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Utility and Demand
Introduction
This chapter explores how consumers make choices given their limited resources, focusing on the concepts of utility, marginal utility, and the theory of consumer choice. It also examines how changes in prices and income affect demand, and introduces behavioral economics as a new way of explaining consumer choices.
Consumption Choices
Factors Influencing Consumption
Consumption possibilities: All the combinations of goods and services a consumer can afford to buy, given their income and the prices of goods.
Preferences: The consumer's likes and dislikes, which determine the benefit or satisfaction (utility) derived from consumption.
A Consumer's Budget Line
The budget line represents the boundary of consumption possibilities, showing all combinations of two goods that exhaust a consumer's income.
Example: Lisa has $40 to spend, movies cost $8 each, and cola costs $4 per case.
Lisa can afford any combination of movies and cola that lies on or inside her budget line.
Points outside the budget line are unaffordable.
Table: Lisa's Consumption Possibilities
Possibility | Movies (per month) | Cola (cases per month) | Total Expenditure ($) |
|---|---|---|---|
A | 0 | 10 | 40 |
B | 1 | 8 | 40 |
C | 2 | 6 | 40 |
D | 3 | 4 | 40 |
E | 4 | 2 | 40 |
F | 5 | 0 | 40 |
Utility: Preferences and Satisfaction
Utility and Total Utility
Utility: The benefit or satisfaction a consumer receives from consuming a good or service.
Total utility: The total benefit gained from consuming a certain quantity of goods. Generally, more consumption leads to higher total utility.
Marginal Utility and Diminishing Marginal Utility
Marginal utility (MU): The change in total utility resulting from consuming one additional unit of a good.
Principle of diminishing marginal utility: As the quantity consumed increases, the marginal utility from each additional unit decreases.
Table: Lisa's Utility from Movies and Cola
Movies (per month) | Total Utility (Movies) | Marginal Utility (Movies) | Cola (cases per month) | Total Utility (Cola) | Marginal Utility (Cola) |
|---|---|---|---|---|---|
0 | 0 | - | 0 | 0 | - |
1 | 50 | 50 | 2 | 90 | 45 |
2 | 90 | 40 | 4 | 160 | 35 |
3 | 120 | 30 | 6 | 225 | 30 |
4 | 140 | 20 | 8 | 248 | 23 |
5 | 150 | 10 | 10 | 260 | 12 |
Maximizing Utility: Consumer Equilibrium
Utility-Maximizing Choice
Consumers aim to allocate their income to maximize total utility. The process involves:
Finding all just-affordable combinations of goods.
Calculating total utility for each combination.
Choosing the combination with the highest total utility.
Table: Lisa's Utility-Maximizing Choice
Movies (per month) | Cola (cases per month) | Total Utility (Movies) | Total Utility (Cola) | Total Utility |
|---|---|---|---|---|
0 | 10 | 0 | 260 | 260 |
1 | 8 | 50 | 248 | 298 |
2 | 6 | 90 | 225 | 315 |
3 | 4 | 120 | 160 | 280 |
4 | 2 | 140 | 90 | 230 |
5 | 0 | 150 | 0 | 150 |
Consumer equilibrium occurs when the consumer has allocated all income in a way that maximizes total utility, given the prices of goods. For Lisa, this is 2 movies and 6 cases of cola per month.
Choosing at the Margin: Marginal Utility per Dollar
Marginal utility per dollar: The marginal utility from a good divided by its price.
Formulas:
For movies:
For cola:
Consumer equilibrium is achieved when:
If , spend more on movies and less on cola. If , spend more on cola and less on movies.
Utility-Maximizing Rule
Spend all available income.
Equalize the marginal utility per dollar for all goods.
Predictions of Marginal Utility Theory
Effects of Price Changes
Fall in the price of a good: Increases the quantity demanded of that good (movement along the demand curve).
Change in the price of one good: Can affect the demand for another good (shift in the demand curve).
Rise in the price of a good: Decreases the quantity demanded of that good.
Table: How a Change in the Price of Movies Affects Lisa's Choices
Movies (per month) | Cola (cases per month) | Marginal Utility per Dollar (Movies) | Marginal Utility per Dollar (Cola) |
|---|---|---|---|
2 | 6 | 5.00 | 5.00 |
3 | 4 | 7.50 | 7.50 |
When the price of movies falls, Lisa buys more movies and less cola.
Effects of Income Changes
Rise in income: Increases the demand for normal goods. Consumers buy more of both goods.
Table: Lisa's Choices with an Income of $56 a Month
Movies (per month) | Cola (cases per month) | Marginal Utility per Dollar (Movies) | Marginal Utility per Dollar (Cola) |
|---|---|---|---|
6 | 4 | 5.00 | 5.00 |
8 | 6 | 4.00 | 4.00 |
The Paradox of Value
Paradox: Why is water, essential to life, cheaper than diamonds, which are not essential?
Resolution: The price reflects marginal utility, not total utility. Water's total utility is high but marginal utility is low due to abundant consumption; diamonds' total utility is low but marginal utility is high due to scarcity.
Consumer Surplus
Consumer surplus: The difference between what a consumer is willing to pay and what they actually pay.
Water: Large consumer surplus due to perfect elasticity of supply and low price.
Diamonds: Small consumer surplus due to perfectly inelastic supply and high price.
New Ways of Explaining Consumer Choices
Behavioral Economics
Behavioral economics: Studies how limits on rational decision-making affect economic behavior.
Three impediments to rational choice:
Bounded rationality: Limited by the brain's computing power; consumers use rules of thumb or gut instinct under uncertainty.
Bounded willpower: Less-than-perfect self-control, leading to decisions that may later be regretted.
Bounded self-interest: Sometimes people suppress their own interests to help others.
The Endowment Effect
Endowment effect: The tendency for people to value something more highly simply because they own it.
Neuroeconomics
Neuroeconomics: The study of brain activity during economic decision-making.
Different decisions activate different areas of the brain, such as the pre-frontal cortex (rational decisions) and the hippocampus (emotional decisions).
Controversy in Economics
Should economics focus on observed decisions or the internal processes of decision-making?
Most economists focus on explaining observed choices rather than internal mental processes.
Summary of Key Formulas
Marginal Utility (MU):
Marginal Utility per Dollar:
Utility-Maximizing Rule:
Examples and Applications
Lisa's choices between movies and cola illustrate how consumers allocate budgets to maximize utility.
Changes in prices and income shift demand curves and alter consumption patterns.
The paradox of value demonstrates the difference between total and marginal utility in determining prices.
