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4 Consumer Choice: Individual and Market Demand Everything is worth what its purchaser will pay for it. PUBLILIUS SYRUS (1ST CENTURY B.C.) Contents ● Scarcity and Demand ● Utility: A Tool to Analyze Purchase Decisions ● Consumer Choice as a Trade-off: Opportunity Cost ● From Individual Demand Curves to Market Demand Curves Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Contents (continued) ● Exceptions to the Law of Demand ● Appendix: Analyzing Consumer Choice Graphically: Indifference Curve Analysis Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Scarcity and Demand ● Income is limited. ● Consumer decisions to purchase different commodities are interdependent. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Utility: A Tool to Analyze Purchase Decisions ● The Purpose of Utility Analysis ♦ The purpose of utility analysis = analyzing how people behave rather than how they think ♦ Theory of consumer choice = each consumer spends his or her income in a way that yields the greatest satisfaction ♦ Utility = amount of satisfaction Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Utility: A Tool to Analyze Purchase Decisions ● Total versus Marginal Utility ♦ Total utility = benefit to a consumer from all the units of a good purchased ♦ Marginal utility = benefit from the last unit of a good purchased ♦ number of goods purchased total utility but a marginal utility Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Utility: A Tool to Analyze Purchase Decisions ● The “Law” of Diminishing Marginal Utility ♦ The law of diminishing marginal utility = the more of a good a consumer has, the less marginal utility an additional unit contributes to overall satisfaction ♦ Additional units of a commodity are worth less and less to a consumer in money terms. Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-1 Your Total and Marginal Utility for Pizza TABLE Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-1 A Marginal Utility Curve: Your Demand for Pizza Marginal Utility (Price) per Pizza FIGURE $16 A 15 14 B C 13 12 D 11 P 10 9 E 8 7 6 F 5 4 G 3 2 1 0 P H 1 2 3 4 5 6 7 8 Number of Pizzas per Month Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Utility: A Tool to Analyze Purchase Decisions ● Using Marginal Utility: The Optimal Purchase Rule ♦ Buy the quantity of each good at which price and marginal utility are exactly equal. ♦ If marginal utility is greater (less) than price, the consumer can improve well being by purchasing more (less). Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-2 Finding Your Optimal Pizza Purchase Quantity Total Net Utility FIGURE $9 8 7 6 5 4 3 2 1 0 –1 –2 M Total net utility hill 1 2 3 4 5 6 Number of Pizzas Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Utility: A Tool to Analyze Purchase Decisions ● From Diminishing Marginal Utility to Downward-Sloping Demand Curves ♦ Law of diminishing marginal utility negative slope of demand curves ♦ price quantity of demand marginal utility ♦ Restores equality between price and marginal utility Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-2 List of Optimal Quantities of Pizza TABLE Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Consumer Choice as a Trade-Off: Opportunity Cost ● Decision to purchase something decision to forgo something else ● Opportunity cost of spending an extra dollar on good X = the utility from good Y the purchaser could have gotten by spending that dollar on good Y Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Consumer Choice as a Trade-Off : Opportunity Cost ● Consumer’s Surplus: The Net Gain from a Purchase ♦ Voluntary purchase benefit > costs ♦ Consumer’s surplus = net benefit to the buyer ♦ Measured by the sum, over each unit bought, of the excess of marginal utility above price Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-3 Calculating Marginal Net Utility (Surplus) TABLE Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-3 Graphic Calculation of Consumer’s Surplus Marginal Utility and Price per Pizza FIGURE $16 $15.00 Marginal utility (demand) curve A 15 14 $13.00 B $4.00 13 $12.50C $11.50 D 12 $2.00 $1.50 11 $0.50 P P 10 9 $8.00 E 8 7 6 $5.00 5 F 4 $3.00 3 G 2 1 $0 0 1 2 3 4 5 6 7 8 Number of Pizzas Purchased Copyright© 2003 South-Western/Thomson Learning. All rights reserved. ? Resolving the DiamondWater Paradox ● Diamonds are scarce and unnecessary high price and high marginal utility Resolving the Diamond-Water Paradox ● Water is plentiful and necessary low price but greater total utility Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Consumer Choice as a Trade-Off : Opportunity Cost ● Income and Quantity Demanded ♦ income purchases of normal goods Income and Quantity Demanded ♦ income purchases of inferior goods Copyright© 2003 South-Western/Thomson Learning. All rights reserved. From Individual to Market Demand Curves ● Market Demand as a Horizontal Sum ♦ Market demand curve = the horizontal sum of the individual demand curves ● The “Law” of Demand ♦ Negative slope for market demand curves ■Individual demand curves usually have negative slopes ■Lower price draws new customers into the market Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-4 Total Market Demand vs. Individual Consumer Demand FIGURE Naomi’s demand M Market demand Price $10 A A K Price Z Price D Alex’s demand N N C C 9 D 0 9 Quantity Demanded (a) 6 Z 0 M 6 Quantity Demanded (b) 0 15 Quantity Demanded (c) Copyright© 2003 South-Western/Thomson Learning. All rights reserved. From Individual to Market Demand Curves ● Exceptions to the Law of Demand ♦ Some inferior goods ♦ Goods whose quality is judged by price ♦ Goods with snob appeal Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Appendix: Analyzing Consumer Choice Graphically: Indifference Curve Analysis Geometry of Available Choices: The Budget Line ● Budget line ♦ Graphical representation of all possible combinations of a household’s purchases of two goods, given their prices and a fixed amount of money to spend ● Properties of the Budget Line ♦ Represents the maximum amounts of the goods the consumer can afford Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-4 Alternative Purchase Combinations TABLE Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-5 A Budget Line 7 Pounds of Cheese FIGURE 6 A 5 G B 4 C 3 2 K D 1 0 1 2 3 E 4 5 6 7 Boxes of Rubber Bands Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Geometry of Available Choices: The Budget Line ● Changes in the Budget Line ♦ income parallel shift in the budget line ♦ relative prices of the goods slope of the budget line Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-6 The Effect of Income Changes on the Budget Line FIGURE 9 U Pounds of Cheese 8 7 6 5 A Income = $18 D 4 Income = $12 3 Income = $9 2 1 0 1 2 N 3 E 4 5 P 6 7 8 Boxes of Rubber Bands Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-7 The Effect of Price Changes on the Budget Line FIGURE Pounds of Cheese 7 6 A 5 Rubber band price = $3.00 Rubber band price = $1.50 4 3 2 1 0 1 2 3 E 4 H 5 6 7 8 Boxes of Rubber Bands Copyright© 2003 South-Western/Thomson Learning. All rights reserved. Properties of the Indifference Curve ● Indifference curve = a line connecting all combinations of the goods that are equally desirable ● Properties of the indifference curve: ♦ higher is better ♦ never intersect ♦ negative slope ♦ bowed in (convex) Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-8 3 Indifference Curves for Cheese and Rubber Bands FIGURE Pounds of Cheese 7 6 5 U 4 T 3 2 IC S 1 0 R W 1 2 Ib Ia 3 4 5 6 7 8 Boxes of Rubber Bands Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Slopes of Indifference Curves and Budget Lines ● Slope of the indifference curve = marginal rate of substitution of the two goods ● The slope of the budget line = relative prices of the two goods Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-9 Slopes of a Budget Line and an Indifference Curve FIGURE I Pounds of Cheese M B R N m D n r E I F B 0 Boxes of Rubber Bands Copyright© 2003 South-Western/Thomson Learning. All rights reserved. FIGURE 4-10 Optimal Consumer Choice Pounds of Cheese 7 6 Ic I aI b 5 4 U T 3 2 K 1 0 W 1 2 3 4 5 6 7 Boxes of Rubber Bands Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Slopes of Indifference Curves and Budget Lines ● Tangency Conditions ♦ Utility maximization point on the budget line tangent to an indifference curve ♦ Marginal rate of substitution = price ratio at that point Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Slopes of Indifference Curves and Budget Lines ● Consequences of Income Changes: Inferior Goods ♦ Inferior goods: indifference curves located such that income ■ purchases of one good ■ purchases of the other Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-11 Rise in Income When Neither Good Is Inferior FIGURE C Optimal consumption curve Pounds of Cheese B E T I2 I1 B 0 1 2 3 C 4 Boxes of Rubber Bands Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-12 Rise in Income, Rubber Bands Are Inferior Good FIGURE Pounds of Cheese C Optimal consumption curve B G H B 0 1 2 3 C 4 Boxes of Rubber Bands Copyright© 2003 South-Western/Thomson Learning. All rights reserved. The Slopes of Indifference Curves and Budget Lines ● Consequences of Price Changes: Deriving the Demand Curve ♦ slope of the budget line ♦ quantity purchased of that good ♦ quantity of the other good Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-13 Consequences of Price Changes Pounds of Cheese FIGURE 6 B E 3 3–4 T 3 C 0 2 3 D 8 4 Boxes of Rubber Bands Copyright© 2003 South-Western/Thomson Learning. All rights reserved. 4-14 Deriving the Demand Curve for Rubber Bands Price of Rubber Bands per Box FIGURE D $4.00 t 3.00 e 1.50 D 1 2 3 4 Quantity of Rubber Bands Demanded (boxes) Copyright© 2003 South-Western/Thomson Learning. All rights reserved.