Consumption Possibilities

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					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.
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          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.
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      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.
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              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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