© 2005 mcgraw-hill ryerson ltd. 1 microeconomics, chapter 6 the theory of consumer choice slides...

© 2005 McGraw-Hill Ryerson Ltd. 1Microeconomics, Chapter 6

The Theory ofThe Theory ofConsumer ChoiceConsumer Choice

SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGESLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE


In this chapter you will learnIn this chapter you will learn

6.16.1 The two explanations for why the demand The two explanations for why the demand curve is downward slopingcurve is downward sloping

6.26.2 The theory of consumer choice The theory of consumer choice

6.3 6.3 The connection between utility maximization The connection between utility maximization and the demand curveand the demand curve

6.46.4 To apply marginal utility theory to real world To apply marginal utility theory to real world situationssituations

6.56.5 What consumer surplus is and how to What consumer surplus is and how to measure itmeasure it


Chapter 6 TopicsChapter 6 Topics

6.16.1 A Closer Look at The Law of Demand A Closer Look at The Law of Demand

6.26.2 Theory of Consumer Choice Theory of Consumer Choice

6.36.3 Utility Maximization and the Demand Utility Maximization and the Demand CurveCurve

6.46.4 Applications & Extensions Applications & Extensions

6.56.5 Consumer Surplus Consumer Surplus


Income & Substitution EffectsIncome & Substitution Effects

The Income EffectThe Income Effect A lower price frees income for additional A lower price frees income for additional

purchases - and vice versapurchases - and vice versa The Substitution EffectThe Substitution Effect

A lower price relative to other goods A lower price relative to other goods attracts new buyers - and vice versaattracts new buyers - and vice versa


Law of Diminishing Marginal UtilityLaw of Diminishing Marginal Utility

gains in satisfaction decline as gains in satisfaction decline as additional units are consumedadditional units are consumed

TerminologyTerminology utilityutility is want-satisfying power is want-satisfying power

Total & Marginal UtilityTotal & Marginal Utility total utilitytotal utility: total amount of satisfaction: total amount of satisfaction marginal utilitymarginal utility: : extraextra satisfaction from satisfaction from

consuming one more unitconsuming one more unit

graphically examined....graphically examined....

Tacosconsumedper meal

TotalUtility

MarginalUtilityTU

01234567

010182428303028

Total and Marginal UtilityTotal and Marginal UtilityTotal Utility

0

10

20

30

40

0 1 2 3 4 5 6 7 8

quantity

tota

l uti

lity

Figure 6-1Figure 6-1



TotalUtility

MarginalUtilityTU

01234567

010182428303028


0

10

20

30

40

0 1 2 3 4 5 6 7 8

quantity

tota

l uti

lity




TotalUtility

MarginalUtilityTU

01234567

010182428303028


0

10

20

30

40

0 1 2 3 4 5 6 7 8

quantity

tota

l uti

lity

Marginal Utility

-5

0

5

10

15

0 1 2 3 4 5 6 7 8

quantity

mar

gina

l util

itiy

10




TotalUtility

MarginalUtilityTU

01234567

010182428303028


0

10

20

30

40

0 1 2 3 4 5 6 7 8

quantity

tota

l uti

lity

Marginal Utility

-5

0

5

10

15

0 1 2 3 4 5 6 7 8

quantity

mar

gina

l util

itiy

10 8




TotalUtility

MarginalUtilityTU

01234567

010182428303028

Total and Marginal UtilityTotal and Marginal Utility

10 8 6 4 2 0 -2

Total Utility

0

10

20

30

40

0 1 2 3 4 5 6 7 8

quantity

tota

l uti

lity

Marginal Utility

-5

0

5

10

15

0 1 2 3 4 5 6 7 8

quantity

mar

gina

l util

itiy




TotalUtility

MarginalUtilityTU

01234567

010182428303028

Total and Marginal UtilityTotal and Marginal Utility

10 8 6 4 2 0 -2

Total Utility

0

10

20

30

40

0 1 2 3 4 5 6 7 8

quantity

tota

l uti

lity

Marginal Utility

-5

0

5

10

15

0 1 2 3 4 5 6 7 8

quantity

mar

gina

l util

itiy

ObserveObserveDiminishingDiminishing

MarginalMarginalUtilityUtility




Marginal Utility, Demand & ElasticityMarginal Utility, Demand & Elasticity

if marginal utility falls rapidly for each if marginal utility falls rapidly for each successive unit…successive unit…

it will take a considerable drop in price it will take a considerable drop in price to cause an increase in quantity to cause an increase in quantity demanded…demanded…

so demand is fairly…so demand is fairly… INELASTICINELASTIC


Theory of Consumer ChoiceTheory of Consumer Choice

A Typical Consumer.…A Typical Consumer.… Exhibits rational behaviorExhibits rational behavior Knows clear-cut preferencesKnows clear-cut preferences Is subject to a budget constraintIs subject to a budget constraint Responds to price changesResponds to price changes


Utility Maximizing RuleUtility Maximizing Rule

The consumer’s money income should The consumer’s money income should be allocated so that the last dollar spent be allocated so that the last dollar spent on each product purchased yields the on each product purchased yields the same amount of extra (marginal) utilitysame amount of extra (marginal) utility


Numerical ExampleNumerical Example

First, put the marginal utilities into a per-First, put the marginal utilities into a per-dollar-spent basisdollar-spent basis

Decision-making process: at each step, Decision-making process: at each step, spend where the marginal utility per spend where the marginal utility per dollar is highestdollar is highest

Product A p=$1Product A p=$1 Product B p=$2Product B p=$2

unit of unit of productproduct

marginal marginal utilityutility MU/pMU/p MUMU MU/pMU/p

11stst 1010 2424

22ndnd 88 2020

33rdrd 77 1818

44thth 66 1616

55thth 55 1212

66thth 44 66

77thth 33 44

1010

88

77

66

5544

33

1212

1010

99

8866

3322

Table 6-1Table 6-1


MU/p, MU/p, Product AProduct A

MU/p, MU/p, Product BProduct B

11stst 1010 11stst 1212

22ndnd 88 22ndnd 1010

33rdrd 77 33rdrd 99

44thth 66 44thth 88

55thth 55 55thth 66

66thth 44 66thth 33

77thth 33 77thth 22

SpendingSpending Product Product AA

Product Product BB

$2$2 11

$3$3 1111

$2$2 11

$3$3 1111

$10$10 4422

Decision-Making ProcessDecision-Making Process


What will the What will the consumer buy first?consumer buy first?

What will the What will the consumer buy first?consumer buy first?And next?And next?And next?And next?


Utility MaximizationUtility Maximization

at each step, spend where MU/$ is at each step, spend where MU/$ is highesthighest

in general, if MU/$ is unequal, spending in general, if MU/$ is unequal, spending should be allocated should be allocated awayaway from the good where MU/$ is low from the good where MU/$ is low toward toward the good where MU/$ is highthe good where MU/$ is high


Algebraic Restatement of theAlgebraic Restatement of theUtility Maximization RuleUtility Maximization Rule

MU of product A

Price of A

MU of product B

Price of B=


Utility Maximization & the Demand CurveUtility Maximization & the Demand Curve

Deriving the Demand CurveDeriving the Demand Curve what if the price of Product B falls to what if the price of Product B falls to

$1?$1?

Product A p=$1Product A p=$1 Product B p=Product B p=$1$1

unit of unit of productproduct

marginal marginal utilityutility MU/pMU/p MUMU MU/pMU/p

11stst 1010 2424

22ndnd 88 2020

33rdrd 77 1818

44thth 66 1616

55thth 55 1212

66thth 44 66

77thth 33 44

1010

88

77

66

5544

33

2424

2020

1818

16161212

66

44

Table 6-1Table 6-1


MU/p, MU/p, Product AProduct A

MU/p, MU/p, Product BProduct B

11stst 1010 11stst 2424

22ndnd 88 22ndnd 2020

33rdrd 77 33rdrd 1818

44thth 66 44thth 1616

55thth 55 55thth 1212

66thth 44 66thth 66

77thth 33 77thth 44

SpendingSpending Product AProduct A Product Product BB

Decision-making ProcessDecision-making Process

$1$1 11

$1$1 11

$1$1 11

$1$1 11$1$1 11

$1$1 11$1$1 11$1$1 11

$10$10 6644$1$1 1111



when pwhen pProduct BProduct B=$2=$2 the quantity demanded is 4the quantity demanded is 4

when pwhen pProduct BProduct B=$1=$1 the quantity demanded is 6the quantity demanded is 6


Product B

price quantity demanded

$1

$2

6

4

4

$1

$2

D

6

price

quantity demanded

Utility Maximization & the Demand CurveUtility Maximization & the Demand CurveFigure 6-2Figure 6-2



Substitution EffectSubstitution Effect when the price of Product B falls, there is a when the price of Product B falls, there is a

substitution of now cheaper Bsubstitution of now cheaper B Income EffectIncome Effect

increase in real income increases increase in real income increases consumption of both A & Bconsumption of both A & B



Applications & ExtensionsApplications & Extensions

DVDs & DVD PlayersDVDs & DVD Players



DVDs & DVD PlayersDVDs & DVD Players The Diamond-Water ParadoxThe Diamond-Water Paradox



DVDs & DVD PlayersDVDs & DVD Players The Diamond-Water ParadoxThe Diamond-Water Paradox The Value of TimeThe Value of Time



DVDs & DVD PlayersDVDs & DVD Players The Diamond-Water ParadoxThe Diamond-Water Paradox The Value of TimeThe Value of Time Cash & Non-cash GiftsCash & Non-cash Gifts


Consumer SurplusConsumer Surplus

the difference between the maximum the difference between the maximum price a consumer is will to pay for price a consumer is will to pay for something & its market price is called something & its market price is called consumer surplusconsumer surplus

one of the key elements in cost-benefit one of the key elements in cost-benefit analysisanalysis


0

10

20

30

40

50

60

70

D=MBD=MBQQ

market pricemarket price

Q*Q*

Consumer SurplusConsumer Surplus

Vijay’s consumer surplusVijay’s consumer surplus



0

10

20

30

40

50

60

70

D=MBD=MBQQ

market pricemarket price

amountamountpaidpaid

Q*Q*

total consumer surplustotal consumer surplus

Consumer SurplusConsumer SurplusFigure 6-3Figure 6-3


Indifference Curve AnalysisIndifference Curve AnalysisAppendix to Chapter 6Appendix to Chapter 6


Qu

an

tity

of

AQ

ua

nti

ty o

f A

Quantity of BQuantity of B

1212

1010

88

66

44

22

002 4 6 8 10 122 4 6 8 10 12

The Budget LineThe Budget Line

Units of AUnits of A

(p=$1.50)(p=$1.50)

Units of BUnits of B

(p=$1.00)(p=$1.00)

Total Total expenditureexpenditure

88 00 $12$12

66 33 $12$12

44 66 $12$12

22 99 $12$12

00 1212 $12$12


Qu

an

tity

of

AQ

ua

nti

ty o

f A


1212

1010

88

66

44

22

002 4 6 8 10 122 4 6 8 10 12



(p=$1.50)(p=$1.50)


(p=$1.00)(p=$1.00)


88 00 $12$12

66 33 $12$12

44 66 $12$12

22 99 $12$12

00 1212 $12$12


AttainableAttainableQ

ua

nti

ty o

f A

Qu

an

tity

of

A


1212

1010

88

66

44

22

002 4 6 8 10 122 4 6 8 10 12

UnattainableUnattainable



(p=$1.50)(p=$1.50)


(p=$1.00)(p=$1.00)


88 00 $12$12

66 33 $12$12

44 66 $12$12

22 99 $12$12

00 1212 $12$12


Qu

an

tity

of

AQ

ua

nti

ty o

f A


1212

1010

88

66

44

22

002 4 6 8 10 122 4 6 8 10 12


An increase in An increase in incomeincome

makes the makes the purchase of purchase of

more of either or more of either or bothboth

items possible items possible

An increase in An increase in incomeincome

makes the makes the purchase of purchase of

more of either or more of either or bothboth

items possible items possible

Income increasesIncome increasesIncome increasesIncome increases


Qu

an

tity

of

AQ

ua

nti

ty o

f A


1212

1010

88

66

44

22

002 4 6 8 10 122 4 6 8 10 12


Price changes Price changes causecause

a change in the a change in the quantityquantity

demanded of the demanded of the itemsitems

Price changes Price changes causecause

a change in the a change in the quantityquantity

demanded of the demanded of the itemsitems

Price of A risesPrice of A risesPrice of A risesPrice of A rises


Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12

combinationcombination Units of Units of AA

Units of Units of BB

jj 1212 22

kk 66 44

ll 44 66

mm 33 88

Indifference CurvesIndifference Curvesj


Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12

j

k



jj 1212 22

kk 66 44

ll 44 66

mm 33 88

Indifference CurvesIndifference Curves


Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12

j

k

l



jj 1212 22

kk 66 44

ll 44 66

mm 33 88



Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12

j

k

lm



jj 1212 22

kk 66 44

ll 44 66

mm 33 88



Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12

j

k

lm

I



jj 1212 22

kk 66 44

ll 44 66

mm 33 88



Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12

j

k

lm

I


Indifference curves Indifference curves are downslopingare downsloping

Indifference curves Indifference curves are downslopingare downsloping


Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12

j

k

lm

I


Indifference curves Indifference curves are convex to the are convex to the

originorigin

Indifference curves Indifference curves are convex to the are convex to the

originorigin


Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12

j

k

lm

I


Marginal rate of Marginal rate of substitution (MRS) substitution (MRS) is the slope of the is the slope of the indifference curve indifference curve

at any pointat any point

Marginal rate of Marginal rate of substitution (MRS) substitution (MRS) is the slope of the is the slope of the indifference curve indifference curve

at any pointat any point

MRS MRS diminishes, so diminishes, so

curve is convexcurve is convex

MRS MRS diminishes, so diminishes, so

curve is convexcurve is convex


Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12


Indifference map Indifference map shows a series of shows a series of

indifference curves, indifference curves, for different levels for different levels

of utilityof utility

Indifference map Indifference map shows a series of shows a series of

indifference curves, indifference curves, for different levels for different levels

of utilityof utility I4

I1I2I3


Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12

Equilibrium at TangencyEquilibrium at Tangency

Point X represents Point X represents the optimal the optimal attainable attainable

combination of combination of products A & Bproducts A & B

Point X represents Point X represents the optimal the optimal attainable attainable

combination of combination of products A & Bproducts A & B XX I4

I1I2I3


The Measurement of UtilityThe Measurement of Utility marginal utility theory assumes utility is marginal utility theory assumes utility is

numerically measurablenumerically measurable indifference curve approach requires only that indifference curve approach requires only that

a consumer specify if a particular combination a consumer specify if a particular combination of products yields more or less utility than of products yields more or less utility than anotheranother

at equilibrium, MRS=Pat equilibrium, MRS=PBB/P/PAA

equivalent to marginal utility approach sinceequivalent to marginal utility approach since

A

B

A

B

A

B

B

B

A

A

MUMU

MRSMUMU

PP

PMU

PMU


Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12

Derivation of the Demand CurveDerivation of the Demand Curve

What happens if What happens if the price of B the price of B

increases to $1.50?increases to $1.50?

What happens if What happens if the price of B the price of B

increases to $1.50?increases to $1.50?XX I4

I1I2I3


Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12


New budget line New budget line reflects the price reflects the price

changechange

New budget line New budget line reflects the price reflects the price

changechange

I2I3I1

I4XX

PPBB=$1.00=$1.00

PPBB=$1.50=$1.50


Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12


New equilibrium New equilibrium point is Xpoint is X''

New equilibrium New equilibrium point is Xpoint is X''

XX''

I2I3I1

I4XX

PPBB=$1.00=$1.00

PPBB=$1.50=$1.50


Qu

an

tity

of

A

Quantity of B

12

10

8

6

4

2

02 4 6 8 10 12


Recording Recording quantities quantities

demanded of B at demanded of B at various prices of B various prices of B yields the demand yields the demand

curve for Bcurve for B

Recording Recording quantities quantities

demanded of B at demanded of B at various prices of B various prices of B yields the demand yields the demand

curve for Bcurve for B

XX''

I2I3I1

I4XX


Qu

an

tity

of

A

Quantity of B2 4 6 8 10 12

XX''

I2I3I1

I4XX

PPBB QQBB

$1.00$1.00 66

$1.50$1.50 33

2

46

10

12

8

Pri

ce

of

B

Quantity of B2 4 6 8 10 12

$0.50

$1.00

$1.50

DDBB

Figure A6-5Figure A6-5

We can derive the We can derive the demand curve demand curve

without measuring without measuring utility in utilsutility in utils

We can derive the We can derive the demand curve demand curve

without measuring without measuring utility in utilsutility in utils

© 2005 mcgraw-hill ryerson ltd. 1 microeconomics, chapter 6 the theory of consumer choice slides...

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