demand © 2006 Thomson/South-Western

Utility Analysis Utility: the sense of pleasure, or satisfaction, that comes from consumption Tastes: preferences for different goods and services  likes and dislikes

Total and Marginal Utility Total utility is the total satisfaction a person derives from consumption Marginal utility is the change in total utility resulting from a one-unit change in consumption of a good Law of Diminishing Marginal Utility The more of a good an individual consumes per time period, other things constant, the smaller the increase in total utility from additional consumption

Exhibit 1: Utility Derived from Water The first column lists possible quantities of water a person might consume after running on a hot day. The second column presents the total utility derived from that consumption. The third column presents the marginal utility of each additional glass of water consumed  change in total utility from consuming an additional unit. Units of Water Consumed Total Marginal (8 ounce glass) Utility Utility 0 0 - 1 40 40 2 60 20 3 70 10 4 75 5 5 73 -2

Exhibit 2: Total and Marginal Utility Total Utility Marginal utility begins to diminish with the first unit Each glass adds less to total utility Total utility increases for the first four glasses, but at a decreasing rate In a world without scarcity the price of water is zero – a person would consume 4 glasses of water Marginal Utility

Utility Maximization with Scarcity Issue here becomes one of maximizing utility subject to the constraint that your income is limited and prices are greater than zero Suppose that we have the following bits of information The price of pizza is $8 The rental price of a movie video is $4 After tax income equals $40 per week

Exhibit 3: Pizza & Video Rentals Marginal Marginal Utility Utility of Pizza of Videos Pizza Total Marginal per Dollar Video Total Marginal per Dollar Consumed Utility Utility Expended Rentals Utility of Utility of Expended Per Week of Pizza of Pizza (price=$8) per Week Videos Videos (price=$4) (1) (2) (3) (4) (5) (6) (7) (8) 0 0 - - 0 0 - - 1 56 56 7 1 40 40 10 2 88 32 4 2 68 28 7 3 112 24 3 3 88 20 5 4 130 18 2¼ 4 100 12 3 5 142 12 1½ 5 108 8 2 6 150 8 1 6 114 6 1½ You spend your entire budget of $40 on pizza  5 pizzas per week at a total utility of 142 Giving up one pizza frees up enough money to rent two videos, and total utility increases from 142 to 198 Reducing consumption to three pizzas further increases total utility from 198 units to 212 units  another utility-increasing move

Utility-Maximizing Condition Consumer equilibrium is achieved when the budget is completely spent and the last dollar spent on each good yields the same utility Where MUp is the marginal utility of pizza, pp is the price of pizza, MUv is the marginal utility of videos, and pv the price of videos

Law of Demand and Marginal Utility We now have a single point on the demand curve for pizzas At a price of $8, the quantity demanded was 3 pizzas per week, based on a given income of $40 per week, a given rental price of $4 per video, and tastes as reflected in the utility numbers To generate another point, suppose the price of pizza declines to $6  Exhibit 4 is the same as Exhibit 3 except that the price of pizza has been reduced

Exhibit 4: Pizza & Video Rentals Marginal Marginal Utility Utility Pizza Total Marginal per Dollar Video Total Marginal per Dollar Consumed Utility Utility Expended Rentals Utility of Utility of Expended Per Week of Pizza of Pizza (price=$6) per Week Videos Videos (price=$4) (1) (2) (3) (4) (5) (6) (7) (8) 0 0 - - 0 0 - - 1 56 56 9 1/3 1 40 40 10 2 88 32 5 1/3 2 68 28 7 3 112 24 4 3 88 20 5 4 130 18 3 4 100 12 3 5 142 12 2 5 108 8 2 6 150 8 1 1/3 6 114 6 1½ Based on the new lower price of pizza we would have $6 unspent. We would increase our consumption to 4 pizzas per week  total utility increases by the 18 units derived from the 4th pizza. We are once again in equilibrium. Have another point on the demand curve for pizza, Price = $6, Qd = 4 pizzas

Exhibit 5: Demand for Pizza Generated from Marginal Utility The original position of consumer equilibrium is at point a, where the consumer purchased 3 units of pizza After the price declines to $6, the consumer purchases 4 units of pizza, as shown by point b a $8 a z z i p b r 6 e p e c i r P 4 2 D 1 2 3 4 Pizzas per week

Exhibit 6: Consumer Surplus $8 7 When price = $8, the marginal utility of other goods is higher than the marginal utility of a Subway If price = $7, consumer is willing and able to buy one per month, at $6, two are purchased; at $5, three are purchased, and so on If the market price is $4 – less than the consumer is willing to pay – this is a consumer surplus 6 Price per Subway 5 4 3 2 1 D 1 2 3 4 5 6 7 8 Subways per month

Exhibit 7: Summing Individual Demands to Derive Market Demand (d) Market demand for Subways (a) You (b) Brittany (c) Chris e $6 c $6 $6 $6 dY + dB + dC = D i r P 4 4 4 4 2 2 2 d d d 2 Y B C 2 4 6 2 4 2 0 2 6 12 Subways per month At a price of $4, you demand 4 Subways, Brittany 2, and Chris none: the market demand at a price of $4 equals 6 When the price is $2, your quantity demanded is 6, Brittany’s is 4, and Chris’s is 2: market demand = 12 The market demand shows the total quantity demanded per period by all consumers at various prices

Exhibit 8: Market Demand and Consumer Surplus The market price is $2 All consumers adjust their quantity demanded until the marginal valuation of the last unit purchased equals $2 However, each consumer gets to buy all other units for $2 each The shaded area depicts the consumer surplus when the price is $2 This area shows the increase in consumer surplus if the price falls to $1 Price per unit $2 1 D Quantity per period

Consumer Surplus Consumer surplus is the net benefit consumers get from market exchange It can be used to measure economic welfare and to compare the effects of such concepts as Different market structures Different tax structures Different public expenditure programs

Role of Time in Demand Because consumption does not occur instantaneously, time also plays an important role in demand analysis The cost of consumption has two components The money price of the good The time price of the good

Role of Time in Demand Other things constant, a good or service that provides the same benefit in less time is preferred The premium for time-saving goods and services depends on the opportunity cost of a persons time Differences in the value of time among consumers help explain differences in the consumption patterns observed in the economy