1. Slides prepared by Dr. Amy Peng, Ryerson University Part Two: Microeconomics of Product Markets CHAPTER 5 CONSUMER CHOICE AND UTILITY MAXIMIZATION

2. ©2007 McGraw-Hill Ryerson Ltd.Chapter 52 In this chapter you will learn: 5.1About total utility, marginal utility, and the law of diminishing marginal utility 5.2 How rational consumers compare marginal utility-to-price ratios for products in purchasing combinations of products that maximize their utility 5.3 How a demand curve can be derived by observing the outcomes of price changes in the utility-maximization model 5.4 How the utility-maximization model helps highlight the income and substitution effects of a price change

3. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.13 Law of Diminishing Marginal Utility Gains in satisfaction decline as additional units are consumed Terminology –utility is want-satisfying power Total Utility and Marginal Utility –total utility: total amount of satisfaction –marginal utility: extra satisfaction from consuming one more unit graphically examined....

4. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.14 Tacos Consumed Total Utility Marginal Utility 0123456701234567 0 10 18 24 28 30 28 Figure 5-1 Total and Marginal Utility

5. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.15 Tacos Consumed Total Utility Marginal Utility 0123456701234567 0 10 18 24 28 30 28 Total and Marginal Utility 10

6. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.16 Tacos Consumed Total Utility Marginal Utility 0123456701234567 0 10 18 24 28 30 28 Total and Marginal Utility 10 8 6 4 2 0 -2 Diminishing Marginal Utility

7. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.17 If marginal utility falls rapidly for each successive unit… It will take a considerable drop in price to cause an increase in quantity demanded… So demand is fairly… INELASTIC Marginal Utility and Demand

8. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.28 Theory of Consumer Choice A Typical Consumer… Exhibits rational behaviour Knows clear-cut preferences Is subject to a budget constraint Responds to price changes

9. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.29 Utility-Maximizing Rule The consumer’s money income should be allocated so that the last dollar spent on each product purchased yields the same amount of extra (marginal) utility

10. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.210 Numerical Example First, put the marginal utilities into a per- dollar-spent basis Decision-making process: at each step, spend where the marginal utility per dollar is highest Table 5-1

11. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.211 Product A p=$1Product B p=$2 Unit of product Marginal utility MU/pMUMU/p 1 st 1024 2 nd 820 3 rd 718 4 th 616 5 th 512 6 th 46 7 th 34 10 876 5 4 3 12 1098 6 3 2 Table 5-1

12. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.212 MU/p, Product A MU/p, Product B 1 st 101 st 12 2 nd 8 10 3 rd 7 9 4 th 6 8 5 th 5 6 6 th 4 3 7 th 3 2 SpendingProduct A Product B$21 $311$21 $311$1042 What will the consumer buy first? And next? Table 5-2 Sequence of Purchases to Achieve Consumer Equilibrium

13. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.213 Utility Maximization At each step, spend where MU/$ is highest In general, if MU/$ is unequal, spending should be allocated –away from the good where MU/$ is low –toward the good where MU/$ is high

14. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.214 MU of product A Price of A MU of product B Price of B = Algebraic Restatement

15. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.315 Utility Maximization and the Demand Curve Deriving the Demand Curve What if the price of Product B falls to $1?

16. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.316 Product A p=$1Product B p= $1 Unit of product Marginal utility MU/pMUMU/p 1 st 1024 2 nd 820 3 rd 718 4 th 616 5 th 512 6 th 46 7 th 34 10 876 5 4 3 24 201816 12 6 4 Table 5-1

17. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.317 MU/p, Product A MU/p, Product B 1 st 101 st 24 2 nd 8 20 3 rd 7 18 4 th 6 16 5 th 5 12 6 th 4 6 7 th 3 4 SpendingProduct AProduct B ◄$11 ◄$11 ◄$11 ◄$11 $11 ◄ ◄ ◄$11$11 $11 ◄ $1064 $11 1 ◄ ◄ Decision Making Process

18. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.318 When p Product B = $2 –the quantity demanded is 4 When p Product B = $1 –the quantity demanded is 6 Utility Maximization and the Demand Curve

19. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.319 Product B PriceQuantity demanded $1 $2 6 4 4 $1 $2 D 6 price quantity demanded Figure 5-2 Deriving an Individual Demand Curve

20. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.320 Substitution Effect –when the price of Product B falls, there is a substitution of now cheaper B Income Effect –increase in real income increases consumption of both A & B Utility Maximization and the Demand Curve

21. ©2007 McGraw-Hill Ryerson Ltd.Chapter 5.421 Applications and Extensions DVDs and DVD Players The Diamond-Water Paradox The Value of Time Cash and Non-Cash Gifts

22. ©2007 McGraw-Hill Ryerson Ltd.Chapter 522 Chapter Summary 5.1 The Law of Diminishing Marginal Utility 5.2 Theory of Consumer Choice –Marginal Utility per Dollar 5.3 Utility Maximization and the Demand Curve –Income and Substitution Effects 5.4 Applications and Extensions