© 2005 Thomson C hapter 5 Marginal Utility and Consumer Choice

© 2005 Thomson 2 Gottheil - Principles of Economics, 4e Economic Principles Total utility and marginal utility Law of diminishing marginal utility Relationship between the law of demand and the marginal-utility-to-price ratio Consumer surplus Difficulties with interpersonal comparison of utility

© 2005 Thomson 3 Gottheil - Principles of Economics, 4e What is Marginal Utility? Util It is a hypothetical unit used to measure how much utility a person obtains from consuming a good.

© 2005 Thomson 4 Gottheil - Principles of Economics, 4e What is Marginal Utility? Utility measures the satisfaction or enjoyment a person obtains from consuming a good.

© 2005 Thomson 5 Gottheil - Principles of Economics, 4e Law of Diminishing Marginal Utility It is the idea that as more of a good is consumed, the utility a person derives from each additional unit diminishes. What is Marginal Utility?

© 2005 Thomson 6 Gottheil - Principles of Economics, 4e The implication of someone experiencing increasing marginal utility for pizza slices is: The next slice of pizza would generate higher marginal utility than the one before. What is Marginal Utility?

© 2005 Thomson 7 Gottheil - Principles of Economics, 4e The implication of someone experiencing increasing marginal utility for pizza slices is: When his stomach is full to bursting from eating so much pizza, the marginal utility from eating yet another slice would be higher than for any of the preceding slices. What is Marginal Utility?

© 2005 Thomson 8 Gottheil - Principles of Economics, 4e The implication of someone experiencing increasing marginal utility for pizza slices is: It is not clear that someone could survive having increasing marginal utility! What is Marginal Utility?

© 2005 Thomson 9 Gottheil - Principles of Economics, 4e It possible for marginal utility to become negative. For example, if you overeat and feel ill, then the marginal utility for the last bit of food you ate is negative. What is Marginal Utility?

© 2005 Thomson 10 Gottheil - Principles of Economics, 4e A rational consumer will not knowingly pay to buy a unit of a good that generates negative marginal utility. Presumably something else could be bought that generates positive marginal utility. Buying something that generates negative marginal utility is not consistent with utility maximization. What is Marginal Utility?

© 2005 Thomson 11 Gottheil - Principles of Economics, 4e EXHIBIT 1TOTAL UTILITY AND MARGINAL UTILITY DERIVED FROM CONSUMING T-BONE STEAKS (UTILS)

© 2005 Thomson 12 Gottheil - Principles of Economics, 4e Exhibit 1: Total Utility and Marginal Utility Derived From Consuming T-Bone Steaks (utils) If marginal utility is declining, but is still positive, total utility is: Total utility increases as long as marginal utility is positive.

© 2005 Thomson 13 Gottheil - Principles of Economics, 4e If marginal utility is declining, but is still positive, total utility is: In Exhibit 1, total utility reaches its maximum at five t-bone steaks. Consuming more than five steaks will reduce total utility. Exhibit 1: Total Utility and Marginal Utility Derived From Consuming T-Bone Steaks (utils)

© 2005 Thomson 14 EXHIBIT 2ATOTAL AND MARGINAL UTILITY

© 2005 Thomson 15 EXHIBIT 2BTOTAL AND MARGINAL UTILITY

© 2005 Thomson 16 Gottheil - Principles of Economics, 4e Exhibit 2: Total and Marginal Utility In Exhibit 2, the curves in Panel a and b represent: The curve in Panel a is the total utility curve for T-bone steaks. Panel a depicts the number of utils, or the amount of utility, a person gains from consuming a certain number of steaks.

© 2005 Thomson 17 Gottheil - Principles of Economics, 4e In Exhibit 2, the curves in Panel a and b represent: Total utility peaks at 81 utils, or 5 steaks. Each steak consumed beyond 5 reduces total utility. Exhibit 2: Total and Marginal Utility

© 2005 Thomson 18 Gottheil - Principles of Economics, 4e In Exhibit 2, the curves in Panel a and b represent: The curve in Panel b is the marginal utility curve for T-bone steaks. The curve depicts the change in total utility a person derives from consuming each additional steak. Exhibit 2: Total and Marginal Utility

© 2005 Thomson 19 Gottheil - Principles of Economics, 4e In Exhibit 2, the curves in Panel a and b represent: When marginal utility is zero, total utility is maximized. Exhibit 2: Total and Marginal Utility

© 2005 Thomson 20 Gottheil - Principles of Economics, 4e What Is Marginal Utility? If water is necessary for life, then the market price of water so much lower than for diamonds because: Market price reflects marginal utility, not total utility. Due to diminishing marginal utility and the abundance of water, the marginal utility of water is lower than for diamonds.

© 2005 Thomson 21 Gottheil - Principles of Economics, 4e A hypothetical circumstance in which the marginal utility of water might exceed the marginal utility of a diamond: If you are lost in the desert and are severely dehydrated, then your marginal utility for a gallon of water might exceed your marginal utility for a diamond. What is Marginal Utility?

© 2005 Thomson 22 Gottheil - Principles of Economics, 4e French Cuisine and Marginal Utility Many courses, each with small portions of food (French cuisine), may generate more utility than one course with a large portion of food because: One large portion will drive down marginal utility. Marginal utility is high for the whole meal.

© 2005 Thomson 23 Gottheil - Principles of Economics, 4e EXHIBIT 3MARGINAL UTILITIES OF CLOTHES AND AMUSEMENT GOODS (UTILS)

© 2005 Thomson 24 Gottheil - Principles of Economics, 4e Exhibit 3: Marginal Utilities of Clothes and Amusement Goods (Utils) Based on the utility data in Exhibit 3, a rational consumer will select the best combination of clothes and amusement goods: By sequentially picking units of clothing and amusement goods that generate the largest MU/P.

© 2005 Thomson 25 Gottheil - Principles of Economics, 4e EXHIBIT 4MARGINAL-UTILITY-TO-PRICE RATIOS OF CLOTHES AND AMUSEMENT GOODS (MU/P)

© 2005 Thomson 26 Gottheil - Principles of Economics, 4e Exhibit 4: Marginal-Utility-to-Price Ratios of Clothes and Amusement Goods (MU/P) If a unit of clothes and amusement goods both cost $10, and if you have $80 to spend, the rational consumer will spend her money: MU/P is equal when three units of clothes and five units of amusement goods are purchased (MU/P = 1.4).

© 2005 Thomson 27 Gottheil - Principles of Economics, 4e Marginal-Utility-to-Price Ratio Marginal-utility-to-price ratio The ratio is calculated by dividing the marginal utility of a good by the price of the good—MU/P.

© 2005 Thomson 28 Gottheil - Principles of Economics, 4e Marginal-Utility-to-Price Ratio The MU/P equalization principle A person’s total utility is maximized when the ratios of marginal utility to price for the last unit of each of the goods consumed are equal.

© 2005 Thomson 29 Marginal-Utility-to-Price Ratio The MU/P equalization principle: MU/P measures marginal utility per dollar spent. Total utility will be maximized (within the constraints of a limited budget) when each individual purchase generates the largest possible MU/P.

© 2005 Thomson 30 Gottheil - Principles of Economics, 4e Marginal-Utility-to-Price Ratio The MU/P equalization principle: A rational and fully-informed consumer will always shift a dollar from a good whose MU/P is lower to one whose MU/P is higher, if such a shift is possible.

© 2005 Thomson 31 Marginal-Utility-to-Price Ratio The MU/P equalization principle: The principle is based on consumer behavior. Consumers will always arrange their sequence of choices among goods starting with the highest MU/P and running down to exhaust an expenditure budget.

© 2005 Thomson 32 Gottheil - Principles of Economics, 4e Marginal-Utility-to-Price Ratio The MU/P equalization principle: The consumer choice process is in equilibrium when: There is no longer any incentive for the consumer to rearrange her purchases. The MU/P is equal for the last unit of each good or service consumed.

© 2005 Thomson 33 Gottheil - Principles of Economics, 4e EXHIBIT 5COMPARING MU/Ps AFTER A 20-PERCENT- OFF SALE ON CLOTHES

© 2005 Thomson 34 Gottheil - Principles of Economics, 4e Exhibit 5: Comparing MU/Ps After a 20 Percent Off Sale on Clothes The MU/P of clothes changes when there is a 20 percent off sale on clothes by: MU/P for each unit of clothing rises when price is reduced by 20 percent. This will cause a rational consumer to consume more clothes.

© 2005 Thomson 35 Gottheil - Principles of Economics, 4e EXHIBIT 6COMPARING MU/Ps AFTER A 50-PERCENT- OFF SALE ON CLOTHES

© 2005 Thomson 36 Gottheil - Principles of Economics, 4e Exhibit 6: Comparing MU/Ps After a 50 Percent Off Sale on Clothes An additional reduction in the price of clothing will change all of the MU/Ps for clothing, and thus change a rational consumer’s consumption of clothing. If the price of clothes falls again, from $8 to $5, the quantity of clothing demanded increases from four to six units.

© 2005 Thomson 37 Gottheil - Principles of Economics, 4e EXHIBIT 7THE DEMAND CURVE FOR CLOTHES

© 2005 Thomson 38 Gottheil - Principles of Economics, 4e Exhibit 7: The Demand Curve for Clothes When the price of clothing falls from $10 to $8 to $5, which of the following occurs: Quantity demanded remains the same. Quantity demanded falls from 6 to 4 to 3. Quantity demanded rises from 3 to 4 to 6.

© 2005 Thomson 39 Gottheil - Principles of Economics, 4e Exhibit 7: The Demand Curve for Clothes When the price of clothing falls from $10 to $8 to $5, which of the following occurs: Quantity demanded remains the same. Quantity demanded falls from 6 to 4 to 3. Quantity demanded rises from 3 to 4 to 6.

© 2005 Thomson 40 Gottheil - Principles of Economics, 4e MU/P Equalization Principle and the Law of Demand Changes in the marginal-utility- to-price ratio are caused by: A change in the marginal utility of a good or a change in the price of a good changes the marginal-utility-to-price ratio, and therefore changes quantity demanded.

© 2005 Thomson 41 Gottheil - Principles of Economics, 4e MU/P Equalization Principle and the Law of Demand The relationship between the MU/P Principle and the Law of Demand: If the price of a good falls: MU/P rises. The rational consumer will increase her consumption of that good. Increase in quantity demanded (movement along the demand curve).

© 2005 Thomson 42 MU/P Equalization Principle and the Law of Demand The relationship between the MU/P Principle and the Law of Demand: If consumer preference for a good decreases: MU/P declines. The rational consumer will reduce consumption. The demand curve shifts to the left (since consumer preference is a nonprice factor).

© 2005 Thomson 43 Gottheil - Principles of Economics, 4e MU/P Equalization Principle and the Law of Demand The relationship between the MU/P Principle and the Law of Demand: If consumer income increases: The consumer can pursue a lower MU/P. The consumer can afford to increase consumption. An increase in the demand for normal goods.

© 2005 Thomson 44 Gottheil - Principles of Economics, 4e MU/P Equalization Principle and the Law of Demand A downward-sloping demand curve is consistent with the law of diminishing marginal utility. Diminishing marginal utility means that MU/P declines as quantity consumed increases.

© 2005 Thomson 45 Gottheil - Principles of Economics, 4e MU/P Equalization Principle and the Law of Demand A downward-sloping demand curve is consistent with the law of diminishing marginal utility. A consumer’s willingness-to-pay falls as quantity consumed increases.

© 2005 Thomson 46 Gottheil - Principles of Economics, 4e Are White Rats Rational Consumers? There is evidence that lab rats make consumer choices based on MU/P. Economists Battalio and Kagel found that white lab rats respond to price and income changes in a manner consistent with economic theory.

© 2005 Thomson 47 Gottheil - Principles of Economics, 4e The MU/P Guide to Auction Bidding MU/P can help guide auction bidding: If a particular MU/P is guaranteed by buying something outside of the auction, and if the marginal utility from the auction good is known, then you can figure out your maximum auction price.

© 2005 Thomson 48 Gottheil - Principles of Economics, 4e Creating Consumer Surplus Consumer surplus The difference between the maximum price a person would be willing to pay for a good or service, and the price the person actually pays. Most consumers receive some consumer surplus from a transaction.

© 2005 Thomson 49 Gottheil - Principles of Economics, 4e Creating Consumer Surplus When market price falls, consumer surplus increases.

© 2005 Thomson 50 Gottheil - Principles of Economics, 4e Creating Consumer Surplus If the price of a good is greater than amount a consumer is willing to pay for that good, the consumer surplus will be negative if the consumer buys the good.

© 2005 Thomson 51 Gottheil - Principles of Economics, 4e Creating Consumer Surplus A rational consumer will not purchase a good that generates negative consumer surplus. A rational consumer will prefer zero consumer surplus (no purchase) to negative consumer surplus.

© 2005 Thomson 52 EXHIBIT 8THE MARKET FOR HORSEBACK RIDING

© 2005 Thomson 53 Gottheil - Principles of Economics, 4e Exhibit 8: The Market for Horseback Riding Exhibit 8 depicts the demand and supply curves for horseback riding. The concept of consumer surplus applies to horseback riding: At a price of $6, all consumers with a willingness-to-pay value of $6 or more will purchase a horseback ride. These consumers receive consumer surplus.

© 2005 Thomson 54 Gottheil - Principles of Economics, 4e Exhibit 8 depicts the demand and supply curves for horseback riding. The concept of consumer surplus applies to horseback riding: Some consumer may be willing to pay $10 for a horseback ride. This consumer will receive $(10 - 6) = $4 of consumer surplus. Exhibit 8: The Market for Horseback Riding

© 2005 Thomson 55 Exhibit 8 depicts the demand and supply curves for horseback riding. The concept of consumer surplus applies to horseback riding: A consumer who has a willingness-to-pay value less than $6: Will not choose to purchase a ride (a rational consumer). Has a negative consumer surplus. Exhibit 8: The Market for Horseback Riding

© 2005 Thomson 56 Gottheil - Principles of Economics, 4e EXHIBIT 9CONSUMER SURPLUS ON THE HORSEBACK- RIDING MARKET

© 2005 Thomson 57 Gottheil - Principles of Economics, 4e Exhibit 9: Consumer Surplus on the Horseback-Riding Market Kim’s consumer surplus from horseback riding is: $(15 - 6) for the first ride. $(12 - 6) for the second ride. $(9 - 6) for the third ride. $(6 - 6) for the fourth ride. These sum to $( ) = $18.

© 2005 Thomson 58 Gottheil - Principles of Economics, 4e Exhibit 9: Consumer Surplus on the Horseback-Riding Market Tony’s consumer surplus from horseback riding is: $(10 - 6) for the first ride. $(8 - 6) for the second ride. $(6 - 6) for the fourth ride. These sum to $( ) = $6.

© 2005 Thomson 59 Gottheil - Principles of Economics, 4e Exhibit 9: Consumer Surplus on the Horseback-Riding Market Randy’s consumer surplus from horseback riding is: $(9 - 6) for the first ride. $(6 - 6) for the fourth ride. These sum to $(3 + 0) = $3.

© 2005 Thomson 60 Gottheil - Principles of Economics, 4e Exhibit 9: Consumer Surplus on the Horseback-Riding Market If Kim, Tony and Randy represent the entire market demand for horseback riding, the total consumer surplus is: $18 (Kim) + $6 (Tony) + $3 (Randy) = $27 in consumer surplus

© 2005 Thomson 61 Gottheil - Principles of Economics, 4e Interpersonal Comparisons of Utility An interpersonal comparison of utility It is a comparison of the marginal utilities that different people derive from a good or a dollar.

© 2005 Thomson 62 Gottheil - Principles of Economics, 4e Interpersonal Comparisons of Utility Is it actually possible to compare the satisfaction that different people derive from a good or a dollar? It is not possible to make an exact comparison of different peoples’ utility.

© 2005 Thomson 63 Gottheil - Principles of Economics, 4e Interpersonal Comparisons of Utility Is it actually possible to compare the satisfaction that different people derive from a good or a dollar? Policies such as those aimed at poverty alleviation rely on society being able to make approximate or reasonable comparisons of utility across different people.