Transcript What is Marginal Utility? - Choose your book for Principles of

Chapter 5
Marginal Utility and
Consumer Choice
© 2002 South-Western
Economic Principles
• Total Utility and Marginal Utility
• Law of Diminishing Marginal Utility
• Relationship Between the Law of Demand
and the Marginal-Utility-To-Price Ratio
• Consumer Surplus
• Difficulties with Interpersonal Comparison
of Utility
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What is Marginal Utility?
Util:
• It is a hypothetical unit used to
measure how much utility a person
obtains from consuming a good.
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What is Marginal Utility?
Utility measures the satisfaction
or enjoyment a person obtains
from consuming a good.
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What is Marginal Utility?
Law of Diminishing Marginal Utility:
• It is the idea that as more of a good is
consumed, the utility a person derives
from each additional unit diminishes.
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What is Marginal Utility?
The implication of someone
experiencing increasing marginal
utility for pizza slices is:
• The next slice of pizza would generate
higher marginal utility than the one before.
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What is Marginal Utility?
The implication of someone
experiencing increasing marginal
utility for pizza slices is:
• When his stomach is full to bursting from
eating so much pizza, the marginal utility
from eating yet another slice would be
higher than for any of the preceding slices.
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What is Marginal Utility?
The implication of someone
experiencing increasing marginal
utility for pizza slices is:
• It is not clear that someone could survive
having increasing marginal utility!
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What is Marginal Utility?
It possible for marginal
utility to become negative.
• For example, if you overeat and feel
ill, then the marginal utility for the last
bit of food you ate is negative.
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What is Marginal Utility?
A rational consumer will not
knowingly pay to buy a unit of
a good that generates negative
marginal utility.
• Presumably something else could be bought
that generates positive marginal utility.
• Buying something that generates negative
marginal utility is not consistent with utility
maximization.
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EXHIBIT 1 TOTAL UTILITY AND MARGINAL UTILITY
DERIVED FROM CONSUMING T-BONE
STEAKS (UTILS)
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Exhibit 1: Total Utility and Marginal
Utility Derived From Consuming T-Bone
Steaks (Utils)
If marginal utility is declining,
but is still positive, total utility is:
• Total utility increases as long as
marginal utility is positive.
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Exhibit 1: Total Utility and Marginal
Utility Derived From Consuming T-Bone
Steaks (Utils)
If marginal utility is declining,
but is still positive, total utility is:
• In Exhibit 1, total utility reaches its
maximum at five t-bone steaks. Consuming
more than five steaks will reduce total utility.
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EXHIBIT 2A TOTAL AND MARGINAL UTILITY
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EXHIBIT 2B TOTAL AND MARGINAL UTILITY
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Exhibit 2: Total and
Marginal Utility
In Exhibit 2, the curves in
Panel a and b represent:
• The curve in Panel a is the total utility
curve for T-bone steaks.
• Panel a depicts the number of utils, or
the amount of utility, a person gains from
consuming a certain number of steaks.
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Exhibit 2: Total and
Marginal Utility
In Exhibit 2, the curves in
Panel a and b represent:
• Total utility peaks at 81 utils, or 5 steaks.
Each steak consumed beyond 5 reduces
total utility.
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Exhibit 2: Total and
Marginal Utility
In Exhibit 2, the curves in
Panel a and b represent:
• The curve in Panel b is the marginal
utility curve for T-bone steaks.
• The curve depicts the change in total
utility a person derives from consuming
each additional steak.
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Exhibit 2: Total and
Marginal Utility
In Exhibit 2, the curves in
Panel a and b represent:
• When marginal utility is zero, total utility
is maximized.
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What is Marginal Utility?
If water is necessary for life, then
the market price of water so much
lower than for diamonds because:
• Market price reflects marginal utility,
not total utility.
• Due to the law of diminishing marginal utility
and the abundance of water, the marginal
utility of water is lower than for diamonds.
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What is Marginal Utility?
A hypothetical circumstance in
which the marginal utility of
water might exceed the marginal
utility of a diamond:
• If you are lost in the desert and are
severely dehydrated, then your marginal
utility for a gallon of water might exceed
your marginal utility for a diamond.
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French Cuisine and Marginal
Utility
Many courses, each with small portions
of food (French cuisine), may generate
more utility than one course with a
large portion of food because:
• One large portion will drive down marginal
utility.
• Marginal utility is high for the whole meal.
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EXHIBIT 3 MARGINAL UTILITIES OF CLOTHES AND
AMUSEMENT GOODS (UTILS)
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Exhibit 3: Marginal Utilities of Clothes and
Amusement Goods (Utils)
Based on the utility data in Exhibit
3, a rational consumer will select the
best combination of clothes and
amusement goods:
• By sequentially picking units of clothing
and amusement goods that generate the
largest MU/P.
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EXHIBIT 4 MARGINAL-UTILITY-TO-PRICE RATIOS OF
CLOTHES AND AMUSEMENT GOODS (MU/P)
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Exhibit 4: Marginal-Utility-to-Price Ratios
of Clothes and Amusement Goods (MU/P)
If a unit of clothes and amusement
goods both cost $10, and if you have
$80 to spend, the rational consumer
will spend her money:
• MU/P is equal when three units of
clothes and five units of amusement
goods are purchased (MU/P = 1.4).
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Marginal-Utility-to-Price Ratio
Marginal-utility-to-price ratio:
• The ratio is calculated by dividing
the marginal utility of a good by the
price of the good -- MU/P.
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Marginal-Utility-to-Price Ratio
The MU/P equalization principle:
• A person’s total utility is maximized
when the ratios of marginal utility to
price for the last unit of each of the goods
consumed are equal.
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Marginal-Utility-to-Price Ratio
The MU/P equalization principle:
• MU/P measures marginal utility per dollar
spent.
• Total utility will be maximized (within the
constraints of a limited budget) when each
individual purchase generates the largest
possible MU/P.
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Marginal-Utility-to-Price Ratio
The MU/P equalization principle:
• A rational and fully-informed consumer will
always shift a dollar from a good whose MU/P
is lower to one whose MU/P is higher, if such a
shift is possible.
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Marginal-Utility-to-Price Ratio
The MU/P equalization principle:
• The principle is based on consumer behavior.
• Consumers will always arrange their
sequence of choices among goods starting with
the highest MU/P and running down to exhaust
an expenditure budget.
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Marginal-Utility-to-Price Ratio
The MU/P equalization principle:
• The consumer choice process is in
equilibrium when:
• There is no longer any incentive for the
consumer to rearrange her purchases.
• The MU/P is equal for the last unit
of each good or service consumed.
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EXHIBIT 5 COMPARING MU/Ps AFTER A 20-PERCENTOFF SALE ON CLOTHES
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Exhibit 5: Comparing MU/Ps After a 20
Percent Off Sale on Clothes
The MU/P of clothes changes
when there is a 20 percent off
sale on clothes by:
• MU/P for each unit of clothing rises when
price is reduced by 20 percent.
• This will cause a rational consumer
to consume more clothes.
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EXHIBIT 6 COMPARING MU/Ps AFTER A 50-PERCENTOFF SALE ON CLOTHES
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Exhibit 6: Comparing MU/Ps After a 50
Percent Off Sale on Clothes
An additional reduction in the price
of clothing will change all of the
MU/Ps for clothing, and thus change
a rational consumer’s consumption
of clothing.
• If the price of clothes falls again, from $8
to $5, the quantity of clothing demanded
increases from four to six units.
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EXHIBIT 7 THE DEMAND CURVE FOR CLOTHES
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Exhibit 7: The Demand Curve for Clothes
When the price of clothing falls
from $10 to $8 to $5, which of the
following occurs:
• Quantity demanded remains the same.
• Quantity demanded falls from 6 to 4 to 3.
• Quantity demanded rises from 3 to 4 to 6.
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Exhibit 7: The Demand Curve for Clothes
When the price of clothing falls
from $10 to $8 to $5, which of the
following occurs:
• Quantity demanded remains the same.
• Quantity demanded falls from 6 to 4 to 3.
• Quantity demanded rises from 3 to 4 to 6.
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MU/P Equalization Principle
and the Law of Demand
Changes in the marginal-utilityto-price ratio are caused by:
• A change in the marginal utility of a good
or a change in the price of a good changes
the marginal-utility-to-price ratio, and
therefore changes quantity demanded.
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MU/P Equalization Principle
and the Law of Demand
The relationship between the MU/P
Principle and the Law of Demand:
• If the price of a good falls:
• MU/P rises.
• The rational consumer will increase her
consumption of that good.
• Increase in quantity demanded (movement
along the demand curve).
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MU/P Equalization Principle
and the Law of Demand
The relationship between the MU/P
Principle and the Law of Demand:
• If consumer preference for a good decreases:
• MU/P declines.
• The rational consumer will reduce
consumption.
• The demand curve shifts to the left (since
consumer preference is a non-price factor).
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MU/P Equalization Principle
and the Law of Demand
The relationship between the MU/P
Principle and the Law of Demand:
• If consumer income increases:
• The consumer can pursue a lower MU/P.
• The consumer can afford to increase
consumption.
• An increase in the demand for normal goods.
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MU/P Equalization Principle
and the Law of Demand
A downward-sloping demand
curve is consistent with the law
of diminishing marginal utility.
• Diminishing marginal utility
means that MU/P declines as
quantity consumed increases.
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MU/P Equalization Principle
and the Law of Demand
A downward-sloping demand
curve is consistent with the law
of diminishing marginal utility.
• A consumer’s willingness-topay falls as quantity consumed
increases.
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Are White Rats Rational
Consumers?
There is evidence that lab rats
make consumer choices based
on MU/P.
• Economists Battalio and Kagel found
that white lab rats respond to price and
income changes in a manner consistent
with economic theory.
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The MU/P Guide to Auction
Bidding
MU/P can help guide auction bidding:
• If a particular MU/P is guaranteed by
buying something outside of the auction,
and if the marginal utility from the auction
good is known, then you can figure out
your maximum auction price.
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Creating Consumer Surplus
Consumer surplus:
• The difference between the maximum price a
person would be willing to pay for a good or
service, and the price the person actually pays.
• Most consumers receive some consumer
surplus from a transaction.
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Creating Consumer Surplus
When market price falls,
consumer surplus increases.
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Creating Consumer Surplus
If the price of a good is greater
than amount a consumer is willing
to pay for that good, the consumer
surplus will be negative if the
consumer buys the good.
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Creating Consumer Surplus
A rational consumer will not
purchase a good that generates
negative consumer surplus.
• A rational consumer will prefer zero
consumer surplus (no purchase) to
negative consumer surplus.
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EXHIBIT 8 THE MARKET FOR HORSEBACK RIDING
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Exhibit 8: The Market for
Horseback Riding
Exhibit 8 depicts the demand and
supply curves for horseback riding.
The concept of consumer surplus
applies to horseback riding:
• At a price of $6, all consumers with a
willingness-to-pay value of $6 or more will
purchase a horseback ride.
• These consumers receive consumer surplus.
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Exhibit 8: The Market for
Horseback Riding
Exhibit 8 depicts the demand and
supply curves for horseback riding.
The concept of consumer surplus
applies to horseback riding:
• Some consumer may be willing to pay $10
for a horseback ride.
• This consumer will receive $(10-6) = $4
of consumer surplus.
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Exhibit 8: The Market for
Horseback Riding
Exhibit 8 depicts the demand and
supply curves for horseback riding.
The concept of consumer surplus
applies to horseback riding:
• A consumer who has a willingness-to-pay
value less than $6:
• This consumer has a negative consumer surplus.
• A rational consumer will not choose to
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purchase a ride.
EXHIBIT 9 CONSUMER SURPLUS ON THE HORSEBACKRIDING MARKET
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Exhibit 9: Consumer Surplus on
the Horseback-Riding Market
Kim’s consumer surplus from
horseback riding is:
• $(15-6) for the first ride.
• $(12-6) for the second ride.
• $(9-6) for the third ride.
• $(6-6) for the fourth ride.
• These sum to $(9+6+3+0) = $18.
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Exhibit 9: Consumer Surplus on
the Horseback-Riding Market
Tony’s consumer surplus from
horseback riding is:
• $(10-6) for the first ride.
• $(8-6) for the second ride.
• $(6-6) for the fourth ride.
• These sum to $(4+2+0) = $6.
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Exhibit 9: Consumer Surplus on
the Horseback-Riding Market
Randy’s consumer surplus
from horseback riding is:
• $(9-6) for the first ride.
• $(6-6) for the fourth ride.
• These sum to $(3+0) = $3.
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Exhibit 9: Consumer Surplus on
the Horseback-Riding Market
If Kim, Tony and Randy represent the
entire market demand for horseback
riding, the total consumer surplus is:
• $18 (Kim) + $6 (Tony) + $3 (Randy)
= $27 in consumer surplus
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Interpersonal Comparisons
of Utility
An interpersonal comparison of utility:
• It is a comparison of the marginal
utilities that different people derive
from a good or a dollar.
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Interpersonal Comparisons
of Utility
Is it actually possible to compare the
satisfaction that different people
derive from a good or a dollar?
• It is not possible to make an exact
comparison of different peoples’
utility.
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Interpersonal Comparisons
of Utility
Is it actually possible to compare the
satisfaction that different people
derive from a good or a dollar?
• Policies such as those aimed at poverty
alleviation rely on society being able to make
approximate or reasonable comparisons of
utility across different people.
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