Consumer Choice and Demand 1
Utility Utility Analysis Sense of pleasure, or satisfaction that comes from consumption Subjective Assumption Taste are given Tastes are relatively stable 2
Total utility Utility Analysis Total satisfaction you derive from consumption Of consuming a particular good Or from all consumption Marginal utility Change in total utility from one-unit change in consumption 3
Law of Diminishing Marginal Utility Law of diminishing marginal utility The more of a good consumed The smaller the increase in total utility Other things constant Marginal utility from each additional unit Declines as more is consumed Disutility Negative marginal utility 4
Units of utility Measuring Utility Each person has a uniquely subjective utility scale Total utility Sum of marginal utilities 5
Exhibit 1 Utility Derived From Drinking Water After Running Four Miles 6
Marginal utility Total utility Exhibit 2 Total Utility and Marginal Utility You Derive From Drinking Water After Running Four Miles 80 60 40 20 0 40 20 (a) Total utility 1 2 3 (b) Marginal utility 4 5 Glasses (8-ounce) Total utility, shown in panel (a), increases with each of the first four glasses of water consumed but by smaller and smaller amounts. The fifth glass causes total utility to fall, implying that marginal utility is negative, as shown in panel (b). 0 1 2 3 4 5 Glasses (8-ounce) 7
Utility Maximization without Scarcity Free good Increase consumption as long as marginal utility is positive Two free goods Increase consumption of each good Until the marginal utility of each is 0 Tastes, preferences 8
Exhibit 3 Total and Marginal Utilities From Pizza and Movies 9
Utility Maximization with Scarcity Goods not free Tastes, preferences Limited income Maximize utility Equilibrium Any affordable change will reduce utility 10
Utility-Maximizing Conditions Consumer equilibrium There is no way to increase utility by reallocating the budget Last $ spent on each good yields the same marginal utility Higher-priced goods must yield more marginal utility than lower-price goods MU p p p MU p m m 11
Exhibit 3 MU and the Law of Demand Max U; budget = $40 Q p = 3; P p = $8; one point on D curve (Q m = 4 ; P m = $4) Price of pizza drops to $6, other things constant (Exhibit 4) Max U; budget = $40 Q p = 4; P p = $6; second point on D curve (Q m = 4 ; P m = $4) 12
Exhibit 4 Total and Marginal Utilities From Pizza and Movies After the Price of Pizza Decreases From $8 to $6 13
Price per pizza Exhibit 5 Demand for Pizza Generated From Marginal Utility $8 a 6 b 4 2 D 0 1 2 3 4 Pizzas per week At a price of $8 per pizza, the consumer is in equilibrium when consuming three pizzas per week (point a). Marginal utility per dollar is the same for all goods consumed. If the price falls to $6, the consumer increases consumption to four pizzas (point b). Points a and b are two points on this consumer s demand curve for pizza. 14
Marginal valuation Consumer Surplus The dollar value of the marginal utility derived from consuming each additional unit of a good Consumer surplus Consumer bonus Value of total utility minus total spending Area under the demand curve, above the price 15
Price per subs Exhibit 6 Consumer Surplus From Sub Sandwiches $8 7 6 5 4 3 2 1 D At a given quantity of sub sandwiches, the height of the demand curve shows the value of the last one purchased. The area under the demand curve for a specific quantity shows the total value a consumer attaches to that quantity. At a price of $4, the consumer purchases four subs. 0 1 2 3 4 5 6 7 8 Subs per month The first one is valued at $7, the second at $6, the third at $5, and the fourth at $4. The consumer values four at $22. Because the consumer pays $4 per sub, all four can be purchased for $16. The difference between what the consumer would have been willing to pay ($22) and what the consumer actually pays ($16) is called consumer surplus. When the price is $4, the consumer surplus is $6, as represented by the dark shaded area under the demand curve above $4. When the price of subs falls to $3, consumer surplus increases by $4, as reflected by the lighter shaded area. 16
Market Demand &Consumer Surplus Market demand curve Horizontal sum of individual D curves Total quantity demanded, per period, by all consumers, at various prices Consumer surplus for the market Amount consumers are willing to pay minus amount they pay Net benefit for consumers Economic welfare 17
Price Exhibit 7 Summing Individual Demand Curves to Derive the Market Demand for Sub Sandwiches (a) Your demand (c) Chris s demand (d) Market demand (b) Brittany s demand $6 $6 $6 $6 4 4 4 4 d Y +d B +d C =D 2 2 2 2 d Y d B d C 0 2 4 6 0 2 4 0 2 Subs per month 0 2 6 12 At a price of $4 per sub, you demand 4 per month, Brittany demands 2, and Chris demands 0. Quantity demanded at a price of $4 is 4+2+0=6 subs per month. At a lower price of $2, you demand 6, Brittany demands 4, Chris demands 2. Quantity demanded at a price of $2 is 12 subs. The market demand curve D is the horizontal sum of individual demand curves d Y, d B, and d C. 18
Price per unit Exhibit 8 Market Demand and Consumer Surplus $2 1 0 Quantity per period D Consumer surplus at a price of $2 is shown by the darker area. If the price falls to $1, consumer surplus increases to include the lighter area. At a zero price, consumer surplus increases to include the entire area under the demand curve. 19
Consumption Money price Time price Role of Time in Demand Willing to pay premium for time-saving goods Opportunity cost of time 20
Appendix Indifference Curves & Utility Maximization Indifference curve Combinations of goods reflect the same total utility Slopes downward to right Convex to origin 21
Movie rentals per week Exhibit 9 An Indifference Curve 10 8 5 4 3 2 a b c d I An indifference curve, such as I, shows all combinations of two goods that provide a particular consumer with the same total utility. Points a through d depict four such combinations. Indifference curves have negative slopes and are convex to the origin. 0 1 2 3 4 5 10 Pizzas per week 22
Appendix Indifference Curves & Utility Maximization Marginal rate of substitution, MRS Number of units of one good that you are willing to give up to get one more unit of the other god Neither gaining nor losing utility in the process Willingness to trade Slope of indifference curve Law of diminishing MRS Diminishing slope of indifference curve 23
Appendix Indifference Curves & Utility Maximization Indifference map Graphical representation of consumer s tastes Each indifference curve: different utility levels The further indifference curve from origin The higher the utility More of both goods 24
Movie rentals per week Exhibit 10 An Indifference Map 10 5 I 4 I 2 I 3 I 1 0 5 10 Pizzas per week Indifference curves I 1 through I 4 are four examples from a particular consumer s indifference map. Indifference curves farther from the origin depict higher levels of utility. A line intersects each higher indifference curve, reflecting more of both goods. 25
Movie rentals per week Exhibit 11 Indifference Curves Do Not Intersect k j i I I 0 Pizzas per week If indifference curves crossed, as at point i, then every point on indifference curve I and every point on indifference curve I would have to reflect the same level of utility as at point i. But point k is a combination with more pizza and more movies than point j, so k must reflect a higher level of utility. This contradiction indicates that indifference curves cannot intersect. 26
Appendix Indifference Curves & Utility Maximization Properties of indifference curves: One indifference curve = a constant level of utility Consumer - indifferent among all consumption combinations along a given curve If total utility is to remain constant An increase in the consumption of one good Must be offset by a decrease in the consumption of the other good Indifference curve slopes downward to right 27
Appendix Indifference Curves & Utility Maximization Properties of indifference curves: Because of the law of diminishing MRS Indifference curves bow in toward the origin Higher indifference curves represent higher levels of utility Indifference curves do not intersect 28
Appendix Indifference Curves & Utility Maximization The budget line Combinations of goods Able to buy Consumption possibilities frontier Slope of budget line: I / p p m I / p p p p m 29
Movie rentals per week Exhibit 12 A Budget Line 10 5 Slope = -p p / p v = -$8/$4 = -2 A budget line shows all combinations of pizza and movies that can be purchased at fixed prices with a given amount of income. If all income is spent on movies, 10 can be purchased. If all income is spent on pizzas, 5 can be purchased. Points between the vertical intercept and the horizontal intercept show combinations of pizzas and movies. The slope of this budget line is 2, illustrating that the price of 1 pizza is 2 movies. 0 5 10 Pizzas per week 30
Appendix Indifference Curves & Utility Maximization Consumer equilibrium at the tangency Maximize utility Indifference curve tangent to budget line MRS MRS p p pm MU p MU p pp MU m MU p m m 31
Movie rentals per week Exhibit 13 Utility Maximization 10 a 5 4 e A consumer s utility is maximized at point e, where indifference curve I 2 is just tangent to the budget line. I 3 I 1 I 2 0 3 5 10 Pizzas per week 32
Appendix Indifference Curves & Utility Maximization Effects of a change in price Derive the D curve Income effect Change in real income Substitution effect Different combination of goods 33
Price per pizza Movies per week Exhibit 14 Effect of a Drop in the Price of Pizza (a) 10 5 e 4 e I I 0 (b) 3 4 5 6.67 Pizzas per week e $8 6 e D A reduction in the price of pizza rotates the budget line rightward in panel (a). The consumer is back in equilibrium at point e along the new budget line. Panel (b) shows that a drop in the price of pizza from $8 to $6 increases quantity demanded from 3 to 4 pizzas. Price and quantity demanded are inversely related. 0 3 4 Pizzas per week 34
Movie rentals per week Exhibit 15 Substitution and Income Effects of a Drop in the Price of Pizza From $8 to $4 10 C 5 4 e e e* 0 3 4 5 F 10 Pizzas per week Substitution effect I I* Income effect A reduction in the price of pizza moves the consumer from point e to point e*. This movement can be decomposed into a substitution effect and an income effect. The substitution effect, shown from e to e', reflects the consumer s reaction to a change in relative prices along the original indifference curve. The income effect, shown from e' to e*, moves the consumer to a higher indifference curve at the new relative price ratio. 35