McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. THE LOGIC OF INDIVIDUAL CHOICE: THE FOUNDATION OF DEMAND AND SUPPLY THE LOGIC OF INDIVIDUAL CHOICE: THE FOUNDATION OF DEMAND AND SUPPLY Chapter 8

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-2 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-3 Today’s lecture will: Explain why economists can believe there are many explanations of individual choice, but nonetheless focus on self-interest. Name three assumptions of the theory of choice and discuss why they may not reflect reality.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-4 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-5 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 satisfaction one gets from one’s consumption of 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-6 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-7 Marginal and Total Utility Number of pizza slices Total utility Marginal utility

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-8 Marginal and Total Utility Total utility Q Total utility Marginal utility Marginal utility Q

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-9 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Principle of Rational Choice Consume another unit of x if: Consume another unit of y if:

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Maximizing Utility Q TU MU MU/P Q TU MU MU/P Big Macs (P = $2)Ice Cream (P = $1)

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Maximizing Utility and Equilibrium Utility is maximized and equilibrium reached when:

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved 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 it is possible to be.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved 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 the consumption of the next-best alternative. If the MU X /P X > MU Y /P Y, the opportunity cost of not consuming good x is greater than the opportunity cost of not consuming good y. So we consume x.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Applying the Theory of Choice to the Real World There are limits on the assumptions underlying the theory of rational decision making. Those assumptions are:  Decision making is costless  Tastes are given  Individuals maximize utility

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The Cost of Decision Making The cost of deciding among hundreds of possible choices lead us to do something 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved Individuals Maximize Utility People may not behave rationally in practice. The ultimatum game shows that people care about fairness as well as income. According to the status quo bias, individuals’ actions are influenced by what the current situation is.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-21Summary 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-22Summary Utility is maximized and equilibrium reached when: Unless MU X /P X = MU Y /P Y, an individual can rearrange his or her consumption to in- crease total utility.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved. 8-23Summary Opportunity cost is the marginal utility per dollar one forgoes from the consumption of the next-best alternative. 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.

McGraw-Hill/Irwin Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved The following table shows your total utility from consuming sodas and grilled cheese sandwiches. Sandwiches Sodas QTUMUMU/$ ________ 1 8________ 251________ 215________ 369________321________ 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? If you buy 2 sandwiches and 2 sodas you will maximize utility.