Chapter 21: Consumer Choice ECON 152 – PRINCIPLES OF MICROECONOMICS Chapter 21: Consumer Choice Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

Utility Theory Utility Utility Analysis Util The want-satisfying power of a good or service Utility Analysis The analysis of consumer decision making based on utility maximization Util A representative unit by which utility is measured

Utility Theory Marginal Utility The change in total utility due to a one-unit change in the quantity of a good or service consumed Marginal utility = change in total utility change in number of units consumed

Total and Marginal Utility of Watching DVDs Figure 20-1, Panel (a)

Total and Marginal Utility of Watching DVDs Total utility is maximized... DVDs Watched per Week Total Utility (utils per week) 1 2 3 4 5 6 7 8 10 12 14 16 18 20 Figure 20-1, Panels (b) and (c) Marginal Utility (utils per week) 1 2 3 5 6 7 -4 -2 4 8 10 DVDs Watched per Week …where marginal utility equals zero.

Total and Marginal Utility of Watching Videos Observations Marginal utility falls as more is consumed Marginal utility equals zero when total utility is at its maximum

Diminishing Marginal Utility The principle that as more of any good or service is consumed, its extra benefit declines Increases in total utility from consumption of a good or service become smaller and smaller as more is consumed during a given time period

Optimizing Consumption Choices Consumer Optimum A choice of a set of goods and services that maximizes the level of satisfaction for each consumer, subject to limited income

Total and Marginal Utility from Consuming DVDs and Pizza Slices on an Income of $26 Total Utility Marginal Utility DVDs of DVDs per Marginal Utility per Dollar per Period (utils) Spent (MUd/Pd) Period (utils) MUd (Price = $5) 0 0.0 —— —— 1 50.0 50.0 10.0 2 95.0 45.0 9.0 3 135.0 40.0 8.0 4 171.5 36.5 7.3 5 200.0 28.5 5.7 Table 20-1

Total and Marginal Utility from Consuming DVDs and Pizza Slices on an Income of $26 Total Utility Marginal Utility Pizza Slices of Pizza Slices Marginal Utility per Dollar per per Period (utils) Spent (MUpPp) Period (utils) MUp (price = $3) 0 0.0 —— —— 1 25 25 8.3 2 47 22 7.3 3 65 18 6.0 4 80 15 5.0 5 89 9 3.0 Table 20-1

Total and Marginal Utility from Consuming DVDs and Pizza Slices on an Income of $26 Marginal Utility Marginal Utility Items per Dollar per Dollar per Spent (DVD) Spent (Pizza) Period (price = $5) (price = $3) 0 —— —— 1 10.0 8.3 2 9.0 7.3 3 8.0 6.0 4 7.3 5.0 5 5.7 3.0 Table 20-1

Steps to Consumer Optimum Buying Decision Remaining Income First DVD $26 - $5 = $21 Second DVD $21 - $5 = $16 First pizza slice $16 - $3 = $13 Third DVD $13 - $5 = $ 8 Fourth DVD and $8 - $5 = $ 3 Second pizza slice $3 - $3 = $ 0 Table 20-2

Optimizing Consumption Choices A little math The rule of equal marginal utilities per dollar spent A 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

Optimizing Consumption Choices A little math The rule of equal marginal utilities per dollar spent MU of good A price of good A = MU of good B price of good B MU of good Z price of good Z ...

How a Price Change Affects Consumer Optimum Income = $26 Qd = 4 MUd Pd 36.5 5 = = 7.3 Qp = 2 MUp Pp 22 3 = = 7.3

How a Price Change Affects Consumer Optimum Assume Price of DVDs Falls to $4 Qd = 4 MUd Pd 36.5 4 = = 9.13 Qp = 2 MUp Pp 22 3 = = 7.3

How a Price Change Affects Consumer Optimum Assume Price of DVDs Falls to $4 Now MUd Pd > MUp Pp Result Buy more DVDs and MUd falls

DVD Rental Prices and Marginal Utility 5 Price per Unit ($ per DVD) Change “Video” to DVD B 4 1 2 3 Figure 20-2 DVD Rentals per Week

How a Price Change Affects Consumer Optimum The Substitution Effect The tendency of people to substitute cheaper commodities for more expensive commodities Purchasing Power The value of money for buying goods and services Real-Income Effect The change in people’s purchasing power that occurs when, other things being constant, the price of one good that they purchase changes

Chapter 21: Consumer Choice ECON 152 – PRINCIPLES OF MICROECONOMICS Chapter 21: Consumer Choice Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

Indifference Curve Analysis ECON 152 – PRINCIPLES OF MICROECONOMICS Appendix E Indifference Curve Analysis Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.

Figure E-1 Combinations That Yield Equal Levels of Satisfaction

Figure E-2 Indifference Curves: Impossibility of an Upward Slope

Figure E-3 Implications of a Straight-Line Indifference Curve

Table E-1 Calculating the Marginal Rate of Substitution

Figure E-4 A Set of Indifference Curves

Figure E-5 The Budget Constraint

Figure E-6 Consumer Optimum

Deriving Demand Curve from Indifference Analysis If the price of meals drops, the consumer can buy more. The Budget Constraint shifts outward along the meals axis. The new point of indifference will be at a higher quantity per week. Thus, lower P, higher QD.

Indifference Curve Analysis ECON 152 – PRINCIPLES OF MICROECONOMICS Appendix E Indifference Curve Analysis Materials include content from Pearson Addison-Wesley which has been modified by the instructor and displayed with permission of the publisher. All rights reserved.