Transcript The Logic of Individual Choice: The Foundation of Supply and

The Logic of Individual Choice:
The Foundation of Supply and
Demand
Chapter 8
Utility Theory and Individual Choice
• Many different sciences try to explain
why people do what they do.
– Psychology, for example, explains behavior in
terms of internal mechanisms, habitual
behaviors, and differentiates between
instinctual and acquired behavior.
• Economists have a simple explanation for
why we do what we do:
Rational self interest.
Utility Theory and Individual Choice
• Economists assume that the human
condition is like a long decision tree: from
the cradle to the grave we move from
one decision to another.
• Decisions are made based on rational
self-interest.
• The assumption of rational self-interest
itself presumes that men and women have
free will to make decisions.
Utility Theory and Individual Choice
• Using this simple theory of human
behavior we can say that two factors
determine what people decide to do:
– The pleasure they receive from doing or
consuming something.
– The price of doing or consuming that
thing.
Utility: Measuring Pleasure
• Economists use the word “Utility” to denote
the pleasure or satisfaction people get from
doing or consuming something.
• While we cannot measure utility we can
evaluate the pleasure obtained from some good
or action relatively.
• For example, we might say that we like apples
and oranges equally but we like bananas more
that either. We might add that we like Pina
Coladas more than bananas.
• In this way, utility is measured using an ordinal
scale.
Measuring Pleasure
• Utility serves as the basis of economists'
analysis of individual choice.
Total Utility
• Total utility refers to the satisfaction
one gets from one’s consumption of a
product.
Marginal Utility
• Marginal utility refers to the
satisfaction you get from the
consumption of one additional unit of a
product above and beyond what you have
consumed up to that point.
Total Utility and Marginal Utility
• As additional units are consumed,
marginal utility decreases while total
utility increases.
• When total utility stops increasing,
marginal utility is zero.
• Beyond this point, total utility
decreases and marginal utility is
negative.
Diminishing Marginal Utility
• The principle of diminishing marginal
utility states that, after some point, the
marginal utility received from each
additional unit of a good decreases with
each additional unit consumed.
Diminishing Marginal Utility
• The principle does not say you do not
enjoy consuming more of a good.
• Only that as you consume more of the
good, you enjoy additional units less
than you enjoyed the initial units.
Marginal and Total Utility
(Measures of utility are hypothetical and for illustration only)
Number of
pizza slices
1
2
3
4
5
6
7
8
9
Total utility
14
26
36
44
50
54
56
56
54
Marginal utility
14
12
10
8
6
4
2
0
-2
Marginal and Total Utility
Total utility
70
60
50
40
30
20
10
0
Total utility
1 2 3 4 5 6 7 8 9
Slices of pizza per hour
Marginal utility
16
14
12
10
8
6
4
2
0
-2
Marginal utility
1 2 3 4 5 6 7 8 9
Slices of pizza per hour
Rational Choice and Marginal Utility
• Rational choice begins with the premise
that rational individuals want as much
satisfaction as they can get from their
available income.
• This is sometimes referred to as the
“more is better” premise.
Buying Units of Utility
• In making choices, essentially what you
are doing is buying units of utility.
• Any choice that does not give you as
many units of utility as possible is an
irrational choice.
• Since you want to get the most for your
money, you make those choices that have
the highest units of utility per unit of
cost.
Choice 1: Pizza and Hero Sandwiches
• You can spend another dollar on a slice of
pizza that gives you an additional 41 units
of utility or spend that dollar on a hero
sandwich that gives you another 30 units
of utility.
Choice 2: Studying
Economics or Psychology
• You can read another chapter of economics and
get 200 units of utility but it will cost you one
hour of your time. Alternatively, you can read
another chapter in psychology, get another 100
units of utility, and only spend 40 minutes doing
so.
• Here the choices are expressed in units of
time rather than in units of money.
• The analysis, however, is the same.
Choice 3: Date with “J” or “G” ?
• You can go out on Friday night with “J”
and get 2000 units of utility but it will
cost you $70. Otherwise, you can go out
with “G” and get 200 units of utility for a
mere $10.
• Since you want to get the most for your
money, you chose the one with the
highest units of utility per dollar.
The Principle of Marginal Choice
• According to the principle of rational
choice you should spend your money on
those things that give you the most
marginal utility (MU) per dollar.
• This principle says nothing more than it is
rational to try to get the most “bang for
your buck.”
The Principle of Marginal Choice
implies that
• If
MUx MUy

Px
Py
• Consume an additional unit of good x.
The Principle of Marginal Choice
also implies that
• If
MUx MUy

Px
Py
• Then consume an additional unit of
good y.
The Principle of Marginal Choice
• By substituting the marginal utilities and
prices of goods into these formulas, you
can always decide which good it makes
more sense to consume.
• Consume the one with the highest
marginal utility per dollar.
Maximizing Utility and Equilibrium
• The goal of the consumer is to maximize their
utility subject to their budget constraint.
• How can we tell if a consumer is maximizing
utility?
• The consumer maximizes utility when they
consume goods such that the ratios of the
marginal utility to price of all goods are equal,.
The Principle of Marginal Choice
• If
MUx MUy

Px
Py
• Then you are in consumer equilibrium and
have maximized utility.
• You cannot increase your utility by
adjusting your choices.
• Any adjustment decreases utility unless
you substitute things of equal utility.
An Example of Maximizing Utility
Big Macs (P = $2)
Ice Cream (P = $1)
Q
TU
MU MU/P
Q
TU
0
1
2
3
4
5
6
7
0
20
34
44
47
47
42
32
20 10
14
7
10
5
3 1.5
0
0
-5 -2.5
-10 -5
0
1
2
3
4
5
6
7
0
29
46
53
55
56
56
52
MU
29
17
7
2
1
0
-4
MU/P
29
17
7
2
1
0
-4
Rational Choice and Marginal Utility
• If MUx/Px > MUz/Pz, consume more of
good x.
• If MUy/Py > MUz/Pz, consume more of
good y.
Rational Choice and Marginal Utility
• The general utility-maximizing rule is
that you are maximizing utility when the
marginal utilities per dollar of the goods
consumed are equal.
Rational Choice and Marginal Utility
• So the general principle of rational
choice is to choose goods and services so
that the marginal utilities per dollar of
goods consumed are equal.
• If
MUx MUy MUz


Px
Py
Pz
• Then you are maximizing utility
Rational Choice and Marginal Utility
• When this principle is met, the consumer
is in equilibrium.
• The cost per additional unit of utility
is equal for all goods and the
consumer is as well off as can be.
Rational Choice and Marginal Utility
• The rule does not say that the rational
consumer should consume a good until its
marginal utility reaches zero.
• The consumer does not have enough
money to buy all he wants.
Rational Choice
and the Laws of Demand and Supply
• The principle of rational choice leads to
the law of demand.
– When the price of a good goes up, the
marginal utility per dollar we get from that
good goes down and we demand less of it.
– If there is diminishing marginal utility and
the price of a good goes up, we consume less
of that good.
Rational Choice and the Laws of Demand
and Supply
• If MUx/Px = MUy/Py and the price of
good y goes up, then MUx/Px > MUy/Py.
• Our condition for maximizing utility is
no longer satisfied.
Rational Choice and the Laws of Demand
and Supply
• To continue maximizing utility, we must
somehow raise the marginal utility we get
from the good whose relative price has
risen and lower the marginal utility we
get from a good whose relative price has
fallen.
Rational Choice and the Laws of Demand
and Supply
• Following the principle of diminishing
marginal utility, we can increase marginal
utility only by decreasing consumption of
the good whose price has risen.
Rational Choice and the Laws of Demand
and Supply
• Since our demand for a good is an
expression of our willingness to pay for
it, quantity demanded is related to
marginal utility.
Rational Choice and the Laws of Demand
and Supply
• Quantity demanded rises as price falls,
other things constant.
• Quantity demanded falls as price
rises, other things constant.
Rational Choice and the Laws of Demand
and Supply
• The above shows the relationship
between marginal utility and the price we
are willing to pay.
Rational Choice and the Laws of Demand
and Supply
• Since our demand for a good is an
expression of our willingness to pay for
it, quantity demanded is related to
marginal utility.
The Law of Supply
• The law of supply comes from the
principle of rational choice.
• The discussion of the principle of
rational choice and the law of demand
also holds for the law of supply.
The Law of Supply
• In supply decisions you are giving up
something – your time, land, or some
other factor of production – and getting
money in return.
Opportunity Cost
• Opportunity cost is the benefit forgone
of the next-best alternative.
• To say MUx/Px > MUy/Py is to say that
the opportunity cost of not consuming
good x is greater than the opportunity
cost of not consuming good y.
• So we consume x.
Opportunity Cost
• When the marginal utilities per dollar
spent are equal, the opportunity cost of
the alternatives are equal.
Applying the Theory of Choice to the Real
World
• There are limits on the assumptions
underlying the theory of rational
decision-making.
The Cost of Decision Making
• The cost of deciding among hundreds of
possible choices lead us to do something
irrational.
• That is, do things without applying the
rational choice model.
The Cost of Decision Making
• A number of economists believe that
most people use bounded rationality
rather than using the rational choice
model.
• Bounded rationality means rationality
based on rules of thumb.
The Cost of Decision Making
• One of these rules of thumb is “you get
what you pay for.”
– The implication is that high price equals
high quality.
– This reliance on price for information
changes the inferences one can draw
from the analysis and can lead to
upward-sloping demand curves.
The Cost of Decision Making
• A second rule of thumb is “follow the
leader.”
– This rule leads to focal point equilibria in
which a set of goods is consumed, not
because the goods are objectively
preferred to other goods, but because
they have become focal points to which
people have gravitated.
The Cost of Decision Making
• Advertisers pay huge sums to mine these
two rules of thumb.
Given Tastes
• A second assumption implicit in
economists’ theory of rational choice is
that utility functions (tastes) are given,
and are not shaped by society.
• This is not true — tastes often are
significantly influenced by society.
Tastes and Individual Choice
• One way in which economists integrate
the above insights into economics is by
emphasizing that the analysis is
conducted on the assumption of “given
tastes.”
• To do otherwise would require a theory
of tastes.
Tastes and Individual Choice
• Whenever a need is satisfied, it is
replaced by another want, which soon
becomes another need.
• Economists take account of changes
in tastes as shift factors of demand.
Conclusion
• Economists use their simple self-interest
theory of choice because it cuts through
many obfuscations.
• In doing so, it often captures a part of
reality that others miss.
Conclusion
• Approaching problems by asking: "What's
in it for the people making the decision?"
is a useful approach that will give you
more insight than many other approaches.
The Logic of Individual
Choice:
The Foundation of Supply
and Demand
End of Chapter 8