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CHAPTER
Utility and Demand
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 sixpacks—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 utilitymaximizing 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