Marg Util Power Point

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Chapter 5 Marginal Utility and

Consumer Choice

ByRavichander Reddy


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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


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What is Marginal Utility?

Util :

It is a hypothetical unit used to

measure how much utility a personobtains from consuming a good.


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Utility measures the satisfactionor enjoyment a person obtainsfrom consuming a good.


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Law of Diminishing Marginal Utility :

It is the idea that as more of a good is

consumed, the utility a person derivesfrom each additional unit diminishes.


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The implication of someoneexperiencing increasing marginalutility for pizza slices is:

The next slice of pizza would generatehigher marginal utility than the one before.


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The implication of someoneexperiencing increasing marginalutility for pizza slices is:

It is not clear that someone could survive

having increasing marginal utility!


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It possible for marginal

utility to become negative. For example, if you overeat and feel

ill, then the marginal utility for the lastbit of food you ate is negative.


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What is Marginal Utility? A rational consumer will not knowingly pay to buy a unit of a good that generates negativemarginal utility.

Presumably something else could be bought

that generates positive marginal utility. Buying something that generates negativemarginal utility is not consistent with utilitymaximization.


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EXHIBIT 1 TOTAL UTILITY AND MARGINAL UTILITYDERIVED FROM CONSUMING T-BONESTEAKS (UTILS)


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EXHIBIT 2A TOTAL AND MARGINAL UTILITY


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EXHIBIT 2B TOTAL AND MARGINAL UTILITY


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Exhibit 2: Total andMarginal 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, orthe amount of utility, a person gains fromconsuming a certain number of steaks.


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Panel a and b represent: Total utility peaks at 81 utils, or 5 steaks.Each steak consumed beyond 5 reducestotal utility.


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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 totalutility a person derives from consumingeach additional steak.


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Panel a and b represent: When marginal utility is zero, total utilityis maximized.


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If water is necessary for life, thenthe market price of water so much

lower than for diamonds because: Market price reflects marginal utility,not total utility. Due to the law of diminishing marginal utilityand the abundance of water, the marginalutility of water is lower than for diamonds.


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A hypothetical circumstance inwhich the marginal utility of

water might exceed the marginalutility of a diamond:

If you are lost in the desert and areseverely dehydrated, then your marginalutility for a gallon of water might exceedyour marginal utility for a diamond.


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French Cuisine and MarginalUtility

Many courses, each with small portionsof food (French cuisine), may generatemore utility than one course with alarge portion of food because:

One large portion will drive down marginalutility. Marginal utility is high for the whole meal.


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EXHIBIT 3 MARGINAL UTILITIES OF CLOTHES ANDAMUSEMENT GOODS (UTILS)


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Exhibit 3: Marginal Utilities of Clothes andAmusement Goods (Utils)

Based on the utility data in Exhibit3, a rational consumer will select thebest combination of clothes andamusement goods:

By sequentially picking units of clothingand amusement goods that generate thelargest MU/P.


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EXHIBIT 4 MARGINAL-UTILITY-TO-PRICE RATIOS OFCLOTHES AND AMUSEMENT GOODS (MU/P)


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Exhibit 4: Marginal-Utility-to-Price Ratiosof Clothes and Amusement Goods (MU/P)

If a unit of clothes and amusementgoods both cost $10, and if you have$80 to spend, the rational consumerwill spend her money:

MU/P is equal when three units of clothes and five units of amusementgoods are purchased ( MU/P = 1.4).


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Marginal-Utility-to-Price Ratio

Marginal-utility-to-price ratio :

The ratio is calculated by dividingthe marginal utility of a good by theprice of the good -- MU/P .


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The MU/P equalization principle :

A persons total utility is maximizedwhen the ratios of marginal utility to

price for the last unit of each of the goodsconsumed are equal.


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The MU/P equalization principle : MU/P measures marginal utility per dollarspent.

Total utility will be maximized (within theconstraints of a limited budget) when eachindividual purchase generates the largestpossible MU/P .


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A rational and fully-informed consumer willalways shift a dollar from a good whose MU/P

is lower to one whose MU/P is higher, if such ashift is possible.


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The principle is based on consumer behavior. Consumers will always arrange theirsequence of choices among goods starting withthe highest MU/P and running down to exhaustan expenditure budget.


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The MU/P equalization principle : The consumer choice process is inequilibrium when:

There is no longer any incentive for theconsumer to rearrange her purchases. The MU/P is equal for the last unitof each good or service consumed.


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EXHIBIT 5 COMPARING MU/P s AFTER A 20-PERCENT-OFF SALE ON CLOTHES


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Exhibit 5: Comparing MU/Ps After a 20Percent 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 whenprice is reduced by 20 percent. This will cause a rational consumerto consume more clothes.


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EXHIBIT 6 COMPARING MU/P s AFTER A 50-PERCENT-OFF SALE ON CLOTHES


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Exhibit 6: Comparing MU/Ps After a 50Percent Off Sale on Clothes

An additional reduction in the priceof clothing will change all of the

MU/Ps for clothing, and thus changea rational consumers consumptionof clothing.

If the price of clothes falls again, from $8to $5, the quantity of clothing demandedincreases from four to six units.


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EXHIBIT 7 THE DEMAND CURVE FOR CLOTHES


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Exhibit 7: The Demand Curve for Clothes

When the price of clothing fallsfrom $10 to $8 to $5, which of thefollowing occurs:

Quantity demanded remains the same. Quantity demanded falls from 6 to 4 to 3. Quantity demanded rises from 3 to 4 to 6.


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Exhibit 7: The Demand Curve for Clothes

When the price of clothing fallsfrom $10 to $8 to $5, which of thefollowing occurs:

Quantity demanded remains the same. Quantity demanded falls from 6 to 4 to 3. Quantity demanded rises from 3 to 4 to 6.


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MU/P Equalization Principleand the Law of Demand

Changes in the marginal-utility-

to-price ratio are caused by: A change in the marginal utility of a goodor a change in the price of a good changes

the marginal-utility-to-price ratio, andtherefore changes quantity demanded.


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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 herconsumption of that good. Increase in quantity demanded (movement

along the demand curve).


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Principle and the Law of Demand: If consumer preference for a good decreases: MU/P declines. The rational consumer will reduceconsumption. The demand curve shifts to the left (sinceconsumer preference is a non-price factor).


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Principle and the Law of Demand: If consumer income increases: The consumer can pursue a lower MU/P . The consumer can afford to increaseconsumption. An increase in the demand for normal goods .


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A downward-sloping demand

curve is consistent with the lawof diminishing marginal utility.

Diminishing marginal utilitymeans that MU/P declines asquantity consumed increases .


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A downward-sloping demand

curve is consistent with the lawof diminishing marginal utility.

A consumers willingness -to-pay falls as quantity consumedincreases .


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Are White Rats RationalConsumers?

There is evidence that lab ratsmake consumer choices basedon MU/P.

Economists Battalio and Kagel foundthat white lab rats respond to price andincome changes in a manner consistentwith economic theory.


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The MU/P Guide to AuctionBidding

MU/P can help guide auction bidding:

If a particular MU/P is guaranteed bybuying something outside of the auction,and if the marginal utility from the auctiongood is known, then you can figure outyour maximum auction price.


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Creating Consumer Surplus

Consumer surplus : The difference between the maximum price aperson would be willing to pay for a good orservice, and the price the person actually pays. Most consumers receive some consumersurplus from a transaction.


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When market price falls,consumer surplus increases .


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If the price of a good is greater

than amount a consumer is willingto pay for that good, the consumersurplus will be negative if theconsumer buys the good.


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A rational consumer will not

purchase a good that generatesnegative consumer surplus. A rational consumer will prefer zeroconsumer surplus (no purchase) tonegative consumer surplus.

EXHIBIT 8 THE MARKET FOR HORSEBACK RIDING


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EXHIBIT 8 THE MARKET FOR HORSEBACK RIDING


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Exhibit 8: The Market forHorseback Riding

Exhibit 8 depicts the demand andsupply curves for horseback riding.

The concept of consumer surplusapplies to horseback riding:

At a price of $6, all consumers with awillingness-to-pay value of $6 or more willpurchase a horseback ride. These consumers receive consumer surplus.


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Some consumer may be willing to pay $10for a horseback ride. This consumer will receive $(10-6) = $4of consumer surplus.


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A consumer who has a willingness-to-payvalue less than $6:

A rational consumer will not choose to

purchase a ride.

This consumer has a negative consumer surplus.

EXHIBIT 9 CONSUMER SURPLUS ON THE HORSEBACK


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EXHIBIT 9 CONSUMER SURPLUS ON THE HORSEBACK-RIDING MARKET


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Exhibit 9: Consumer Surplus onthe Horseback-Riding Market

Kims consumer surplus fromhorseback 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.


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Tonys consumer surplus fromhorseback 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.


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Randys consumer surplusfrom horseback riding is:

$(9-6) for the first ride. $(6-6) for the fourth ride.

These sum to $(3+0) = $3.


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If Kim, Tony and Randy represent theentire market demand for horsebackriding, the total consumer surplus is:

$18 (Kim) + $6 (Tony) + $3 (Randy)

= $27 in consumer surplus

I l C i


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Interpersonal Comparisonsof Utility

An interpersonal comparison of utility :

It is a comparison of the marginalutilities that different people derive

from a good or a dollar.

I t l C i


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Is it actually possible to compare thesatisfaction that different peoplederive from a good or a dollar?

It is not possible to make an exact comparison of different peoplesutility.

I t l C i


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Is it actually possible to compare thesatisfaction that different peoplederive from a good or a dollar? Policies such as those aimed at povertyalleviation rely on society being able to makeapproximate or reasonable comparisons of utility across different people.

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