Download Chapter 6

Chapter 6
Consumer Choice Theory
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2002 South-Western College Publishing
1
What is util?
A hypothetical unit used
to measure how much
utility a person obtains
from consuming a good
2
What is utility?
The satisfaction, or
pleasure, that people
receive from consuming a
good or service
3
What is total utility?
The amount of satisfaction
received from all the units
of a good or service
consumed
4
Why does a
consumer buy one
bundle of goods,
rather than another?
Consumers make one
choice over another
depending on their
marginal utility
5
What is marginal utility?
The change in total utility
from one additional unit
of a good or service
6
What is the law of
diminishing
marginal utility?
The principle that the
extra satisfaction of a
good or service declines
as people consume
more in a given period
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8
6
4
2
Marginal Utility
Diminishing Marginal Utility
MU
1
2
3
4
Q
8
Total Utility
16
TU
12
8
4
1
2
3
4
Q
9
When is total
utility maximized?
When the marginal utility
per dollar of each good
is equal and the entire
budget is spent
10
What is
consumer equilibrium?
A condition in which total
utility cannot increase
by spending more of a
given budget on one
good and spending less
on another good
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Even though water
provides a greater utility
than diamonds, why are
diamonds more
expensive?
Water is plentiful in most
of the world, so its
marginal utility is low
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8
6
4
2
Marginal Utility
Marginal Utility of Diamonds
S
MUd
MU
1
2
3
4
Q
13
Marginal Utility of Water
4
2
Marginal Utility
8
6
S
MUw
1
2
MU
3
4
Q
14
Marginal Utility for Big Macs and
Milkshakes (utils per day) ($2 each)
BIG MACS
Quantity
MU MU/P
MILKSHAKES
MU
MU/P
1
8
4
6
3
2
4
2
4
2
3
2
1
1
1/2
4
1
1/2
0
0
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Consumer Equilibrium
=
=
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Consumer Equilibrium
Price of Big Mac = $2
=
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What happens if the
price of a Big Mac
falls to $1 and upsets
the previous
equilibrium?
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Consumer Equilibrium
Price of Big Mac = $1
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What happens to the
number of Big Macs
bought when the
price drops?
To restore maximum
total utility, the
consumer spends more
on Big Macs
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What does this
discussion of
utility reveal?
The law of demand, that
is, as the price of a good
declines, consumers will
buy more units of the
good, and vice versa
21
What are two
alternative explanations
of demand?
Income effect
Substitution effect
22
What is the
income effect?
The change in
quantity demanded
of a good or service
caused by a change
in real income
(purchasing power)
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What does the income
effect show?
As prices decline, your
real income increases,
increasing your buying
power, so you buy more
units, ceteris paribus
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What is the
substitution effect?
The change in quantity
demanded of a good
or service caused by
the change in its price
relative to substitutes
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What does the
substitution
effect show?
Suppose the price of a Pepsi
falls and the price of a Coke
remains unchanged; you
will buy more Pepsi,
because relatively, it is less
expensive than Coke
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What does the
substitution and
income effect prove?
The law of demand, that
is, as the price of a
good declines,
consumers will buy
more units of the good,
and vice versa
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What is a normal good?
A good that consumers
will buy more of as
their incomes increase
28
What is an
inferior good?
A good that consumers
will buy less of as their
incomes increase
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Key Concepts
30
Key Concepts
•
•
•
•
•
What is util?
What is utility?
What is total utility?
What is marginal utility?
What is the law of diminishing marginal
utility?
• When is total utility maximized?
• What is consumer equilibrium?
31
Key Concepts cont.
• What are two alternative explanations of
demand?
• What is the income effect?
• What is the substitution effect?
• What does the substitution and Income effect
prove?
• What is a normal good?
• What is an inferior good?
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Summary
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Utility is the satisfaction or
pleasure derived from
consumption of a good or
service. Actual measurement of
utility is impossible, but
economists assume it can be
measured by a fictitious unit
called the util.
34
Total utility is the total level of
satisfaction derived from all units
of a good or service consumed.
Marginal utility is the change in
total utility from a one unit
change in the quantity of a good
or service consumed.
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8
6
4
2
Marginal Utility
Diminishing Marginal Utility
MU
1
2
3
4
Q
36
Total Utility
16
TU
12
8
4
1
2
3
4
Q
37
The law of diminishing
marginal utility states that
marginal utility of a good or
service eventually declines
as consumption increases.
38
Consumer equilibrium is the
condition of reaching the
maximum level of satisfaction,
given a budget, when the marginal
utility per dollar spent on each
good purchased is equal.
39
Consumer equilibrium and the law
of diminishing marginal utility can
be used to derive a downwardsloping demand curve. When the
price of a good falls, consumer
equilibrium no longer holds
because the marginal utility the
marginal utility per dollar for the
good rises.
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To restore equilibrium, the
consumer must increase
consumption. As the quantity
demanded increases, the
marginal utility falls until
equilibrium is again achieved.
Thus, the price falls and the
quantity demanded rises, as
predicted by the law of demand
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Consumer Equilibrium
=
=
42
The income effect and the
substitution effect are
complementary explanations for
the law of demand. When the
price changes, these effects
work in combination to change in
the quantity demanded in the
opposite directions.
43
As the price falls, real purchasing
power increases, causing an
increase in the consumer’s
willingness and ability to purchase
a good or service. This is the
income effect. Also, as the price
falls, the consumer substitutes the
cheaper the cheaper good for other
goods that are now relatively more
expensive. This is the substitution
effect.
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If the marginal utility per last
dollar spend on each good is
equal and the entire budget is
spent, total utility is maximized.
45
When the price of a normal good
falls, the income effect and the
substitution effect combine to
cause the quantity demanded to
increase.
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Chapter 6 Quiz
©2002 South-Western College Publishing
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1. As an individual consumes more of a
given good, the marginal utility of that
good to the consumer
a. rises at an increasing rate.
b. rises at a decreasing rate.
c. falls.
d. rises.
C. As a consumer consumes more and
more of anything, the satisfaction
received on the last unit becomes less
and less with each unit.
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2. The amount of added utility that a
consumer gains from the consumption
of one more unit of a good is called
a. incremental utility.
b. total utility.
c. diminishing utility.
d. marginal utility.
D. The word “margin” means that last
unit or the last increment.
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3. A certain consumer buys only food and
compact discs. If the quantity of food
bought increases, while that of compact
discs remains the same, the marginal
utility of food will
a. fall relative to the marginal utility of
compact discs.
b. rise relative to the marginal utility of
compact discs.
c. rise, but not as fast as the marginal
utility of compact discs falls.
A. As more units of food are purchased,
the marginal utility diminishes, while
that of compact disks remains the same.
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4. Rational consumers will continue to
consume two goods until
a. the marginal utility per dollar’s worth of
the two goods is the same.
b. the marginal utility is the same for each
good.
c. the prices of the two goods are equal.
d. the prices of the two goods are unequal.
A. If a consumer can raise his/her
marginal utility by purchasing more of a
good, more units of that good will be
purchased. At the point that marginal
utility cannot be increased by
purchasing more units of either good,
the consumer will stop purchasing. 51
5. Assume a person’s consumption of just
the right amounts of pork and chicken is
in equilibrium. We can conclude that the
a. marginal utility of pork must equal the
marginal utility of chicken.
b. price of pork must equal the price of
chicken.
c. ratio of marginal cost to price must be
the same in both the pork and the
chicken markets.
d. ratio of marginal utility to price must
be the same for pork and chicken.
D. In terms of satisfaction, the two goods
become identical at the point of
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equilibrium.
6. Assume an individual consumes only
milk and doughnuts, and he/she has
arranged consumption so that the last
glass of milk yields 12 utils and the last
doughnut 6 utils. If the price of milk is $1
per glass and the price of a doughnut is
$.50, we can conclude that the
a. consumer should consume less milk
and more doughnuts.
b. price of milk is too high relative to
doughnuts.
c. consumer should consume more milk
and fewer doughnuts.
d. consumer is in equilibrium.
D. At this point, the ratio of utils to
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price is the same.
7. Suppose an individual consumes pizza
and cola. To reach consumer
equilibrium, the individual must consume
pizza and cola so that the
a. price paid for the two goods is the
same.
b. marginal utility of the two goods is
equal.
c. ratio of marginal utility to price is the
same for both goods.
d. ratio of marginal utility of cola to
marginal utility of pizza is 1.
C. When the ratio of utils to price is the same
for two goods, the consumer cannot
increase his/her satisfaction by buying
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more of either.
8. A state of consumer equilibrium for
goods consumed prevails when the
a. marginal utility of all goods is the
same.
b. marginal utility per dollar’s worth of
two goods is the same.
c. price of two goods is the same.
d. marginal cost per dollar spent on two
goods is the same.
B. When the marginal utility of two goods
is the same, the consumer cannot
increase his/her level of satisfaction by
purchasing more of either good.
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9. The change in quantity demanded
resulting from a change in purchasing
power is known as the
a. income effect.
b. substitution effect.
c. law of demand.
d. consumer equilibrium effect.
A. When prices decline the purchasing
power of the consumer increases, and
vice versa. Therefore, a change in
prices has the same effect on the
buying power of the consumer as if
his/her income had changed.
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Total Utility for Multiplex Tickets,
Video Rentals, and Popcorn
Total Utility
from Multiplex
Tickets
Total Utility
from Video
Rentals
Total Utility
from Popcorn
1 movie (30 utils) 1 video (14 utils) 1 bag (8 utils)
2 movies (54 utils) 2 videos (24 utils)2 bags (13 utils)
3 movies (72 utils) 3 videos (30 utils)3 bags (15 utils)
4 movies (84 utils) 4 videos (32 utils)4 bags (16 utils)
Exhibit 4
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10. In exhibit 4, assume Multiplex tickets
cost $6 each, video rentals cost $2 each,
and bags of popcorn cost $1 each. What
is the marginal utility of renting a third
video?
a. 6 utils.
b. 8 utils.
c. 10 utils.
d. 30 utils.
A. If the total utility for 2 videos is 24
utils and the total utility for 3 videos
is 30 utils, the additional utils added
by the third video is 6.
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11. In exhibit 4, assume Multiplex tickets cost $6
each, video rentals cost $2 each, and bags of
popcorn cost $1 each. Suppose the consumer
has $12 per week to spend on Multiplex tickets,
video rentals, and popcorn. What combination of
goods will give the consumer the most utility?
a. 30 movies, 30 videos, and no popcorn.
b. 30 movies, 24 videos, and 13 bags of popcorn.
c. 30 movies, 14 videos, and 16 bags of popcorn.
d. 54 movies, no video, and no bags of popcorn.
B. 67 total utils are achieved with this
combination, b yields 67 utils, c yields
60 utils and d yields 54 utils.
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END
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