Download Chapter 7: The Logic of Individual Choice: The Foundation of Supply

Chapter 7:
The Logic of
Individual Choice:
The Foundation of
Supply and Demand
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
1
Chapter Objectives

1a. Explain why economists can believe
there are many explanations of individual
choice but nonetheless focus on self-interest.
1b. Discuss the principle of diminishing
marginal utility.

2. Summarize the principle of rational choice.
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2
Chapter Objectives

3. Explain why a consumer is maximizing
total utility when
MUX/PX = MUY/PY.

4. Explain how the principle of rational
choice accounts for the Law of Demand.

5. Explain four alternative rules for decisionmaking.
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3
Chapter Objectives

6a. Illustrate how economists use
indifference curves to represent people’s
preferences.
6b. Use indifference curves to demonstrate
how a person maximizes utility given a limited
income.
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4
Utility Theory and Individual Choice

According to economists, we behave the way
we do because of rational self interest.

Individuals want to maximize the amount of
satisfaction they receive through consuming
goods and services.
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5
Measuring Pleasure

Economists use the concept of utility—the
pleasure or satisfaction that one gets from
consuming a good or service.

A util is a unit of satisfaction created by
economists to “measure” utility.
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6
Total Utility and Marginal Utility

It is important to distinguish between
marginal and total utility.

Total utility refers to the satisfaction one
gets from one’s consumption of a product.
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7
Marginal Utility

Marginal utility refers to the satisfaction you
get from the consumption of one additional
unit of a product above and beyond what you
have consumed up to that point.
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8
Diminishing Marginal Utility

The principle of diminishing marginal
utility – after some point, the marginal utility
received from each additional unit of a good
will begin to decrease with each additional
unit consumed.
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9
Marginal and Total Utility
Pizza
slices
1
2
3
4
5
6
7
8
9
Total utility
14
26
36
44
50
54
56
56
54
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rights reserved.
Marginal utility
14
12
10
8
6
4
2
0
-2
10
Marginal and Total Utility
Total utility
70
60
50
40
30
20
10
0
Total utility
1 2 3 4 5 6 7 8 9
Slices of pizza per hour
16
14
12
10
8
6
4
2
0
-2
Marginal utility
Marginal utility
1 2 3 4 5 6 7 8 9
Slices of pizza per hour
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11
Maximizing Utility
Hamburgers (P = $2)
Ice Cream (P = $1)
Q
TU
MU MU/P
Q
TU
0
1
2
3
4
5
6
7
0
20
32
38
41
41
36
26
20 10
12
6
6
3
3 1.5
0
0
-5 -2.5
-10 -5
0
1
2
3
4
5
6
7
0
29
46
53
56
57
57
53
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rights reserved.
MU
29
17
7
3
1
0
-4
MU/P
29
17
7
3
1
0
-4
12
Maximizing Utility
Total $
spent
Purchase?
MU/P
MU
$1
1st ice cream cone
29
29
$2
2nd ice cream cone
17
17
$4
1st hamburger
10
20
$5
3rd ice cream cone
7
7
$7
2nd hamburger
6
12
$9
3rd hamburger
3
6
$10
4th ice cream cone
3
3
Total utility =
94 utils
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13
Rational Choice and Marginal Utility

If MUx/Px > MUz/Pz,
consume more of good x.

If MUy/Py > MUz/Pz,
consume more of good y.

MUx MUy MUz


When
Px
Py
Pz you are
maximizing utility
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14
Opportunity Cost

Opportunity cost is the benefit
forgone of the next-best alternative.

It is essentially the marginal utility
per dollar you forgo.
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15
Cost of Decision Making

A number of economists believe that most
people use bounded rationality rather than
using the rational choice model.

Bounded rationality means rationality based
on rules of thumb.
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16
Cost of Decision Making

We employ a variety of simple rules to make
some of our decisions:




Price conveys information
Follow the leader
Habit
Custom
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17
Graph the Budget Line

The budget constraint represents all the
combinations of two goods that a person can
afford to buy with a given income.

The budget constraint is also called the
income constraint, or budget line.
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18
Budget Constraint

Chocolate bars cost $1 and pop costs 50
cents a can.

Ella has $10 to spend.

She can buy 10 chocolate bars or 20 cans of
pop or some combination of both.
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19
Budget Line
Income = $10
Chocolate bars
10
Slope = - Ppop/Pchocolate
8
= -½
6
4
2
0
2 4 6 8 10 12 14 16 18 20 22
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Cans of pop
20
Budget Line Rotates
Chocolate bars
Income = $10
Pop Price = $1
10
8
6
4
Slope = - Ppop/Pchocolate
= -1
2
0
2 4 6 8 10 12 14 16 18 20 22
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rights reserved.
Cans of pop
21
Indifference Curve

Indifference curve – a curve that shows
combinations of goods amongst which an
individual is indifferent.

The slope of the indifference curve is the ratio
of marginal utilities of the two goods.
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22
Indifference Curve
Chocolate bars
|Slope|= MUpop/MUchocolate bars
20
16
12
8
4
0
= MRS of pop for chocolate bars
A
B
C
Indifference curve
D E
U
2 4 6 8 10 12 14 16 18 20 22
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Cans of pop
23
Marginal Rate of Substitution

The slope of the indifference curve is called
the marginal rate of substitution (MRS).

Marginal rate of substitution – the rate at
which one good must be added when the
other is taken away in order to keep the
individual indifferent between the two
combinations.
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24
Marginal Rate of Substitution

Law of diminishing marginal rate of
substitution – for each additional unit of a
good, the smaller the amount of the other
good needed to be given up to keep you on
your original indifference curve.
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25
Mapping of Indifference Curves
Chocolate bars
20
16
12
8
4
0
A
B
C
D
U3
E
U2
U1
2 4 6 8 10 12 14 16 18 20 22
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Cans of pop
26
Indifference Curves Cannot Cross
Chocolate bars
Thus,
20
A is preferred to D.
12
A
B
B is indifferent to C
C
8
4
0
????
A is preferred to B
16
D
U2
U1
C is preferred to D
2 4 6 8 10 12 14 16 18 20 22
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Cans of pop
27
Maximizing Utility

Ella will maximize her utility by consuming on
the highest indifference curve possible, given
her budget constraint.

The best combination is the point where the
indifference curve and the budget line are
tangent.
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28
Maximizing Utility
Chocolate bars
20
Slope= -MUpop/MUchocolate bars
16
12
8
4
0
Slope= -Ppop/Pchocolate bars
2 4 6 8 10 12 14 16 18 20 22
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rights reserved.
Cans of pop
29
Maximizing Utility

The best combination is the point where the
slope of the budget line equals the slope of
the indifference curve.
Ppop MUpop
MUChoc MUpop

so that

PChoc MUChoc
PChoc
Ppop
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30
The Logic of Individual
Choice: The Foundation of
Supply and Demand
End of Chapter 7
© 2006 McGraw-Hill Ryerson Limited. All
rights reserved.
31
Describing Consumer
Preferences Using Indifference
Curves
Chapter 7 Appendix
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rights reserved.
32
Income Expansion Path
Good Y
Good Y
IEP
IEP
U3
U3
U1
a) Normal good
U2
U1
U2
Good X
a) Inferior good
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Good X
33
Engel Curves
Quantity
Demanded
Income elastic normal good
(luxury)
X1
Income inelastic
normal good
(necessity)
X2
X3
Inferior good
Income
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34
Price Expansion Path
Good Y
B/Py
PEP
U2
U1
B/(Px)1
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B/(Px)2
Good X
35
Income Effect

Income effect reflects the purchasing power
change as a result of the change in price.


With a price decrease we can afford to buy more
– a purchasing power increase.
With a price increase we can afford to buy less –
a purchasing power decrease.
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36
Substitution Effect

Substitution effect reflects our willingness to
switch consumption away from goods that
become relatively more expensive.

If the relative price of a good falls, we buy more of
it;

At the same time, we buy less of the relatively
more expensive product.
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37
Income and Substitution Effects
Good Y
Normal Good
B/Py
E
G
PEP
U2
F
Substitution
Effect
U1
B/(Px)1
Income Effect
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B/(Px)2
Good X
38
Income and Substitution Effects
Good Y
PEP
Inferior Good
B/Py
G
E
U2
F
Substitution
Effect
U1
Income Effect B/(Px)
1
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B/(Px)2
Good X
39
Derive the Demand Curve for Good X
Good Y
A
X1
B
C
B/P1X2 X3
PEP
B/P2
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Price-expansion
path
B/P3 Good X
40
Derive the Demand Curve for Good X
Price of
Good X
P1
Demand Curve
A
B
P2
C
P3
Demand
X1
X2 X3
Quantity of
Good X
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41
Describing Consumer
Preferences Using Indifference
Curves
End of Chapter 7 Appendix
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rights reserved.
42