Transcript Ch21-- Consumer Choice

Chapter 5

Utility is a measure of the satisfaction
received from possessing or consuming
goods and services.
2

Economists assume that:
◦ Tastes and preferences are fixed and given, and
play a large role in decision making.
◦ Consumers make choices that give them the
greatest utility—they maximize utility.
3

Marginal utility: the extra utility derived
from consuming one more unit of a good
or service.
change in total utility
marginal utility 
change in quantity
4

Principle of diminishing marginal utility: the
more of a good that one obtains in a
specific period of time, the less the
additional utility derived from an additional
unit of the good.
◦ As you consume more and more of something,
the satisfaction with each unit declines.

Disutility: dissatisfaction
5
Chapter 21 - Consumer Choice
6
Hours of Util of Each Hour
Listening (marginal utility)
Total
Utility
1
200
200
2
98
298
3
50
348
4
10
358
5
0
358
6
-70
288
7
-200
88
7


Utility diminishes with increasing quantities –
especially in a limited time—the shorter the
time period, the more quickly marginal utility
diminishes.
“All You Can Eat”—restaurants with this policy
assume that you will stop eating when your
marginal utility falls to zero.
8

Consumers are not identical—the rate at
which marginal utility diminishes depends on
individual tastes and preferences, and so
differs across consumers.
9

Each consumer allocates a specific
budget to expenditure, and then
allocates the expenditure to maximize
utility.
10


When you cannot increase
utility by spending more
on one good and less on
another within a given
budget, you are said to be
in a state of consumer
equilibrium.
The conditions for
consumer equilibrium are
expressed by the formula
on the right
MU(A) =
P(A)
MU(B)
P(B)
Units
1
2
3
4
5
6
7
8
9
Pizza
Utils
22
18
14
9
6
2
1
0
-4
Hot dogs
Utils
15
13
10
8
6
4
2
1
0
Notes:
Budget: $10
First Prices $1 each
Adjust Pizza to $2
Derive 2 points on D for Pizza
12

Equimarginal principle: To maximize utility,
consumers allocate their incomes among goods
so as to equate the marginal utilities per dollar
(MU/P) of the expenditure on the last unit of
each good purchased. This is also referred to as
the consumer equilibrium.
MUCD MUgas MUmovie
MU X



PCD
Pgas
Pmovie
PX
13


Consumers allocate their income among
goods and services in order to maximize
utility according to the equimarginal
principle.
A change in the price of any good disturbs
the consumer’s equilibrium—the ratio of
MU to P on the last unit of each good will
no longer be equal.
14


The consumer must reallocate income
across goods
With income fixed, if the price of one good
rises, the consumer is able to buy fewer
goods and services, causing the consumer
to demand less.
◦ This shows as a decrease in quantity demanded
for the good whose price rose
◦ It shows as a decrease in demand for other goods
15

When the price of one good falls while
everything else is constant, two things
occur:
1. Other goods become relatively more expensive.
So consumers buy more of the less expensive
good and less of the more expensive goods.
This is called the substitution effect.
2. The consumer can buy more total goods with
the same income. Therefore they buy more of
the now lower priced good. This is called the
income effect.
16
Normal Good
17
Inferior Good
18


An individual consumer’s demand curve
measures the value that the consumer
places on each unit of good being
considered.
Consumer surplus for each unit is a
measure of the difference between what a
consumer is willing and able to pay for a
unit of the good and the market price of a
good that the consumer actually has to pay.
19

The height of the demand
curve represents the value
the consumer places on any
given unit purchased, (as
measured by willingness to pay)
If a consumer buys 9 pounds
of wheat…
 The total value to the
consumer of the entire 9
units of wheat is measured
by the area ABCD lying
below the demand curve
Suppose the consumer pays
$.20 per pound for the
wheat

Total consumer value may
then be divided into two
parts:
◦ The turquoise rectangle AECD
represents the amount spent.
◦ The purple triangle BCE, which
is the difference between total
consumer value and
expenditure, is called
consumer surplus

Consumer surplus is the
difference between what
consumers actually pay and
the maximum they would
have been willing to pay




Producer’s revenue equals
price times quantity
It is shown by the area
AECD (both orange and green),
and consists of two parts:
The height of the supply
curve represents the
variable cost (opportunity
cost) of each unit, so the
area AFCD (green) represents
total variable cost
The difference between
revenue and total variable
cost (orange triangle FCE)
is called producer surplus
Dolan, Economics Combined Version 4e,
Ch. 5
Producer surplus can be
thought of in two ways


As the difference
between the revenue
producers receive and
the minimum they would
have been willing to
accept, at the margin, to
supply each additional
unit
As the part of revenue
that producers have
available to cover fixed
costs and profit
Dolan, Economics Combined Version 4e,
Ch. 5
The combined surplus
(adjusted for fixed costs)
represents the total value
added or gains from trade


Producer surplus is the
value that producers gain
compared with using the
same variable resources to
produce other goods
consumer surplus is the
value that consumers gain
compared with using the
same money to buy other
goods
Dolan, Economics Combined Version 4e,
Ch. 5

Total value added may be
increased in two ways
◦ By innovations that increase
the product’s value to
consumers and shift the
demand curve
◦ By innovations that reduce
the cost of production and
shift the supply curve


Innovations that increase
value added improve
economic efficiency
Improvements in efficiency
are shared between
producers and consumers
Dolan, Economics Combined Version 4e,
Ch. 5
26
27

A tax of $.50 per gallon on
gasoline raises the equilibrium
price from $1 to $1.40 per gallon.
◦ The price that sellers receive after
the tax is paid falls to $.90.
◦ Revenue collected by the
government equals the tax times Q2,
the equilibrium quantity after tax.
◦ The economic burden of the revenue
is divided between consumers and
sellers.

There is also an excess burden,
which takes the form of the
consumer and producer surpluses
that would be realized from the
sale of the additional quantity that
would have been sold without the
tax. This is shown by the area of
the triangle between the supply
and demand curves.