Utility and Demand Michael Parkin ECONOMICS 5e

TM 8-2 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain the household’s budget constraint Define total utility and marginal utility Explain the marginal utility theory of consumer choice Use marginal utility theory to predict the effects of changing prices and incomes

TM 8-3 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain the connection between individual demand and market demand Explain the paradox of value

TM 8-4 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain the household’s budget constraint Define total utility and marginal utility Explain the marginal utility theory of consumer choice Use marginal utility theory to predict the effects of changing prices and incomes

TM 8-5 Copyright © 1998 Addison Wesley Longman, Inc. Household Consumption Choices Two concepts determining consumption choices Budget constraint Preferences

TM 8-6 Copyright © 1998 Addison Wesley Longman, Inc. Budget Constraint Consumption choices are constrained by the household’s income and prices. These limits are described by its budget line.

TM 8-7 Copyright © 1998 Addison Wesley Longman, Inc. Consumption Possibilities Movies ($6) Soda ($3) Expenditure Expenditure Possibility Quantity (dollars) Six-packs (dollars) a b c d e f

TM 8-8 Copyright © 1998 Addison Wesley Longman, Inc. Affordable Consumption Possibilities Movies (per month) a b c d e f Unaffordable Soda (six-packs per month)

TM 8-9 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain the household’s budget constraint Define total utility and marginal utility Explain the marginal utility theory of consumer choice Use marginal utility theory to predict the effects of changing prices and incomes

TM 8-10 Copyright © 1998 Addison Wesley Longman, Inc. Preferences Consumption decisions depend upon a person’s likes and dislikes, or preferences. Utility is the benefit or satisfaction that a person gets from the consumption of a good or service.

TM 8-11 Copyright © 1998 Addison Wesley Longman, Inc. Preferences Total utility is the total benefit that a person gets from the consumption of goods and services. Marginal Utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed.

TM 8-12 Copyright © 1998 Addison Wesley Longman, Inc. Preferences Diminishing marginal utility occurs when the marginal utility decreases as the quantity of a good consumed increases. Why does marginal utility decrease?

TM 8-13 Copyright © 1998 Addison Wesley Longman, Inc. Maria’s Total Utility from Movies and Soda MoviesSoda Quantity Six-packs per month Total Utility Total utility MoviesSoda Quantity Six-packs per month Total Utility Total utility

TM 8-14 Copyright © 1998 Addison Wesley Longman, Inc. Total Utility and Marginal Utility QuantityTotal utilityMarginal utility Movies

TM 8-15 Copyright © 1998 Addison Wesley Longman, Inc. Total Utility and Marginal Utility QuantityTotal utilityMarginal utility Movies

TM 8-16 Copyright © 1998 Addison Wesley Longman, Inc. Total Utility and Marginal Utility Units of utility 50 …and diminishing marginal utility Quantity (movies per month) Units of utility Increasing total utility... Quantity (movies per month) Marginal utility Total utility

TM 8-17 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain the household’s budget constraint Define total utility and marginal utility Explain the marginal utility theory of consumer choice Use marginal utility theory to predict the effects of changing prices and incomes

TM 8-18 Copyright © 1998 Addison Wesley Longman, Inc. Maximizing Utility Marginal Utility Theory Assumes people choose the consumption possibility that maximizes their total utility. People’s wants exceed the resources available to satisfy those wants. Choices In making choices, people try to maximize total utility.

TM 8-19 Copyright © 1998 Addison Wesley Longman, Inc. Maria's Affordable Combinations Movies Soda Total utility Quantity from moviesSix-packs per month Total utility and soda Total utility per month a b c d e f

TM 8-20 Copyright © 1998 Addison Wesley Longman, Inc. Maximizing Utility Consumer equilibrium A situation in which a consumer has allocated all his or her available income in a way that, given the prices of goods and services, maximizes his or her total utility. Occurs at the combination that equates the marginal utility per dollar spent for all goods.

TM 8-21 Copyright © 1998 Addison Wesley Longman, Inc. Maximizing Utility Consumer equilibriumMarginal utility from movies from soda Price of a movie Price of soda = OR MU m MU s P m P s =

TM 8-22 Copyright © 1998 Addison Wesley Longman, Inc. Equalizing Marginal Utilities per Dollar Spent a b c d e f Movies ($6 each)Soda ($3 per six-pack) Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spentQuantity utility spent

TM 8-23 Copyright © 1998 Addison Wesley Longman, Inc. MU s P s MU m P m Movies Soda Possibility a b c d e f Utility gain from more soda and fewer movies Utility gain from more movies and less soda Marginal utility per dollar spent (units of utility per dollar) Maximum total utility Equalizing Marginal Utilities per Dollar Spent

TM 8-24 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives Explain the household’s budget constraint Define total utility and marginal utility Explain the marginal utility theory of consumer choice Use marginal utility theory to predict the effects of changing prices and incomes

TM 8-25 Copyright © 1998 Addison Wesley Longman, Inc. If the price of a good changes, the marginal utility per dollar spent will change. As a result, the quantity demanded for the good will change. Also, the demand for the good may change if people substitute goods for one another. Predictions of Marginal Utility Theory

TM 8-26 Copyright © 1998 Addison Wesley Longman, Inc. What happens to the Maria’s consumption of movies and soda if the price of movies fall to $3? How a Change in Price of Movies Affects Maria’s Choices

TM 8-27 Copyright © 1998 Addison Wesley Longman, Inc. How a Change in Price of Movies Affects Maria’s Choices Movies ($3 each) Soda ($3 per six pack) Quantity Marginal utility Per dollar spent Six-packs Marginal utility Per dollar spent

TM 8-28 Copyright © 1998 Addison Wesley Longman, Inc. A Fall in the Price of Movies Quantity (movies per month)Quantity (six-packs per month) Price (dollars per movie) Movies Soda Maria’s demand for soda when movies cost $3 Maria’s demand for movies Price (dollars per six-pack) Maria’s demand for soda when movies cost $6

TM 8-29 Copyright © 1998 Addison Wesley Longman, Inc. What happens to the Maria’s consumption of movies and soda if the price of sodas rise to $6? How a Change in Price of Movies Affects Maria’s Choices

TM 8-30 Copyright © 1998 Addison Wesley Longman, Inc. How a Change in Price of Soda Affects Maria’s Choices Movies ($3 each) Soda ($3 per six pack) Quantity Marginal utility Per dollar spent Six-packs Marginal utility Per dollar spent

TM 8-31 Copyright © 1998 Addison Wesley Longman, Inc. A Rise in the Price of Soda Quantity (six-packs per month) Quantity (movies per month) Price (dollars per six-pack) MoviesSoda Price (dollars per movie) Maria’s demand for soda Maria’s demand for movies when soda costs $3 Maria’s demand for movies when soda costs $6

TM 8-32 Copyright © 1998 Addison Wesley Longman, Inc. Predictions of Marginal Utility Theory Marginal utility theory predicts two results: When the price of a good rises, the quantity demanded for that good decreases. If the price of one good rises, the demand for another good that can serve as a substitute increases.

TM 8-33 Copyright © 1998 Addison Wesley Longman, Inc. A Rise in Income What happens to Maria’s consumption of movies and soda if her income rises from $30 a month to $42?

TM 8-34 Copyright © 1998 Addison Wesley Longman, Inc. Maria’s Choices with an Income of $42 a Month Movies ($3 per movie) Soda ($3 per six pack)Marginal utility utility per dollar per dollar Quantity spentSix-packs spent

TM 8-35 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain the connection between individual demand and market demand Explain the paradox of value

TM 8-36 Copyright © 1998 Addison Wesley Longman, Inc. Individual Demand and Market Demand Market demand The relationship between the total quantity demanded of a good and its price. Individual demand The relationship between quantity demanded of a good by a single individual and its price.

TM 8-37 Copyright © 1998 Addison Wesley Longman, Inc. Individual and Market Demand Curves PriceQuantity of movies demanded (dollars per movie) Maria Ivan Market

TM 8-38 Copyright © 1998 Addison Wesley Longman, Inc. Individual and Market Demand Curves PriceQuantity of movies demanded (dollars per movie) Maria Ivan Market

TM 8-39 Copyright © 1998 Addison Wesley Longman, Inc. Individual and Market Demand Curves Price (dollars per movie) Price (dollars per movie) Quantity (movies per month) Maria’s demand 5 movies Ivan’s demand 2 movies

TM 8-40 Copyright © 1998 Addison Wesley Longman, Inc. Individual and Market Demand Curves Price (dollars per movie) Quantity (movies per month) Market Demand = 7 movies

TM 8-41 Copyright © 1998 Addison Wesley Longman, Inc. Learning Objectives (cont.) Explain the connection between individual demand and market demand Explain the paradox of value

TM 8-42 Copyright © 1998 Addison Wesley Longman, Inc. Efficiency, Price, and Value The Paradox of Value Why does water, which is essential for life, cost so little? Why do diamonds, which are useless compared to water, cost so much?

TM 8-43 Copyright © 1998 Addison Wesley Longman, Inc. The Paradox of Value Consumer surplus from water Quantity of water Price of water D S PwPw Water QwQw

TM 8-44 Copyright © 1998 Addison Wesley Longman, Inc. The Paradox of Value Quantity of diamonds S D QDQD Diamonds Consumer surplus from diamonds Price of a diamond PDPD

TM 8-45 Copyright © 1998 Addison Wesley Longman, Inc. The Paradox of Value Diamonds have a high price and a high marginal utility, while water has a low price and a low marginal utility. The marginal utility per dollar spent is the same for diamonds as for water.