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CHAPTER 8
THE LOGIC OF INDIVIDUAL CHOICE:
THE FOUNDATION OF SUPPLY AND DEMAND

LAUGHER CURVE
Two economists are out for a stroll together.
Q. How do you identify the University of Chicago economist?
A. He's the one walking randomly.
______________________________________________________________________________
CHAPTER OVERVIEW: What’s It All About?
This chapter is a paradox. On the one hand it introduces utility theory, rational choice and
marginal utility, maximizing utility, and how the principle of rational choice ties into the laws of
supply and demand. On the other hand, when these theories are applied to the real world
economists rightfully throw up their hands and admit that the theory of choice is a poor way to
explain the behavior of most individuals. This is not to say that economists can’t shed light on
the real motivations underlying people’s actions, motivations that individuals will not even admit
they have. “Why should barbers have licenses?” Conventional answer: “To protect the public.”
Real answer, “To limit the number of barbers.” “Why should government support Amtrak?”
Conventional answer: “To serve the traveling public.” Real answer: “To protect union jobs.”
CHAPTER OBJECTIVES: Students Should Be Able To …
1. Discuss the principle of diminishing marginal utility. Eating a steak (or a tofu salad) can be
pure pleasure. Eating a second steak on top of the first steak would be work. Eating a third
steak would … gasp! forget it! This is the principle of diminishing marginal utility.
2. Summarize the principle of rational choice. People prefer more to less, and will make
choices that will give them as much satisfaction as possible. The problem is not having
enough money which forces them to choose among available alternatives. The principle is to
spend money on those goods that give you the most marginal utility (MU) per dollar.
3. Explain the relationship between marginal utility and price when a consumer is maximizing
total utility. When the ratios of the marginal utility to the price of the goods are equal, you
are maximizing utility.
4. Explain how the principle of rational choice accounts for the laws of demand and supply.
On the demand side, if the price of a good rises, you will increase your total utility by
consuming less of it. On the supply side, if there is diminishing marginal utility and the price
of supplying a good goes up, you supply more of that good.
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5. Explain why economists can believe there are many explanations of individual choice but
nonetheless focus on self-interest. It is impossible to create a universal theory of choice
owing to the multitude of tastes a population may have. Therefore, economists focus on the
individual and what makes him or her function. Going back to Adam Smith, self-interest is
the best candidate for understanding that function.
WHAT’S NEW? Revisions to This Edition
The chapter was revised so that the analysis of choice more clearly includes the budget
constraint. In addition, a new section discusses conspicuous consumption based on the work of
Thorstein Veblen.
DISCUSSION STARTERS: Get Your Class Rolling
1. What some examples of bounded rationality (rules of thumb) that you commonly use?
2. When is it rational to be irrational?
3. What does it mean when someone says that one product is a “better deal” than another
product?
4. Why don’t people select the very same food items at the cafeteria every time they’re offered?
TIPS FOR TEACHING LARGE SECTIONS
Sweet Utility: A Simple Yet Sweet Demonstration of Utility Theory
The following activity is a short demonstration that conveys two basic points about utility
theory:
1) We can study how an individual ranks his or her preferences.
2) We cannot compare utility or happiness between two people.
Apply this activity early in your discussion of utility, after you have described utility and units of
utility, but before you have begun discussion of marginal or total utility.
For this activity you will need to buy six pieces of candy. For instance, you might buy
two Snicker's Bars, two bags of M&M's, and two bags of Skittles. Give one set of candy (one of
each type) to one student and give one set of candy to another student. Ask the students to
independently determine how much pleasure they get from each item measured in units of utility.
They may ask "what scale" to use. Tell the students it is up to them. Do not let the two students
communicate with each other. After two or three minutes, ask each student to share the units of
utility they assigned to each item and write the information on the board as follows:
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Snickers
M&Ms
Skittles
TOM
1,000 units of utility
2,000 units of utility
1,500 units of utility
JANE
9 units of utility
4 units of utility
7 units of utility
There are a few outcomes to point out to students. No common scale for units of utility exists, so
we cannot directly compare satisfaction across people. Tom assigns a higher number to all three
candies, but that does not mean he gets more happiness from the candy than Jane does.
However, from these numbers we can see how each individual ranks the three candies.
ON THE WEB: Integrating New Media into the Classroom
http://www.aef.com/start.asp is the Web site of Advertising Educational Foundation, an
advertising advocacy group. Their many topics attempt to explain and defend national
advertising practices. Politics: advocacy, pro-business.
http://www.cohums.ohio-state.edu/philo/bentham.html is the Jeremy Bentham Web site of Ohio
State University. Besides being treated to a photograph of Bentham’s fully-clothed mummified
remains at University College London, we are told, among other things, that “students from
King’s College (UCL’s ancient enemy) stole his head and played a game of rugby football with
it as part of their rag week festivities. Politics: none.
STUDENT STUMBLING BLOCKS: Common Areas of Difficulty
Estimating Utility: An In-Class Review
Suppose you are interested in buying just bottles of wine and pounds of cheese for an upcoming
party. Assume you have only $45 to spend, the price per bottle of wine is $5 (belly washers, not
the genuine article) and the price of cheese (imported from Wisconsin, of course) is $10 per
pound. You have estimated the utility or satisfaction from the consumption of wine and cheese
at the party according to the following table.
WINE
Quantity
0
1
2
3
4
5
CHEESE
Total Utility
0
100
175
225
250
260
Quantity
0
1
2
3
4
5
Total Utility
0
130
250
350
425
465
Q: How many bottles of wine and pounds of cheese should you buy for the party? Why?
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ANS: You should buy 3 bottles of wine and 3 pounds of cheese because the marginal utility in
relation to the price of wine and cheese is equal at this quantity of wine and cheese bought.
MUw/Pw = MUc/Pc at 3 bottles of wine and 3 pounds of cheese. See the table below. Note:
Marginal utility is a value between levels of consumption. Also notice that no other combination
of wine and cheese will yield as much utility (575 units of utility) for $45.
WINE
Quantity
0
1
2
3
4
5
Total Utility
0
100
175
225
250
260
Marginal Utility
0
100
75
50
25
10
MUw/Pw
0
20
15
10
5
2
Quantity
0
1
2
3
4
5
CHEESE
Total Utility
Marginal Utility
0
0
130
130
250
120
350
100
425
75
465
40
MUc/Pc
0
13
12
10
7.5
4
TIES TO THE TOOLS: Bringing the Boxes into the Classroom
Beyond the Tools: Psychology and Economics
One area of economics that is getting increasing attention is experimental economics, especially
at the nexus of economics and psychology. While these experiments are interesting they do not
take the place of standard economic reasoning.
Knowing the Tools: Income and Substitution Effects
If prices rise while our income remains the same, we are poorer. The reduction in quantity
demanded because we are poorer is called the income effect. A second effect is that since
relative prices have also changed (gone up), there is a substitution effect. So even if you are
given money to make up for your being poor, the quantity bought of a given good will still
decrease.
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Applying the Tools: Making Stupid Decisions
If you read between the lines of the Constitution, you will see that you have the right to act
stupidly. That includes lawmakers. Part of our actions depend on what we have been taught.
Do we really know what we want or are we reflecting the choices our parents, teachers, and
leaders made before us and taught us? Henry David Thoreau once said: “Live the life you
imagined.” Easy to say, hard to do.
LECTURE OUTLINE: A Map of the Chapter
I. Utility theory and individual choice.
A. Economists have an answer to the question of why we do what we do -- self interest.
1. Economists' analysis of individual choice does not deny that most of us have our quirks.
2. A good beginning in understanding individual choice is to focus on the rational part of
people's behavior.
3. Using that simple theory, two things determine what people do:
a. The pleasure people get from doing or consuming something.
b. The price of doing or consuming that something.
B. 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.
C. Economists cannot measure pleasure.
1. How does one measure pleasure? Up to now, science has not been able to provide an
answer. Economists, however, use the concept of utility -- the pleasure or satisfaction
that one expects to get from consuming a good or service.
2. Utility serves as the basis of economists' analysis of individual choice.
D. Total utility and marginal utility are related, but rational choice uses marginal utility. See
Figure 8-1.
1. Total utility refers to the satisfaction one gets from a product.
2. Marginal utility refers to the satisfaction one gets from one additional unit of a product
above and beyond what one has consumed up to that point.
3. As additional units are consumed, marginal utility decreases while total utility
increases.
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4. When total utility stops increasing, marginal utility is zero. Beyond this point, total
utility decreases and marginal utility is negative.
E. Diminishing marginal utility is important to the theory of rational choice.
1. The principle of diminishing marginal utility states that, after some point, the
marginal utility received from each additional unit of a good decreases with each
additional unit consumed (Chapter Objective 1).
2. The principle does not say you do not enjoy consuming more of a good, only that as
you consume more of the good, you enjoy additional units less than you enjoyed the
initial units.
II. Rational choice and marginal utility.
A. Rational choice begins with the premise that rational individuals want as much satisfaction
as they can get from their available income.
1. Choice l: pizza and hero sandwiches.
a. Any choice (for the same amount of money) that does not give you as many units of
utility as possible is an irrational choice.
b. In making choices, essentially what you are doing is buying units of utility.
c. Since you want to get the most for your money, you make those choices that have the
highest unit of utility per unit of cost.
2. Choice 2: studying economics or psychology.
a. Here the choices are expressed in units of time rather than in units of money.
b. The analysis, however, is the same.
3. Choice 3: a date with Jerry or Jeff.
B. The basic principle of rational choice is to spend your money on those goods that give
you the most marginal utility (MU) per dollar (Chapter Objective 2).
1. If MUx > MUy ,
choose to consume an additional unit of good x.
Px
Py
2. If MUx < MUy ,
choose to consume an additional unit of good y.
Px
Py
3. If MUx = MUy ,
you are maximizing utility; you cannot increase your utility by
Px
Py adjusting your choices.
4. By substituting the marginal utilities and prices of goods into these formulas, you can
always decide which good it makes more sense to consume.
5. Consume the one with the highest marginal utility per dollar.
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6. When the ratios of the marginal utility to price of goods are equal, you are maximizing
utility (Chapter Objective 3).
If MUx = MUy , you are maximizing utility; you are in equilibrium.
Px
Py
C. Individuals often face simultaneous decisions.
1. Assume you have been presented with all three choices simultaneously (the pizza
example, the reading example, and the dating example), and you have chosen rationally
on each. Are you being rational? No, you are not.
2. In order to use the studying example, time must be translated into money as in the other
two examples.
3. As consumption is being varied from one choice to a combination of choices, the
marginal utilities of the other choices will fall.
4. You vary your consumption until you maximize utility -- when the marginal utility per
dollar spent on each choice is equal.
III. Maximizing utility and equilibrium: When you are maximizing utility you are in equilibrium
A. By adjusting your spending, you can achieve equilibrium.
1. Adjust consumption up or down.
2. The principle of diminishing marginal utility operates in reverse. Thus, as we consume
less of an item, the marginal utility we get from the last unit consumed increases.
B. Table 8-1 provides an example of maximizing utility.
C. The general principle of rational choice. That principle is to consume more of a good that
provides a higher marginal utility per dollar.
1. If:
MUx > MUz , consume more of good x.
Px
Pz
2. If:
MUy > MUz , consume more of good y.
Py
Pz
3. The general utility-maximizing rule is that you are maximizing utility when the
marginal utilities per dollar of the goods consumed are equal.
4. Thus, extending the principle of rational choice.
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When
MUx = MUy = MUz you are maximizing utility.
Px
Py
Pz
a. When this principle is met, the consumer is in equilibrium; the cost per additional
util is equal for all goods and the consumer is as well off as it is possible to be.
b. Note that the rule does not say that the rational consumer should consume a good
until its marginal utility reaches zero. The reason is that the consumer does not have
enough money to buy all he wants.
IV. The principle of rational choice and the laws of demand and supply.
A. Marrying the principle of marginal utility with the law of demand, we get: When the price
of a good goes up, the marginal utility per dollar we get from that good goes down and we
demand less of it.
1. According to the principle of rational choice, if there is diminishing marginal utility and
the price of a good goes up, we consume less of that good. Hence, the principle of
rational choice leads to the law of demand (Chapter Objective 4a).
2. If:
MUx = MUy
Px
Py
and the price of good y goes up, then:
MUx > MUy
Px
Py
3. Our utility-maximizing rule is no longer satisfied.
4. In order to satisfy our utility-maximizing rule so that our choice will be rational, we
must somehow raise the marginal utility we get from the good whose price has risen.
5. Following the principle of diminishing marginal utility, we can increase marginal utility
only by decreasing our consumption of the good whose price has risen. Our marginal
utility rule underlies the law of demand:
a. Quantity demanded rises as price falls, other things constant.
b. Quantity demanded falls as price rises, other things constant.
6. The above shows the relationship between marginal utility and the price we are willing
to pay. Since our demand for a good is an expression of our willingness to pay for it,
quantity demanded is related to marginal utility.
B. The law of supply comes from the principle of rational choice.
1. The discussion of the principle of rational choice and the law of demand also holds for
the law of supply (Chapter Objective 4b).
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2. In supply decisions you are giving up something – your time, land, or some other factor
of production – and getting money in return.
C. Opportunity cost is the benefit foregone of the next-best alternative.
1. To say:
MUx > MUy
Px
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 consume x.
2. When the marginal utilities per dollar spent are equal, the opportunity cost of the
alternatives are equal.
V. Applying economists' theory of choice to the real world.
A. The cost of decision making.
1. The cost to the individual of deciding among hundreds of possible choices leads us to
do something irrational -- to do things without applying the rational-choice model.
2. A number of economists have come to believe that most people use bounded rationality
-- rationality based on rules of thumb -- rather than using the rational choice model.
3. One of these rules of thumb is "you get what you pay for."
a. The implication is that high price equals high quality.
b. This reliance on price for information changes the inferences one can draw from the
analysis and can lead to upward-sloping demand curves.
4. A second example of bounded rationality is "follow the leader."
a. Advertisers pay huge sums to mine these two rules of thumb.
b. In technical terms, the "follow the leader" rule leads to focal point equilibrium in
which a set of goods is consumed, not because the goods are objectively preferred to
other goods, but simply because through luck, or advertising, they have become focal
points to which people have gravitated.
B. The theory of rational choice takes tastes as given.
1. A second assumption implicit in economists' theory of rational choice is that utility
functions (tastes) are given, and are not shaped by society.
2. This is not true. Tastes often are significantly influenced by society. See the baseball
and tobacco examples in the text.
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Chapter 8: The Logic of Individual Choice: The Foundation of Supply and Demand
C. Conspicuous consumption, a term popularized by Thorstein Veblen, points to the
consumption of goods and services not for one’s direct pleasure, but to impress others.
D. Individual choice is affected by tastes.
1. One way in which economists integrate the above insights into economics is by
emphasizing that the analysis is conducted on the assumption of "given tastes."
2. To do otherwise would require a theory of tastes.
3. Whenever a need is satisfied, it is replaced by another want, which soon becomes
another need.
4. Economists take account of changes in tastes as shift factors of demand.
NOTE: For a more formal analysis of individual choice, see Appendix A, "Indifference Curve
Analysis."
CHAPTER SUPPLEMENTS: Other Classroom Aids to Use
 Classic Readings in Economics: "The Theory of the Leisure Class," pp. 155-157.
Thorstein Veblen's classic work, written in 1899, puts forth his theory of "conspicuous
consumption" and "pecuniary emulation," words that are part of every-day language usage.
 Classic Readings in Economics: "The Dependence Effect," pp. 155-157. This 1952
selection by John Kenneth Galbraith parallels and further develops Thorstein Veblen's idea
of "conspicuous consumption." Specifically, Galbraith argues that the process of production
creates wants and then satisfies them.
 Economics: An Honors Companion: "Theory of Choice and Consumer Behavior, " pp.
159-172. Includes Hicksian and Slutsky Compensating Variations.
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POP QUIZ
NAME: __________________________________
COURSE: ________________________________
1. Marginal utility refers to:
a. the total satisfaction one gets from a product.
b. the total satisfaction one gets from one additional unit of a product above and beyond what
one has consumed up to that point.
c. the decreasing satisfaction one gets with each additional unit consumed.
d. consuming more of good increases its total utility.
2. Regarding utility:
a. the total satisfaction one gets from one’s consumption is called marginal utility.
b. if you buy one Big Mac that gives you marginal utility of 400 and a second one that gives
you marginal utility of 250, total utility of eating two Big Macs is 650.
c. according to the law of diminishing marginal utility the more we consume of something,
the smaller the total satisfaction received from that good.
d. total utility received from the consumption of a good will be maximized when marginal
utility is at a maximum.
3. Which correctly predicts how the rational consumer reacts to the given situation?
a. If MUx/Px < MUy/Py then the rational consumer will buy more of both x and y.
b. If MUx/Px > MUy/Py then the rational consumer will buy more of y.
c. If MUx/Px = MUy/Py then the rational consumer will buy more of x.
d. If MUx/Px > MUy/Py then the rational consumer will buy more of x.
4. Paulo is deciding where to spend his spring vacation. A trip to the Cancun will give him
4,000 units of satisfaction and cost $600. A trip to Fort Lauderdale will give him 3,000 units
of satisfaction and cost him $425. Paulo will most likely do best going to:
a. Cancun because his total pleasure will be greatest.
b. Fort Lauderdale because it is cheapest.
c. Cancun because his pleasure per dollar will be greatest.
d. Fort Lauderdale because his pleasure per dollar will be greatest.
5. Economists assume that consumers will choose to buy and consume:
a. those goods that cost the least.
b. those goods with the highest utility.
c. that combination of goods which causes the marginal utilities per dollar to be equal.
d. that combination of goods in which the total utility of each good equals its price.
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Chapter 8: The Logic of Individual Choice: The Foundation of Supply and Demand
6. If MUx/Px = MUy/Py and the price of y increases, then the rational consumer will:
a. continuing consuming the same combination of x and y.
b. buy more of y.
c. buy more of x.
d. buy less of x and y.
7. You are maximizing utility when:
a. MUx/Px > MUz/Pz.
b. MUy/Py > MUz/Pz.
c. MUx/Px < MUz/Pz.
d. MUx/Px = MUy/Py = MUz/Pz.
8. The principle of rational choice states that:
a. it is best to buy the lowest-price product.
b. to maximize utility, choose goods until the opportunity cost of all alternatives are equal.
c. to maximize utility, choose goods until the opportunity cost of all alternatives are positive.
d. it is best to buy the good or service with the highest quality.
9. The reality is that people:
a. do not use utility terminology because a specific measure of utility does not exist.
b. use utility terminology if they are college graduates in economics.
c. who “really, really need” need something are trying to maximize total utility.
d. never have enough money to maximize utility.
10. An example of conspicuous consumption is:
a. when a back-hoe operator buys a trailer to haul it.
b. when an NBA star hires a gardener.
c. a deep suntan bought at a tanning salon.
d. when a farmer’s wife buys a sunhat.
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ANSWERS TO POP QUIZ
1. b 2. b 3. d 4. c 5. c 6. c 7. d 8. b 9. a 10. c
CASE STUDIES: Real-World Cases of Textbook Concepts
Case Study 8-1: The Civilizing Effect of the Market
Let’s play a game. Let’s randomly pick pairs of people from the same community and tell
neither the other’s identity. Offer Player #1 $100 and test his generosity by telling him to split
the money any way he chooses with Player #2. Add one catch to restrain Player #1 from being
too selfish: if Player #2 refuses the offer, neither gets anything.
A purely rational person (a bond trader?) would offer as little as possible, say $10. If Player #2
were coldly rational too, he would accept since $10 is better that nothing.
But the real world does not act that way. In many experiments of this sort, those playing the role
of Player #1 are more generous than bond traders. People playing the role of Player #2 were
more likely to reject small offers, even though they lost out on any money.
Now move the scene. How would those living in a hunter-gatherer society compare with those
living in a capitalistic society? Anthropologists performed this experiment with the nomadic
Hazda who forage in Tanzania and farmers in Hamilton, Missouri. Hazda Players #1s offered
the equivalent of $33 while the Americans offered $48.
The anthropologists concluded that the more involved people are in market activities (working
for wages, buying and selling goods and services to others, etc.) the more generous they are.
How could this counterintuitive reaction be? An anthropologist at CalTech suggests three
reasons:



Altruism is a luxury that only developed societies can afford.
Market societies grow accustomed to conventions such as splitting windfalls 50-50.
Markets do change the way people behave, but not in the way most people think.
“Markets teach us to behave decently to strangers. A market is an arena in which you can
encounter somebody you’ve never seen before and engage in mutually beneficial activity.
People overlook assumptions about trust built into market economies. When you take a taxi, you
could walk out without paying the fare. But people generally don’t.”
Source: “The Civilizing Effect of the Market,” The Wall Street Journal, January 24, 2002, p. A1.
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Chapter 8: The Logic of Individual Choice: The Foundation of Supply and Demand
Questions:
1. Is this an example of diminishing marginal utility?
2. According to what the text is saying who do you think is making the most rational choice
playing the role of Player #1: the bond trader, the American farmer, or the Hazda nomad?
3. According to what the text is saying who do you think is making the most rational choice
playing the role of Player #2: the bond trader, the American farmer, or the Hazda nomad?
4. Do you think the players are acting in their own self interest?
5. Do you agree that altruism is more likely to be found in market economies than in less
developed economies?
Case Study 8-2: Are Japanese Parents More Selfish Than American
Parents?
Nearly everyone knows that the Japanese save more money than Americans do, and that they are
more community minded as well. How do the two nations compare when it comes to bequest
motives and bequest divisions?
Charles Yuji Horioka, in a National Bureau of Economic Research working paper entitled “Are
the Japanese Selfish, Altruistic, or Dynastic?” explored the attitudes and actions of parents in
both nations as to the money and property they left their children. He identified three classes of
bequests:

The selfish. Selfish parents either leave money to their children in return for receiving
care in their old age, or they attempt to spend all their money before they die.

The altruistic. The altruists leave money to their children no matter what, with the most
altruistic leaving the most to their poorest child.

The dynastic. Dynastic parents leave money to preserve a family business or a name.
They usually bequest all or most of their fortune to one child.
He found that selfishness is well entrenched in both nations but more so in Japan. Depending on
the years involved, 77 to 91 percent of Japanese said they were disinterested with amassing
wealth for the purpose of passing it on to their children, while 57 percent of Americans surveyed
felt the same way.
When it came to splitting the inheritance among their children, 84 percent of Americans but only
44 percent of Japanese would divide the money equally. Also, 29 percent of the Japanese but
only 3 percent of the Americans would give more or all the money to the child or children that
took care of them in their old age.
Sources: Margaret Popper, “Not So Fixated on Bequests,” Business Week, December 24, 2001,
p. 26; and Charles Yuji Horioka, “Are the Japanese Selfish, Altruistic, or Dynastic?” National
Bureau of Economic Research Working Paper w8577, November 2001,
http://papers/nber.org/papers/w8577.
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Questions:
1. Who are maximizing their rational choice, the Japanese or the Americans?
2. Which of the three forms would Adam Smith agree is the best choice?
3. In which nation do you think collective choice outweighs individual choice?
4. Does opportunity cost play a role in bequest decisions?
5. Would there be diminishing marginal utility in the selfish strategy?
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