© 2006 mcgraw-hill ryerson limited. all rights reserved.1 chapter 7: the logic of individual...
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© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
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Chapter 7: The Logic of Individual Choice: The Foundation of Supply and Demand Prepared by:Kevin Richter, Douglas CollegeCharlene Richter,British Columbia Institute of Technology
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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.
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Chapter Objectives
3. Explain why a consumer is maximizing total utility when
MUX/PX = MUY/PY.
4. Explain how the principle of rational choice accounts for the Law of Demand.
5. Explain four alternative rules for decision-making.
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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.
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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.
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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.
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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.
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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.
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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.
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Pizza slices
123456789
Total utility
142636445054565654
Marginal utility
14121086420-2
Marginal and Total Utility
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Total utility Marginal utility
Slices of pizza per hour
70
60
50
40
30
20
10
01 2 3 4 5 6 7 8 9
Slices of pizza per hour
16141210
86420
-2 1 2 3 4 5 6 7 8 9
Marginal and Total Utility
Total utility Marginal utility
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Maximizing Utility
Q
01234567
TU
020323841413626
MU
2012
630
-5-10
MU/P
1063
1.50
-2.5-5
Q
01234567
TU
029465356575753
MU
2917
7310
-4
MU/P
2917
7310
-4
Hamburgers (P = $2) Ice Cream (P = $1)
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Maximizing Utility
Total $ spent
Purchase? MU/P MU
$1 1st ice cream cone 29 29
$2 2nd ice cream cone 17 17
$4 1st hamburger 10 20
$5 3rd ice cream cone 7 7
$7 2nd hamburger 6 12
$9 3rd hamburger 3 6
$10 4th ice cream cone 3 3
Total utility = 94 utils
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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.
z
z
y
y
x
x
P
MU
P
MU
P
MU
When you are maximizing utility
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Opportunity Cost
Opportunity cost is the benefit forgone of the next-best alternative.
It is essentially the marginal utility per dollar you forgo.
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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.
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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
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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.
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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.
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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 = - Ppop/Pchocolate
= - ½
Income = $10
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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 = - Ppop/Pchocolate
= - 1
Income = $10Pop Price = $1
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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.
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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|= MUpop/MUchocolate bars
= MRS of pop for chocolate bars
U
AB
CD E
Indifference curve
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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
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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
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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
U2
ABC
DE
U1
U3
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0
4
8
12
16
20
2 4 6 8 10 12 14 16 18 20 22
Chocolate bars
Cans of pop
U1
AB
C
DU2
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
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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
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0
4
8
12
16
20
2 4 6 8 10 12 14 16 18 20 22
Chocolate bars
Cans of pop
U2
U1
Slope= -Ppop/Pchocolate bars
Maximizing Utility
U3
Slope= -MUpop/MUchocolate bars
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The best combination is the point where the slope of the budget line equals the slope of the indifference curve.
pop
pop
Choc
Choc
Choc
pop
Choc
pop
P
MU
P
MU that so
MU
MU
P
P
Maximizing Utility
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The Logic of Individual Choice: The Foundation of Supply and DemandEnd of Chapter 7
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Chapter 7 Appendix
Describing Consumer Preferences Using Indifference Curves
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Income Expansion Path
U1 U2
U3
U3
U2
U1
IEP
IEPGood Y Good Y
Good X Good Xa) Normal good a) Inferior good
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Engel Curves
Quantity Demanded
Income
X1
X2
X3
Income elastic normal good (luxury)
Income inelasticnormal good (necessity)
Inferior good
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Price Expansion PathGood Y
Good XB/(Px)1
B/Py
B/(Px)2
PEP
U1
U2
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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.
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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.
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Income and Substitution EffectsGood Y
Good XB/(Px)1
B/Py
B/(Px)2
PEP
U1
U2
E
F
G
SubstitutionEffect
Income Effect
Normal Good
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Good Y
Good XB/(Px)1
B/Py
B/(Px)2
PEP
U1
U2
E
F
G
SubstitutionEffect
Income Effect
Inferior Good
Income and Substitution Effects
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Good Y
Good X
PEPA B
C
X1
X2
X3
Price-expansionpath
B/P1 B/P2 B/P3
Derive the Demand Curve for Good X
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Derive the Demand Curve for Good XPrice of
Good X
Quantity of Good X
A
B
C
X1
X2
X3
Demand
P1
P2
P3
Demand Curve
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Describing Consumer Preferences Using Indifference Curves
End of Chapter 7 Appendix