Chapter 6 Consumer Choice Theory Lecture Slides Economics for Today Irvin B. Tucker © 2011 South-Western, a part of Cengage Learning

What does this chapter cover? It expands the understanding of demand by investigating why people buy goods and services © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What does utility mean? The satisfaction, or pleasure, that people receive from consuming a good or service © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What is total utility? The amount of satisfaction received from all the units of a good or service consumed © 2011 South-Western, a part of Cengage Learning

Why does a consumer buy one bundle of goods, rather than another? Consumers make one choice over another depending on their marginal utility © 2011 South-Western, a part of Cengage Learning

What is marginal utility? The change in total utility from one additional unit of a good or service © 2011 South-Western, a part of Cengage Learning

What is the law of diminishing marginal utility? The principle that the extra satisfaction of a good or service declines as people consume more in a given period © 2011 South-Western, a part of Cengage Learning

MU 8 6 4 2 Exhibit 1(a) Marginal Utility 0 1 2 3 4 Marginal Utility per Big Mac (utils) 4 2 MU 0 1 2 3 4 Quantity of Big Macs (number consumed per day) 8 © 2011 South-Western, a part of Cengage Learning

TU Exhibit 1(b) Total Utility 16 12 8 4 0 1 2 3 4 Total Utility (utils) 8 4 0 1 2 3 4 Quantity of Big Macs (number consumed per day) 9 © 2011 South-Western, a part of Cengage Learning

When is total utility maximized? When the marginal utility per dollar of each good is equal and the entire budget is spent © 2011 South-Western, a part of Cengage Learning

What is consumer equilibrium? A condition in which total utility cannot increase by spending more of a given budget on one good and spending less on another good © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning Even though water provides a greater utility than diamonds, why are diamonds more expensive? Water is plentiful in most of the world, so its marginal utility is low © 2011 South-Western, a part of Cengage Learning

S MU Exhibit 2(a) Marginal Utility of Diamonds Marginal Utility per Carat (utils) MUd MU Quantity of Diamonds (carats per year) 13 © 2011 South-Western, a part of Cengage Learning

S MU MUw Exhibit 2 Marginal Utility of Water Marginal Utility per gallon (utils) MU MUw Quantity of Water (gallons per year) 14 © 2011 South-Western, a part of Cengage Learning

Exhibit 3 Marginal Utility for Big Macs and Milkshakes (utils per day) Quantity MU MU/P MU MU/P 1 2 3 4 8 4 2 1 4 2 1 1/2 6 4 1 3 2 1/2 Note: The price per Big Mac and per milkshake is $2. © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning Consumer Equilibrium MU A price A MU B price B MU Z price Z = = © 2011 South-Western, a part of Cengage Learning

Consumer Equilibrium Price of Big Mac = $2 MU of Big Mac price of Big Mac MU of milkshake price of milkshake = 4 utils $2 4 utils $2 = © 2011 South-Western, a part of Cengage Learning

Consumer Equilibrium Price of Big Mac = $1 MU of Big Mac price of Big Mac MU of milkshake price of milkshake > 4 utils $1 > 4 utils $2 © 2011 South-Western, a part of Cengage Learning

What happens to the number of Big Macs bought when the price drops? To restore maximum total utility, the consumer spends more on Big Macs © 2011 South-Western, a part of Cengage Learning

What does this discussion of utility reveal? The law of demand, that is, as the price of a good declines, consumers will buy more units of the good, and vice versa © 2011 South-Western, a part of Cengage Learning

What are two alternative explanations of demand? Income effect Substitution effect © 2011 South-Western, a part of Cengage Learning

What is the income effect? The change in quantity demanded of a good or service caused by a change in real income (purchasing power) © 2011 South-Western, a part of Cengage Learning

What does the income effect show? As prices decline, your real income increases, increasing your buying power, so you buy more units, ceteris paribus © 2011 South-Western, a part of Cengage Learning

Quantity demanded of good X increases Real purchasing power increases Price of good X falls © 2011 South-Western, a part of Cengage Learning

What is the substitution effect? The change in quantity demanded of a good or service caused by the change in its price relative to substitutes © 2011 South-Western, a part of Cengage Learning

What does the substitution effect show? Suppose the price of a Pepsi falls and the price of a Coke remains unchanged; you will buy more Pepsi, because relatively, it is less expensive than Coke © 2011 South-Western, a part of Cengage Learning

Quantity demanded of good X increases Consumers switch from good Y to good X Price of competing good Y rises © 2011 South-Western, a part of Cengage Learning

What do the substitution and income effects prove? The law of demand, that is, as the price of a good declines, consumers will buy more units of the good, and vice versa © 2011 South-Western, a part of Cengage Learning

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