chapters 8 utility and demand
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CHAPTERS 8Utility and Demand
Marginal Utility Theory The purpose of marginal utility
theory is to explain an individual household’s demand.
Marginal utility theory predicts that individual demand curves slope downward.
Therefore, market demand curves must also slope downward.
Household Consumption Choices
Two factors determine a household’s consumption choices: Its budget constraint (how much money
it has to spend and the prices of each good or service it buys)
Its preferences (how much it likes each good relative to others)
Budget Constraint A household’s consumption choices
are constrained by its income and by the prices of the goods and services it buys.
The limits to a household’s consumption choices are described by its budget constraint or sometimes called its budget line.
Example - Lisa’s Consumption Possibilities
Lisa has $30 per month to spend on movies and soda.
Movies cost $6 each. If she spends her entire budget on movies, she can see 5 per month.
Soda costs $3 per six-pack. If she spends her entire budget on soda, she can drink 10 six-packs a month.
Movies ($6) Soda ($3) Expenditure
ExpenditurePossibility Q (dollars) Q (dollars)
a 0 0 10 30b 1 6 8 24c 2 12 6 18d 3 18 4 12e 4 24 2 6f 5 30 0 0
Consumption Possibilities
Consumption Possibilities
Movies (per month)
0 1 2 3 4 5
2
4
6
8
10So
da (s
ix-p
acks
per
mon
th) a
b
c
d
e
f
Consumption Possibilities
Movies (per month)
0 1 2 3 4 5
2
4
6
8
10 a
b
c
d
e
f
Soda
(six
-pac
ks p
er m
onth
)
Each point on line exhausts the entire $30 budget
Affordable
Consumption Possibilities
Movies (per month)
0 1 2 3 4 5
2
4
6
8
10 a
b
c
d
e
f
Unaffordable
Soda
(six
-pac
ks p
er m
onth
)
Preferences The combination of goods and
services a person chooses to consume from the available choices on the budget line is determined by their likes and dislikes — their preferences.
The satisfaction a person gets from consumption is called utility.
Lisa’s Preferences How Lisa spends her $30 per month
depends on her preferences for movies and soda.
Each additional movie or soda she consumes increases her total utility.
Utility Is an Abstract Concept
We cannot directly observe values for utility.
However, each of us knows what we like and what we dislike.
We will consume more of the goods and services we like and less of those we dislike.
Total Utility Total utility is the total benefit or
satisfaction that a person gets from the consumption of goods and services.
Total utility depends on the level of consumption — more consumption generally increases total utility.
Lisa’s Total Utility The more movies Lisa sees each
month, the greater her total utility from movies.
The more soda Lisa drinks each month, the greater her total utility from soda.
Marginal Utility Marginal utility is the change in total
utility resulting from a one-unit increase in the quantity of a good consumed.
Total Utility and Marginal Utility
Quantity Total utility Marginal utility
0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
Movies
-
Total Utility and Marginal Utility
Quantity Total utility Marginal utilityMovies
-50
0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
Total Utility and Marginal Utility
Quantity Total utility Marginal utilityMovies
-5038
0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
Total Utility and Marginal Utility
Quantity Total utility Marginal utilityMovies
-503833
0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
Total Utility and Marginal Utility
Quantity Total utility Marginal utilityMovies
-50383329
0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
Total Utility and Marginal Utility
Quantity Total utility Marginal utilityMovies
-5038332925
0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
Total Utility and Marginal Utility
Quantity Total utility Marginal utilityMovies
-503833292521
0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
Total Utility and Marginal Utility
Quantity Total utility Marginal utilityMovies
-50383329252118
0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
Total Utility and Marginal Utility
Quantity Total utility Marginal utilityMovies
-5038332925211815
0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
Total Utility and Marginal Utility
Quantity Total utility Marginal utilityMovies
-503833292521181512
0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
Total Utility and Marginal Utility
Quantity Total utility Marginal utilityMovies
-503833292521181512 9
0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
Diminishing Marginal Utility As consumption of a good or service
increases, the incremental (or marginal) satisfaction we get from consuming one more unit decreases.
This decrease is called the principle of diminishing marginal utility.
Total Utility and Marginal Utility
0 1 2 3 4 5
Uni
ts o
f util
ity 50 50
100
150
200
0 1 2 3 4 5Quantity (movies per month)
Uni
ts o
f util
ity
Quantity (movies per month)
0 1 2 3 4 5
50 50
100
150
200
0 1 2 3 4 5Quantity (movies per month)
Uni
ts o
f util
ity Totalutility
Quantity (movies per month)
Total Utility and Marginal Utility
Uni
ts o
f util
ity
50
0 1 2 3 4 5
50 50
100
150
200
0 1 2 3 4 5Quantity (movies per month)
Uni
ts o
f util
ity
Increasingtotal utility...
Totalutility
Quantity (movies per month)
Total Utility and Marginal Utility
Uni
ts o
f util
ity
3850
0 1 2 3 4 5
50
…and diminishingmarginal utility
50
100
150
200
0 1 2 3 4 5Quantity (movies per month)
Uni
ts o
f util
ity
Increasingtotal utility...
Totalutility
Quantity (movies per month)
Total Utility and Marginal Utility
Uni
ts o
f util
ity
333850
0 1 2 3 4 5
50
…and diminishingmarginal utility
50
100
150
200
0 1 2 3 4 5Quantity (movies per month)
Uni
ts o
f util
ity
Increasingtotal utility...
Totalutility
Quantity (movies per month)
Total Utility and Marginal Utility
Uni
ts o
f util
ity
29333850
0 1 2 3 4 5
50
…and diminishingmarginal utility
50
100
150
200
0 1 2 3 4 5Quantity (movies per month)
Uni
ts o
f util
ity
Increasingtotal utility...
Totalutility
Quantity (movies per month)
Total Utility and Marginal Utility
Uni
ts o
f util
ity
2529333850
0 1 2 3 4 5
50
…and diminishingmarginal utility
50
100
150
200
0 1 2 3 4 5Quantity (movies per month)
Uni
ts o
f util
ity
Increasingtotal utility...
Totalutility
Quantity (movies per month)
Total Utility and Marginal Utility
Uni
ts o
f util
ity
2529333850
0 1 2 3 4 5
50
…and diminishingmarginal utility
Marginalutility
50
100
150
200
0 1 2 3 4 5Quantity (movies per month)
Uni
ts o
f util
ity
Increasingtotal utility...
Totalutility
Quantity (movies per month)
Total Utility and Marginal Utility
Uni
ts o
f util
ity
Total Utility and Marginal Utility
Quantity Total utility Marginal utility Soda
- 0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
Total Utility and Marginal Utility
Quantity Total utility Marginal utility Soda
-75
0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
Total Utility and Marginal Utility
Quantity Total utility Marginal utility Soda
-7542
0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
Total Utility and Marginal Utility
Quantity Total utility Marginal utility Soda
-754236
0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
Total Utility and Marginal Utility
Quantity Total utility Marginal utility Soda
-75423628
0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
Total Utility and Marginal Utility
Quantity Total utility Marginal utility Soda
-7542362825
0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
Total Utility and Marginal Utility
Quantity Total utility Marginal utility Soda
-754236282519
0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
Total Utility and Marginal Utility
Quantity Total utility Marginal utility Soda
-75423628251918
0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
Total Utility and Marginal Utility
Quantity Total utility Marginal utility Soda
-7542362825191817
0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
Total Utility and Marginal Utility
Quantity Total utility Marginal utility Soda
-754236282519181716
0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
Total Utility and Marginal Utility
Quantity Total utility Marginal utility Soda
-75423628251918171615
0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
Maximizing Utility A household’s income and the prices
it faces limit the total utility it can obtain.
We assume that households consume the quantities of goods and services that maximize total utility.
People must make hard choices because wants exceed resources.
The Utility-maximizing Choice
A consumer equilibrium is a situation in which a consumer has allocated his or her income in the way that, given the prices of goods and services, maximizes his or her total utility.
Lisa's Affordable Combinations
Movies Soda Total utility
Quantity from movies Six-packsper month Total utility and soda Total utility per month
a 0 0 291 10
b 1 50 260 8
c 2 88 225 6
d 3 121 181 4
e 4 150 117 2
f 5 175 0 0
Lisa's Affordable Combinations
Movies Soda Total utility
Quantity from movies Six-packsper month Total utility and soda Total utility per month
a 0 0 291 291 10
b 1 50 260 8
c 2 88 225 6
d 3 121 181 4
e 4 150 117 2
f 5 175 0 0
Lisa's Affordable Combinations
Movies Soda Total utility
Quantity from movies Six-packsper month Total utility and soda Total utility per month
a 0 0 291 291 10
b 1 50 310 260 8
c 2 88 225 6
d 3 121 181 4
e 4 150 117 2
f 5 175 0 0
Lisa's Affordable Combinations
Movies Soda Total utility
Quantity from movies Six-packsper month Total utility and soda Total utility per month
a 0 0 291 291 10
b 1 50 310 260 8
c 2 88 313 225 6
d 3 121 181 4
e 4 150 117 2
f 5 175 0 0
Lisa's Affordable Combinations
Movies Soda Total utility
Quantity from movies Six-packsper month Total utility and soda Total utility per month
a 0 0 291 291 10
b 1 50 310 260 8
c 2 88 313 225 6
d 3 121 302 181 4
e 4 150 117 2
f 5 175 0 0
Lisa's Affordable Combinations
Movies Soda Total utility
Quantity from movies Six-packsper month Total utility and soda Total utility per month
a 0 0 291 291 10
b 1 50 310 260 8
c 2 88 313 225 6
d 3 121 302 181 4
e 4 150 267 117 2
f 5 175 0 0
Lisa's Affordable Combinations
Movies Soda Total utility
Quantity from movies Six-packsper month Total utility and soda Total utility per month
a 0 0 291 291 10
b 1 50 310 260 8
c 2 88 313 225 6
d 3 121 302 181 4
e 4 150 267 117 2
f 5 175 175 0 0
Lisa's Affordable Combinations
Movies Soda Total utility
Quantity from movies Six-packsper month Total utility and soda Total utility per month
a 0 0 291 291 10
b 1 50 310 260 8
c 2 88 313 225 6
d 3 121 302 181 4
e 4 150 267 117 2
f 5 175 175 0 0
Equalizing Marginal Utility Per Dollar Spent
The allocation that maximizes total utility will also make the marginal utility per dollar spent on each good equal for all goods.
The marginal utility per dollar spent is the marginal utility obtained from the last unit of a good consumed divided by the price of the good.
Maximizing Total Utility Total utility is maximized when all the
consumer’s income is spent and when the marginal utility per dollar spent is equal for all goods.
If all income is not spent, utility could be improved by spending more. Therefore, the consumer will spend all income.
Lisa Maximizes Utility She spends all her income andMUmovies/ Pmovies = MUsoda/ Psoda
Equivalently:MUmovies/MUsoda = Pmovies/ Psoda
Equalizing Marginal Utilities Per Dollar Spent
a 0 0 - 10 15b 1 50 8 17c 2 38 6 19d 3 33 4 28e 4 29 2 42 f 5 25 0 0 -
Movies ($6 each) Soda ($3 per six-pack)Marginal Marginal utility utility
Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
Equalizing Marginal Utilities Per Dollar Spent
a 0 0 - 10 15b 1 50 8.33 8 17c 2 38 6 19d 3 33 4 28e 4 29 2 42 f 5 25 0 0 -
Movies ($6 each) Soda ($3 per six-pack)Marginal Marginal utility utility
Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
Equalizing Marginal Utilities Per Dollar Spent
a 0 0 - 10 15b 1 50 8.33 8 17c 2 38 6.33 6 19d 3 33 4 28e 4 29 2 42 f 5 25 0 0 -
Movies ($6 each) Soda ($3 per six-pack)Marginal Marginal utility utility
Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
Equalizing Marginal Utilities per Dollar Spent
a 0 0 - 10 15b 1 50 8.33 8 17c 2 38 6.33 6 19d 3 33 5.50 4 28e 4 29 2 42 f 5 25 0 0 -
Movies ($6 each) Soda ($3 per six-pack)Marginal Marginal utility utility
Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
Equalizing Marginal Utilities Per Dollar Spent
a 0 0 - 10 15b 1 50 8.33 8 17c 2 38 6.33 6 19d 3 33 5.50 4 28e 4 29 4.83 2 42 f 5 25 0 0 -
Movies ($6 each) Soda ($3 per six-pack)Marginal Marginal utility utility
Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
Equalizing Marginal Utilities Per Dollar Spent
a 0 0 - 10 15b 1 50 8.33 8 17c 2 38 6.33 6 19d 3 33 5.50 4 28e 4 29 4.83 2 42 f 5 25 4.17 0 0 -
Movies ($6 each) Soda ($3 per six-pack)Marginal Marginal utility utility
Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
Equalizing Marginal Utilities Per Dollar Spent
a 0 0 - 10 15 5.00b 1 50 8.33 8 17c 2 38 6.33 6 19d 3 33 5.50 4 28e 4 29 4.83 2 42 f 5 25 4.17 0 0 -
Movies ($6 each) Soda ($3 per six-pack)Marginal Marginal utility utility
Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
Equalizing Marginal Utilities Per Dollar Spent
a 0 0 - 10 15 5.00b 1 50 8.33 8 17 5.67c 2 38 6.33 6 19d 3 33 5.50 4 28e 4 29 4.83 2 42 f 5 25 4.17 0 0 -
Movies ($6 each) Soda ($3 per six-pack)Marginal Marginal utility utility
Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
Equalizing Marginal Utilities Per Dollar Spent
a 0 0 - 10 15 5.00b 1 50 8.33 8 17 5.67c 2 38 6.33 6 19 6.33d 3 33 5.50 4 28e 4 29 4.83 2 42 f 5 25 4.17 0 0 -
Movies ($6 each) Soda ($3 per six-pack)Marginal Marginal utility utility
Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
Equalizing Marginal Utilities Per Dollar Spent
a 0 0 - 10 15 5.00b 1 50 8.33 8 17 5.67c 2 38 6.33 6 19 6.33d 3 33 5.50 4 28 9.33e 4 29 4.83 2 42 f 5 25 4.17 0 0 -
Movies ($6 each) Soda ($3 per six-pack)Marginal Marginal utility utility
Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
Equalizing Marginal Utilities Per Dollar Spent
a 0 0 - 10 15 5.00b 1 50 8.33 8 17 5.67c 2 38 6.33 6 19 6.33d 3 33 5.50 4 28 9.33e 4 29 4.83 2 42
14.00f 5 25 4.17 0 0 -
Movies ($6 each) Soda ($3 per six-pack)Marginal Marginal utility utility
Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
Equalizing Marginal Utilities Per Dollar Spent
a 0 0 - 10 15 5.00b 1 50 8.33 8 17 5.67c 2 38 6.33 6 19 6.33d 3 33 5.50 4 28 9.33e 4 29 4.83 2 42
14.00f 5 25 4.17 0 0 -
Movies ($6 each) Soda ($3 per six-pack)Marginal Marginal utility utility
Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
Lisa Maximizes Utility She spends all her income andMUmovies/ Pmovies = MUsoda/ Psoda
(38/6) = (19/3) = 6.33 Equivalently:MUmovies/MUsoda = Pmovies/ Psoda
(38/19) = (6/3) = 2
Why the Marginal Utility Rule Maximizes Total Utility
Case I If the ratio of marginal utility to price
is higher for movies than for soda, Lisa can increase total utility by consuming less soda and more movies.
If MUmovies/ Pmovies > MUsoda/ Psoda then the next movie provides more satisfaction per dollar than a soda.
Why the Marginal Utility Rule Maximizes Total Utility
Case II If the ratio of marginal utility to price
is lower for movies than for soda, Lisa can increase total utility by consuming more soda and less movies.
If MUmovies/ Pmovies < MUsoda/ Psoda then the next soda provides more satisfaction per dollar than a movie.
Equalizing Marginal Utilities Per Dollar Spent
MoviesSodaPossibility
0 1 2 3 4 510 8 6 4 2 0a b c d e f
4.00
8.33
12.00
16.00
6.335.67
Mar
gina
l util
ity p
er d
olla
r sp
ent
(uni
ts o
f util
ity p
er d
olla
r)
Equalizing Marginal Utilities Per Dollar Spent
MoviesSodaPossibility
0 1 2 3 4 510 8 6 4 2 0a b c d e f
4.00
8.33
12.00
16.00
6.335.67
Mar
gina
l util
ity p
er d
olla
r sp
ent
(uni
ts o
f util
ity p
er d
olla
r)
MUm
Pm
Equalizing Marginal Utilities Per Dollar Spent
MoviesSodaPossibility
0 1 2 3 4 510 8 6 4 2 0a b c d e f
4.00
8.33
12.00
16.00
6.335.67
MUs
Ps
MUm
Pm
Mar
gina
l util
ity p
er d
olla
r sp
ent
(uni
ts o
f util
ity p
er d
olla
r)
Equalizing Marginal Utilities Per Dollar Spent
MoviesSodaPossibility
0 1 2 3 4 510 8 6 4 2 0a b c d e f
4.00
8.33
12.00
16.00
6.335.67
MUs
Ps
MUm
Pm
Maximumtotal utility
Case IIUtility gainfrom moresoda and fewer movies
Case IUtility gainfrom moremovies and less soda
Mar
gina
l util
ity p
er d
olla
r sp
ent
(uni
ts o
f util
ity p
er d
olla
r)
Consuming Only Sodas
MoviesSodaPossibility
0 1 2 3 4 510 8 6 4 2 0a b c d e f
MUs
Ps
MUm
Pm
Mar
gina
l util
ity p
er d
olla
r sp
ent
(uni
ts o
f util
ity p
er d
olla
r)
Consuming Only Movies
MoviesSodaPossibility
0 1 2 3 4 510 8 6 4 2 0a b c d e f
MUs
Ps
MUm
Pm
Mar
gina
l util
ity p
er d
olla
r sp
ent
(uni
ts o
f util
ity p
er d
olla
r)
The Power ofMarginal Analysis
The method we have used to maximize Lisa’s utility is an example of marginal analysis.
By comparing marginal gain with marginal loss, we can guarantee that total utility is maximized.
New Ways of Explaining Consumer ChoicesBehavioral Economics
Behavioral economics studies the ways in which limits on the human brain’s ability to compute and implement rational decisions influence economic behavior—both the decisions that people make and the consequences of those decisions for the way markets work.There are three impediments to rational choice:
Bounded rationality Bounded willpower Bounded self-interest
New Ways of Explaining Consumer Choices
Bounded RationalityBounded rationality is rationality that is limited by the computing power of the human brain. Faced with uncertainty, consumers cannot rationally make choices and instead rely on other decision-making methods such as rules of thumb, listening to the views of others, or gut instinct.
New Ways of Explaining Consumer Choices
Bounded WillpowerBounded will-power is the less-than-perfect willpower that prevents us from making a decision that we know, at the time of implementing the decision, we will later regret.
New Ways of Explaining Consumer Choices
Bounded Self-InterestBounded self-interest is the limited self-interest that sometimes results in suppressing our own interests to help others. Main applications are in finance where uncertainty is the key factor and savings where future is the key factor.
New Ways of Explaining Consumer Choices
One behavior observed by behavioral economists is more general and might affect your choices.The Endowment Effect
The endowment effect is the tendency for people to value something more highly simply because they own it.
New Ways of Explaining Consumer Choices
NeuroeconomicsNeuroeconomics is the study of the activity of the human brain when a person makes an economic decision.Different decisions appear to activate different areas of the brain. Some decisions are made
In the pre-frontal cortex where memories are stored and data analyzed and where decisions might be deemed rational.
In the hippocampus where memories of anxiety and fear are stored and where decisions might be deemed irrational.
New Ways of Explaining Consumer Choices
ControversyShould economics focus on explaining the decisions we observe or should it focus on what goes on inside people’s heads?This is the controversy.For most economists, the goal of economics is to explain the decisions that we observe people make, and not to explain what goes on inside people’s heads.
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