THE LOGIC OF INDIVIDUAL CHOICE: THE FOUNDATION OF DEMAND AND SUPPLY Chapter 8 THE LOGIC OF INDIVIDUAL CHOICE: THE FOUNDATION OF DEMAND AND SUPPLY

Today’s lecture will: Discuss the principle of diminishing marginal utility. Talk about the principle of rational choice. Explain the relationship between marginal utility and price when a consumer is maximizing total utility. Explain how the principle of rational choice accounts for the laws of supply and demand.

Today’s lecture will: Name three assumptions of the theory of choice and discuss why they may not reflect reality. Give an example of how behavioral economics changes the assumption of utility maximization.

Utility Theory and Individual Choice According to economists, our behavior is motivated by rational self interest. According to this theory, two things determine what people do: The pleasure people get from doing or consuming something The price of doing or consuming that something.

Total Utility and Marginal Utility Utility is the pleasure or satisfaction that one expects to get from consuming a good or service. 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 of the product above what you have consumed up to that point.

Diminishing Marginal Utility The principle of diminishing marginal utility – 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. When total utility is at a maximum, marginal utility is zero. Beyond this point, total utility decreases and marginal utility is negative.

Marginal and Total Utility Number of pizza slices Total utility Marginal utility 14 1 2 3 4 5 6 7 8 9 14 12 26 10 36 8 44 6 50 4 54 2 56 56 -2 54

Marginal and Total Utility 70 60 Total utility Marginal and Total Utility 50 Total utility 40 30 20 10 Q 1 2 3 4 5 6 7 8 9 16 14 12 Marginal utility 10 8 Marginal utility 6 4 2 Q 1 2 3 4 5 6 7 8 9 -2 Slices of pizza

Rational Choice and Marginal Utility Rational individuals want as much satisfaction as they can get from their income. According to the basic principle of rational choice you should spend your money on those goods that give you the most marginal utility per dollar. Any choice that does not give you as many units of utility as possible for the same amount of money is an irrational choice.

The Principle of Rational Choice Consume another unit of x if: Consume another unit of y if:

Maximizing Utility and Equilibrium Utility is maximized and equilibrium reached when:

Maximizing Utility Big Macs (P = $2) Ice Cream (P = $1) Q TU MU MU/P Q TU MU MU/P 1 2 3 4 5 6 7 20 34 44 47 42 32 1 2 3 4 5 6 7 29 46 53 55 56 52 20 14 10 3 -5 -10 10 7 5 1.5 -2.5 -5 29 17 7 2 1 -4 29 17 7 2 1 -4

Extending the Principle of Rational Choice Utility is maximized when: The cost per additional unit of utility is equal for all goods and the consumer is as well off as is possible.

Rational Choice and the Law of Demand When the price of a good goes up, the marginal utility per dollar (MU/$) from it goes down, and we consume less of it and its marginal utility increases. Quantity demanded falls as price rises. When the price of a good decreases, the MU/$ increases, and we consume more of it and its marginal utility decreases. Quantity demanded increases as price falls.

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 because the price increase makes one poorer. The substitution effect is the reduction in quantity demanded when price increases because you substitute another good for the more expensive one.

Rational Choice and the Law of Supply The higher the wage, the higher the marginal utility of the goods you can get for the wage. This gives an upward sloping supply curve. 8.00 6.50 6.00

Opportunity Cost Opportunity cost is the benefit forgone of the next-best alternative. In the context of utility, it is the marginal utility per dollar you forgo from consuming the next-best alternative. If the MUX/PX > MUY/PY, the opportunity cost of not consuming good x is greater than the opportunity cost of not consuming good y. So we consume x.

Applying the Theory of Choice to the Real World The assumptions underlying the theory of rational decision making place limits on the use of the theory. Those assumptions are: Decision making is costless Tastes are given Individuals maximize utility

The Cost of Decision Making The costs of deciding among hundreds of possible choices may lead us to do some things that seem irrational. Most people may use bounded rationality – rationality based on rules of thumb. “You get what you pay for” –the implication that high price equals high quality “Follow the leader” – leads to focal point equilibria – a set of goods is consumed because they have become focal points to which people have gravitated.

Given Tastes Implicit in the theory of rational choice is that utility functions are given, not shaped by society. Tastes are often significantly influenced by society. Conspicuous consumption – the consumption of goods not for one’s direct pleasure, but to show off to others.

Individuals Maximize Utility People may not behave rationally in practice. Behavioral economics studies the psychological foundations of choice through experiments. The experiment of the ultimatum game shows that people care about fairness as well as income. Experiments also reveal a status quo bias, individuals’ actions are influenced by what the current situation is.

Summary Total utility is the satisfaction obtained from consuming a product. Marginal utility is the satisfaction obtained from consuming one additional unit of a product. The principle of diminishing marginal utility states that after some point, the marginal utility of consuming more of the good will fall.

Summary Utility is maximized and equilibrium reached when: Unless MUX/PX= MUY/PY, an individual can rearrange his or her consumption to in- crease total utility.

Summary The laws of demand and supply can be derived from the principle of rational choice. If the price of a good increases, you will decrease consumption of that good so that its marginal utility increases. If your wage rises, the marginal utility of the goods you can buy with your wage will rise and you will work more to maximize utility. Behavioral economists argue that often the assumptions of the theory of choice, costless decision making, given tastes, and utility maximization may not always apply when people make decisions.

The following table shows your total utility from consuming sodas and grilled cheese sandwiches. Sandwiches Sodas Q TU MU MU/$ Q TU MU MU/$ 0 0 0 0 27 ____ ____ 1 8 ____ ____ 2 48 ____ ____ 2 15 ____ ____ 3 66 ____ ____ 3 21 ____ ____ Review Question 8-1 Find the marginal utility for grilled cheese sandwiches and sodas. Review Question 8-2 Suppose that sandwiches cost $3 each and the price sodas is $1. Find the marginal utility per dollar for sodas and sandwiches. How many of each will you buy if you have $8 to spend and you want to maximize your total utility? 27 9 8 8 21 7 7 7 18 6 6 6 If you buy 2 sandwiches and 2 sodas you will maximize utility.