Download utlity and demand 1 Ch 7 Utility and Demand I. Household

Ch 7 Utility and Demand
I.
Household Consumption Choices
A. Consumption Possibilities
1.
A household’s consumption
choices depend on its
consumption possibilities and its
preferences.
2.
A household’s consumption
possibilities are constrained by its
budget and the prices of the
goods and services it buys.
3.
Figure 7.1 shows a budget line,
which separates those
combinations of goods that the
household can afford (points
below and on the budget line)
from those combinations that it
cannot afford (points above the
budget line).
B. Preferences
1.
A household’s preferences
determine the benefits or
satisfaction a person receives
consuming a good or service.
2.
The benefit or satisfaction from
the consumption a good or
service is called utility.
C. Total Utility
1.
Total utility is the total benefit a person gets from the consumption of goods. Generally,
more consumption gives more utility.
2.
The table in Figure 7.2 provides an example of total utility schedules and Figure 7.2(a)
shows a total utility curve. Total utility increases with the consumption of a good.
152
CHAPTER 7
D. Marginal Utility
1.
Marginal utility is the change in total utility that results from a one-unit increase in the
quantity of a good consumed.
2.
As the quantity consumed of a good increases, the marginal utility from consuming it
decreases.
3.
We call this decrease in marginal utility as the quantity of the good consumed increases
the principle of diminishing marginal utility. Figure 7.2(b) illustrates the concept of
diminishing marginal utility.
4.
Utility is similar to temperature. Both are abstract concepts and both are measured in
arbitrary units.
II. Maximizing Utility
A. The key assumption of marginal utility theory is that the household chooses the consumption
possibility that maximizes total utility.
B. The Utility-Maximizing Choice
1.
We can find the utility-maximizing choice by looking at the total utility that arises from
each affordable combination.
2.
A consumer equilibrium is a situation in which a consumer has allocated all his or
her available income in the way that, given the prices of goods and services, maximizes
his or her total utility.
C. Equalizing Marginal Utility per Dollar Spent
UTLITY AND DEMAND
153
1.
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 spent on all
goods.
2.
The marginal utility per dollar spent is the marginal utility from a good divided by
its price.
a) That is: the marginal utility per dollar spent on movies is MUM/PM and the marginal
utility per dollar spent on soda is MUS/PS.
3.
Table 7.3 and Figure 7.3 show why the utility maximizing rule works.
a)
If MUM/PM > MUS/PS, then moving a dollar from soda to movies increases the total
utility from movies by more than it decreases the total utility from soda, so total
utility increases.
b) Similarly, if MUS/PS > MUM/PM,then moving a dollar from movies to soda increases
the total utility from soda by more than it decreases the total utility from movies, so
total utility increases.
c) Only when MUM/PM = MUS/PS, is it not possible to reallocate the budget and
increase total utility.
154
CHAPTER 7
III. Predictions of Marginal Utility Theory
A. A Fall in the Price of a Movie
1.
When the price of a good falls the quantity demanded of that good increases—the demand
curve slopes downward.
a) For example, if the price of a movie falls, we know that MUM/PM rises, so before the
consumer changes the quantities consumed, MUM/PM > MUS/PS.
b) To restore consumer equilibrium (and thereby maximize his or her total utility) the
consumer increases the quantity of movies consumed, which decreases the MUM.
Eventually the quantity of movies increases enough so that MUM/PM = MUS/PS.
2.
Table 7.4 and Figure 7.4 (a) illustrate how a fall in the price of a movie increases the
quantity of movies demanded.
B. A Rise in the Price of Soda
1.
When the price of a good rises the quantity demanded of that good decreases—the
demand curve slopes downward.
UTLITY AND DEMAND
155
a)
For example, if the price of soda rises, we know that MUS/PS falls, so before the
consumer changes the quantities consumed, MUS/PS < MUM/PM.
b) To restore consumer equilibrium (and thereby maximize his or her total utility) the
consumer decreases the quantity of soda consumed, which increases the MUS.
Eventually the quantity of
soda decreases enough so that
MUM/PM = MUS/PS.
2.
Table 7.5 and Figure 7.5 illustrate
how a rise in the price of a soda
decreases the quantity of sodas
demanded.
C. A Rise in Income
1.
When income increases, the demand for a normal good increases.
D. Individual Demand and Market Demand
1.
The market demand for a good is the relationship between the price of the good and
total quantity demanded of that good.
2.
The individual demand for a good is the relationship between the price of the good and
the quantity demanded by one person.
156
CHAPTER 7
3.
Figure 7.6 shows how we sum the individual demand curves to obtain the market
demand.
E. Marginal Utility and Elasticity
1.
We can predict the price elasticity of demand for a good by knowing the characteristics
of the marginal utility of the good.
2.
If marginal utility diminishes rapidly as the quantity consumed increases, then a given
price change requires a small quantity change in order for the consumer to restore his or
her consumer equilibrium. In this case demand is inelastic.
3.
If marginal utility diminishes slowly as the quantity consumed increases, then a given
price change requires a large quantity change in order for the consumer to restore his or
her consumer equilibrium. In this case demand is elastic.
IV. Efficiency, Price, and Value
A. Consumer Efficiency and Consumer Surplus
1.
When consumers maximize their utility, they are using resources efficiently.
2.
At the consumer equilibrium, the marginal benefit from a good or service is the
maximum price the consumer is willing to pay for an extra unit of that good or service
when his or her utility is maximized.
UTLITY AND DEMAND
157
B. The Paradox of Value
1.
The paradox of value “Why is water, which
is essential to life, far cheaper than
diamonds, which are not essential?” is
resolved by distinguishing between total
utility and marginal utility.
2.
Figure 7.7 illustrates the resolution of the
paradox.
a)
As Figure 7.7a demonstrates, the total
utility and consumer surplus from water
is large but the marginal utility and the
price of water is small.
b) In contrast, Figure 7.7b shows that the
total utility and consumer surplus from
diamonds is small but the marginal
utility and the price of a diamond is
large.
c)
The small marginal utility and price for
water combined with the high marginal
utility and price for a diamond allow for
the consumer to be in his or her
equilibrium, in which MUW/PW =
MUD/PD.