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3 Consumer Choice: Individual and Market Demand Outline ● Scarcity and Demand ● Utility: A Tool to Analyze Purchase Decisions ● Consumer Choice as a Trade-off: Opportunity Cost ● From Individual Demand Curves to Market Demand Curves ● Exceptions to the Law of Demand Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Scarcity and Demand ● Income is limited → consumers face constraints on their choices ● Wealthy and poor individuals have limited incomes relative to their desires. ● Every decision has an opportunity cost. ♦ ↑purchases of clothing → ↓purchases of restaurant meals Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Utility: A Tool to Analyze Purchase Decisions ● How do consumers make choices? ♦ Theory of consumer choice = each consumer spends his or her income in a way that yields the greatest satisfaction or utility. ♦ Cannot measure utility (or satisfaction) directly. How should we measure your utility of a movie theater ticket? Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total vs. marginal utility ● Total utility = largest sum of money that a consumer will voluntarily give up for a good ♦ E.g., I will buy 7 pints of Chunky Monkey only if it costs $21.50 or less. So the TU (or benefit) that I receive from 7 pints is $21.50. ● Marginal utility = addition to TU that an individual receives by consuming 1 more unit of the good ♦ E.g., if I consumed 6 pints of Chunky Monkey, MU measures how much add. satisfaction I get by consuming 7 pints instead. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. TABLE 1. Leah’s Total and Marginal Utility from Chunky Monkey Quantity (per month) Total Utility (dollars) Marginal Utility (dollars) Label for graph 0 0.00 ------ ------ 1 6.00 6.00 A 2 11.00 5.00 B 3 15.00 4.00 C 4 18.00 3.00 D 5 20.00 2.00 E 6 21.00 1.00 F 7 21.50 0.50 G 8 21.50 0.00 H Total vs. marginal utility ● TU: 1 pint is worth no more than $6.00 to me and 2 pints are worth no more than $11.00 to me, etc. ● MU: 1st pint is worth $6 to me and 2nd pint is worth $5.00 to me, while the 3rd is worth $4.00, etc. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 1. Leah’s Marginal Utility Curve for Chunky Monkey Marginal Utility (Price) per pint FIGURE $7 6 5 4 $3 2 1 0 A B C D Price E F G H 1 2 3 4 5 6 7 8 Number of pints per Month “Law” of Diminishing MU ● Law of diminishing MU = the more of a good a consumer has, the less MU an additional unit contributes to overall satisfaction. ● Additional units of a good are worth less and less to a consumer in money terms. ♦ E.g., each add. pint is worth less to me. 1st pint eat by myself; 2nd share with my husband; 3rd share with my friend; 4th share with my dog, Dante; 5th share with my mother-in-law. Thus, each successive pint has a lower priority. Can you think of any exceptions to the law of diminishing marginal utility? Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total vs. marginal utility ● Graph of MU has (-) slope → ↓MU as ↑Qd. ● ↑TU as long as MU is (+). ♦ E.g., when a commodity is very scarce (diamonds), economists expect it to have high MU even though it provides very little TU. Can you think of a good that has a very low MU but a very high TU? Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Using MU: The Optimal Purchase Rule How many pints of Chunky Monkey should I purchase? ● Goal: max. total benefit from pints while min. their cost. As long as MU is (+), ↑TU by consuming more pints. But each add. pint costs money. ● Net TU = TU – total expenditure; where TE = P*Qd. ● Max. net TU by watching net MU; net MU = MU – P. ♦ E.g., If P = $3.00/pint and I buy 3 pints, then net MU = $1.00; so I can ↑net TU by purchasing more. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Using MU: The Optimal Purchase Rule ● Two rules govern the optimal purchase rule: 1. if net MU is (+) (or MU > P) → consumer buys too little of the good to max. net TU 2. if net MU is (-) (or MU < P) → consumer buys too much of the good to max. net TU ● Combining these 2 rules → net TU is maximized when net MU = 0 (or MU = P). MU = P is the optimal purchase rule Copyright© 2006 South-Western/Thomson Learning. All rights reserved. From MU to Demand Curves ● Demand curve = MU curve ♦ Law of diminishing MU (-) slope of D curves ♦ P Qd MU ■ E.g., P = $3 → Qd = 4 pints. But if the ↑P to $5 → Qd = 2 pints. If ↓P to $2 → Qd = 5 pints. As ↑P, use the good for higher valued uses –to share with my friend or husband. As ↓P, use the good for lower valued uses –to share with my dog or mother-in-law. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Consumer Choice as a TradeOff: Opportunity Cost ● Recall the importance of opportunity cost ● Decision to purchase something decision to forgo something else ♦ Real cost of 4 pints purchased for $3.00 each is not the $12 given up. It is the 4 movie rentals that are given up. I have given up $12 worth of other goods to buy 4 pints of Chunky Monkey. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Consumer Surplus ● CS = net TU = TU - TE ● Economists assume that firms max profit and consumers max CS. ● Consumer must experience some gain from a voluntary transaction; otherwise the consumer would refuse to purchase the good. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. TABLE 2. Calculating CS Quantity (pints per mo.) Marginal Utility Price Net MU (per unit surplus) 1 $ 6.00 $ 3.00 $ 3.00 2 5.00 3.00 2.00 3 4.00 3.00 1.00 4 3.00 3.00 0.00 5 2.00 3.00 -1.00 Two ways of calculating CS: (1) CS = TU – TE or (2) CS = ∑(MU – P) Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Marginal Utility and Price per pint FIGURE 2. Graph of CS MU 7 6 $6 A $5 5 MU (or D) curve CS per unit B $3 $4 $2 4 C $1 $3 3 D P $2 $0 2 E 0 F $.50 $1 1 1 2 3 4 5 6 G $0 7 H 8 Number of pints purchased Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Graph of Consumer Surplus ● CS = area under D curve and above P. ♦ Leah was willing to pay $18 for the 4 pints (i.e., the TU of 4 pints), but only paid $12 (i.e., $3*4) so her total CS = $6. ● TU = area under entire D curve ● TE = rectangular area that reflects P*Qd Copyright© 2006 South-Western/Thomson Learning. All rights reserved. From Individual to Market D Curves ● Market D curve = horizontal sum of individual D curves ● Steps to move from individual D to market D: 1. Pick any relevant P. 2. Find Qd at that P for each person. 3. Add the Qd at that P to get Qd in the market. Repeat these steps for all possible prices. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 3. Total Market D vs. Individual Consumer D FIGURE $7 $3 Joe’s demand L L M Market demand Price Z Price Price D Leah’s demand J J K M M 4 D 0 4 Quantity Demanded (a) 3 Z 0 1 3 Quantity Demanded (b) M 0 1 7 Quantity Demanded (c) From Individual to Market D Curves ● The “Law” of Demand ♦ (-) slope for market D curves ■ Individual D curves have (-) slopes because of the law of diminishing MU ■ Lower P draws new customers into the market ● E.g., Fig. 3, only Joe will buy Chunky Monkey at P = $7. Yet, at P < $7, Leah will also purchase ice cream. As ↓P, Joe will buy more and Leah will enter the market, insuring that ↑Qd as ↓P. Copyright© 2006 South-Western/Thomson Learning. All rights reserved. From Individual to Market D Curves ● Exceptions to the “Law” of Demand ♦ Goods whose quality is judged by price –if a ↓P signals poor quality → ↓Qd ■ E.g., Bayer aspirin vs. generic brand aspirin ♦ Goods with snob appeal –some people buy expensive goods to advertise their wealth ■ E.g., Rolls Royce Copyright© 2006 South-Western/Thomson Learning. All rights reserved.