ECONOMICS 5 e Michael Parkin Utility and Demand

ECONOMICS 5 e Michael Parkin Utility and Demand

Learning Objectives • Explain the household’s budget constraint • Define 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -2

Learning Objectives (cont. ) • Explain the connection between individual demand market demand • Explain the paradox of value Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -3

Learning Objectives • Explain the household’s budget constraint • Define 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -4

Household Consumption Choices Two concepts determining consumption choices • Budget constraint • Preferences Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -5

Budget Constraint • Consumption choices are constrained by the household’s income and prices. • These limits are described by its budget line. Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -6

Consumption Possibilities Possibility Movies ($6) Soda ($3) Expenditure Quantity (dollars) Expenditure Six-packs (dollars) a 0 0 10 30 b 1 6 8 24 c d 2 3 12 18 6 4 18 12 e f 4 5 24 30 2 0 6 0 Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -7

Consumption Possibilities Soda (six-packs per month) 5 a b 4 c 3 Unaffordable d 2 1 Affordable e f 0 Copyright © 1998 Addison Wesley Longman, Inc. 1 2 3 4 5 Movies (per month) TM 8 -8

Learning Objectives • Explain the household’s budget constraint • Define 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -9

Preferences Consumption decisions depend upon a person’s likes and dislikes, or preferences. Utility is the benefit or satisfaction that a person gets from the consumption of a good or service. Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -10

Preferences Total utility is the total benefit that a person gets from the consumption of goods and services. Marginal Utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed. Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -11

Preferences Diminishing marginal utility occurs when the marginal utility decreases as the quantity of a good consumed increases. Why does marginal utility decrease? Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -12

Maria’s Total Utility from Movies and Soda Movies Soda Quantity Six-packs per month Total Utility Total utility 0 1 2 3 4 5 6 7 0 50 88 121 150 175 196 214 Copyright © 1998 Addison Wesley Longman, Inc. 0 75 117 153 181 206 225 243 Movies Soda Quantity Six-packs per month Total Utility Total utility 8 9 10 11 12 13 14 229 241 250 256 259 261 262 260 276 291 305 318 330 341 TM 8 -13

Total Utility and Marginal Utility Movies Quantity Total utility Marginal utility 0 0 1 50 2 88 3 121 4 150 5 175 Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -14

Total Utility and Marginal Utility Movies Quantity Total utility Marginal utility 0 0 50 1 50 38 2 88 33 3 121 29 4 150 25 5 175 Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -15

Total utility 200 150 100 Increasing total utility. . . 50 0 Units of utility Total Utility and Marginal Utility …and diminishing marginal utility 50 1 2 3 4 5 Quantity (movies per month) Copyright © 1998 Addison Wesley Longman, Inc. 0 Marginal utility 1 2 3 4 5 Quantity (movies per month) TM 8 -16

Learning Objectives • Explain the household’s budget constraint • Define 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -17

Maximizing Utility Marginal Utility Theory Assumes people choose the consumption possibility that maximizes their total utility. People’s wants exceed the resources available to satisfy those wants. Choices In making choices, people try to maximize total utility. Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -18

Maria'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 Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -19

Maximizing Utility Consumer equilibrium A situation in which a consumer has allocated all his or her available income in a way that, given the prices of goods and services, maximizes his or her total utility. Occurs at the combination that equates the marginal utility per dollar spent for all goods. Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -20

Maximizing Utility Consumer equilibrium Marginal utility from movies = Price of a movie Marginal utility from soda Price of soda OR MUm Pm Copyright © 1998 Addison Wesley Longman, Inc. = MUs Ps TM 8 -21

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 Copyright © 1998 Addison Wesley Longman, Inc. 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 15 17 19 28 42 Marginal utility per dollar spent 5. 00 5. 67 6. 33 9. 33 14. 00 TM 8 -22

Marginal utility per dollar spent (units of utility per dollar) Equalizing Marginal Utilities per Dollar Spent MUs Ps 16. 00 12. 00 Utility gain from more soda and fewer movies Maximum total utility 8. . 33 6. . 33 5. . 67 4. 00 Movies Soda Possibility Copyright © 1998 Addison Wesley Longman, Inc. 0 10 a 1 8 b Utility gain from more movies and less soda 2 6 c MUm Pm 3 4 d 4 2 e 5 0 f TM 8 -23

Learning Objectives • Explain the household’s budget constraint • Define 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 Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -24

Predictions of Marginal Utility Theory If the price of a good changes, the marginal utility per dollar spent will change. As a result, the quantity demanded for the good will change. Also, the demand for the good may change if people substitute goods for one another. Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -25

How a Change in Price of Movies Affects Maria’s Choices What happens to the Maria’s consumption of movies and soda if the price of movies fall to $3? Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -26

How a Change in Price of Movies Affects Maria’s Choices Movies ($3 each) Quantity 0 1 2 3 4 5 6 7 8 9 10 Soda ($3 per six pack) Marginal utility Per dollar spent Six-packs 16. 67 12. 67 11. 00 9. 67 8. 33 7. 00 6. 00 5. 00 4. 00 3. 00 10 9 8 7 6 5 4 3 2 1 0 Copyright © 1998 Addison Wesley Longman, Inc. Marginal utility Per dollar spent 5. 00 5. 33 5. 67 6. 00 6. 33 8. 33 9. 33 12. 00 14. 00 25. 00 TM 8 -27

Movies 6 Maria’s demand for movies 3 0 2 5 Price (dollars per six-pack) Price (dollars per movie) A Fall in the Price of Movies Quantity (movies per month) Copyright © 1998 Addison Wesley Longman, Inc. Soda 6 Maria’s demand for soda when movies cost $3 3 0 5 6 Quantity (six-packs per month) TM 8 -28

How a Change in Price of Movies Affects Maria’s Choices What happens to the Maria’s consumption of movies and soda if the price of sodas rise to $6? Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -29

How a Change in Price of Soda Affects Maria’s Choices Movies ($3 each) Quantity 0 2 4 6 8 10 Marginal utility Per dollar spent 12. 67 9. 67 7. 00 5. 00 3. 00 Copyright © 1998 Addison Wesley Longman, Inc. Soda ($3 per six pack) Six-packs Marginal utility Per dollar spent 5 4 3 2 1 4. 17 4. 67 6. 00 7. 00 12. 50 TM 8 -30

Soda 6 Maria’s demand for soda 3 0 2 5 Price (dollars per movie) Price (dollars per six-pack) A Rise in the Price of Soda Quantity (six-packs per month) Copyright © 1998 Addison Wesley Longman, Inc. Movies 6 Maria’s demand for movies when soda costs $3 3 0 5 6 Quantity (movies per month) TM 8 -31

Predictions of Marginal Utility Theory Marginal utility theory predicts two results: When the price of a good rises, the quantity demanded for that good decreases. If the price of one good rises, the demand for another good that can serve as a substitute increases. Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -32

A Rise in Income What happens to Maria’s consumption of movies and soda if her income rises from $30 a month to $42? Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -33

Maria’s Choices with an Income of $42 a Month Movies ($3 per movie) Marginal utility per dollar Quantity spent 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Copyright © 1998 Addison Wesley Longman, Inc. 16. 67 12. 67 11. 00 9. 67 8. 33 7. 00 6. 00 5. 00 4. 00 3. 00 2. 00 1. 00 0. 67 0. 33 Soda ($3 per six pack) Marginal utility per dollar Six-packs spent 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 3. 67 4. 00 4. 33 4. 67 5. 00 5. 33 5. 67 6. 00 6. 33 8. 33 9. 33 12. 00 14. 00 25. 00 TM 8 -34

Learning Objectives (cont. ) • Explain the connection between individual demand market demand • Explain the paradox of value Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -35

Individual Demand Market demand The relationship between the total quantity demanded of a good and its price. Individual demand The relationship between quantity demanded of a good by a single individual and its price. Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -36

Individual and Market Demand Curves Price Quantity of movies demanded (dollars per movie) Maria 7 1 0 6 2 0 5 3 0 4 4 1 3 5 2 2 6 3 Copyright © 1998 Addison Wesley Longman, Inc. Ivan Market TM 8 -37

Individual and Market Demand Curves Price Quantity of movies demanded (dollars per movie) Maria 7 1 0 1 6 2 0 2 5 3 0 3 4 4 1 5 3 5 2 7 2 6 3 9 Copyright © 1998 Addison Wesley Longman, Inc. Ivan Market TM 8 -38

8 Maria’s demand 6 4 3 2 Price (dollars per movie) Individual and Market Demand Curves 8 6 4 3 2 5 movies 0 2 4 2 movies 5 6 8 Quantity (movies per month) Copyright © 1998 Addison Wesley Longman, Inc. Ivan’s demand 0 2 4 5 6 8 Quantity (movies per month) TM 8 -39

Price (dollars per movie) Individual and Market Demand Curves 8 Market Demand 6 4 3 2 5 + 2 = 7 movies 0 Copyright © 1998 Addison Wesley Longman, Inc. 2 4 6 7 8 10 Quantity (movies per month) TM 8 -40

Learning Objectives (cont. ) • Explain the connection between individual demand market demand • Explain the paradox of value Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -41

Efficiency, Price, and Value The Paradox of Value Why does water, which is essential for life, cost so little? Why do diamonds, which are useless compared to water, cost so much? Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -42

Price of water The Paradox of Value Water Consumer surplus from water Pw S D Qw Quantity of water Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -43

The Paradox of Value Price of a diamond S Diamonds Consumer surplus from diamonds PD D QD Copyright © 1998 Addison Wesley Longman, Inc. Quantity of diamonds TM 8 -44

The Paradox of Value Diamonds have a high price and a high marginal utility, while water has a low price and a low marginal utility. The marginal utility per dollar spent is the same for diamonds as for water. Copyright © 1998 Addison Wesley Longman, Inc. TM 8 -45