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
Utility Theory and Individual Choice

According to economists, we behave the way
we do because of rational self interest.
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2
Utility Theory and Individual Choice

Using this simple theory, two things
determine what people do:

The pleasure people get from doing or consuming
something.

The price of doing or consuming that something.
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3
Utility Theory and Individual Choice

Price is the market's tool to bring quantity
supplied equal to the quantity demanded.

Changes in price provide incentives for
people to change what they are doing.
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4
Measuring Pleasure

Economists start with a proposition that
individuals try to get as much pleasure as
possible out of life.

The goods and services we consume provide
value (satisfaction) to us.
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5
Measuring Pleasure

Individuals want to maximize the amount of
satisfaction they receive through consuming
goods and services.
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6
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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7
Utility

Utility serves as the basis of economists'
analysis of individual choice.

It is personal and individual.

Utility cannot be compared across individuals.
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8
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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9
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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10
Marginal Utility

As additional units are consumed, marginal
utility decreases while total utility increases.

When total utility stops increasing, marginal
utility is zero.

Beyond this point, total utility decreases and
marginal utility is negative.
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11
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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12
Diminishing Marginal Utility

The principle does not say you do not enjoy
consuming more of a good.

For example, as you consume more pizza, you
enjoy additional slices less than you enjoyed the
initial slices.
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13
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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Marginal utility
14
12
10
8
6
4
2
0
-2
14
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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15
Rational Choice and Marginal Utility

Because people face a budget constraint,
they must choose among alternatives.

Rational individuals want as much
satisfaction as they can get from their
available income.
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16
Rational Choice

In making choices, you are essentially buying
units of utility.

Any choice that does not give you as many
units of utility as possible for the same
amount of money is an irrational choice.
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17
Rational Choice

Since you want to get the most for your
money, you make those choices that have
the highest units of utility per unit of cost.
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18
Principle of Rational Choice

According to the basic principle of rational
choice you should spend your money on
those goods that give you the most marginal
utility (MU) per dollar.
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19
Principle of Rational Choice

If:
MUx MUy

Px
Py
consume an additional unit of good x.
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20
Principle of Rational Choice

If:
MUx MUy

Px
Py
consume an additional unit of good y.
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21
Principle of Rational Choice

You can always decide which good it makes
more sense to consume.

Substitute the marginal utilities and prices of
goods into these formulas.

Consume the one with the highest marginal utility
per dollar.
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22
Simultaneous Decisions

Individuals often face simultaneous
decisions.

As consumption is being varied from one
choice to a combination of choices, the
marginal utilities of the other choices will fall.
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23
Maximizing Utility

You vary your consumption until you
maximize utility.

That occurs when the marginal utilities per
dollar spent on each of the choices are equal.
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24
Maximizing Utility

Total utility is maximized when marginal utility
per dollar spent of two goods is equal:
MUx MUy

Px
Py

You cannot increase your utility by adjusting
your choices.
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25
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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MU
29
17
7
3
1
0
-4
MU/P
29
17
7
3
1
0
-4
26
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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27
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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28
Rational Choice and Marginal Utility

The general utility-maximizing rule is that you
are maximizing utility when the marginal
utilities per dollar are equal across all goods
you consume.
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29
Rational Choice and Marginal Utility

When this principle is met, the consumer has
reached his maximum utility, given his
income.

The cost per additional unit of utility is equal
for all goods and the consumer is as well off
as it is possible to be.
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30
Rational Choice and Marginal Utility

The rule does not say that the rational
consumer should consume a good until its
marginal utility reaches zero.

The consumer does not have enough money
to buy all he wants.
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31
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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32
Opportunity Cost

To say MUx/Px > MUy/Py is to say
that the opportunity cost of not
consuming good x is greater than the
opportunity cost of not consuming
good y.

So we should consume more x.
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33
Opportunity Cost

When all the marginal utilities per
dollar spent are equal, the opportunity
cost of all the alternatives are equal.
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34
Rational Choice and the Law of
Demand

The principle of rational choice leads to the
law of demand.

When the price of a good goes up, the marginal
utility per dollar goes down and we consume less
of it.
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35
Rational Choice and the Law of
Demand

Initially MUx/Px = MUy/Py

When the price of good y goes up, then
MUx/Px > MUy/Py.

Our condition for maximizing utility is no
longer satisfied.
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36
Rational Choice and the Laws of
Demand and Supply

To maximize utility now we must:

consume less of the good whose relative
price has risen, thereby raising the marginal
utility we get from it, and

consume more of the good whose relative
price has fallen, thereby lowering the
marginal utility we get from it.
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37
Rational Choice and the Law of
Demand

MUx decreases as we buy more good x
(diminishing marginal utility).

MUy increases as we buy less of good y.

We are back to a point where MUx/Px =
MUy/Py and we maximize utility.

Consuming more x and less y than before.
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38
Rational Choice and the Law of
Demand

So when the price of a good goes up, we
choose to consume less of that good.
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39
Rational Choice and the Law of
Demand

Since our demand for a good is an
expression of our willingness to pay for it,
quantity demanded is related to marginal
utility.
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40
Rational Choice and the Law of
Demand

Quantity demanded rises as price falls, other
things constant.

Quantity demanded falls as price rises, other
things constant.
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41
Applying the Theory of Choice to the
Real World

There are limits on the assumptions
underlying the theory of rational decisionmaking.

In reality, people make hundreds of choices
every day.

It is difficult to believe that we are going to
apply principles of rational choice to all those
decisions.
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42
Cost of Decision Making

Some decisions are difficult to make because
we lack information, or there is some
uncertainty involved, or it is a complex
decision.

Each decision requires us to use our limited
cognitive ability to receive, process, store and
retrieve information.
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43
Cost of Decision Making

The cost of deciding among hundreds of
possible choices leads us to do something
irrational.

That is, do things without applying the
rational choice model.
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44
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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45
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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46
Cost of Decision Making

One of these rules of thumb is “you get what
you pay for.”

Higher priced goods tend to be better than
lower-priced goods.

We can use this simple rule to make a quick
decision – we rely on price to convey information
about quality.
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47
Cost of Decision Making

A second rule of thumb is “follow the leader.”

Sometimes we just do what others are doing.

Clothes manufacturers try to exploit this decision
rule with their advertising efforts by convincing us
that “everyone” is wearing a particular style.
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48
Habit

Habit explains a lot of our choices.

We did the marginal utility calculation some
time ago and we continue with the same
choice.

We rely on our previous judgment.
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49
Custom

Employing the rule of custom can ease the
burden of decision making.
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50
Maximizing Utility Using Indifference
Curves

Economists often use graphic representation
of the consumer’s choice.

The problem consists of two parts:


The budget constraint (or the income constraint)
Indifference curves, which represent utility
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51
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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52
Ella’s Choice

Ella eats chocolate bars and drinks pop.

She wants to maximize her utility given her
budget constraint.
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53
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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54
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
55
Budget Line

The slope of the budget line is the ratio of the
prices of the two goods.

The slope changes when the prices change.
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56
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
57
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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58
Graph the Indifference Curve

Indifference curves are downward sloping
and bowed inward.
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59
Indifference Curve

Ella is equally as well off (her utility is the
same) from consuming bundles A, B, C, D or
E.
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60
Indifference Curve
Chocolate bars
|Slope|= MUpop/MUchocolate bars
20
16
12
8
4
0
= MRS of pop for chocolate bars
A
B
Indifference curve
C
D E
U
2 4 6 8 10 12 14 16 18 20 22
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Cans of pop
61
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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62
Marginal Rate of Substitution

The slope is bowed inward, indicating that the
MRS is decreasing as Ella’s bundles contain
more of the good on the horizontal axis.
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63
Marginal Rate of Substitution

The reason for decreasing MRS is that as
Ella gets more and more of one good, she is
willing to give up lots of it to get more of the
relatively scarce good.
|Slope| = MUpop/MUchocolate = MRS
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64
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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65
Mapping of Indifference Curves

Ella will have a whole group of indifference
curves, each representing a different level of
utility.
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66
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
67
Mapping of Indifference Curves

The bundles of goods forming indifference
curve U3 give Ella higher utility than bundles
along U2.

The bundles of goods forming indifference
curve U1 give Ella less utility than bundles
along U2.
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68
Utility Maximization

Since more is preferred to less, Ella is better
off with the indifference curve that is farthest
to the right.
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69
Indifference Curves Cannot Cross

If indifference curves crossed, it would violate
the “more-is-preferred-to-less” principle.
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70
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
71
Maximizing Utility

The goal for a consumer is to get to the
highest indifference curve possible, given her
income constraint.

More is preferred to less.
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72
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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73
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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Cans of pop
74
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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75
Maximizing Utility

In other words, utility is maximized when the
slopes of the budget constraint and the
indifference curve are equal.
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76
Income Expansion Path

Income expansion path (IEP) traces all the
best (utility-maximizing) choices a consumer
makes as income changes.
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77
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
78
Engel Curves

An Engel curve plots all the best choices a
consumer makes against INCOME.

It is an income-quantity relationship
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79
Engel Curves
Quantity
Demanded
Income elastic normal good
(luxury)
X1
Income inelastic
normal good
(necessity)
X2
X3
Inferior good
Income
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80
Price Expansion Path

Price expansion path (PEP) traces all the
best choices of a consumer as the relative
price changes.
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81
Price Expansion Path
Good Y
B/Py
PEP
U2
U1
B/(Px)1
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B/(Px)2
Good X
82
The Logic of Individual
Choice: The Foundation of
Supply and Demand
End of Chapter 7
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rights reserved.
83