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SAYRE | MORRIS Seventh Edition CHAPTER 5 Consumer Choice © 2012 McGraw-Hill Ryerson Limited 5-1 CHAPTER 5 Consumer Choice Learning Objectives: LO1: Explain the law of diminishing marginal utility LO2: Derive a consumers’ purchasing rule which ensures that satisfaction is maximized LO3: Explain how marginal utility theory is applicable to real-world examples LO4: Provide a theoretical rationale for downward sloping demand curves © 2012 McGraw-Hill Ryerson Limited 5-2 CHAPTER 5 Consumer Choice Learning Objectives: LO5: Understand why consumers generally value a product more than the price they pay LO6: Understand why some sellers charge different prices to different consumers for the same product © 2012 McGraw-Hill Ryerson Limited 5-3 LO1 Diminishing Marginal Utility Marginal • extra or additional unit Utility • the satisfaction or pleasure derived from the consumption of a product © 2012 McGraw-Hill Ryerson Limited 5-4 LO1 Diminishing Marginal Utility Marginal Utility • the amount of additional utility derived from the consumption of an extra unit of a product total utility Marginal utility (MU) quantity Total Utility • the sum of the marginal utility from each unit © 2012 McGraw-Hill Ryerson Limited 5-5 LO1 Diminishing Marginal Utility Marginal Utility applies when: • the consumer is behaving rationally • the consumer’s objective is maximum satisfaction • purchases and consumption take place over a short period of time • the units purchased may sometimes be sets of items © 2012 McGraw-Hill Ryerson Limited 5-6 LO1 Diminishing Marginal Utility TABLE 5.1 Total Marginal Utility Quantity Marginal Utility (MU) Total Utility (TU) 1 45 45 2 36 81 3 25 106 4 21 127 5 12 139 6 0 139 7 -6 133 © 2012 McGraw-Hill Ryerson Limited 5-7 LO1 Diminishing Marginal Utility Law of Diminishing Marginal Utility • the amount of additional utility decreases as successive units of a product are consumed © 2012 McGraw-Hill Ryerson Limited 5-8 LO1 © 2012 McGraw-Hill Ryerson Limited 5-9 LO1 Self-Test Complete the table, which shows Michelle’s utility for milkshakes. Quantity 1 2 3 4 5 6 7 8 Total Utility (TU) 20 35 _____ _____ 58 60 _____ _____ © 2012 McGraw-Hill Ryerson Limited Marginal Utility (MU) _____ _____ 10 8 _____ _____ 0 –5 5-10 LO1 Self-Test Complete the table, which shows Michelle’s utility for milkshakes. Quantity 1 2 3 4 5 6 7 8 Total Utility (TU) 20 35 45 _____ _____ 53 58 60 60 _____ 55 _____ © 2012 McGraw-Hill Ryerson Limited Marginal Utility (MU) _____ 20 _____ 15 10 8 _____ 5 2 _____ 0 –5 5-11 LO2 Optimal Purchasing Rule • A rational consumer should purchase the product that yields the greatest marginal utility per dollar MU per $ spent MU price MU A MU B if consume more A PA PB MU A MU B if consume more B PA PB © 2012 McGraw-Hill Ryerson Limited 5-12 LO2 Optimal Purchasing Rule • in order to maximize utility, a consumer should spend her budget so that $MU spent on all products is equal MU A MU B MU Z ....... PA PB Pz © 2012 McGraw-Hill Ryerson Limited 5-13 LATTÉS Quantity MU 1 2 3 4 5 6 45 36 25 21 12 0 PIECES OF PASTRY MU per $ (price = $3) 15 12 8.3 7 4 0 Purchase Product first second third first pastry first latté second pastry second latté third pastry third latté fourth latté fourth fifth sixth seventh LO2 Total spent Quantity MU 1 2 3 4 5 6 64 52 40 26 10 0 MU per $ (price = $4) 16 13 10 6.5 2.5 0 $4 7 11 MU per $ Spent $16 15 13 Marginal utility 64 45 52 Total utility 64 109 161 14 12 36 197 18 10 40 237 21 24 8.3 7 25 21 262 283 © 2012 McGraw-Hill Ryerson Limited 5-14 LO2 Self-Test Given the following marginal utilities and prices, which product would a rational consumer choose? Apple Marginal Utility Price Beer Ice Cream Hot Dog 120 300 140 150 $1.50 $4.00 $2.00 $3.00 © 2012 McGraw-Hill Ryerson Limited 5-15 LO2 Self-Test Given the following marginal utilities and prices, which product would a rational consumer choose? Apple Marginal Utility Price Beer Ice Cream Hot Dog 120 300 140 150 $1.50 $4.00 $2.00 $3.00 A rational consumer would choose an apple because it has the highest MU per $ as seen here: MU/Price Apple Beer Ice Cream Hot Dog 80 75 70 50 © 2012 McGraw-Hill Ryerson Limited 5-16 LO3 Marginal Utility Theory Insights into Consumer Behaviour • products with low income elasticities (water, food) have the highest initial marginal utilities, will be purchased first • rule applies only to the purchasing of the product, not to its repeated “consumption” • cannot compare utilities between people © 2012 McGraw-Hill Ryerson Limited 5-17 LO4 Marginal Utility and Demand Akio’s Dollar Marginal Utility Quantity Consumed 1 2 3 4 5 6 7 Demand Curve, Derived $MU Price $8 5 4 3 2 1 0 $10 9 8 7 6 5 4 3 2 1 © 2012 McGraw-Hill Ryerson Limited Quantity Demanded 0 0 1 1 1 2 3 4 5 6 5-18 LO4 Marginal Utility and Demand © 2012 McGraw-Hill Ryerson Limited 5-19 LO4 Diamond Water Paradox • Why is water (which has a very high value in use) inexpensive, while diamonds (which have a low value in use) expensive? • Value in use is reflected in the total utility of a product • Value in exchange (the price) is determined by its marginal utility. © 2012 McGraw-Hill Ryerson Limited 5-20 LO5 Consumer Surplus • the difference between what a customer is willing to pay and the actual price of the product Drums of Water First Second Third Fourth $MU $1000 500 200 100 Price $25 25 25 25 Marginal Consumer Total Consumer Surplus Surplus $975 $975 475 1450 175 1625 75 1700 marginal consumer surplus (MCS) $MU price total consumer surplus4 units MCS1 MCS2 MCS3 MCS4 © 2012 McGraw-Hill Ryerson Limited 5-21 LO5 Consumer Surplus Consumer surplus = ½ x (32-20) x (60,000-0) = $360,000 OR add up all consumer surpluses © 2012 McGraw-Hill Ryerson Limited 5-22 LO5 Consumer Surplus © 2012 McGraw-Hill Ryerson Limited 5-23 LO5 Self-Test Assuming partial units cannot be bought, what is the marginal consumer surplus for each unit bought, and what is the total consumer surplus if the price is $6? Price $10 9 8 7 6 Quantity 1 2 3 4 5 © 2012 McGraw-Hill Ryerson Limited 5-24 LO5 Self-Test Price $10 9 8 7 6 Qty 1st 2nd 3rd 4th 5th Quantity 1 2 3 4 5 Willing to pay Actual Price Marginal Surplus $10 $6 $4 9 6 $3 8 6 $2 7 6 $1 6 6 0 Total consumer surplus = $10 © 2012 McGraw-Hill Ryerson Limited 5-25 LO6 Price Discrimination • the selling of an identical product at a different price to different customers • for reasons other than differences in the cost of production • consumers have different demands for the same product • are therefore prepared to pay different prices © 2012 McGraw-Hill Ryerson Limited 5-26 LO6 Price Discrimination © 2012 McGraw-Hill Ryerson Limited 5-27 LO6 Price Discrimination To practice price discrimination, must: • identify groups of customers with different demand elasticities • separate them from the others • ensure that those obtaining the lower prices cannot resell the product • ensure that the seller has control over the price © 2012 McGraw-Hill Ryerson Limited 5-28 LO6 Self-Test Demand for haircuts from seniors differs greatly from that from your other customers: Price 20 18 16 14 12 10 8 Qd Seniors 1 4 7 10 13 16 19 Qd Others 9 10 11 12 13 14 15 a) If you could only charge one price to all customers, which price would give you the greatest sales revenue? b) Suppose that you charged a different price for seniors. What prices would you charge each group in order to maximize your sales revenue? © 2012 McGraw-Hill Ryerson Limited 5-29 LO6 Self-Test Price 20 18 16 14 12 10 8 Qd Seniors 1 4 7 10 13 16 19 TR Qd Others TR TR Total $20 72 112 140 156 160 152 9 10 11 12 13 14 15 $180 180 176 168 156 140 120 $200 252 288 308 312 300 282 a) If you could only charge one price to all customers, which price would give you the greatest sales revenue? $12, which gives a total sales revenue of $312 © 2012 McGraw-Hill Ryerson Limited 5-30 LO6 Self-Test Price 20 18 16 14 12 10 8 Qd Seniors 1 4 7 10 13 16 19 TR Qd Others TR TR Total $20 72 112 140 156 160 152 9 10 11 12 13 14 15 $180 180 176 168 156 140 120 $200 252 288 308 312 300 282 b) Suppose that you charged a different price for seniors. What prices would you charge each group to maximize your revenue? $10 to seniors (total revenue of $160). $18 (or $20) to the other customers (total revenue of $180). (In total, then, the sales revenue would be $340.) © 2012 McGraw-Hill Ryerson Limited 5-31 Chapter 5 Summary • • • • • Marginal utility and total utility Consumers’ optimal purchasing rule The law of diminishing marginal utility and how it relates to a downward sloping demand curve Consumer surplus and how to calculate it Price discrimination and the conditions required © 2012 McGraw-Hill Ryerson Limited 5-32