Chapter 5 Consumer Choice Utility and Human

Chapter 5 Consumer Choice

Utility and Human Nature Utility is a measure of the satisfaction received from possessing or consuming goods and services. 2

Utility and Human Nature 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 Marginal utility: the extra utility derived from consuming one more unit of a good or service. 4

Marginal Utility 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

Total and Marginal Utility of Downloading and Listening to Digital Music Albums Chapter 21 - Consumer Choice 6

Total and Marginal Utility Hours of Util of Each Hour Listening (marginal utility) Total Utility 1 200 2 98 298 3 50 348 4 10 358 5 0 358 6 -70 288 7 -200 88 7

Diminishing Marginal 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

Diminishing Marginal Utility Consumers are not identical—the rate at which marginal utility diminishes depends on individual tastes and preferences, and so differs across consumers. 9

Utility and Choice Each consumer allocates a specific budget to expenditure, and then allocates the expenditure to maximize utility. 10

Consumer Equilibrium 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)

Utility Schedules 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

Utility and Choice 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. 13

The Downward Slope of the Demand Curve 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 Downward Slope of the Demand Curve 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

Change in Quantity Demanded (the product whose price changed) 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

Substitution Effect and Income Effect of a Price change: Quantity Demanded Normal Good 17

Substitution Effect and Income Effect of a Price change: Quantity Demanded Inferior Good 18

Consumer Surplus 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

Consumer Value 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

Consumer Surplus and expenditure 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 surplus and variable cost 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 4 e, Ch. 5

The meaning of producer surplus 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 4 e, Ch. 5

Value added (gains from exchange) 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 4 e, Ch. 5

Increasing value added 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 4 e, Ch. 5

Dead Weight Loss from Taxes 26

Dead weight loss from Price Ceiling 27

Excess Burden of a Tax 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 Q 2, 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.