3 3 Consumer Choice: Individual and Market Demand

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Scarcity and Demand ●Utility: A Tool to Analyze Purchase Decisions ●Consumer Choice as a Trade-off: Opportunity Cost ●From Individual Demand Curves to Market Demand Curves ●Exceptions to the Law of Demand ●Scarcity and Demand ●Utility: A Tool to Analyze Purchase Decisions ●Consumer Choice as a Trade-off: Opportunity Cost ●From Individual Demand Curves to Market Demand Curves ●Exceptions to the Law of Demand Outline Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

Scarcity and Demand ●Income is limited → consumers face constraints on their choices ●Wealthy and poor individuals have limited incomes relative to their desires. ●Every decision has an opportunity cost. ♦↑purchases of clothing → ↓purchases of restaurant meals ●Income is limited → consumers face constraints on their choices ●Wealthy and poor individuals have limited incomes relative to their desires. ●Every decision has an opportunity cost. ♦↑purchases of clothing → ↓purchases of restaurant meals

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Utility: A Tool to Analyze Purchase Decisions ●How do consumers make choices? ♦Theory of consumer choice = each consumer spends his or her income in a way that yields the greatest satisfaction or utility. ♦Cannot measure utility (or satisfaction) directly. How should we measure your utility of a movie theater ticket? ●How do consumers make choices? ♦Theory of consumer choice = each consumer spends his or her income in a way that yields the greatest satisfaction or utility. ♦Cannot measure utility (or satisfaction) directly. How should we measure your utility of a movie theater ticket?

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Total utility = largest sum of money that a consumer will voluntarily give up for a good ♦E.g., I will buy 7 pints of Chunky Monkey only if it costs $21.50 or less. So the TU (or benefit) that I receive from 7 pints is $ ●Marginal utility = addition to TU that an individual receives by consuming 1 more unit of the good ♦E.g., if I consumed 6 pints of Chunky Monkey, MU measures how much add. satisfaction I get by consuming 7 pints instead. ●Total utility = largest sum of money that a consumer will voluntarily give up for a good ♦E.g., I will buy 7 pints of Chunky Monkey only if it costs $21.50 or less. So the TU (or benefit) that I receive from 7 pints is $ ●Marginal utility = addition to TU that an individual receives by consuming 1 more unit of the good ♦E.g., if I consumed 6 pints of Chunky Monkey, MU measures how much add. satisfaction I get by consuming 7 pints instead. Total vs. marginal utility

TABLE 1. Leah’s Total and Marginal Utility from Chunky Monkey Quantity (per month) Total Utility (dollars) Marginal Utility (dollars) Label for graph A B C D E F G H

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total vs. marginal utility ●TU: 1 pint is worth no more than $6.00 to me and 2 pints are worth no more than $11.00 to me, etc. ●MU: 1 st pint is worth $6 to me and 2 nd pint is worth $5.00 to me, while the 3 rd is worth $4.00, etc. ●TU: 1 pint is worth no more than $6.00 to me and 2 pints are worth no more than $11.00 to me, etc. ●MU: 1 st pint is worth $6 to me and 2 nd pint is worth $5.00 to me, while the 3 rd is worth $4.00, etc.

FIGURE 1. Leah’s Marginal Utility Curve for Chunky Monkey Number of pints per Month 8 Marginal Utility (Price) per pint $ H F E D C B A $7 G Price

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Law of diminishing MU = the more of a good a consumer has, the less MU an additional unit contributes to overall satisfaction. ●Additional units of a good are worth less and less to a consumer in money terms. ♦E.g., each add. pint is worth less to me. 1 st pint eat by myself; 2 nd share with my husband; 3 rd share with my friend; 4 th share with my dog, Dante; 5 th share with my mother-in-law. Thus, each successive pint has a lower priority. Can you think of any exceptions to the law of diminishing marginal utility? ●Law of diminishing MU = the more of a good a consumer has, the less MU an additional unit contributes to overall satisfaction. ●Additional units of a good are worth less and less to a consumer in money terms. ♦E.g., each add. pint is worth less to me. 1 st pint eat by myself; 2 nd share with my husband; 3 rd share with my friend; 4 th share with my dog, Dante; 5 th share with my mother-in-law. Thus, each successive pint has a lower priority. Can you think of any exceptions to the law of diminishing marginal utility? “Law” of Diminishing MU

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Total vs. marginal utility ●Graph of MU has (-) slope → ↓MU as ↑Qd. ●↑TU as long as MU is (+). ♦E.g., when a commodity is very scarce (diamonds), economists expect it to have high MU even though it provides very little TU. Can you think of a good that has a very low MU but a very high TU? ●Graph of MU has (-) slope → ↓MU as ↑Qd. ●↑TU as long as MU is (+). ♦E.g., when a commodity is very scarce (diamonds), economists expect it to have high MU even though it provides very little TU. Can you think of a good that has a very low MU but a very high TU?

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Using MU: The Optimal Purchase Rule How many pints of Chunky Monkey should I purchase? ●Goal: max. total benefit from pints while min. their cost. As long as MU is (+), ↑TU by consuming more pints. But each add. pint costs money. ●Net TU = TU – total expenditure; where TE = P*Qd. ●Max. net TU by watching net MU; net MU = MU – P. ♦E.g., If P = $3.00/pint and I buy 3 pints, then net MU = $1.00; so I can ↑net TU by purchasing more. How many pints of Chunky Monkey should I purchase? ●Goal: max. total benefit from pints while min. their cost. As long as MU is (+), ↑TU by consuming more pints. But each add. pint costs money. ●Net TU = TU – total expenditure; where TE = P*Qd. ●Max. net TU by watching net MU; net MU = MU – P. ♦E.g., If P = $3.00/pint and I buy 3 pints, then net MU = $1.00; so I can ↑net TU by purchasing more.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Using MU: The Optimal Purchase Rule ●Two rules govern the optimal purchase rule: 1.if net MU is (+) (or MU > P) → consumer buys too little of the good to max. net TU 2.if net MU is (-) (or MU < P) → consumer buys too much of the good to max. net TU ●Combining these 2 rules → net TU is maximized when net MU = 0 (or MU = P). MU = P is the optimal purchase rule ●Two rules govern the optimal purchase rule: 1.if net MU is (+) (or MU > P) → consumer buys too little of the good to max. net TU 2.if net MU is (-) (or MU < P) → consumer buys too much of the good to max. net TU ●Combining these 2 rules → net TU is maximized when net MU = 0 (or MU = P). MU = P is the optimal purchase rule

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Demand curve = MU curve ♦Law of diminishing MU  (-) slope of D curves ♦  P   Qd   MU ■E.g., P = $3 → Qd = 4 pints. But if the ↑P to $5 → Qd = 2 pints. If ↓P to $2 → Qd = 5 pints. As ↑P, use the good for higher valued uses –to share with my friend or husband. As ↓P, use the good for lower valued uses –to share with my dog or mother-in-law. ●Demand curve = MU curve ♦Law of diminishing MU  (-) slope of D curves ♦  P   Qd   MU ■E.g., P = $3 → Qd = 4 pints. But if the ↑P to $5 → Qd = 2 pints. If ↓P to $2 → Qd = 5 pints. As ↑P, use the good for higher valued uses –to share with my friend or husband. As ↓P, use the good for lower valued uses –to share with my dog or mother-in-law. From MU to Demand Curves

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Consumer Choice as a Trade- Off: Opportunity Cost ●Recall the importance of opportunity cost ●Decision to purchase something  decision to forgo something else ♦Real cost of 4 pints purchased for $3.00 each is not the $12 given up. It is the 4 movie rentals that are given up. I have given up $12 worth of other goods to buy 4 pints of Chunky Monkey. ●Recall the importance of opportunity cost ●Decision to purchase something  decision to forgo something else ♦Real cost of 4 pints purchased for $3.00 each is not the $12 given up. It is the 4 movie rentals that are given up. I have given up $12 worth of other goods to buy 4 pints of Chunky Monkey.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Consumer Surplus ●CS = net TU = TU - TE ●Economists assume that firms max profit and consumers max CS. ●Consumer must experience some gain from a voluntary transaction; otherwise the consumer would refuse to purchase the good. ●CS = net TU = TU - TE ●Economists assume that firms max profit and consumers max CS. ●Consumer must experience some gain from a voluntary transaction; otherwise the consumer would refuse to purchase the good.

TABLE 2. Calculating CS Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Quantity (pints per mo.) Marginal UtilityPriceNet MU (per unit surplus) 1$ 6.00$ Two ways of calculating CS: (1) CS = TU – TE or (2) CS = ∑(MU – P)

FIGURE 2. Graph of CS Marginal Utility and Price per pint $ $.50 $1 $2 0 Number of pints purchased Copyright© 2006 South-Western/Thomson Learning. All rights reserved. 7 $6 $3 A B C $5 $4 $3 D E F G H $2 $1 P $0 MU CS per unit MU (or D) curve

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. Graph of Consumer Surplus ●CS = area under D curve and above P. ♦Leah was willing to pay $18 for the 4 pints (i.e., the TU of 4 pints), but only paid $12 (i.e., $3*4) so her total CS = $6. ●TU = area under entire D curve ●TE = rectangular area that reflects P*Qd ●CS = area under D curve and above P. ♦Leah was willing to pay $18 for the 4 pints (i.e., the TU of 4 pints), but only paid $12 (i.e., $3*4) so her total CS = $6. ●TU = area under entire D curve ●TE = rectangular area that reflects P*Qd

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. ●Market D curve = horizontal sum of individual D curves ●Steps to move from individual D to market D: 1.Pick any relevant P. 2.Find Qd at that P for each person. 3.Add the Qd at that P to get Qd in the market. Repeat these steps for all possible prices. ●Market D curve = horizontal sum of individual D curves ●Steps to move from individual D to market D: 1.Pick any relevant P. 2.Find Qd at that P for each person. 3.Add the Qd at that P to get Qd in the market. Repeat these steps for all possible prices. From Individual to Market D Curves

FIGURE 3. Total Market D vs. Individual Consumer D Price 43 (c) Quantity Demanded 70 M M Market demand (b) Quantity Demanded 30 Z Z Joe’s demand (a) Quantity Demanded Price $3 40 MMJJLL K D D Leah’s demand $7 1 1

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. From Individual to Market D Curves ●The “Law” of Demand ♦(-) slope for market D curves ■Individual D curves have (-) slopes because of the law of diminishing MU ■Lower P draws new customers into the market ●E.g., Fig. 3, only Joe will buy Chunky Monkey at P = $7. Yet, at P < $7, Leah will also purchase ice cream. As ↓P, Joe will buy more and Leah will enter the market, insuring that ↑Qd as ↓P. ●The “Law” of Demand ♦(-) slope for market D curves ■Individual D curves have (-) slopes because of the law of diminishing MU ■Lower P draws new customers into the market ●E.g., Fig. 3, only Joe will buy Chunky Monkey at P = $7. Yet, at P < $7, Leah will also purchase ice cream. As ↓P, Joe will buy more and Leah will enter the market, insuring that ↑Qd as ↓P.

Copyright© 2006 South-Western/Thomson Learning. All rights reserved. From Individual to Market D Curves ●Exceptions to the “Law” of Demand ♦Goods whose quality is judged by price –if a ↓P signals poor quality → ↓Qd ■E.g., Bayer aspirin vs. generic brand aspirin ♦Goods with snob appeal –some people buy expensive goods to advertise their wealth ■E.g., Rolls Royce ●Exceptions to the “Law” of Demand ♦Goods whose quality is judged by price –if a ↓P signals poor quality → ↓Qd ■E.g., Bayer aspirin vs. generic brand aspirin ♦Goods with snob appeal –some people buy expensive goods to advertise their wealth ■E.g., Rolls Royce