Utility and Demand

CHAPTER 7

After studying this chapter you will be able to

Explain what limits a household’s consumption choices

Describe preferences using the concept of utility and distinguish between total utility and marginal utility

Explain the marginal utility theory of consumer choice

Use marginal utility theory to predict the effects of changing prices and incomes

Explain the paradox of value

Water, Water, Everywhere

Why is water, which is so vital to life, far cheaper than diamonds, which are not essential?

Why does a National Football League player, on the average, earn more than 45 times the amount that a child-care worker earns??

This chapter helps you to answer questions such as these.

The Household’s Budget

Consumption Possibilities

A household’s consumption possibilities are constrained by its income and the prices of the goods and services it buys.

A household has a given amount of income to spend and cannot influence the prices of the goods and services it buys.

A household’s budget line describes the limits to a household’s consumption choices.

The Household’s Budget

Figure 7.1 shows a budget line for movies and soda.

The household can afford all the points on or below the budget line.

The household cannot afford the points beyond the budget line.

The Household’s Budget

Relative Price

A relative price is the price of one good divided by the price of another good.

The price of a movie is $6 and the price of soda is $3 a six-pack.

So the relative price of a movie is $6 per movie divided by $3 per six-pack, which equals 2 six-packs per movie.

The Household’s Budget

A Price Change

A change in the price of the good on the x-axis changes the affordable quantity of that good and changes the slope of the budget line.

Figure 7.2(a) shows the rotation of a budget line after a change in the relative price of movies.

The Household’s Budget

Real Income

A household’s real income is the household’s income expressed as the quantity of goods that the household can afford to buy.

Expressed in terms of soda, Lisa’s real income is 10 six-packs—the maximum quantity of six-packs that she can buy.

Lisa’s real income equals her money income ($30) divided by the price of a six-pack ($3).

The Household’s Budget

A Change in Income

An change in the income brings a parallel shift of the budget line.

The slope of the budget line doesn’t change because the relative price doesn’t change.

Figure 7.2(b) shows how the budget line shifts when income changes.

Preferences and Utility

Preferences

A household’s preferences determine the benefits or satisfaction a person receives consuming a good or service.

The benefit or satisfaction from consuming a good or service is called utility.

Total Utility

Total utility is the total benefit a person gets from the consumption of goods. Generally, more consumption gives more utility.

Preferences and Utility

Table 7.1 on page 157 provides an example of total utility schedule.

Figure 7.2(a) shows a total utility curve.

Total utility increases with the consumption of a good.

Preferences and Utility

Marginal Utility

Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed.

As the quantity consumed of a good increases, the marginal utility from consuming it decreases.

We call this decrease in marginal utility as the quantity of the good consumed increases the principle of diminishing

marginal utility.

Preferences and Utility

Figure 7.2(b) illustrates diminishing marginal utility.

Utility is analogous to temperature.

Both are abstract concepts and both are measured in arbitrary units.

Maximizing Utility

The key assumption of marginal utility theory is that the household chooses the consumption possibility that maximizes total utility.

The Utility-Maximizing Choice

We can find the utility-maximizing choice by looking at the total utility that arises from each affordable combination.

Table 7.2 (page 158) shows an example of the utility-maximizing combination, which is called a consumer

equilibrium.

Maximizing Utility

Equalizing Marginal Utility per Dollar

Using marginal analysis, a consumer’s total utility is maximized by following the rule:

Spend all available income and equalize the marginal

utility per dollar for all goods.

The marginal utility per dollar is the marginal utility from a good divided by its price.

Maximizing Utility

The Utility-Maximizing Rule:

� Call the marginal utility of movies MUM .

� Call the marginal utility of soda MUS .

� Call the price of movies PM .

� Call the price of soda PS .

� The marginal utility per dollar from seeing movies is MUM/PM .

� The marginal utility per dollar from soda is MUS/PS.

Maximizing Utility

Total utility is maximized when:

MUM/PM = MUS/PS

Table 7.3 (page 159) and Figure 7.4 on the next slide show why the utility maximizing rule works.

Maximizing Utility

If MUM/PM > MUS/PS,

then moving a dollar from soda to movies increases the total utility from movies by more than it decreases the total utility from soda, so total utility increases.

Only when MUM/PM = MUS/PS, is it not possible to reallocate the budget and increase total utility.

Maximizing Utility

If MUS/PS > MUM/PM,

then moving a dollar from movies to soda increases the total utility from soda by more than it decreases the total utility from movies, so total utility increases.

Only when MUM/PM = MUS/PS, is it not possible to reallocate the budget and increase total utility.

Predictions of Marginal Utility Theory

A Fall in the Price of a Movie

When the price of a good falls the quantity demanded of that good increases—the demand curve slopes downward.

For example, if the price of a movie falls, we know that MUM/PM rises, so before the consumer changes the quantities consumed, MUM/PM > MUS/PS.

To restore consumer equilibrium (maximum total utility) the consumer increases the quantity of movies consumed to drive down the MUM and restore MUM/PM = MUS/PS.

Predictions of Marginal Utility Theory

A change in the price of one good changes the demand for another good.

You’ve seen that if the price of a movie falls, MUM/PM rises, so before the consumer changes the quantities consumed, MUM/PM > MUS/PS.

To restore consumer equilibrium (maximum total utility) the consumer decreases the quantity of soda consumed to drive up the MUS and restore MUM/PM = MUS/PS.

Predictions …

Table 7.4 and Figure 7.5 illustrate these predictions.

A fall in the price of a movie increases the quantity of movies demanded—a movement along the demand curve for movies,

and decreases the demand for soda—a shift of the demand curve for soda.

Predictions of Marginal Utility Theory

A Rise in the Price of Soda

Now suppose the price of soda rises.

We know that MUS/PS falls, so before the consumer changes the quantities consumed, MUS/PS < MUM/PM.

To restore consumer equilibrium (maximum total utility) the consumer decreases the quantity of soda consumed to drive up the MUS and increases the quantity of movies consumed to drive down MUM. These changes restore MUM/PM = MUS/PS.

Predictions …

Table 7.5 and Figure 7.6 illustrate these predictions.

A rise in the price of soda decreases the quantity of soda demanded—a movement along the demand curve for soda,

and increases the demand for movies—a shift of the demand curve for movies.

Predictions of Marginal Utility Theory

A Rise in Income

When income increases, the demand for a normal good increases.

Table 7.6 (p. 163) illustrates this prediction.

Table 7.7 (p. 163) summarizes the assumptions and predictions of marginal utility theory.

Predictions of Marginal Utility Theory

Temperature: An Analogy

Utility is similar to temperature. Both are abstract concepts, and both have units of measurement that are arbitrary.

The concept of utility helps us make predictions about consumption choices in much the same way that the concept of temperature enables us to predict when water will turn to ice or steam.

The concept of utility helps us understand why people buy more of a good when its price falls and why people buy more of most goods when their incomes increases.

Efficiency, Price, and Value

Consumer Efficiency

When consumers maximize their utility, they are using resources efficiently.

Marginal benefit from a good or service is the maximum price the consumer is willing to pay for an extra unit of that good or service when utility is maximized.

Efficiency, Price, and Value

The Paradox of Value

The paradox of value “Why is water, which is essential to life, far cheaper than diamonds, which are not essential?”is resolved by distinguishing between total utility and marginal utility.

Figure 7.7 on the next slide illustrates the resolution of the paradox.

Efficiency, Price, and Value

We get total utility from consumption, but the more we consume of something the smaller is the marginal utility from it.

For water, the price is low, total utility is large, and marginal utility is small.

For diamonds, the price is high, total utility is small, and marginal utility is high.

But marginal utility per dollar is the same for water and diamonds.

Efficiency, Price, and Value

Value and Consumer Surplus

The supply of water is perfectly elastic, so the quantity of water consumed is large and the consumer surplus from water is large.

In contrast, the supply of diamonds in perfectly inelastic, so the price is high and the consumer surplus from diamonds is small.

THE END