Consumer Choice Theory Key Concepts Summary 2005 SouthWestern

Consumer Choice Theory • Key Concepts • Summary © 2005 South-Western College Publishing 1

What does this chapter cover? It takes a closer look at movements along the demand supply curves introduced in the previous chapter 2

What is util? A hypothetical unit used to measure how much utility a person obtains from consuming a good 3

What is utility? The satisfaction, or pleasure, that people receive from consuming a good or service 4

What is total utility? The amount of satisfaction received from all the units of a good or service consumed 5

Why does a consumer buy one bundle of goods, rather than another? Consumers make one choice over another depending on their marginal utility 6

What is marginal utility? The change in total utility from one additional unit of a good or service 7

What is the law of diminishing marginal utility? The principle that the extra satisfaction of a good or service declines as people consume more in a given period 8

8 6 4 2 Marginal Utility Diminishing Marginal Utility MU 1 2 3 4 Q 9

16 12 Utils Total Utility TU 8 4 1 2 3 4 Q 10

When is total utility maximized? When the marginal utility per dollar of each good is equal and the entire budget is spent 11

What is consumer equilibrium? A condition in which total utility cannot increase by spending more of a given budget on one good and spending less on another good 12

Even though water provides a greater utility than diamonds, why are diamonds more expensive? Water is plentiful in most of the world, so its marginal utility is low 13

8 6 4 2 Marginal Utility of Diamonds S MUd MU 1 2 3 4 Q 14

Marginal Utility of Water 4 2 Marginal Utility 8 6 S MUw 1 2 MU 3 4 Q 15

Marginal Utility for Big Macs and Milkshakes (utils per day) ($2 each) BIG MACS Quantity MU MU/P MILKSHAKES MU MU/P 1 8 4 6 3 2 4 2 3 2 1 1 1/2 4 1 1/2 0 0 16

Consumer Equilibrium MU A price A = MU B price B MU Z = price Z 17

Consumer Equilibrium Price of Big Mac = $2 MU of Big Mac price of Big Mac 4 utils $2 MU of milkshake = price of milkshake = 4 utils $2 18

What happens if the price of a Big Mac falls to $1 and upsets the previous equilibrium? 19

Consumer Equilibrium Price of Big Mac = $1 MU of Big Mac MU of milkshake > price of Big Mac milkshake 4 utils > 4 utils $1 $2 20

What happens to the number of Big Macs bought when the price drops? To restore maximum total utility, the consumer spends more on Big Macs 21

What does this discussion of utility reveal? The law of demand, that is, as the price of a good declines, consumers will buy more units of the good, and vice versa 22

What are two alternative explanations of demand? Income effect Substitution effect 23

What is the income effect? The change in quantity demanded of a good or service caused by a change in real income (purchasing power) 24

What does the income effect show? As prices decline, your real income increases, increasing your buying power, so you buy more units, ceteris paribus 25

What is the substitution effect? The change in quantity demanded of a good or service caused by the change in its price relative to substitutes 26

What does the substitution effect show? Suppose the price of a Pepsi falls and the price of a Coke remains unchanged; you will buy more Pepsi, because relatively, it is less expensive than Coke 27

What does the substitution and income effect prove? The law of demand, that is, as the price of a good declines, consumers will buy more units of the good, and vice versa 28

What is a normal good? A good that consumers will buy more of as their incomes increase 29

What is an inferior good? A good that consumers will buy less of as their incomes increase 30

Key Concepts 31

• • • What is util? What is utility? What is total utility? What is marginal utility? What is the law of diminishing marginal utility? • When is total utility maximized? • What is consumer equilibrium? 32

• What are two alternative explanations of demand? • What is the income effect? • What is the substitution effect? • What does the substitution and Income effect prove? • What is a normal good? • What is an inferior good? 33

Summary 34

Utility is the satisfaction or pleasure derived from consumption of a good or service. Actual measurement of utility is impossible, but economists assume it can be measured by a fictitious unit called the util. 35

Total utility is the total level of satisfaction derived from all units of a good or service consumed. Marginal utility is the change in total utility from a one unit change in the quantity of a good or service consumed. 36

8 6 4 2 Marginal Utility Diminishing Marginal Utility MU 1 2 3 4 Q 37

16 12 Utils Total Utility TU 8 4 1 2 3 4 Q 38

The law of diminishing marginal utility states that marginal utility of a good or service eventually declines as consumption increases. 39

Consumer equilibrium is the condition of reaching the maximum level of satisfaction, given a budget, when the marginal utility per dollar spent on each good purchased is equal. 40

Consumer equilibrium and the law of diminishing marginal utility can be used to derive a downwardsloping demand curve. When the price of a good falls, consumer equilibrium no longer holds because the marginal utility per dollar for the good rises. 41

To restore equilibrium, the consumer must increase consumption. As the quantity demanded increases, the marginal utility falls until equilibrium is again achieved. Thus, the price falls and the quantity demanded rises, as predicted by the law of demand 42

Consumer Equilibrium MU A price A = MU B price B MU Z = price Z 43

The income effect and the substitution effect are complementary explanations for the law of demand. When the price changes, these effects work in combination to change in the quantity demanded in the opposite directions. 44

As the price falls, real purchasing power increases, causing an increase in the consumer’s willingness and ability to purchase a good or service. This is the income effect. Also, as the price falls, the consumer substitutes the cheaper good for other goods that are now relatively more expensive. This is the substitution effect. 45

If the marginal utility per last dollar spend on each good is equal and the entire budget is spent, total utility is maximized. 46

When the price of a normal good falls, the income effect and the substitution effect combine to cause the quantity demanded to increase. 47

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