Transcript MicroChap07.ppt
Chapter 7: The Logic of Individual Choice: The Foundation of Supply and Demand Prepared by: Kevin Richter, Douglas College Charlene Richter, British Columbia Institute of Technology © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
1
Utility Theory and Individual Choice According to economists, we behave the way we do because of
rational self interest
.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
2
Utility Theory and Individual Choice Using this simple theory, two things determine what people do: The pleasure people get from doing or consuming something.
The price of doing or consuming that something.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
3
Utility Theory and Individual Choice 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.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
4
Measuring Pleasure Economists start with a proposition that individuals try to get as much pleasure as possible out of life.
The goods and services we consume provide value (satisfaction) to us.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
5
Measuring Pleasure Individuals want to maximize the amount of satisfaction they receive through consuming goods and services.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
6
Measuring Pleasure Economists use the concept of
utility
—the pleasure or satisfaction that one gets from consuming a good or service.
A
util
is a unit of satisfaction created by economists to “measure” utility.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
7
Utility Utility serves as the basis of economists' analysis of individual choice.
It is personal and individual. Utility cannot be compared across individuals.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
8
Total Utility and Marginal Utility It is important to distinguish between marginal and total utility.
Total utility
refers to the satisfaction one gets from one’s consumption of a product.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
9
Marginal Utility
Marginal utility
refers to the satisfaction you get from the consumption of one additional unit of a product above and beyond what you have consumed up to that point.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
10
Marginal Utility As additional units are consumed, marginal utility decreases while total utility increases.
When total utility stops increasing, marginal utility is zero.
Beyond this point, total utility decreases and marginal utility is negative.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
11
Diminishing Marginal Utility The
principle of diminishing marginal utility
– after some point, the marginal utility received from each additional unit of a good will begin to decrease with each additional unit consumed. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
12
Diminishing Marginal Utility The principle does not say you do not enjoy consuming more of a good.
For example, as you consume more pizza, you enjoy additional slices less than you enjoyed the initial slices.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
13
Marginal and Total Utility
Pizza slices
1 2 3 4 5 6 7 8 9
Total utility
14 26 36 44 50 54 56 56 54 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
Marginal utility
14 12 10 8 6 4 2 0 -2 14
Marginal and Total Utility 70 60 50 40 30 20 10 0
Total utility
Total utility 1 2 3 4 5 6 7 8 9 Slices of pizza per hour 16 14 12 10 8 6 4 2 0 -2
Marginal utility
1 2 3 4 5 6 7 8 9 Slices of pizza per hour © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
Marginal utility 15
Rational Choice and Marginal Utility Because people face a budget constraint, they must choose among alternatives.
Rational individuals want as much satisfaction as they can get from their available income.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
16
Rational Choice In making choices, you are essentially buying units of utility.
Any choice that does not give you as many units of utility as possible for the same amount of money is an irrational choice.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
17
Rational Choice Since you want to get the most for your money, you make those choices that have the highest units of utility per unit of cost.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
18
Principle of Rational Choice According to the basic principle of
choice rational
you should spend your money on those goods that give you the most marginal utility (MU) per dollar.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
19
Principle of Rational Choice If:
MU x P x
MU y P y
consume an additional unit of good
x
.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
20
Principle of Rational Choice If:
MU x P x
MU y P y
consume an additional unit of good
y
.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
21
Principle of Rational Choice You can always decide which good it makes more sense to consume.
Substitute the marginal utilities and prices of goods into these formulas. Consume the one with the highest marginal utility per dollar.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
22
Simultaneous Decisions Individuals often face simultaneous decisions.
As consumption is being varied from one choice to a combination of choices, the marginal utilities of the other choices will fall.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
23
Maximizing Utility You vary your consumption until you maximize utility.
That occurs when the marginal utilities per dollar spent on each of the choices are equal.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
24
Maximizing Utility Total utility is maximized when marginal utility per dollar spent of two goods is equal:
MU x P x
MU y P y
You cannot increase your utility by adjusting your choices.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
25
Maximizing Utility
Q Hamburgers (P = $2) TU MU MU/P
0 1 2 3 4 5 6 7 0 20 32 38 41 41 36 26 20 12 6 3 0 -5 -10 10 6 3 1.5
0 -2.5
-5
Q Ice Cream (P = $1) TU MU MU/P
0 1 2 3 4 5 6 7 0 29 46 53 56 57 57 53 29 17 7 3 1 0 -4 29 17 7 3 1 0 -4 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
26
Maximizing Utility
Total $ spent
$1 $2 $4 $5 $7 $9 $10
Purchase?
1 st ice cream cone 2 nd ice cream cone 1 st hamburger 3 rd ice cream cone 2 nd hamburger 3 rd hamburger 4 th ice cream cone
MU/P
29 17 10 7 6 3 3 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
MU
29 17 20 7 12 6 3 Total utility = 94 utils 27
Rational Choice and Marginal Utility If
MUx/Px
>
MUz/Pz
, consume more of good x.
If
MUy/Py
>
MUz/Pz
, consume more of good y.
When
MU x
MU y P x P y
maximizing utility
MU z P z
you are © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
28
Rational Choice and Marginal Utility The general utility-maximizing rule is that you are maximizing utility when the marginal utilities per dollar are equal across all goods you consume.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
29
Rational Choice and Marginal Utility When this principle is met, the consumer has reached his maximum utility, given his income.
The cost per additional unit of utility is equal for all goods and the consumer is as well off as it is possible to be.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
30
Rational Choice and Marginal Utility The rule does not say that the rational consumer should consume a good until its marginal utility reaches zero.
The consumer does not have enough money to buy all he wants.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
31
Opportunity Cost
Opportunity cost
is the benefit forgone of the next-best alternative.
It is essentially the marginal utility per dollar you forgo.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
32
Opportunity Cost To say MUx/Px > MUy/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 should consume more x.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
33
Opportunity Cost When all the marginal utilities per dollar spent are equal, the opportunity cost of all the alternatives are equal.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
34
Rational Choice and the Law of Demand The principle of rational choice leads to the law of demand.
When the price of a good goes up, the marginal utility
per dollar
goes down and we consume less of it.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
35
Rational Choice and the Law of Demand Initially
MUx/Px
=
MUy/Py
When the price of good y goes up, then
MUx/Px
>
MUy/Py
.
Our condition for maximizing utility is no longer satisfied. © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
36
Rational Choice and the Laws of Demand and Supply To maximize utility now we must: consume less of the good whose relative price has risen, thereby raising the marginal utility we get from it, and consume more of the good whose relative price has fallen, thereby lowering the marginal utility we get from it.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
37
Rational Choice and the Law of Demand MUx decreases as we buy more good x (diminishing marginal utility). MUy increases as we buy less of good y.
We are back to a point where
MUx/Px MUy/Py
and we maximize utility.
= Consuming more x and less y than before.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
38
Rational Choice and the Law of Demand So when the price of a good goes up, we choose to consume less of that good.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
39
Rational Choice and the Law of Demand Since our demand for a good is an expression of our willingness to pay for it, quantity demanded is related to marginal utility.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
40
Rational Choice and the Law of Demand Quantity demanded rises as price falls, other things constant.
Quantity demanded falls as price rises, other things constant.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
41
Applying the Theory of Choice to the Real World There are limits on the assumptions underlying the theory of rational decision making.
In reality, people make hundreds of choices every day.
It is difficult to believe that we are going to apply principles of rational choice to all those decisions.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
42
Cost of Decision Making Some decisions are difficult to make because we lack information, or there is some uncertainty involved, or it is a complex decision.
Each decision requires us to use our limited cognitive ability to receive, process, store and retrieve information.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
43
Cost of Decision Making The cost of deciding among hundreds of possible choices leads us to do something irrational.
That is, do things without applying the rational choice model.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
44
Cost of Decision Making A number of economists believe that most people use bounded rationality rather than using the rational choice model.
Bounded rationality
on rules of thumb.
means rationality based © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
45
Cost of Decision Making We employ a variety of simple rules to make some of our decisions: Price conveys information Follow the leader Habit Custom © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
46
Cost of Decision Making One of these rules of thumb is “you get what you pay for.” Higher priced goods tend to be better than lower-priced goods.
We can use this simple rule to make a quick decision – we rely on price to convey information about quality.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
47
Cost of Decision Making A second rule of thumb is “follow the leader.” Sometimes we just do what others are doing.
Clothes manufacturers try to exploit this decision rule with their advertising efforts by convincing us that “everyone” is wearing a particular style.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
48
Habit Habit explains a lot of our choices. We did the marginal utility calculation some time ago and we continue with the same choice.
We rely on our previous judgment.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
49
Custom Employing the rule of custom can ease the burden of decision making.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
50
Maximizing Utility Using Indifference Curves Economists often use graphic representation of the consumer’s choice.
The problem consists of two parts: The budget constraint (or the income constraint) Indifference curves, which represent utility © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
51
Graph the Budget Line The
budget constraint
represents all the combinations of two goods that a person can afford to buy with a given income.
The budget constraint is also called the income constraint, or budget line.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
52
Ella’s Choice Ella eats chocolate bars and drinks pop.
She wants to maximize her utility given her budget constraint.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
53
Budget Constraint Chocolate bars cost $1 and pop costs 50 cents a can.
Ella has $10 to spend.
She can buy 10 chocolate bars or 20 cans of pop or some combination of both.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
54
Budget Line Chocolate bars 10 4 2 8 6 0 Income = $10 Slope = - P 2 4 6 8 10 12 14 16 18 20 22 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
= - ½ pop /P chocolate Cans of pop 55
Budget Line The slope of the budget line is the ratio of the prices of the two goods.
The slope changes when the prices change.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
56
Budget Line Rotates Chocolate bars 10 4 2 8 6 0 Income = $10 Pop Price = $1 Slope = - P = - 1 2 4 6 8 10 12 14 16 18 20 22 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
pop /P chocolate Cans of pop 57
Indifference Curve
Indifference curve
– a curve that shows combinations of goods amongst which an individual is indifferent.
The slope of the indifference curve is the ratio of marginal utilities of the two goods.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
58
Graph the Indifference Curve Indifference curves are downward sloping and bowed inward.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
59
Indifference Curve Ella is equally as well off (her utility is the same) from consuming bundles A, B, C, D or E.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
60
Indifference Curve Chocolate bars 20 16 12 8 4 A B C D E |Slope|= MU U pop /MU chocolate bars = MRS of pop for chocolate bars Indifference curve 0 2 4 6 8 10 12 14 16 18 20 22 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
Cans of pop 61
Marginal Rate of Substitution The slope of the indifference curve is called the
marginal rate of substitution (MRS).
Marginal rate of substitution
– the rate at which one good must be added when the other is taken away in order to keep the individual indifferent between the two combinations.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
62
Marginal Rate of Substitution The slope is bowed inward, indicating that the MRS is decreasing as Ella’s bundles contain more of the good on the horizontal axis.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
63
Marginal Rate of Substitution The reason for decreasing MRS is that as Ella gets more and more of one good, she is willing to give up lots of it to get more of the relatively scarce good.
|Slope| = MU pop /MU chocolate = MRS © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
64
Marginal Rate of Substitution
Law of diminishing marginal rate of substitution
– for each additional unit of a good, the smaller the amount of the other good needed to be given up to keep you on your original indifference curve.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
65
Mapping of Indifference Curves Ella will have a whole group of indifference curves, each representing a different level of utility.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
66
Mapping of Indifference Curves Chocolate bars 20 16 12 8 4 0 A B C D E U 1 U 2 U 3 2 4 6 8 10 12 14 16 18 20 22 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
Cans of pop 67
Mapping of Indifference Curves The bundles of goods forming indifference curve U 3 give Ella higher utility than bundles along U 2 .
The bundles of goods forming indifference curve U 1 give Ella less utility than bundles along U 2 .
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
68
Utility Maximization Since more is preferred to less, Ella is better off with the indifference curve that is farthest to the right.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
69
Indifference Curves Cannot Cross If indifference curves crossed, it would violate the “more-is-preferred-to-less” principle.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
70
Indifference Curves Cannot Cross Chocolate bars 20 16 12 8 4
A is preferred to B
A B D
B is indifferent to C
C U 1 U 2
C is preferred to D
0
Thus, A is preferred to D.
2 4 6 8 10 12 14 16 18 20 22
????
Cans of pop © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
71
Maximizing Utility The goal for a consumer is to get to the highest indifference curve possible, given her income constraint.
More is preferred to less.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
72
Maximizing Utility Ella will maximize her utility by consuming on the highest indifference curve possible, given her budget constraint.
The best combination is the point where the indifference curve and the budget line are tangent.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
73
Maximizing Utility Chocolate bars 20 16 12 8 4 0 Slope= -MU pop 2 4 6 8 10 12 14 16 18 20 22 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
/MU chocolate bars Slope= -P pop /P chocolate bars Cans of pop 74
Maximizing Utility The best combination is the point where the slope of the budget line equals the slope of the indifference curve.
P pop P Choc MU pop MU Choc so that MU Choc P Choc MU pop P pop © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
75
Maximizing Utility In other words, utility is maximized when the slopes of the budget constraint and the indifference curve are equal.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
76
Income Expansion Path
Income expansion path (IEP)
traces all the best (utility-maximizing) choices a consumer makes as income changes.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
77
Income Expansion Path Good Y Good Y IEP IEP U 3 U 3 U 2 U 1 a) Normal good U 2 Good X © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
U 1 a) Inferior good Good X 78
Engel Curves An
Engel curve
plots all the best choices a consumer makes against
INCOME
.
It is an income-quantity relationship © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
79
Engel Curves Quantity Demanded Income elastic normal good (luxury) X 1 Income inelastic normal good (necessity) X 2 Inferior good X 3 Income © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
80
Price Expansion Path
Price expansion path (PEP)
traces all the best choices of a consumer as the relative price changes.
© 2006 McGraw-Hill Ryerson Limited. All rights reserved.
81
Price Expansion Path Good Y B/Py U 1 PEP U 2 B/(Px) 1 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
B/(Px) 2 Good X 82
The Logic of Individual Choice: The Foundation of Supply and Demand
End of Chapter 7 © 2006 McGraw-Hill Ryerson Limited. All rights reserved.
83