CHAPTER 8 UTILITY AND DEMAND 8 1 Consumption Choices Consumption Possibilities All of the things you can afford to buy A household s consumption choices are determined by its consumption possibilities and preferences A Consumer s Budget Line Budget Line the limit to a household s consumption choices o Marks the boundary between those combinations of goods and services that a household can afford to buy and those that it cannot afford All the points on the budget line and inside it is affordable Points outside the line are unaffordable Change in Consumption Possibilities Changes when the income or price changes A in INCOME shifts the budget line OUTWARD but leaves the slope UNCHANGED A change in PRICE changes the slope of the line Preferences a description of a person s likes and dislikes and the intensity of those Want to explain what determines demand and marginal benefit Utility the benefit or satisfaction that a person gets from the consumption of goods Preferences feelings o Achieving this goal can be done with utility and services o Cardinal Utility can be measured and compared between people o Ordinal Utility if a change makes them better or worse o Total Utility the total benefit that a person gets from the consumption of all the Two utility concepts different goods and services MORE consumption gives MORE utility o Marginal Utility the change in total utility resulting from a one unit increase in the quantity of a good consumed Is positive but it diminishes as the quantity of a good consumed increases MU TotalUtility Q Positive Marginal Utility All the things that people want more of have a positive marginal utility Few activities generate negative marginal utility and a lower total utility o Total utility increases as the quantity consumed increases o Ex Hard Labor and Polluted Air Diminishing Marginal Utility consumed of a good Diminishing Marginal Utility the tendency for marginal utility to as the quantity Consumed Goods Marginal Utility Consumer Equilibrium 8 2 Utility Maximizing Choice Consumer Equilibrium a situation in which a consumer has allocated all his or her available income in the way that given the price of goods and services maximizes his or her total utility o No tendency for people to change consumption patterns because no other consumption pattern will achieve a higher total utility MU x P X MU Y PY Incentive to not consume as much of Y and switch our consumption to X o Good X offers more bang for buck o o MU Y PY MU x P X MU x P X Incentive to not consume as much of X and switch our consumption to Y MU Y PY Price of X Good X becomes a worse buy lower bang for your buck Price of X Good X becomes a better buy higher bang for your buck Price of Y Good Y becomes a worse buy lower bang for your buck Price of Y Good Y becomes a better buy higher bang for your buck Marginal Utility per Dollar Marginal Utility in total utility that results from consuming one more unit of a good Marginal Utility per Dollar the marginal utility from a good that results from spending one more dollar on it o Bang for your buck how much benefit you re getting per dollar spent o It is calculated as the marginal utility from the good divided by its price MarginalUtility Price Utility Maximizing Rule A consumer s objective is to maximize total utility A consumer s total utility is maximized by the following rule o Spend all the available income o Equalize the marginal utility per dollar for all goods Because more consumption brings more utility only those choices that exhaust Spend All the Available Income income can maximize utility The Power of Marginal Analysis If the marginal gain from an action exceeds the marginal loss take action 8 3 Predictions of Marginal Utility Theory Price of water is low and the price of a diamond is high but water is essential and The Paradox of Value diamonds are not The Paradox Resolved Paradox can be resolved by distinguishing between total utility and marginal utility o Marginal Utility Predicts law of demand Price People quantity they demand Price People quantity they demand Resolves the Paradox Value High Price Small demand in consumers income in demand for normal good Total utility from water is enormous but the more we consume of something the its marginal utility Diamonds have small total utility but because we buy few it has a high marginal utility When the high marginal utility from diamonds is divided by the high price of a diamond the result is a number that equals the low marginal utility from water divided by the low price of water Value and Consumer Surplus Water is cheap but bring a large consumer surplus Diamonds are expensive but bring a small consumer surplus Temperature An Analogy Utility is similar to temperature both are abstract concepts Utility helps us to make predictions about consumption choices Marginal Utility Theory provides insights into buying plans and has some powerful implications o Helps us to understand why people buy more of a good or service when the price falls and why people buy more of most goods when their income increases Behavioral Economics 8 4 New Ways of Explaining Consumer Choices Behavioral Economics a study of the ways in which limits on the human brain s for the way markets work Three impediments that prevent Rational Choice ability to compute and implement rational decisions influences economic behavior o Both the decisions that people make and the consequences of those decisions o Looks for anomalies o Bounded Rationality o Bounded Willpower Rationality that is limited by the computing power of the human brain Less than perfect willpower that prevents us from deciding that we know at the time of implementing the decision we will later regret Limited self interest that results in sometimes suppressing our own o Bounded Self Interest interests to help others The Endowment Effect o Tendency for people to value something more highly simply because they own it Behavior that contradicts marginal utility theory Neuroeconomics Neuroeconomics the study of the activity of the human brain when a person makes an economic decision o Uses observational tools and ideas of neuroscience to obtain a better o Prefrontal Cortex understanding of economic decisions Controversy Behavioral economics and neuroeconomics generate controversy CHAPTER 9 POSSIBILITIES PREFERENCES AND CHOICES 9 1 Consumption Possibilities Budget Line Budget Line the limit to a household s consumption choices Divisible Goods o Can be bought in