E-201.Study Guide Chapter8. Key Terms and Questions

E-201.Study Guide Chapter8. Key Terms and Questions -...

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131 8 UTILITY AND DEMAND K e y C o n c e p t s Maximizing Utility Consumers’ goal is to obtain the most total utility; they maximize their total utility. Utility is the benefit or satisfaction from consumption of goods or services. Total utility is the total benefit that a person gets from the consumption of all the goods and services he or she consumes. Marginal utility ( MU ) is the change in total utility from a one-unit increase in the quantity of a good consumed. MU is positive, but because of dimin- ishing marginal utility , falls as the consumption of the good increases. A consumer equilibrium occurs when all the con- sumer’s available income is allocated in the way that maximizes his or her total utility. Total utility is maximized when: all the consumer’s income is spent; and the marginal utility per dollar , which is the mar- ginal utility from a good divided by its price, is equal for all goods. In terms of a formula, for the choice between two goods, movies and sodas, the second requirement for maximizing utility is that movie and soda consumption is such that: s s m m P MU P MU = with MU m the marginal utility from an additional mov- ie, P m the price of a movie, and MU s and P s the analo- gous variables for soda. If the two marginal utilities per dollar are not equal, the consumer can increase his or her total utility by rearranging his or her spending. For instance, if the marginal utility per dollar from a movie exceeds the marginal utility per dollar from a soda, the consumer can increase his or her utility by switching a dollar from sodas to movies. Equating the marginal utilities per dollar is an example of marginal analysis . Marginal analysis says that if the marginal gain from an action exceeds the marginal loss, take the action. The units of utility are arbitrary. Rearranging the for- mula for utility maximization, s s m m P MU P MU = , as m m S S MU P P MU × = shows that we can determine how much larger one marginal utility, MU S in the rear- ranged formula, is than the other marginal utility. Predictions of Marginal Utility Theory Marginal utility theory predicts the law of demand: A fall in the price of a movie raises the marginal utility per dollar from movies. Consumers increase the quantity of movies viewed as they substitute movies for sodas. The lower price increases the quantity demanded so there is a movement down along the demand curve to the increased quantity of movies. Similarly, a rise in the price of a movie de- creases the quantity demanded and creates an upward movement along a negatively sloped demand curve. A change in the price of a movie affects the demand curve for soda. Soda is a substitute for movies, so when movies fall in price, the demand curve for so- da shifts leftward. Similarly when movies rise in price the demand curve for soda shifts rightward.
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