1. Copyright © 2006 Pearson Education Canada Utility and Demand PART 3Households’ Choices 8 CHAPTER

2. Copyright © 2006 Pearson Education Canada Objectives After studying this chapter, you will 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  Use marginal utility theory to predict the effects of changing prices and incomes  Explain the paradox of value

3. Copyright © 2006 Pearson Education Canada Household’s Budget A household’s consumption choices are determined by:  Consumption possibilities  Preferences Consumption Possibilities A household’s consumption possibilities are constrained by its budget and the prices of the goods and services it buys. A budget line describes the limits to a household’s consumption choices.

4. Copyright © 2006 Pearson Education Canada Household’s Budget Figure 7.1 shows a budget line. The household can afford all the points on or below the budget line. The household cannot afford the points beyond the budget line.

5. Copyright © 2006 Pearson Education Canada Household’s Budget Relative Price A relative price is the price of one good divided by the price of another good. The price of a movie is $6 and the price of pop is $3 a six- pack. So the relative price of a movie is $6 per movie divided by $3 per six-pack, which equals 2 six-packs per movie

6. Copyright © 2006 Pearson Education Canada Household’s Budget A fall in the price of the good on the x-axis increases the affordable quantity of that good and decreases 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.

7. Copyright © 2006 Pearson Education Canada 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 pop, 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).

8. Copyright © 2006 Pearson Education Canada Household’s Budget An change in the household’s 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.

9. Copyright © 2006 Pearson Education Canada 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.

10. Copyright © 2006 Pearson Education Canada Preferences and Utility Table 7.1 provides an example of total utility schedule. Figure 7.3(a) shows a total utility curve. Total utility increases with the consumption of a good.

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12. 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.

13. Copyright © 2006 Pearson Education Canada Preferences and Utility Figure 7.3(b) illustrates diminishing marginal utility.

14. Copyright © 2006 Pearson Education Canada 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 shows an example of the utility-maximizing combination, which is called a consumer equilibrium.

15. Copyright © 2006 Pearson Education Canada 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 on all goods. The marginal utility per dollar is the marginal utility from a good divided by its price.