© 2005 McGraw-Hill Ryerson Ltd. 1 Microeconomics, Chapter 6 The Theory of Consumer Choice SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE

© 2005 McGraw-Hill Ryerson Ltd. 2 Microeconomics, Chapter 6 In this chapter you will learn 6.1 The two explanations for why the demand curve is downward sloping 6.2 The theory of consumer choice 6.3 The connection between utility maximization and the demand curve 6.4 To apply marginal utility theory to real world situations 6.5 What consumer surplus is and how to measure it

© 2005 McGraw-Hill Ryerson Ltd. 3 Microeconomics, Chapter 6 Chapter 6 Topics 6.1 A Closer Look at The Law of Demand 6.2 Theory of Consumer Choice 6.3 Utility Maximization and the Demand Curve 6.4 Applications & Extensions 6.5 Consumer Surplus

© 2005 McGraw-Hill Ryerson Ltd. 4 Microeconomics, Chapter 6 Income & Substitution Effects u The Income Effect  A lower price frees income for additional purchases - and vice versa u The Substitution Effect  A lower price relative to other goods attracts new buyers - and vice versa

© 2005 McGraw-Hill Ryerson Ltd. 5 Microeconomics, Chapter 6 Law of Diminishing Marginal Utility u gains in satisfaction decline as additional units are consumed u Terminology  utility is want-satisfying power u Total & Marginal Utility  total utility: total amount of satisfaction  marginal utility: extra satisfaction from consuming one more unit graphically examined....

Tacos consumed per meal Total Utility Marginal Utility  TU Total and Marginal Utility Figure 6-1 © 2005 McGraw-Hill Ryerson Ltd. 6 Microeconomics, Chapter 6

Tacos consumed per meal Total Utility Marginal Utility  TU Total and Marginal Utility Figure 6-1 © 2005 McGraw-Hill Ryerson Ltd. 7 Microeconomics, Chapter 6

Tacos consumed per meal Total Utility Marginal Utility  TU Total and Marginal Utility Figure 6-1 © 2005 McGraw-Hill Ryerson Ltd. 8 Microeconomics, Chapter 6

Tacos consumed per meal Total Utility Marginal Utility  TU Total and Marginal Utility 10 Figure 6-1 © 2005 McGraw-Hill Ryerson Ltd. 9 Microeconomics, Chapter 6

Tacos consumed per meal Total Utility Marginal Utility  TU Total and Marginal Utility 10 8 Figure 6-1 © 2005 McGraw-Hill Ryerson Ltd. 10 Microeconomics, Chapter 6

Tacos consumed per meal Total Utility Marginal Utility  TU Total and Marginal Utility Figure 6-1 © 2005 McGraw-Hill Ryerson Ltd. 11 Microeconomics, Chapter 6

Tacos consumed per meal Total Utility Marginal Utility  TU Total and Marginal Utility ObserveDiminishingMarginalUtility Figure 6-1 © 2005 McGraw-Hill Ryerson Ltd. 12 Microeconomics, Chapter 6

© 2005 McGraw-Hill Ryerson Ltd. 13 Microeconomics, Chapter 6 Marginal Utility, Demand & Elasticity u if marginal utility falls rapidly for each successive unit… u it will take a considerable drop in price to cause an increase in quantity demanded… u so demand is fairly… u INELASTIC

© 2005 McGraw-Hill Ryerson Ltd. 14 Microeconomics, Chapter 6 Chapter 6 Topics 6.1 A Closer Look at The Law of Demand 6.2 Theory of Consumer Choice 6.3 Utility Maximization and the Demand Curve 6.4 Applications & Extensions 6.5 Consumer Surplus

© 2005 McGraw-Hill Ryerson Ltd. 15 Microeconomics, Chapter 6 Theory of Consumer Choice A Typical Consumer.… u Exhibits rational behavior u Knows clear-cut preferences u Is subject to a budget constraint u Responds to price changes

© 2005 McGraw-Hill Ryerson Ltd. 16 Microeconomics, Chapter 6 Utility Maximizing Rule u The consumer’s money income should be allocated so that the last dollar spent on each product purchased yields the same amount of extra (marginal) utility

© 2005 McGraw-Hill Ryerson Ltd. 17 Microeconomics, Chapter 6 Numerical Example u First, put the marginal utilities into a per- dollar-spent basis u Decision-making process: at each step, spend where the marginal utility per dollar is highest

Product A p=$1 Product B p=$2 unit of product marginal utility MU/pMUMU/p 1 st nd rd th th th 46 7 th Table 6-1 © 2005 McGraw-Hill Ryerson Ltd. 18 Microeconomics, Chapter 6

MU/p, Product A MU/p, Product B 1 st nd rd th th th th 3 2Spending Product A Product B $21 $311 $21 $311$1042 Decision-Making Process © 2005 McGraw-Hill Ryerson Ltd. 19 Microeconomics, Chapter 6 What will the consumer buy first? And next?

© 2005 McGraw-Hill Ryerson Ltd. 20 Microeconomics, Chapter 6 Utility Maximization u at each step, spend where MU/$ is highest u in general, if MU/$ is unequal, spending should be allocated  away from the good where MU/$ is low  toward the good where MU/$ is high

© 2005 McGraw-Hill Ryerson Ltd. 21 Microeconomics, Chapter 6 Algebraic Restatement of the Utility Maximization Rule MU of product A Price of A MU of product B Price of B =

© 2005 McGraw-Hill Ryerson Ltd. 22 Microeconomics, Chapter 6 Chapter 6 Topics 6.1 A Closer Look at The Law of Demand 6.2 Theory of Consumer Choice 6.3 Utility Maximization and the Demand Curve 6.4 Applications & Extensions 6.5 Consumer Surplus

© 2005 McGraw-Hill Ryerson Ltd. 23 Microeconomics, Chapter 6 Utility Maximization & the Demand Curve Deriving the Demand Curve u what if the price of Product B falls to $1?

Product A p=$1 Product B p=$1 unit of product marginal utility MU/pMUMU/p 1 st nd rd th th th 46 7 th Table 6-1 © 2005 McGraw-Hill Ryerson Ltd. 24 Microeconomics, Chapter 6

MU/p, Product A MU/p, Product B 1 st nd rd th th th th 3 4Spending Product A Product B Decision-making Process $11 $11 $11 $11 $11 $11$11 $11 $1064 $11 1 © 2005 McGraw-Hill Ryerson Ltd. 25 Microeconomics, Chapter 6

© 2005 McGraw-Hill Ryerson Ltd. 26 Microeconomics, Chapter 6 u when p Product B =$2  the quantity demanded is 4 u when p Product B =$1  the quantity demanded is 6 Utility Maximization & the Demand Curve

Product B pricequantity demanded $1 $ $1 $2 D 6 price quantity demanded Utility Maximization & the Demand Curve Figure 6-2 © 2005 McGraw-Hill Ryerson Ltd. 27 Microeconomics, Chapter 6

© 2005 McGraw-Hill Ryerson Ltd. 28 Microeconomics, Chapter 6 u Substitution Effect  when the price of Product B falls, there is a substitution of now cheaper B u Income Effect  increase in real income increases consumption of both A & B Utility Maximization & the Demand Curve

© 2005 McGraw-Hill Ryerson Ltd. 29 Microeconomics, Chapter 6 Chapter 6 Topics 6.1 A Closer Look at The Law of Demand 6.2 Theory of Consumer Choice 6.3 Utility Maximization and the Demand Curve 6.4 Applications & Extensions 6.5 Consumer Surplus

© 2005 McGraw-Hill Ryerson Ltd. 30 Microeconomics, Chapter 6 Applications & Extensions u DVDs & DVD Players

© 2005 McGraw-Hill Ryerson Ltd. 31 Microeconomics, Chapter 6 Applications & Extensions u DVDs & DVD Players u The Diamond-Water Paradox

© 2005 McGraw-Hill Ryerson Ltd. 32 Microeconomics, Chapter 6 Applications & Extensions u DVDs & DVD Players u The Diamond-Water Paradox u The Value of Time

© 2005 McGraw-Hill Ryerson Ltd. 33 Microeconomics, Chapter 6 Applications & Extensions u DVDs & DVD Players u The Diamond-Water Paradox u The Value of Time u Cash & Non-cash Gifts

© 2005 McGraw-Hill Ryerson Ltd. 34 Microeconomics, Chapter 6 Chapter 6 Topics 6.1 A Closer Look at The Law of Demand 6.2 Theory of Consumer Choice 6.3 Utility Maximization and the Demand Curve 6.4 Applications & Extensions 6.5 Consumer Surplus

© 2005 McGraw-Hill Ryerson Ltd. 35 Microeconomics, Chapter 6 Consumer Surplus u the difference between the maximum price a consumer is will to pay for something & its market price is called consumer surplus u one of the key elements in cost-benefit analysis

© 2005 McGraw-Hill Ryerson Ltd. 36 Microeconomics, Chapter 6 D=MB Q market price Q* Consumer Surplus Vijay’s consumer surplus Figure 6-3

© 2005 McGraw-Hill Ryerson Ltd. 37 Microeconomics, Chapter 6 D=MB Q market price amountpaid Q* total consumer surplus Consumer Surplus Figure 6-3

© 2005 McGraw-Hill Ryerson Ltd. 38 Microeconomics, Chapter 6 Chapter 6 Topics 6.1 A Closer Look at The Law of Demand 6.2 Theory of Consumer Choice 6.3 Utility Maximization and the Demand Curve 6.4 Applications & Extensions 6.5 Consumer Surplus

© 2005 McGraw-Hill Ryerson Ltd. 39 Microeconomics, Chapter 6 Indifference Curve Analysis Appendix to Chapter 6

© 2005 McGraw-Hill Ryerson Ltd. 40 Microeconomics, Chapter 6 Quantity of A Quantity of B The Budget Line Units of A (p=$1.50) Units of B (p=$1.00) Total expenditure 80$12 63$12 46$12 29$12 012$12

© 2005 McGraw-Hill Ryerson Ltd. 41 Microeconomics, Chapter 6 Quantity of A Quantity of B The Budget Line Units of A (p=$1.50) Units of B (p=$1.00) Total expenditure 80$12 63$12 46$12 29$12 012$12

© 2005 McGraw-Hill Ryerson Ltd. 42 Microeconomics, Chapter 6 Quantity of A Quantity of B The Budget Line Units of A (p=$1.50) Units of B (p=$1.00) Total expenditure 80$12 63$12 46$12 29$12 012$12

© 2005 McGraw-Hill Ryerson Ltd. 43 Microeconomics, Chapter 6 Quantity of A Quantity of B The Budget Line Units of A (p=$1.50) Units of B (p=$1.00) Total expenditure 80$12 63$12 46$12 29$12 012$12

© 2005 McGraw-Hill Ryerson Ltd. 44 Microeconomics, Chapter 6 Quantity of A Quantity of B The Budget Line Units of A (p=$1.50) Units of B (p=$1.00) Total expenditure 80$12 63$12 46$12 29$12 012$12

© 2005 McGraw-Hill Ryerson Ltd. 45 Microeconomics, Chapter 6 Attainable Quantity of A Quantity of B Unattainable The Budget Line Units of A (p=$1.50) Units of B (p=$1.00) Total expenditure 80$12 63$12 46$12 29$12 012$12

© 2005 McGraw-Hill Ryerson Ltd. 46 Microeconomics, Chapter 6 Quantity of A Quantity of B The Budget Line An increase in income makes the purchase of more of either or both items possible An increase in income makes the purchase of more of either or both items possible Income increases

© 2005 McGraw-Hill Ryerson Ltd. 47 Microeconomics, Chapter 6 Quantity of A Quantity of B The Budget Line Price changes cause a change in the quantity demanded of the items Price changes cause a change in the quantity demanded of the items Price of A rises

© 2005 McGraw-Hill Ryerson Ltd. 48 Microeconomics, Chapter 6 Quantity of A Quantity of B combination Units of A Units of B j122 k64 l46 m38 Indifference Curves j

© 2005 McGraw-Hill Ryerson Ltd. 49 Microeconomics, Chapter 6 Quantity of A Quantity of B j k combination Units of A Units of B j122 k64 l46 m38 Indifference Curves

© 2005 McGraw-Hill Ryerson Ltd. 50 Microeconomics, Chapter 6 Quantity of A Quantity of B j k l combination Units of A Units of B j122 k64 l46 m38 Indifference Curves

© 2005 McGraw-Hill Ryerson Ltd. 51 Microeconomics, Chapter 6 Quantity of A Quantity of B j k l m combination Units of A Units of B j122 k64 l46 m38 Indifference Curves

© 2005 McGraw-Hill Ryerson Ltd. 52 Microeconomics, Chapter 6 Quantity of A Quantity of B j k l m I combination Units of A Units of B j122 k64 l46 m38 Indifference Curves

© 2005 McGraw-Hill Ryerson Ltd. 53 Microeconomics, Chapter 6 Quantity of A Quantity of B j k l m I Indifference Curves Indifference curves are downsloping

© 2005 McGraw-Hill Ryerson Ltd. 54 Microeconomics, Chapter 6 Quantity of A Quantity of B j k l m I Indifference Curves Indifference curves are convex to the origin

© 2005 McGraw-Hill Ryerson Ltd. 55 Microeconomics, Chapter 6 Quantity of A Quantity of B j k l m I Indifference Curves Marginal rate of substitution (MRS) is the slope of the indifference curve at any point MRS diminishes, so curve is convex

© 2005 McGraw-Hill Ryerson Ltd. 56 Microeconomics, Chapter 6 Quantity of A Quantity of B Indifference Curves Indifference map shows a series of indifference curves, for different levels of utility I4I4 I1I1 I2I2 I3I3

© 2005 McGraw-Hill Ryerson Ltd. 57 Microeconomics, Chapter 6 Quantity of A Quantity of B Equilibrium at Tangency Point X represents the optimal attainable combination of products A & B X I4I4 I1I1 I2I2 I3I3

© 2005 McGraw-Hill Ryerson Ltd. 58 Microeconomics, Chapter 6 The Measurement of Utility u marginal utility theory assumes utility is numerically measurable u indifference curve approach requires only that a consumer specify if a particular combination of products yields more or less utility than another u at equilibrium, MRS=P B /P A u equivalent to marginal utility approach since

© 2005 McGraw-Hill Ryerson Ltd. 59 Microeconomics, Chapter 6 Quantity of A Quantity of B Derivation of the Demand Curve What happens if the price of B increases to $1.50? X I4I4 I1I1 I2I2 I3I3

© 2005 McGraw-Hill Ryerson Ltd. 60 Microeconomics, Chapter 6 Quantity of A Quantity of B Derivation of the Demand Curve New budget line reflects the price change I2I2 I3I3 I1I1 I4I4 X P B =$1.00 P B =$1.50

© 2005 McGraw-Hill Ryerson Ltd. 61 Microeconomics, Chapter 6 Quantity of A Quantity of B Derivation of the Demand Curve New equilibrium point is X ' X'X'X'X' I2I2 I3I3 I1I1 I4I4 X P B =$1.00 P B =$1.50

© 2005 McGraw-Hill Ryerson Ltd. 62 Microeconomics, Chapter 6 Quantity of A Quantity of B Derivation of the Demand Curve Recording quantities demanded of B at various prices of B yields the demand curve for B X'X'X'X' I2I2 I3I3 I1I1 I4I4 X

© 2005 McGraw-Hill Ryerson Ltd. 63 Microeconomics, Chapter 6 Quantity of A Quantity of B X'X'X'X' I2I2 I3I3 I1I1 I4I4 X PBPBPBPB QBQBQBQB$1.006 $ Price of B Quantity of B $0.50 $1.00 $1.50 DBDBDBDB Figure A6-5 We can derive the demand curve without measuring utility in utils