Utility and Demand CHAPTER 7

After studying this chapter you will be able to Explain what limits a household’s consumption choices Describe preferences using the concept of utility and distinguish between total utility and marginal utility Explain the marginal utility theory of consumer choice Explain the paradox of value

The Household’s Budget Consumption Possibilities A household’s consumption possibilities are constrained by its income and the prices of the goods and services it buys. A household has a given amount of income to spend and cannot influence the prices of the goods and services it buys. A household’s budget line describes the limits to a household’s consumption choices.

The Household’s Budget Figure 7.1 shows a budget line for movies and soda. The household can afford all the points on or below the budget line. The household cannot afford the points beyond the budget line.

The Household’s Budget A Price Change A change in the price of the good on the x-axis changes the affordable quantity of that good and changes the slope of the budget line. Figure 7.2(a) shows the rotation of a budget line after a change in the relative price of movies.

The Household’s Budget Real Income A household’s real income is the household’s income expressed as the quantity of goods that the household can afford to buy. Expressed in terms of soda, Lisa’s real income is 10 six- packs—the maximum quantity of six-packs that she can buy. Lisa’s real income equals her money income ($30) divided by the price of a six-pack ($3).

The Household’s Budget A Change in Income An change in the income brings a parallel shift of the budget line. The slope of the budget line doesn’t change because the relative price doesn’t change. Figure 7.2(b) shows how the budget line shifts when income changes.

Preferences and Utility Preferences A household’s preferences determine the benefits or satisfaction a person receives consuming a good or service. The benefit or satisfaction from consuming a good or service is called utility. Total Utility Total utility is the total benefit a person gets from the consumption of goods. Generally, more consumption gives more utility.

Preferences and Utility Table 7.1 on page 157 provides an example of total utility schedule. Figure 7.2(a) shows a total utility curve. Total utility increases with the consumption of a good.

Preferences and Utility Marginal Utility Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed. As the quantity consumed of a good increases, the marginal utility from consuming it decreases. We call this decrease in marginal utility as the quantity of the good consumed increases the principle of diminishing marginal utility.

Preferences and Utility Figure 7.2(b) illustrates diminishing marginal utility. Utility is analogous to temperature. Both are abstract concepts and both are measured in arbitrary units.

Maximizing Utility The key assumption of marginal utility theory is that the household chooses the consumption possibility that maximizes total utility. The Utility-Maximizing Choice We can find the utility-maximizing choice by looking at the total utility that arises from each affordable combination. Table 7.2 (page 158) shows an example of the utility- maximizing combination, which is called a consumer equilibrium.

Maximizing Utility Equalizing Marginal Utility per Dollar Using marginal analysis, a consumer’s total utility is maximized by following the rule: Spend all available income and equalize the marginal utility per dollar for all goods. The marginal utility per dollar is the marginal utility from a good divided by its price.

Maximizing Utility Total utility is maximized when: MU M /P M = MU S /P S Table 7.3 (page 159) and Figure 7.4 on the next slide show why the utility maximizing rule works.

Maximizing Utility If MU M /P M > MU S /P S, then moving a dollar from soda to movies increases the total utility from movies by more than it decreases the total utility from soda, so total utility increases. Only when MU M /P M = MU S /P S, is it not possible to reallocate the budget and increase total utility.

Maximizing Utility If MU S /P S > MU M /P M, then moving a dollar from movies to soda increases the total utility from soda by more than it decreases the total utility from movies, so total utility increases. Only when MU M /P M = MU S /P S, is it not possible to reallocate the budget and increase total utility.

Efficiency, Price, and Value Consumer Efficiency When consumers maximize their utility, they are using resources efficiently. Marginal benefit from a good or service is the maximum price the consumer is willing to pay for an extra unit of that good or service when utility is maximized.

Efficiency, Price, and Value The Paradox of Value The paradox of value “Why is water, which is essential to life, far cheaper than diamonds, which are not essential?” is resolved by distinguishing between total utility and marginal utility. Figure 7.7 on the next slide illustrates the resolution of the paradox.

Efficiency, Price, and Value Value and Consumer Surplus The supply of water is perfectly elastic, so the quantity of water consumed is large and the consumer surplus from water is large. In contrast, the supply of diamonds in perfectly inelastic, so the price is high and the consumer surplus from diamonds is small.

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