CHAPTERS 8 Utility and Demand Marginal Utility Theory

CHAPTERS 8 Utility and Demand

Marginal Utility Theory w The purpose of marginal utility theory is to explain an individual household’s demand. w Marginal utility theory predicts that individual demand curves slope downward. w Therefore, market demand curves must also slope downward.

Household Consumption Choices w 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 w A household’s consumption choices are constrained by its income and by the prices of the goods and services it buys. w 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 w Lisa has $30 per month to spend on movies and soda. w Movies cost $6 each. If she spends her entire budget on movies, she can see 5 per month. w Soda costs $3 per six-pack. If she spends her entire budget on soda, she can drink 10 six-packs a month.

Consumption Possibilities Movies ($6) Soda ($3) Expenditure Possibility Q a b c d e f 0 1 2 3 4 5 (dollars) 0 6 12 18 24 30 Expenditure Q 10 8 6 4 2 0 (dollars) 30 24 18 12 6 0

Consumption Possibilities Soda (six-packs per month) 10 a b 8 c 6 d 4 e 2 f 0 1 2 3 4 5 Movies (per month)

Consumption Possibilities Soda (six-packs per month) 10 a b 8 Each point on line exhausts the entire $30 budget c 6 d 4 e 2 f 0 1 2 3 4 5 Movies (per month)

Consumption Possibilities Soda (six-packs per month) 10 a b 8 c 6 Unaffordable d 4 2 Affordable e f 0 1 2 3 4 5 Movies (per month)

Preferences w 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. w The satisfaction a person gets from consumption is called utility.

Lisa’s Preferences w How Lisa spends her $30 per month depends on her preferences for movies and soda. w Each additional movie or soda she consumes increases her total utility.

Utility Is an Abstract Concept w We cannot directly observe values for utility. w However, each of us knows what we like and what we dislike. w We will consume more of the goods and services we like and less of those we dislike.

Total Utility w Total utility is the total benefit or satisfaction that a person gets from the consumption of goods and services. w Total utility depends on the level of consumption — more consumption generally increases total utility.

Lisa’s Total Utility w The more movies Lisa sees each month, the greater her total utility from movies. w The more soda Lisa drinks each month, the greater her total utility from soda.

Marginal Utility w 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 Movies Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 50 88 121 150 175 196 214 229 241 250 -

Total Utility and Marginal Utility Movies Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 50 88 121 150 175 196 214 229 241 250 50

Total Utility and Marginal Utility Movies Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 50 88 121 150 175 196 214 229 241 250 50 38

Total Utility and Marginal Utility Movies Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 50 88 121 150 175 196 214 229 241 250 50 38 33

Total Utility and Marginal Utility Movies Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 50 88 121 150 175 196 214 229 241 250 50 38 33 29

Total Utility and Marginal Utility Movies Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 50 88 121 150 175 196 214 229 241 250 50 38 33 29 25

Total Utility and Marginal Utility Movies Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 50 88 121 150 175 196 214 229 241 250 50 38 33 29 25 21

Total Utility and Marginal Utility Movies Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 50 88 121 150 175 196 214 229 241 250 50 38 33 29 25 21 18

Total Utility and Marginal Utility Movies Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 50 88 121 150 175 196 214 229 241 250 50 38 33 29 25 21 18 15

Total Utility and Marginal Utility Movies Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 50 88 121 150 175 196 214 229 241 250 50 38 33 29 25 21 18 15 12

Total Utility and Marginal Utility Movies Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 50 88 121 150 175 196 214 229 241 250 50 38 33 29 25 21 18 15 12 9

Diminishing Marginal Utility w As consumption of a good or service increases, the incremental (or marginal) satisfaction we get from consuming one more unit decreases. w This decrease is called the principle of diminishing marginal utility.

Units of utility Total Utility and Marginal Utility 200 150 100 50 1 2 3 4 5 Quantity (movies per month)

Total utility 200 150 Units of utility Total Utility and Marginal Utility 100 50 1 2 3 4 5 Quantity (movies per month)

Total utility 200 150 Units of utility Total Utility and Marginal Utility 100 Increasing total utility. . . 50 50 50 0 1 2 3 4 5 Quantity (movies per month)

Total utility 200 150 Units of utility Total Utility and Marginal Utility 100 Increasing total utility. . . 50 …and diminishing marginal utility 50 50 38 0 1 2 3 4 5 Quantity (movies per month)

Total utility 200 150 Units of utility Total Utility and Marginal Utility 100 Increasing total utility. . . 50 …and diminishing marginal utility 50 50 38 0 1 2 3 4 5 Quantity (movies per month) 0 1 33 2 3 4 5 Quantity (movies per month)

Total utility 200 150 Units of utility Total Utility and Marginal Utility 100 Increasing total utility. . . 50 …and diminishing marginal utility 50 50 38 0 1 2 3 4 5 Quantity (movies per month) 0 1 33 2 29 3 4 5 Quantity (movies per month)

Total utility 200 150 Units of utility Total Utility and Marginal Utility 100 Increasing total utility. . . 50 …and diminishing marginal utility 50 50 38 0 1 2 3 4 5 Quantity (movies per month) 0 1 33 2 29 3 25 4 5 Quantity (movies per month)

Total utility 200 150 Units of utility Total Utility and Marginal Utility 100 Increasing total utility. . . 50 …and diminishing marginal utility 50 50 38 0 1 2 3 4 5 Quantity (movies per month) 0 1 Marginal utility 33 2 29 3 25 4 5 Quantity (movies per month)

Total Utility and Marginal Utility Soda Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 75 117 153 181 206 225 243 260 276 291 -

Total Utility and Marginal Utility Soda Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 75 117 153 181 206 225 243 260 276 291 75

Total Utility and Marginal Utility Soda Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 75 117 153 181 206 225 243 260 276 291 75 42

Total Utility and Marginal Utility Soda Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 75 117 153 181 206 225 243 260 276 291 75 42 36

Total Utility and Marginal Utility Soda Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 75 117 153 181 206 225 243 260 276 291 75 42 36 28

Total Utility and Marginal Utility Soda Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 75 117 153 181 206 225 243 260 276 291 75 42 36 28 25

Total Utility and Marginal Utility Soda Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 75 117 153 181 206 225 243 260 276 291 75 42 36 28 25 19

Total Utility and Marginal Utility Soda Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 75 117 153 181 206 225 243 260 276 291 75 42 36 28 25 19 18

Total Utility and Marginal Utility Soda Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 75 117 153 181 206 225 243 260 276 291 75 42 36 28 25 19 18 17

Total Utility and Marginal Utility Soda Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 75 117 153 181 206 225 243 260 276 291 75 42 36 28 25 19 18 17 16

Total Utility and Marginal Utility Soda Quantity 0 1 2 3 4 5 6 7 8 9 10 Total utility Marginal utility 0 75 117 153 181 206 225 243 260 276 291 75 42 36 28 25 19 18 17 16 15

Maximizing Utility w A household’s income and the prices it faces limit the total utility it can obtain. w We assume that households consume the quantities of goods and services that maximize total utility. w People must make hard choices because wants exceed resources.

The Utility-maximizing Choice w 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 Quantity per month Total utility from movies and soda Total utility Six-packs 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 Quantity per month Total utility a 0 0 b 1 c Total utility from movies and soda 291 Total utility Six-packs per month 291 10 50 260 8 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 Quantity per month Total utility from movies and soda Total utility Six-packs per month a 0 0 291 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 Quantity per month Total utility from movies and soda Total utility Six-packs per month a 0 0 291 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 Quantity per month Total utility from movies and soda Total utility Six-packs per month a 0 0 291 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 Quantity per month Total utility from movies and soda Total utility Six-packs per month a 0 0 291 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 Quantity per month Total utility from movies and soda Total utility Six-packs per month a 0 0 291 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 Quantity per month Total utility from movies and soda Total utility Six-packs per month a 0 0 291 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

Equalizing Marginal Utility Per Dollar Spent w The allocation that maximizes total utility will also make the marginal utility per dollar spent on each good equal for all goods. w 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 w 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. w If all income is not spent, utility could be improved by spending more. Therefore, the consumer will spend all income.

Lisa Maximizes Utility w She spends all her income and MUmovies/ Pmovies = MUsoda/ Psoda w Equivalently: MUmovies/MUsoda = Pmovies/ Psoda

Equalizing Marginal Utilities Per Dollar Spent Movies ($6 each) Quantity a b c d e f 0 1 2 3 4 5 Marginal utility 0 50 38 33 29 25 Soda ($3 per six-pack) Marginal utility per dollar spent - Marginal Quantity utility 10 8 6 4 2 0 15 17 19 28 42 0 Marginal utility per dollar spent -

Equalizing Marginal Utilities Per Dollar Spent Movies ($6 each) Quantity a b c d e f 0 1 2 3 4 5 Marginal utility 0 50 38 33 29 25 Marginal utility per dollar spent 8. 33 Soda ($3 per six-pack) Marginal Quantity utility 10 8 6 4 2 0 15 17 19 28 42 0 Marginal utility per dollar spent -

Equalizing Marginal Utilities Per Dollar Spent Movies ($6 each) Quantity a b c d e f 0 1 2 3 4 5 Marginal utility 0 50 38 33 29 25 Marginal utility per dollar spent 8. 33 6. 33 Soda ($3 per six-pack) Marginal Quantity utility 10 8 6 4 2 0 15 17 19 28 42 0 Marginal utility per dollar spent -

Equalizing Marginal Utilities per Dollar Spent Movies ($6 each) Quantity a b c d e f 0 1 2 3 4 5 Marginal utility 0 50 38 33 29 25 Marginal utility per dollar spent 8. 33 6. 33 5. 50 Soda ($3 per six-pack) Marginal Quantity utility 10 8 6 4 2 0 15 17 19 28 42 0 Marginal utility per dollar spent -

Equalizing Marginal Utilities Per Dollar Spent Movies ($6 each) Quantity a b c d e f 0 1 2 3 4 5 Marginal utility 0 50 38 33 29 25 Marginal utility per dollar spent 8. 33 6. 33 5. 50 4. 83 Soda ($3 per six-pack) Marginal Quantity utility 10 8 6 4 2 0 15 17 19 28 42 0 Marginal utility per dollar spent -

Equalizing Marginal Utilities Per Dollar Spent Movies ($6 each) Quantity a b c d e f 0 1 2 3 4 5 Marginal utility 0 50 38 33 29 25 Marginal utility per dollar spent 8. 33 6. 33 5. 50 4. 83 4. 17 Soda ($3 per six-pack) Marginal Quantity utility 10 8 6 4 2 0 15 17 19 28 42 0 Marginal utility per dollar spent -

Equalizing Marginal Utilities Per Dollar Spent Movies ($6 each) Quantity a b c d e f 0 1 2 3 4 5 Marginal utility 0 50 38 33 29 25 Marginal utility per dollar spent 8. 33 6. 33 5. 50 4. 83 4. 17 Soda ($3 per six-pack) Marginal Quantity utility 10 8 6 4 2 0 15 17 19 28 42 0 Marginal utility per dollar spent 5. 00 -

Equalizing Marginal Utilities Per Dollar Spent Movies ($6 each) Quantity a b c d e f 0 1 2 3 4 5 Marginal utility 0 50 38 33 29 25 Marginal utility per dollar spent 8. 33 6. 33 5. 50 4. 83 4. 17 Soda ($3 per six-pack) Marginal Quantity utility 10 8 6 4 2 0 15 17 19 28 42 0 Marginal utility per dollar spent 5. 00 5. 67 -

Equalizing Marginal Utilities Per Dollar Spent Movies ($6 each) Quantity a b c d e f 0 1 2 3 4 5 Marginal utility 0 50 38 33 29 25 Marginal utility per dollar spent 8. 33 6. 33 5. 50 4. 83 4. 17 Soda ($3 per six-pack) Marginal Quantity utility 10 8 6 4 2 0 15 17 19 28 42 0 Marginal utility per dollar spent 5. 00 5. 67 6. 33 -

Equalizing Marginal Utilities Per Dollar Spent Movies ($6 each) Quantity a b c d e f 0 1 2 3 4 5 Marginal utility 0 50 38 33 29 25 Marginal utility per dollar spent 8. 33 6. 33 5. 50 4. 83 4. 17 Soda ($3 per six-pack) Marginal Quantity utility 10 8 6 4 2 0 15 17 19 28 42 0 Marginal utility per dollar spent 5. 00 5. 67 6. 33 9. 33 -

Equalizing Marginal Utilities Per Dollar Spent Movies ($6 each) Quantity a b c d e f 0 1 2 3 4 5 Marginal utility 0 50 38 33 29 25 Marginal utility per dollar spent 8. 33 6. 33 5. 50 4. 83 4. 17 Soda ($3 per six-pack) Marginal Quantity utility 10 8 6 4 2 0 15 17 19 28 42 0 Marginal utility per dollar spent 5. 00 5. 67 6. 33 9. 33 14. 00 -

Equalizing Marginal Utilities Per Dollar Spent Movies ($6 each) Quantity a b c d e f 0 1 2 3 4 5 Marginal utility 0 50 38 33 29 25 Marginal utility per dollar spent 8. 33 6. 33 5. 50 4. 83 4. 17 Soda ($3 per six-pack) Marginal Quantity utility 10 8 6 4 2 0 15 17 19 28 42 0 Marginal utility per dollar spent 5. 00 5. 67 6. 33 9. 33 14. 00 -

Lisa Maximizes Utility w She spends all her income and MUmovies/ Pmovies = MUsoda/ Psoda (38/6) = (19/3) = 6. 33 w Equivalently: MUmovies/MUsoda = Pmovies/ Psoda (38/19) = (6/3) =2

Why the Marginal Utility Rule Maximizes Total Utility Case I w 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. w 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 w 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. w If MUmovies/ Pmovies < MUsoda/ Psoda then the next soda provides more satisfaction per dollar than a movie.

Marginal utility per dollar spent (units of utility per dollar) Equalizing Marginal Utilities Per Dollar Spent 16. 00 12. 00 8. 33 6. 33 5. 67 4. 00 Movies Soda Possibility 0 10 a 1 8 b 2 6 c 3 4 d 4 2 e 5 0 f

Marginal utility per dollar spent (units of utility per dollar) Equalizing Marginal Utilities Per Dollar Spent 16. 00 12. 00 8. 33 6. 33 5. 67 4. 00 MUm Pm Movies Soda Possibility 0 10 a 1 8 b 2 6 c 3 4 d 4 2 e 5 0 f

Marginal utility per dollar spent (units of utility per dollar) Equalizing Marginal Utilities Per Dollar Spent MUs Ps 16. 00 12. 00 8. 33 6. 33 5. 67 4. 00 MUm Pm Movies Soda Possibility 0 10 a 1 8 b 2 6 c 3 4 d 4 2 e 5 0 f

Marginal utility per dollar spent (units of utility per dollar) Equalizing Marginal Utilities Per Dollar Spent MUs Ps 16. 00 12. 00 Case II Utility gain from more soda and fewer movies Maximum total utility 8. 33 6. 33 5. 67 4. 00 Movies Soda Possibility 0 10 a Case I Utility gain from more movies and less soda 1 8 b 2 6 c MUm Pm 3 4 d 4 2 e 5 0 f

Consuming Only Sodas Marginal utility per dollar spent (units of utility per dollar) MUs Ps Movies Soda Possibility MUm Pm 0 10 a 1 8 b 2 6 c 3 4 d 4 2 e 5 0 f

Marginal utility per dollar spent (units of utility per dollar) Consuming Only Movies Soda Possibility MUm Pm MUs Ps 0 10 a 1 8 b 2 6 c 3 4 d 4 2 e 5 0 f

The Power of Marginal Analysis w The method we have used to maximize Lisa’s utility is an example of marginal analysis. w By comparing marginal gain with marginal loss, we can guarantee that total utility is maximized.

New Ways of Explaining Consumer Choices w. Behavioral 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 w. Bounded Rationality §Bounded 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 w. Bounded Willpower §Bounded 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 w. Bounded Self-Interest §Bounded 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 w. One behavior observed by behavioral economists is more general and might affect your choices. w. 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 w. Neuroeconomics §Neuroeconomics 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 w. Controversy §Should 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.