8 UTILITY AND DEMAND After studying this chapter you will be able to Explain the limits to consumption and describe preferences using the concept of utility Explain the marginal utility theory of consumer choice Use marginal utility theory to predict the effects of changes in prices and incomes and to explain the paradox of value Describe some new ways of explaining consumer choices 2014 Pearson Addison Wesley You want Adele s album 21 Will you buy a CD for 9 99 or will you download it for 10 99 What determines our choices about how we buy recorded music You know that diamonds are expensive and water is cheap Doesn t that seem odd Why do we place a higher value on useless diamonds than on essential to life water 2014 Pearson Addison Wesley Consumption Choices The choices you make as a buyer of goods and services are influenced by many factors which economists summarize as Consumption Choices Preferences Consumption Choices Consumption Choices are all the things that you can afford to buy 2014 Pearson Addison Wesley Consumption Choices We ll study the Consumption Choices of Lisa who buys only two goods movies and soda A Consumer s Budget Line Consumption Choices are limited by income the price of a movie and the price of soda When Lisa spends all of her income she reaches the limits of her Consumption Choices Lisa s budget line shows the limits of her Consumption Choices 2014 Pearson Addison Wesley Consumption Choices Lisa has 40 to spend the price of a movie is 8 and the price of soda is 4 a case 2014 Pearson Addison Wesley Consumption Choices Lisa can afford any of the combinations at the points A to F Some goods are indivisible and must be bought in whole units at the points marked Other goods are divisible goods and can be bought in any quantity The line through points A to F is Lisa s budget line 2014 Pearson Addison Wesley Consumption Choices The budget line is a constraint on Lisa s consumption choices Lisa can afford any point on her budget line or inside it Lisa cannot afford any point outside her budget line 2014 Pearson Addison Wesley Consumption Choices Preferences The choice that Lisa makes depends on her preferences her likes and dislikes Her 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 total utility 2014 Pearson Addison Wesley Maximizing Utility Table 8 1 shows Lisa s total utility schedule Total utility from a good increases as the quantity of the good increases For example as Lisa sees more movies in a month her total utility from movies increases 2014 Pearson Addison Wesley Maximizing Utility Marginal Utility Marginal utility from a good is the change in total utility that results from a unit increase in the quantity of the good consumed As the quantity consumed of a good increases the marginal utility from it decreases We call this decrease in marginal utility as the quantity of the good consumed increases the principle of diminishing marginal utility 2014 Pearson Addison Wesley Maximizing Utility Table 8 1 shows how to calculate Lisa s marginal utility from her total utility Marginal utility from a good decreases as the quantity of the good increases For example as the number of movies seen in a month increases marginal utility from movies decreases 2014 Pearson Addison Wesley Maximizing Utility Figure 8 2 a shows Lisa s total utility and marginal utility from soda Total utility from soda increases as more soda is consumed The bars along the total utility curve show the extra total utility marginal utility from each additional case of soda 2014 Pearson Addison Wesley Maximizing Utility Figure 8 2 b illustrates diminishing marginal utility As Lisa increases the quantity of soda she drinks her marginal utility ie satisfaction from each additional soda diminishes 2014 Pearson Addison Wesley Utility Maximizing Choice The key assumption is that the household chooses the consumption possibility that maximizes total utility A Spreadsheet Solution The direct way to find the utility maximizing choice is to make a table in a spreadsheet and do the calculations Find the just affordable combinations Find the total utility for each just affordable combination The utility maximizing combination is the consumer s choice 2014 Pearson Addison Wesley Utility Maximizing Choice Find Just Affordable Combinations Lisa has 40 a month to spend on movies and soda The price of a movie is 8 and the price of soda is 4 a case Each row of Table 8 2 shows a combination of movies and soda that exhausts Lisa s 40 2014 Pearson Addison Wesley Utility Maximizing Choice Find the Total Utility for Each Just Affordable Combination When Lisa sees 1 movie and drinks 8 cases of soda a month she gets 50 units of utility from the 1 movie and 248 units of utility from the 8 cases of soda Her total utility is 298 units 2014 Pearson Addison Wesley Utility Maximizing Choice Consumer Equilibrium Lisa chooses the combination that gives her the highest total utility Lisa maximizes her total utility when she sees 2 movies and drinks 6 cases of soda a month Lisa gets 90 units of utility from the 2 movies and 225 units of utility from the 6 cases of soda 2014 Pearson Addison Wesley Utility Maximizing Choice Consumer equilibrium is the situation in which Lisa has allocated all of her available income in the way that maximizes her total utility given the prices of movies and soda Lisa s consumer equilibrium is 2 movies and 6 cases of soda a month 2014 Pearson Addison Wesley Utility Maximizing Choice A more natural way of finding the consumer equilibrium is to use the idea of choices made at the margin Choosing at the Margin Having made a choice would spending a dollar more or a dollar less on a good bring more total utility Marginal utility is the increase in total utility that results from consuming one more unit of the good The marginal utility per dollar is the marginal utility from a good that results from spending one more dollar on it 2014 Pearson Addison Wesley Marginal decision making is the core of the economic way of thinking Aside from the concept of opportunity cost marginal reasoning is the most important tool for understanding the economic perspective In Chapter 2 We derived the marginal cost of production from the PPF In Chapter 5 We discovered that competitive equilibrium is efficient because marginal benefit on the demand curve equals