Download 20 – Consumer Choice

Chapter 20 - Consumer Choice
Overview
In this chapter the classical theory of consumer choice using cardinal utility analysis is discussed. The modern theory of
consumer choice using indifference curve analysis is presented in the chapter appendix. The classical approach assumes
that people attempt to maximize their total utility subject to a budget constraint. This early approach predicts how rational
consumers will allocate their limited incomes so as to maximize utility. Therefore, the chapter defines and distinguishes
between total and marginal utility. The law of diminishing marginal utility is discussed and related to the law of demand.
The rule for consumer total utility maximization is that income be spent so that the marginal utility per last dollar spent on
each good purchased can be equated is discussed. This analysis is then used to derive the demand curve. Finally an
examination of behavioral economics is made comparing it to utility analysis.
Outline
I.
Utility Theory: Utility is a term that economists use for satisfaction or want satisfying power of a good or service.
Utility is common to all goods that are desired. The concept of utility is purely subjective; there is no way to measure the
amount of utility that a consumer might be able to obtain from a particular good. Utility does not mean “useful” or
“utilitarian” or practical. The utility that individuals receive from consuming a good depends on their tastes and
preferences. This chapter presents consumer decision making based on utility maximization.
A.
Utility and Utils: Economists first developed utility theory in terms of units of measurable utility, to which they
applied the term util. The ideas from such analysis are useful in understanding the way in which consumers choose among
alternatives.
B.
Total and Marginal Utility: Total utility is the amount of utility or satisfaction measured in utils from consuming a
good or service. Marginal utility is the change in total utility due to a one-unit change in the quantity of a good consumed.
C.
Applying Marginal Analysis to Utility: The formula for marginal utility is this: Marginal Utility = change in total
utility ÷ change in number of units consumed. (See Figure 20—1.)
II.
Graphical Analysis: A complete example is presented in Figure 20—1.
A.
Marginal Utility: Marginal utility is derived graphically. (See Figure 20—1.)
III.
Diminishing Marginal Utility: The principle that as more of any good or service is consumed, its extra benefit
declines. Increases in total utility from the consumption of a good or a service become smaller and smaller as more is
consumed during a given time period. (See Figure 20—1.)
IV.
Optimizing Consumption Choices: Consumer optimum is a choice of a set of goods and services that maximizes
the utility of each consumer, subject to limited income. This optimum is reached when the marginal utility of the last
dollar spent on each good yields the same utility and all income is spent. (See Tables 20—1 and 20—2.)
A.
A Two-Good Example: The rule of consumer optimum can be stated in algebraic terms by examining the ratio of
marginal utilities and prices of individual products. The rule of equal marginal utilities per dollar spent states that a
consumer maximizes utility when money income is allocated so that the last dollar spent on good x. and good y yields
equal amounts of marginal utility.
B.
A Two-Good Consumer Optimum: A complete numerical example is worked out in Tables 20-1 and 20-2 that
show that a consumer’s money income should be allocated so that the last dollar spent on each good yields the same
amount of marginal utility (when all income is spent), because this yields the largest possible total utility.
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C.
A Little Math: The rule of consumer optimum can be stated in algebraic terms by examining the ratio of marginal
utilities and prices of individual products. The rule of equal marginal utilities per dollar spent states that a consumer
maximizes utility when money income is allocated so that the last dollar spent on good x, good y, good z, etc., yield equal
amounts of marginal utility.
V.
How a Price Change Affects the Consumer Optimum:
A.
A Consumer’s Response to a Price Change: Starting from the consumer optimum, let the price of good A
decrease. Consumers respond to the price decrease by consuming more. With a lower price, the marginal utility of the last
dollar spent on good A is greater than the marginal utility per dollar spent on other goods. If the law of diminishing
marginal utility holds, the purchase and consumption of additional units of A causes the marginal utility per dollar spent
on good A to fall. Eventually, the value of marginal utility per dollar spent on good A will fall by enough to equate it with
the marginal utility per last dollar spent on each of the other goods and services consumed. Thus the decrease in the price
of good A results in an increase of the quantity of good A purchased. (See Figure 20—3.)
B.
The Substitution Effect: The substitution effect is the tendency of consumers to substitute relatively cheaper
goods for relatively more expensive ones.
1.
An Example: If the relative price of a good falls, consumers will substitute in favor of this lower priced good and
against the other similar goods they have been purchasing and vice versa.
2.
Purchasing Power and Real Income: The real-income effect occurs when a change causes a change in the
purchasing power of a buyer’s income. A decrease in price will cause an increase in the quantity demanded since a fall in
the price of any good consumed results in an increase in real income (purchasing power).
VI.
The Demand Curve Revisited: Linking the “law” of diminishing marginal utility and rule of equal marginal
utilities per dollar gives a negative relationship between the quantity demanded of a good or service and its price. (See
Figure 20—3.)
A.
Marginal Utility, Total tJtility, and the Diamond-Water Paradox: While the total utility of water is very high,
water is much cheaper than diamonds, which have a much lower total utility. This is explained by the supply of water
being great relative to demand so that the marginal utility of the last unit consumed is low and thus its price is low. The
supply of diamonds is very small compared to the demand for diamonds and thus the marginal utility of the last unit
consumed is high and thus its price is high. (See Figure 20—4.)
VII.
Behavioral Economics and Consumer Choice Theory: Behavioral economists have doubts about the rationality
assumption, which causes them to question the utility-based theory of consumer choice.
A.
Does Behavioral Economics Better Predict Consumer Choices?: The assumption of rationality can be shown to be
violated in actual choice making. The replacement for the rationality assumption is the assumption of bounded rationality
where there are too many choices to be completely considered.
B.
Consumer Choice Theory Remains Alive and Well: Economists continue to assume that consumers behave as ~f
they are rational because such an assumption allows the development of testable hypotheses concerning how consumers
respond to changes in prices, incomes and other factors. The predictions from these hypotheses are by and large supported
by the actual choices that consumers make.
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