Transcript Principles of Economics Third Edition by Fred Gottheil

Chapter 5
Marginal Utility and
Consumer Choice
© 2005 Thomson
Economic Principles
Total utility and marginal utility
Law of diminishing marginal utility
Relationship between the law of demand
and the marginal-utility-to-price ratio
Consumer surplus
Difficulties with interpersonal comparison
of utility
Gottheil - Principles of Economics, 4e
© 2005 Thomson
2
What is Marginal Utility?
Util
• It is a hypothetical unit used to measure
how much utility a person obtains from
consuming a good.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
3
What is Marginal Utility?
Utility measures the satisfaction
or enjoyment a person obtains
from consuming a good.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
4
What is Marginal Utility?
Law of Diminishing Marginal Utility
• It is the idea that as more of a good is
consumed, the utility a person derives
from each additional unit diminishes.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
5
What is Marginal Utility?
The implication of someone
experiencing increasing marginal
utility for pizza slices is:
• The next slice of pizza would generate
higher marginal utility than the one before.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
6
What is Marginal Utility?
The implication of someone
experiencing increasing marginal
utility for pizza slices is:
• When his stomach is full to bursting from
eating so much pizza, the marginal utility
from eating yet another slice would be
higher than for any of the preceding
slices.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
7
What is Marginal Utility?
The implication of someone
experiencing increasing marginal
utility for pizza slices is:
• It is not clear that someone could survive
having increasing marginal utility!
Gottheil - Principles of Economics, 4e
© 2005 Thomson
8
What is Marginal Utility?
It possible for marginal utility to
become negative.
• For example, if you overeat and feel ill,
then the marginal utility for the last bit
of food you ate is negative.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
9
What is Marginal Utility?
A rational consumer will not
knowingly pay to buy a unit of a
good that generates negative
marginal utility.
• Presumably something else could be bought
that generates positive marginal utility.
• Buying something that generates negative
marginal utility is not consistent with
utility maximization.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
10
EXHIBIT 1 TOTAL UTILITY AND MARGINAL UTILITY
DERIVED FROM CONSUMING T-BONE
STEAKS (UTILS)
Gottheil - Principles of Economics, 4e
© 2005 Thomson
11
Exhibit 1: Total Utility and Marginal
Utility Derived From Consuming T-Bone
Steaks (utils)
If marginal utility is declining,
but is still positive, total utility is:
• Total utility increases as long as marginal
utility is positive.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
12
Exhibit 1: Total Utility and Marginal
Utility Derived From Consuming T-Bone
Steaks (utils)
If marginal utility is declining,
but is still positive, total utility is:
• In Exhibit 1, total utility reaches its
maximum at five t-bone steaks. Consuming
more than five steaks will reduce total
utility.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
13
EXHIBIT 2A TOTAL AND MARGINAL UTILITY
14
© 2005 Thomson
EXHIBIT 2B TOTAL AND MARGINAL UTILITY
15
© 2005 Thomson
Exhibit 2: Total and Marginal Utility
In Exhibit 2, the curves in Panel a
and b represent:
• The curve in Panel a is the total utility
curve for T-bone steaks.
• Panel a depicts the number of utils, or
the amount of utility, a person gains
from consuming a certain number of
steaks.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
16
Exhibit 2: Total and Marginal Utility
In Exhibit 2, the curves in Panel a
and b represent:
• Total utility peaks at 81 utils, or 5 steaks.
Each steak consumed beyond 5 reduces
total utility.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
17
Exhibit 2: Total and Marginal Utility
In Exhibit 2, the curves in Panel a
and b represent:
• The curve in Panel b is the marginal
utility curve for T-bone steaks.
• The curve depicts the change in total
utility a person derives from
consuming each additional steak.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
18
Exhibit 2: Total and Marginal Utility
In Exhibit 2, the curves in Panel a
and b represent:
• When marginal utility is zero, total utility
is maximized.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
19
What Is Marginal Utility?
If water is necessary for life, then
the market price of water so much
lower than for diamonds because:
• Market price reflects marginal utility,
not total utility.
• Due to diminishing marginal utility and the
abundance of water, the marginal utility
of water is lower than for diamonds.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
20
What is Marginal Utility?
A hypothetical circumstance in
which the marginal utility of
water might exceed the marginal
utility of a diamond:
• If you are lost in the desert and are severely
dehydrated, then your marginal utility for a
gallon of water might exceed your
marginal utility for a diamond.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
21
French Cuisine and Marginal Utility
Many courses, each with small
portions of food (French cuisine),
may generate more utility than one
course with a large portion of food
because:
• One large portion will drive down
marginal utility.
• Marginal utility is high for the whole
meal.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
22
EXHIBIT 3 MARGINAL UTILITIES OF CLOTHES AND
AMUSEMENT GOODS (UTILS)
Gottheil - Principles of Economics, 4e
© 2005 Thomson
23
Exhibit 3: Marginal Utilities of Clothes
and Amusement Goods (Utils)
Based on the utility data in Exhibit
3, a rational consumer will select
the best combination of clothes and
amusement goods:
• By sequentially picking units of clothing
and amusement goods that generate
the largest MU/P.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
24
EXHIBIT 4 MARGINAL-UTILITY-TO-PRICE RATIOS OF
CLOTHES AND AMUSEMENT GOODS (MU/P)
Gottheil - Principles of Economics, 4e
© 2005 Thomson
25
Exhibit 4: Marginal-Utility-to-Price Ratios of
Clothes and Amusement Goods (MU/P)
If a unit of clothes and amusement
goods both cost $10, and if you
have $80 to spend, the rational
consumer will spend her money:
• MU/P is equal when three units of clothes
and five units of amusement goods are
purchased (MU/P = 1.4).
Gottheil - Principles of Economics, 4e
© 2005 Thomson
26
Marginal-Utility-to-Price Ratio
Marginal-utility-to-price ratio
• The ratio is calculated by dividing the
marginal utility of a good by the price of
the good—MU/P.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
27
Marginal-Utility-to-Price Ratio
The MU/P equalization principle
• A person’s total utility is maximized
when the ratios of marginal utility to
price for the last unit of each of the goods
consumed are equal.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
28
Marginal-Utility-to-Price Ratio
The MU/P equalization principle:
• MU/P measures marginal utility per
dollar spent.
• Total utility will be maximized (within the
constraints of a limited budget) when
each individual purchase generates
the largest possible MU/P.
29
© 2005 Thomson
Marginal-Utility-to-Price Ratio
The MU/P equalization principle:
• A rational and fully-informed consumer
will always shift a dollar from a good
whose MU/P is lower to one whose MU/P
is higher, if such a shift is possible.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
30
Marginal-Utility-to-Price Ratio
The MU/P equalization principle:
• The principle is based on consumer
behavior.
• Consumers will always arrange their
sequence of choices among goods starting
with the highest MU/P and running
down to exhaust an expenditure budget.
31
© 2005 Thomson
Marginal-Utility-to-Price Ratio
The MU/P equalization principle:
• The consumer choice process is in
equilibrium when:
• There is no longer any incentive for the
consumer to rearrange her purchases.
• The MU/P is equal for the last unit
of each good or service consumed.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
32
EXHIBIT 5 COMPARING MU/Ps AFTER A 20-PERCENTOFF SALE ON CLOTHES
Gottheil - Principles of Economics, 4e
© 2005 Thomson
33
Exhibit 5: Comparing MU/Ps After a
20 Percent Off Sale on Clothes
The MU/P of clothes changes
when there is a 20 percent off sale
on clothes by:
• MU/P for each unit of clothing rises when
price is reduced by 20 percent.
• This will cause a rational consumer
to consume more clothes.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
34
EXHIBIT 6 COMPARING MU/Ps AFTER A 50-PERCENTOFF SALE ON CLOTHES
Gottheil - Principles of Economics, 4e
© 2005 Thomson
35
Exhibit 6: Comparing MU/Ps After a
50 Percent Off Sale on Clothes
An additional reduction in the price
of clothing will change all of the
MU/Ps for clothing, and thus change
a rational consumer’s consumption of
clothing.
• If the price of clothes falls again, from $8
to $5, the quantity of clothing demanded
increases from four to six units.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
36
EXHIBIT 7 THE DEMAND CURVE FOR CLOTHES
Gottheil - Principles of Economics, 4e
© 2005 Thomson
37
Exhibit 7: The Demand Curve
for Clothes
When the price of clothing falls
from $10 to $8 to $5, which of the
following occurs:
• Quantity demanded remains the same.
• Quantity demanded falls from 6 to 4 to 3.
• Quantity demanded rises from 3 to
4 to 6.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
38
Exhibit 7: The Demand Curve
for Clothes
When the price of clothing falls
from $10 to $8 to $5, which of the
following occurs:
• Quantity demanded remains the same.
• Quantity demanded falls from 6 to 4 to 3.
• Quantity demanded rises from 3 to
4 to 6.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
39
MU/P Equalization Principle and
the Law of Demand
Changes in the marginal-utilityto-price ratio are caused by:
• A change in the marginal utility of a
good or a change in the price of a good
changes the marginal-utility-to-price
ratio, and therefore changes quantity
demanded.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
40
MU/P Equalization Principle and
the Law of Demand
The relationship between the MU/P
Principle and the Law of Demand:
If the price of a good falls:
• MU/P rises.
• The rational consumer will increase her
consumption of that good.
• Increase in quantity demanded
(movement along the demand curve).
Gottheil - Principles of Economics, 4e
© 2005 Thomson
41
MU/P Equalization Principle and
the Law of Demand
The relationship between the MU/P
Principle and the Law of Demand:
If consumer preference for a good decreases:
• MU/P declines.
• The rational consumer will reduce
consumption.
• The demand curve shifts to the left
(since consumer preference is a
nonprice factor).
42
© 2005 Thomson
MU/P Equalization Principle and
the Law of Demand
The relationship between the MU/P
Principle and the Law of Demand:
If consumer income increases:
• The consumer can pursue a lower MU/P.
• The consumer can afford to increase
consumption.
• An increase in the demand for normal
goods.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
43
MU/P Equalization Principle and
the Law of Demand
A downward-sloping demand
curve is consistent with the law of
diminishing marginal utility.
• Diminishing marginal utility means that
MU/P declines as quantity consumed
increases.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
44
MU/P Equalization Principle and
the Law of Demand
A downward-sloping demand
curve is consistent with the law of
diminishing marginal utility.
• A consumer’s willingness-to-pay falls as
quantity consumed increases.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
45
Are White Rats Rational
Consumers?
There is evidence that lab rats
make consumer choices based
on MU/P.
• Economists Battalio and Kagel found that
white lab rats respond to price and income
changes in a manner consistent with
economic theory.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
46
The MU/P Guide to Auction
Bidding
MU/P can help guide auction
bidding:
• If a particular MU/P is guaranteed by
buying something outside of the auction,
and if the marginal utility from the auction
good is known, then you can figure out
your maximum auction price.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
47
Creating Consumer Surplus
Consumer surplus
• The difference between the maximum
price a person would be willing to pay for a
good or service, and the price the person
actually pays.
• Most consumers receive some
consumer surplus from a transaction.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
48
Creating Consumer Surplus
When market price falls,
consumer surplus increases.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
49
Creating Consumer Surplus
If the price of a good is greater
than amount a consumer is
willing to pay for that good, the
consumer surplus will be negative
if the consumer buys the good.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
50
Creating Consumer Surplus
A rational consumer will not
purchase a good that generates
negative consumer surplus.
• A rational consumer will prefer zero
consumer surplus (no purchase) to
negative consumer surplus.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
51
EXHIBIT 8 THE MARKET FOR HORSEBACK RIDING
52
© 2005 Thomson
Exhibit 8: The Market for
Horseback Riding
Exhibit 8 depicts the demand and
supply curves for horseback riding.
The concept of consumer surplus
applies to horseback riding:
• At a price of $6, all consumers with a
willingness-to-pay value of $6 or more will
purchase a horseback ride.
• These consumers receive consumer
53
surplus.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
Exhibit 8: The Market for
Horseback Riding
Exhibit 8 depicts the demand and
supply curves for horseback riding.
The concept of consumer surplus
applies to horseback riding:
• Some consumer may be willing to pay $10
for a horseback ride.
• This consumer will receive $(10 - 6) =
$4 of consumer surplus.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
54
Exhibit 8: The Market for
Horseback Riding
Exhibit 8 depicts the demand and
supply curves for horseback riding.
The concept of consumer surplus
applies to horseback riding:
A consumer who has a willingness-to-pay
value less than $6:
• Has a negative consumer surplus.
• Will not choose to purchase a ride
55
(a rational consumer).
© 2005 Thomson
EXHIBIT 9 CONSUMER SURPLUS ON THE HORSEBACKRIDING MARKET
Gottheil - Principles of Economics, 4e
© 2005 Thomson
56
Exhibit 9: Consumer Surplus on the
Horseback-Riding Market
Kim’s consumer surplus from
horseback riding is:
• $(15 - 6) for the first ride.
• $(12 - 6) for the second ride.
• $(9 - 6) for the third ride.
• $(6 - 6) for the fourth ride.
• These sum to $(9 + 6 + 3 + 0) = $18.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
57
Exhibit 9: Consumer Surplus on the
Horseback-Riding Market
Tony’s consumer surplus from
horseback riding is:
• $(10 - 6) for the first ride.
• $(8 - 6) for the second ride.
• $(6 - 6) for the fourth ride.
• These sum to $(4 + 2 + 0) = $6.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
58
Exhibit 9: Consumer Surplus on the
Horseback-Riding Market
Randy’s consumer surplus from
horseback riding is:
• $(9 - 6) for the first ride.
• $(6 - 6) for the fourth ride.
• These sum to $(3 + 0) = $3.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
59
Exhibit 9: Consumer Surplus on the
Horseback-Riding Market
If Kim, Tony and Randy
represent the entire market
demand for horseback riding, the
total consumer surplus is:
• $18 (Kim) + $6 (Tony) + $3 (Randy)
= $27 in consumer surplus
Gottheil - Principles of Economics, 4e
© 2005 Thomson
60
Interpersonal Comparisons
of Utility
An interpersonal comparison of
utility
• It is a comparison of the marginal
utilities that different people derive from
a good or a dollar.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
61
Interpersonal Comparisons
of Utility
Is it actually possible to compare
the satisfaction that different people
derive from a good or a dollar?
• It is not possible to make an exact
comparison of different peoples’
utility.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
62
Interpersonal Comparisons
of Utility
Is it actually possible to compare the
satisfaction that different people
derive from a good or a dollar?
• Policies such as those aimed at poverty
alleviation rely on society being able to make
approximate or reasonable comparisons
of utility across different people.
Gottheil - Principles of Economics, 4e
© 2005 Thomson
63