1. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.1 Chapter 7: The Logic of Individual Choice: The Foundation of Supply and Demand Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology

2. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 2 Chapter Objectives 1a. Explain why economists can believe there are many explanations of individual choice but nonetheless focus on self-interest. 1b. Discuss the principle of diminishing marginal utility. 2. Summarize the principle of rational choice.

3. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 3 Chapter Objectives 3. Explain why a consumer is maximizing total utility when MU X /P X = MU Y /P Y. 4. Explain how the principle of rational choice accounts for the Law of Demand. 5. Explain four alternative rules for decision- making.

4. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 4 Chapter Objectives 6a. Illustrate how economists use indifference curves to represent people’s preferences. 6b. Use indifference curves to demonstrate how a person maximizes utility given a limited income.

5. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 5 Utility Theory and Individual Choice According to economists, we behave the way we do because of rational self interest. Individuals want to maximize the amount of satisfaction they receive through consuming goods and services.

6. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 6 Measuring Pleasure Economists use the concept of utility—the pleasure or satisfaction that one gets from consuming a good or service. A util is a unit of satisfaction created by economists to “measure” utility.

7. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 7 Total Utility and Marginal Utility It is important to distinguish between marginal and total utility. Total utility refers to the satisfaction one gets from one’s consumption of a product.

8. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 8 Marginal Utility Marginal utility refers to the satisfaction you get from the consumption of one additional unit of a product above and beyond what you have consumed up to that point.

9. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 9 Diminishing Marginal Utility The principle of diminishing marginal utility – after some point, the marginal utility received from each additional unit of a good will begin to decrease with each additional unit consumed.

10. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 10 Pizza slices 1 2 3 4 5 6 7 8 9 Total utility 14 26 36 44 50 54 56 54 Marginal utility 14 12 10 8 6 4 2 0 -2 Marginal and Total Utility

11. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 11 Total utilityMarginal utility Slices of pizza per hour 70 60 50 40 30 20 10 0 123456789 Slices of pizza per hour 16 14 12 10 8 6 4 2 0 -2 123456789 Marginal and Total Utility Total utility Marginal utility

12. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 12 Maximizing Utility Q 0 1 2 3 4 5 6 7 TU 0 20 32 38 41 36 26 MU 20 12 6 3 0 -5 -10 MU/P 10 6 3 1.5 0 -2.5 -5 Q 0 1 2 3 4 5 6 7 TU 0 29 46 53 56 57 53 MU 29 17 7 3 1 0 -4 MU/P 29 17 7 3 1 0 -4 Hamburgers (P = $2)Ice Cream (P = $1)

13. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 13 Maximizing Utility Total $ spent Purchase?MU/PMU $11 st ice cream cone29 $22 nd ice cream cone17 $41 st hamburger1020 $53 rd ice cream cone77 $72 nd hamburger612 $93 rd hamburger36 $104 th ice cream cone33 Total utility = 94 utils

14. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 14 Rational Choice and Marginal Utility If MUx/Px > MUz/Pz, consume more of good x. If MUy/Py > MUz/Pz, consume more of good y. When you are maximizing utility

15. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 15 Opportunity Cost Opportunity cost is the benefit forgone of the next-best alternative.  It is essentially the marginal utility per dollar you forgo.

16. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 16 Cost of Decision Making A number of economists believe that most people use bounded rationality rather than using the rational choice model. Bounded rationality means rationality based on rules of thumb.

17. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 17 Cost of Decision Making We employ a variety of simple rules to make some of our decisions:  Price conveys information  Follow the leader  Habit  Custom

18. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 18 Graph the Budget Line The budget constraint represents all the combinations of two goods that a person can afford to buy with a given income. The budget constraint is also called the income constraint, or budget line.

19. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 19 Budget Constraint Chocolate bars cost $1 and pop costs 50 cents a can. Ella has $10 to spend. She can buy 10 chocolate bars or 20 cans of pop or some combination of both.

20. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 20 Budget Line 0 2 4 6 8 10 2 4 6 8 10 12 14 16 18 20 22 Chocolate bars Cans of pop Slope = - P pop /P chocolate = - ½ Income = $10

21. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 21 Budget Line Rotates 0 2 4 6 8 10 2 4 6 8 10 12 14 16 18 20 22 Chocolate bars Cans of pop Slope = - P pop /P chocolate = - 1 Income = $10 Pop Price = $1

22. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 22 Indifference Curve Indifference curve – a curve that shows combinations of goods amongst which an individual is indifferent. The slope of the indifference curve is the ratio of marginal utilities of the two goods.

23. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 23 Indifference Curve 0 4 8 12 16 20 2 4 6 8 10 12 14 16 18 20 22 Chocolate bars Cans of pop |Slope|= MU pop /MU chocolate bars = MRS of pop for chocolate bars U A B C D E Indifference curve

24. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 24 The slope of the indifference curve is called the marginal rate of substitution (MRS). Marginal rate of substitution – the rate at which one good must be added when the other is taken away in order to keep the individual indifferent between the two combinations. Marginal Rate of Substitution

25. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 25 Law of diminishing marginal rate of substitution – for each additional unit of a good, the smaller the amount of the other good needed to be given up to keep you on your original indifference curve. Marginal Rate of Substitution

26. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 26 Mapping of Indifference Curves 0 4 8 12 16 20 2 4 6 8 10 12 14 16 18 20 22 Chocolate bars Cans of pop U2U2 A B C D E U 1 U 3

27. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 27 0 4 8 12 16 20 2 4 6 8 10 12 14 16 18 20 22 Chocolate bars Cans of pop U1U1 A B C D U2U2 A is preferred to B C is preferred to D B is indifferent to C Thus, A is preferred to D. ???? Indifference Curves Cannot Cross

28. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 28 Ella will maximize her utility by consuming on the highest indifference curve possible, given her budget constraint. The best combination is the point where the indifference curve and the budget line are tangent. Maximizing Utility

29. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 29 0 4 8 12 16 20 2 4 6 8 10 12 14 16 18 20 22 Chocolate bars Cans of pop U2U2 U1U1 Slope= -P pop /P chocolate bars Maximizing Utility U3U3 Slope= -MU pop /MU chocolate bars

30. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 30 The best combination is the point where the slope of the budget line equals the slope of the indifference curve. Maximizing Utility

31. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.31 The Logic of Individual Choice: The Foundation of Supply and Demand End of Chapter 7

32. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.32 Chapter 7 Appendix Describing Consumer Preferences Using Indifference Curves

33. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 33 Income Expansion Path U1U1 U2U2 U3U3 U3U3 U2U2 U1U1 IEP Good Y Good X a) Normal good a) Inferior good

34. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 34 Engel Curves Quantity Demanded Income X1X1 X2X2 X3X3 Income elastic normal good (luxury) Income inelastic normal good (necessity) Inferior good

35. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 35 Price Expansion Path Good Y Good X B/(Px) 1 B/Py B/(Px) 2 PEP U1U1 U2U2

36. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 36 Income Effect Income effect reflects the purchasing power change as a result of the change in price.  With a price decrease we can afford to buy more – a purchasing power increase.  With a price increase we can afford to buy less – a purchasing power decrease.

37. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 37 Substitution Effect Substitution effect reflects our willingness to switch consumption away from goods that become relatively more expensive.  If the relative price of a good falls, we buy more of it;  At the same time, we buy less of the relatively more expensive product.

38. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 38 Income and Substitution Effects Good Y Good X B/(Px) 1 B/Py B/(Px) 2 PEP U1U1 U2U2 E F G Substitution Effect Income Effect Normal Good

39. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 39 Good Y Good X B/(Px) 1 B/Py B/(Px) 2 PEP U1U1 U2U2 E F G Substitution Effect Income Effect Inferior Good Income and Substitution Effects

40. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 40 Good Y Good X PEP A B C X1X1 X2X2 X3X3 Price-expansion path B/P 1 B/P 2 B/P 3 Derive the Demand Curve for Good X

41. © 2006 McGraw-Hill Ryerson Limited. All rights reserved. 41 Derive the Demand Curve for Good X Price of Good X Quantity of Good X A B C X1X1 X2X2 X3X3 Demand P1P1 P2P2 P3P3 Demand Curve

42. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.42 Describing Consumer Preferences Using Indifference Curves End of Chapter 7 Appendix