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The Logic of Individual Choice: The Foundation of Supply and Demand 10

The Logic of Individual Choice:

The Foundation of Supply and Demand

The theory of economics must begin with a correct theory

of consumption.

— Stanley Jevons

CHAPTER 10

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


Utility Theory and Individual Choice

• Our behavior is motivated by rational self-interest

• According to this theory, two things determine what people do:

• Utility which is the pleasure or satisfaction that people get from doing or consuming something

• The price of doing, or consuming, that something

10-2


Total Utility and Marginal Utility

• Utility = satisfaction

• Total utility is the total satisfaction one gets from consuming a product

• Marginal utility is the satisfaction you get from the consumption of one additional unit

• Utility is commonly measured in utils

10-3


Diminishing Marginal Utility

• 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

• As additional units are consumed, marginal utility decreases, but total utility continues to increase

10-4


Application: Total Utility and Marginal Utility

Number of Pizza Slices Total Utility Marginal Utility

0 0 14

1 14 12

2 26 10

3 368

4 446

5 504

6 542

7 560

8 56

-29 54

TU is increasing, but atsome point decreases

MU is decreasing as more units are consumed, but at some point

becomes negative


Diminishing Marginal Utility

• When total utility is at a maximum, marginal utility is zero (remember this)

• Beyond this point, total utility decreases and marginal utility is negative

McGraw-Hill/Irwin Colander, Economics 6


Total Utility Curve and Marginal Utility Curve

Units of Utility

Q

Total utility reaches its maximum at 8 units

10

60

40

50

70

Units of Utility

Q1 2 3 4 5 6 7 8

Total Utility Curve Marginal Utility Curve

Marginal utility is zero when it crosses the

quantity axis. It demonstrates the law of

diminishing marginal utility.

1 2 3 4 5 6 7 8

30

20

2

12

8

10

14

6

4

–2

0

10-7


Rational Choice and Marginal Utility

• Consume another unit of X if:

• Consume another unit of Y if:

• The principle of rational choice states that people spend their money on those goods the give them the most marginal utility (MU) per dollar

Y

Y

X

X

P

MU

P

MU

X

X

Y

Y

P

MU

P

MU

10-8


Maximizing Utility and Equilibrium

• The utility maximizing rule states that when the ratios of the marginal utility to price of the two goods are equal, you are maximizing utility (and you are at equilibrium)

• If , you are maximizing utility

• MU=marginal utility and P=price

Y

Y

X

X

P

MU

P

MU

10-9


Maximizing Utility

Big Macs (P = $2)

Q TU MU MU/P

0 0 20 10

1 20 14 7

2 3410 5

3 443 1.5

4 470 0

5 47-5 -2.5

6 42-10 -5

7 32

Ice Cream (P = $1)

Q TU MU MU/P

0 0 29 29

1 29 17 17

2 46 7 7

3 532 2

4 551 1

5 560 0

6 56-4 -4

7 52

Suppose you have $7 to spend. How will you spend it? (Refer to P. 236-237)

10-10


Maximizing Utility

• Using the chart, look for where the MU/P of both goods are equal (the utility maximizing rule)

• Then, see if those prices and quantities for each good sum to the amount of money you have to spend (in this case, $7)

• Big Macs: 2 ($2)=$4

• Ice cream: 3($1)=$3


$7


Extending the Principle of Rational Choice

• Utility is maximized when:

• What if you were consuming three goods?

• You would consume them where the MU/P for all three goods is equal

Z

Z

Y

Y

X

X

P

MU

P

MU

P

MU

10-12


Rational Choice and the Law of Demand

• When the price of a good increases, the marginal utility per dollar (MU/P) from it decreases, and we consume less of it

• By consuming less is the only way to increase marginal utility

• Remember, quantity demanded falls as price rises

10-13


Rational Choice and the Law of Demand

• When the price of a good decreases, the MU/P increases, and we consume more of it

• By consuming more, we decrease our marginal utility

• Remember, quantity demanded increases as price falls



Rational Choice and the Law of Demand: Income and Substitution Effects

• The inverse relationship between price and quantity demanded is due to the income and substitution effects

• The income effect is the reduction in quantity demanded when price increases

10-15


Rational Choice and the Law of Demand: Income and Substitution Effects

• The substitution effect is the reduction in quantity demanded when price increases

• You will substitute another good for the more expensive good

• Look at the Big Mac and ice cream example again



Income and Substitution Effects

Big Macs (P = $2)

Q TU MU MU/P

0 0 20 10

1 2014 7

2 3410 5

3 44

Ice Cream (P = $2)

Q TU MU MU/P

0 0 29 14.5

1 29 17 8.5

2 467 3.5

3 53

• Suppose ice cream is now $2

• You are given an extra $3 to make up for this price increase (so there is no income effect)

• How will your spending change (substitution effect)?

10-17



• In this case, you will substitute based on total utility, even though you were given $3 to compensate for the increase in the price of ice cream

• You will now buy 3 Big Macs and 2 ice creams




Big Macs (P = $2)

Q TU MU MU/P

0 0 20 10

1 2014 7

2 3410 5

3 44

Ice Cream (P = $2)

Q TU MU MU/P

0 0 29 14.5

1 29 17 8.5

2 467 3.5

3 53

•Why?

•We are looking for the greatest MU/P:

•We will consume the 1st ice cream, the 1st Big Mac, the 2nd ice cream, the 2nd Big Mac, and the 3rd Big Mac

10-19


Utility and Consumer Surplus

10-20

Quantity of Tacos

Total Benefit of Tacos

Quantity of Pizzas

Total Benefit of Pizza

0 $0 0 $0

1 $6 1 $6

2 $10 2 $10

3 $12 3 $12

Tacos cost $2 and pizza costs $1.What is the consumer surplus if Mary consumes 3 tacos?


Utility and Consumer Surplus

10-21

Quantity of Tacos


Quantity of Pizzas


0 $0 0 $0

1 $6 1 $6

2 $10 2 $10

3 $12 3 $12

Tacos cost $2 and pizza costs $1.What is the consumer surplus if Mary consumes 3 tacos?

• The total benefit of 3 tacos is $12. 3 tacos will cost Mary $6. CS= $12-$6= $6


Utility and Optimal Combination

10-22

Quantity of Tacos


Quantity of Pizzas


0 $0 0 $0

1 $6 1 $6

2 $10 2 $10

3 $12 3 $12

Tacos cost $2 and pizza costs $1.What is Mary’s optimal combination if she has $7 to spend?



10-23

Quantityof Tacos


MB ofTacos

MU/PTacos

Quantityof Pizzas


MB of Pizza

MU/PPizza

0 $0 0 0 0 $0 0 0

1 $6 6 3 1 $6 6 6

2 $10 4 2 2 $10 4 4

3 $12 2 1 3 $12 2 2

Tacos cost $2 and pizza costs $1.What is Mary’s optimal combination if she has $7 to spend?

• First we need to calculate MB (MU) and MU/P.• Find where the MU/P for tacos is equal to that for pizza.• Her optimal quantity would be 2 tacos and 3 pizzas.



10-24

Quantityof Tacos


MB ofTacos

MU/PTacos

Quantityof Pizzas


MB of Pizza

MU/PPizza

0 $0 0 0 0 $0 0 0

1 $6 6 3 1 $6 6 3

2 $10 4 2 2 $10 4 2

3 $12 2 1 3 $12 2 1

Tacos cost $2 and pizza now costs $2.What is Mary’s optimal combination if she now has $8 to spend?

• Although Mary had an extra dollar to spend, her optimal quantity would be 2 tacos and 2 pizzas.

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The Logic of Individual Choice: The Foundation of Supply ...lopiccolo.weebly.com/uploads/7/7/7/4/7774746/ch_10_notes_17.pdf · The Foundation of Supply and Demand 10 Maximizing Utility