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Principles 6E:001 of Economics Spring, 2008 Chapter 5 Consumer Choice Some things to look for Two related but distinct questions: How do consumers make choices? How should we model that decision process? It's the total that matters, but getting there involves Marginal decisions. Ch.5 2 New Concepts Monetary Utility Marginal utility Diminishing Marginal Utility The optimal purchase rule: Marginal Monetary Utility = Price (approximately) Individual Demand Consumer Surplus Market Demand is a "horizontal sum" Ch.5 3 1 Budget Allocation You have $40 in Pocket money for the weekend. How would you allocate it across the 8 items in the table? What thought processes would guide your allocation Ch.5 $10 $ 2 $ 1 $10 $ 5 $10 $30 $ 5 $__ Pizza Ramen Noodles Soda Movie Newspaper Book Shirt Gym Savings 4 How do economists model such decisions? Optimization subject to constraints Constraints are income, also prices and items to choose from Objective is to maximize happiness, satisfaction, pleasure, ... We call it "Utility" (Dictionary definition: Usefulness. The quality or condition of being useful.) Ch.5 5 Problem: How to measure Utility Each thing we consume gives us utility. How much is not so important It is the comparison between alternatives that makes "Utility" a useful concept. We choose to consume the things that give us the most utility Ch.5 6 2 The Book's Solution Baumol and Blinder introduce Utility as a relative concept. The "Utility" of an item is measured by the amount of money we would give up to get it. They call it "Monetary Utility" But then they drop the qualifier "Monetary" That's non-conventional, and not entirely satisfactory, but still useful Ch.5 7 Ttl. Utility Marginal Utility The "addition to utility of consuming one more unit" will prove to be a very useful concept We call it Marginal Utility # Units TTL Util. Mrg Util. Ch.5 30 25 20 15 10 5 0 0 1 2 3 4 5 6 7 Units cons um e d 8 Marg. Utility 10 8 6 4 2 1 8 8 2 14 6 3 18 4 4 21 3 5 23 2 6 24 1 7 24 0 0 0 1 2 3 4 5 6 7 Units 8 consum ed 8 Law of Diminishing Utility Marginal For most goods, the more we consume the slower our satisfaction increases That property is called "Diminishing Marginal Utility" Total utility continues to grow, but marginal utility decreases Ch.5 9 3 The optimal purchase rule Implicit in the book's definition of Monetary Utility is the notion of a tradeoff Increasing consumption of one good means we have less money to spend on other goods The definition also suggests a solution: If marginal utility exceeds price, continue buying more. If marginal utility is less than price, buy less. Optimum: MU = P Ch.5 10 Demand Curve The Marginal Utility curve is the Demand curve reinterpreted! According to the Optimal Purchase Rule: If P = 8, buy 1 unit If P = 6, buy 2 If P = 4, buy 3 ... # units 0 1 2 3 4 5 6 7 Ttl. Utility 0 8 14 18 21 23 24 24 Marg. Utility 8 6 4 3 2 1 0 11 If Marg. Utility is diminishing, then demand is downward sloping Ch.5 Consumer Surplus Marginal Utility indicates what we would be willing to pay for each additional unit If we pay the same price for all units, then the first few units cost us less than we would have been willing to pay We call that difference a Surplus The sum of these surpluses is Consumer Surplus. Ch.5 12 4 Market Demand Demand for the market is the sum of individual demands Price 30 25 20 15 10 5 0 Ch.5 Alice's demand 0 0 3 6 9 12 15 Naomi's demand 0 1.5 3 4.5 6 7.5 9 Total demand 0 1.5 6 10.5 15 19.5 24 13 Market Demand Market Demand is the "Horizontal Sum" of individual demands FIGURE 4-4 from TextBook Alex's demand D Price Price Z Naomi's demand Price M Market demand K $10 A A N N C 9 6 C D 0 9 Quantity Demanded (a) 0 6 Z 0 15 Quantity Demanded (c) Quantity Demanded (b) M Ch.5 14 New Concepts, Reviewed Monetary Utility: a measure of satisfaction Marginal utility: additional utility from last unit consumed Diminishing Marginal Utility Optimal purchase rule: MU = Price (approx.) Individual Demand Consumer Surplus net of marginal utility over price Normal and Inferior goods Market Demand is a "horizontal sum" Ch.5 15 5

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