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PART 3
Households’ Choices
Utility and Demand
Copyright © 2006 Pearson Education Canada
8
CHAPTER
Objectives
After studying this chapter, you will 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
Copyright © 2006 Pearson Education Canada
Household’s Budget
A household’s consumption choices are determined by:
 Consumption possibilities
 Preferences
Consumption Possibilities
A household’s consumption possibilities are constrained
by its budget and the prices of the goods and services it
buys.
A budget line describes the limits to a household’s
consumption choices.
Copyright © 2006 Pearson Education Canada
Household’s Budget
Figure 7.1 shows a budget
line.
The household can afford
all the points on or below
the budget line.
The household cannot
afford the points beyond
the budget line.
Copyright © 2006 Pearson Education Canada
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 pop is $3 a sixpack.
So the relative price of a movie is $6 per movie divided by
$3 per six-pack, which equals 2 six-packs per movie
Copyright © 2006 Pearson Education Canada
Household’s Budget
A fall in the price of the
good on the x-axis
increases the affordable
quantity of that good and
decreases 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.
Copyright © 2006 Pearson Education Canada
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 pop, 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).
Copyright © 2006 Pearson Education Canada
Household’s Budget
An change in the
household’s 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.
Copyright © 2006 Pearson Education Canada
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.
Copyright © 2006 Pearson Education Canada
Preferences and Utility
Table 7.1 provides an
example of total utility
schedule.
Figure 7.3(a) shows a total
utility curve.
Total utility increases with
the consumption of a
good.
Copyright © 2006 Pearson Education Canada
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.
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Preferences and Utility
Figure 7.3(b) illustrates
diminishing marginal utility.
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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 shows an example of the utility-maximizing
combination, which is called a consumer equilibrium.
Copyright © 2006 Pearson Education Canada
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 on all goods.
The marginal utility per dollar is the marginal utility from
a good divided by its price.
Copyright © 2006 Pearson Education Canada