Consumer choices The Benefit Side of Demand Chapter 5

2 Recall: The Law of Demand People do less of what they want to do as the cost of doing it rises The benefit of an activity equals the highest price we ’ d be willing to pay to pursue it (i.e., the reservation price). As the cost of an activity rises and exceeds the reservation price, less of the activity will be pursued.

3 The difference among needs, wants and demand Needs: minimum requirement to stay alive Wants: –“ tastes ” or “ preferences ” –quality of life –living standard –satisfaction Demand: –Willingness –Ability

4 Translating Wants into Demand Measuring Wants: The Concept of Utility –Utility The satisfaction people derive from their consumption activities –Assumption People allocate their income to maximize their satisfaction or total utility

5 Utility Total utility: –Total satisfaction from consuming a certain amount of goods and services Average utility: –Average satisfaction from consuming each unit of goods and services –AU = TU / Q Marginal utility: –Additional utility from consuming one additional unit of goods and services –MU = change in TU / change in Q

6 Example: QTUAUMU 00/

7 Sarah ’ s Total Utility from Ice Cream Consumption Figure 5.2, p.130 Based on table 5.1, p.129

8 Diminishing Marginal Utility Figure 5.3, p. 131 Based on Table 5.2, p.130

9 Key Points TU first increases then max out and starts to decrease TU increases at a slower pace TU is maximized when MU=0 MU is decreasing but positive when TU is increasing MU is decreasing and negative when TU is decreasing MU = 0 when TU is maximized

10 Decision Rule The goal: max TU Decision rule: –Increase Q as long as MU > 0 –consume up to Q when MU = 0

11 In the example Did not consider cost One product: no trade-off  introduce cost  include other products --to represent consumption bundle --to show trade-off

12 Translating Wants into Demand The Law of Diminishing Marginal Utility –The tendency for the additional utility gained from consuming an additional unit of a good to diminish as consumption increases beyond some point

13 Translating Wants into Demand Allocating a fixed income between two goods –Assume Two goods: Chocolate and vanilla ice cream Price of chocolate equals $2/pint Price of vanilla equals $1/pint Sarah ’ s budget = $400/yr Currently Sarah is consuming 200 pints of vanilla and 100 pints of chocolate Question –Is Sarah maximizing her total utility?

14 Marginal Utility Curves for Two Flavors of Ice Cream (II) Figure 5.5, p. 133

15 Translating Wants into Demand At 200 vanilla and 100 chocolate –Marginal utility vanilla/P $12/1 = 12 utils/$ –Marginal utility chocolate/P 16/2 = 8 utils/$ MU/P for vanilla not equal to MU/P for chocolate –MU/P for vanilla higher than MU/P for chocolate –Increase Q for vanilla to reduce MU for V –Decrease Q for chocolate to increase MU for Ch Until MU/P for vanilla = MU/P for chocolate

16 Optimal Consumption Figure 5.6, p.134

17 Translating Wants into Demand The Rational Spending Rule –Spending should be allocated across goods so that the marginal utility per dollar is the same for each good.

18 Translating Wants into Demand The Rational Spending Rule –How is the rational spending rule related to the cost-benefit principle? –How should Sarah respond to a reduction in the price of chocolate ice cream?

19 Translating Wants into Demand Assume –Budget = $400 –P C = $2 & P V = $1 –Q C = 75 & Q V = 250

20 Translating Wants into Demand Assume –Price of chocolate falls to $1