Ch 7 Utility and Demand I. Household Consumption Choices A. Consumption Possibilities 1. A household’s consumption choices depend on its consumption possibilities and its preferences. 2. A household’s consumption possibilities are constrained by its budget and the prices of the goods and services it buys. 3. Figure 7.1 shows a budget line, which separates those combinations of goods that the household can afford (points below and on the budget line) from those combinations that it cannot afford (points above the budget line). B. Preferences 1. A household’s preferences determine the benefits or satisfaction a person receives consuming a good or service. 2. The benefit or satisfaction from the consumption a good or service is called utility. C. Total Utility 1. Total utility is the total benefit a person gets from the consumption of goods. Generally, more consumption gives more utility. 2. The table in Figure 7.2 provides an example of total utility schedules and Figure 7.2(a) shows a total utility curve. Total utility increases with the consumption of a good. 152 CHAPTER 7 D. Marginal Utility 1. Marginal utility is the change in total utility that results from a one-unit increase in the quantity of a good consumed. 2. As the quantity consumed of a good increases, the marginal utility from consuming it decreases. 3. We call this decrease in marginal utility as the quantity of the good consumed increases the principle of diminishing marginal utility. Figure 7.2(b) illustrates the concept of diminishing marginal utility. 4. Utility is similar to temperature. Both are abstract concepts and both are measured in arbitrary units. II. Maximizing Utility A. The key assumption of marginal utility theory is that the household chooses the consumption possibility that maximizes total utility. B. The Utility-Maximizing Choice 1. We can find the utility-maximizing choice by looking at the total utility that arises from each affordable combination. 2. A consumer equilibrium is a situation in which a consumer has allocated all his or her available income in the way that, given the prices of goods and services, maximizes his or her total utility. C. Equalizing Marginal Utility per Dollar Spent UTLITY AND DEMAND 153 1. Using marginal analysis, a consumer’s total utility is maximized by following the rule: Spend all available income and equalize the marginal utility per dollar spent on all goods. 2. The marginal utility per dollar spent is the marginal utility from a good divided by its price. a) That is: the marginal utility per dollar spent on movies is MUM/PM and the marginal utility per dollar spent on soda is MUS/PS. 3. Table 7.3 and Figure 7.3 show why the utility maximizing rule works. a) If MUM/PM > MUS/PS, then moving a dollar from soda to movies increases the total utility from movies by more than it decreases the total utility from soda, so total utility increases. b) Similarly, if MUS/PS > MUM/PM,then moving a dollar from movies to soda increases the total utility from soda by more than it decreases the total utility from movies, so total utility increases. c) Only when MUM/PM = MUS/PS, is it not possible to reallocate the budget and increase total utility. 154 CHAPTER 7 III. Predictions of Marginal Utility Theory A. A Fall in the Price of a Movie 1. When the price of a good falls the quantity demanded of that good increases—the demand curve slopes downward. a) For example, if the price of a movie falls, we know that MUM/PM rises, so before the consumer changes the quantities consumed, MUM/PM > MUS/PS. b) To restore consumer equilibrium (and thereby maximize his or her total utility) the consumer increases the quantity of movies consumed, which decreases the MUM. Eventually the quantity of movies increases enough so that MUM/PM = MUS/PS. 2. Table 7.4 and Figure 7.4 (a) illustrate how a fall in the price of a movie increases the quantity of movies demanded. B. A Rise in the Price of Soda 1. When the price of a good rises the quantity demanded of that good decreases—the demand curve slopes downward. UTLITY AND DEMAND 155 a) For example, if the price of soda rises, we know that MUS/PS falls, so before the consumer changes the quantities consumed, MUS/PS < MUM/PM. b) To restore consumer equilibrium (and thereby maximize his or her total utility) the consumer decreases the quantity of soda consumed, which increases the MUS. Eventually the quantity of soda decreases enough so that MUM/PM = MUS/PS. 2. Table 7.5 and Figure 7.5 illustrate how a rise in the price of a soda decreases the quantity of sodas demanded. C. A Rise in Income 1. When income increases, the demand for a normal good increases. D. Individual Demand and Market Demand 1. The market demand for a good is the relationship between the price of the good and total quantity demanded of that good. 2. The individual demand for a good is the relationship between the price of the good and the quantity demanded by one person. 156 CHAPTER 7 3. Figure 7.6 shows how we sum the individual demand curves to obtain the market demand. E. Marginal Utility and Elasticity 1. We can predict the price elasticity of demand for a good by knowing the characteristics of the marginal utility of the good. 2. If marginal utility diminishes rapidly as the quantity consumed increases, then a given price change requires a small quantity change in order for the consumer to restore his or her consumer equilibrium. In this case demand is inelastic. 3. If marginal utility diminishes slowly as the quantity consumed increases, then a given price change requires a large quantity change in order for the consumer to restore his or her consumer equilibrium. In this case demand is elastic. IV. Efficiency, Price, and Value A. Consumer Efficiency and Consumer Surplus 1. When consumers maximize their utility, they are using resources efficiently. 2. At the consumer equilibrium, the marginal benefit from a good or service is the maximum price the consumer is willing to pay for an extra unit of that good or service when his or her utility is maximized. UTLITY AND DEMAND 157 B. The Paradox of Value 1. The paradox of value “Why is water, which is essential to life, far cheaper than diamonds, which are not essential?” is resolved by distinguishing between total utility and marginal utility. 2. Figure 7.7 illustrates the resolution of the paradox. a) As Figure 7.7a demonstrates, the total utility and consumer surplus from water is large but the marginal utility and the price of water is small. b) In contrast, Figure 7.7b shows that the total utility and consumer surplus from diamonds is small but the marginal utility and the price of a diamond is large. c) The small marginal utility and price for water combined with the high marginal utility and price for a diamond allow for the consumer to be in his or her equilibrium, in which MUW/PW = MUD/PD.
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