© 2003 mcgraw-hill ryerson limited the logic of individual choice: the foundation of supply and...
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© 2003 McGraw-Hill Ryerson Limited
The Logic of The Logic of Individual Choice:Individual Choice:The Foundation of The Foundation of
Supply and DemandSupply and Demand
Chapter 8Chapter 8
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Utility Theory and Utility Theory and Individual ChoiceIndividual Choice Economists have an answer to the
question of why people behave as they do — self interest. Economists' analysis of individual
choice does not deny individual differences.
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Utility Theory and Utility Theory and Individual ChoiceIndividual Choice Using the simple concept of self-
interest, two things determine what people do:
The pleasure people get from doing or consuming something.
The price of doing or consuming that something.
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Utility Theory and Utility Theory and Individual ChoiceIndividual Choice Price is the market's tool to bring quantity
supplied equal to the quantity demanded.
Changes in price provide incentives for people to change what they are doing.
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Measuring PleasureMeasuring Pleasure
Economists start with a proposition that individuals try to get as much pleasure as possible out of life.
The goods and services we consume provide value (satisfaction) to us.
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Measuring PleasureMeasuring Pleasure Individuals want to maximize the
amount of satisfaction they receive through consuming goods and services.
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Measuring PleasureMeasuring Pleasure
Economists use the concept of utility—the pleasure or satisfaction that one gets from consuming a good or service.
A util is a unit created by economists to “measure” utility.
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UtilityUtility
Utility serves as the basis of economists' analysis of individual choice.
It is personal and individual.
Utility cannot be compared across individuals.
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Total UtilityTotal Utility
Total utility refers to the total satisfaction one gets from consuming a product.
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Marginal UtilityMarginal Utility
Marginal utility refers to the satisfaction one gets from the consumption of one additional unit of a product above and beyond what on has consumed up to that point.
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Total Utility and Total Utility and Marginal UtilityMarginal Utility As additional units are consumed,
marginal utility decreases while total utility increases.
When marginal utility is zero, total utility stops increasing. Beyond this point, marginal utility is negative and total
utility decreases.
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Number of pizza slices
123456789
Total utility
142636445054565654
Marginal utility
14121086420-2
Marginal and Total Marginal and Total Utility, Utility, Fig. 8-1a, p 180Fig. 8-1a, p 180
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Total utility Marginal utility
Slices of pizza per hour
70
60
50
40
30
20
10
01 2 3 4 5 6 7 8 9
Slices of pizza per hour
16141210
86420
-2 1 2 3 4 5 6 7 8 9
Marginal and Total Marginal and Total Utility, Utility, Fig. 8-1b and c, p 180Fig. 8-1b and c, p 180
Total utility Marginal utility
Utils Utils
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Diminishing Marginal Diminishing Marginal UtilityUtility The principle of diminishing marginal
utility states that, at some point, the marginal utility received from each additional unit of a good begins to decrease with each additional unit consumed.
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Diminishing Marginal Diminishing Marginal UtilityUtility This principle does not say you do not
enjoy consuming more of a good. It only states that as you consume more of the
good, you enjoy additional units less than you enjoyed the initial units.
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Rational Choice and Rational Choice and Marginal UtilityMarginal Utility The analysis of rational choice begins
with the premise that rational individuals want as much satisfaction as they can get from their available income.
Rational means that people prefer more to less and will make choices that give them as much satisfaction as possible.
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Rational ChoicesRational Choices
In making choices, essentially what you are doing is buying units of utility.
Any choice (for the same amount of money) that does not give you as many units of utility as possible is an irrational choice.
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Rational choicesRational choices
Since you want to get the most for your money, you make those choices that have the highest units of utility per dollar spent.
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Maximizing UtilityMaximizing Utility
Total utility is maximized when marginal utility per dollar spent of two goods is equal.
y
y
x
x
P
MU
P
MU=
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Maximizing UtilityMaximizing Utility
If:
y
y
x
x
P
MU
P
MU
Choose to consume an additional unit of good x.
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Maximizing UtilityMaximizing Utility
If:
y
y
x
x
P
MU
P
MU
Choose to consume an additional unit of good y.
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Maximizing UtilityMaximizing Utility
By substituting the marginal utilities and prices of goods into these formulas, you can always decide which good it makes more sense to consume.
Consume the one with the highest marginal utility per dollar.
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Maximizing Utility and Maximizing Utility and EquilibriumEquilibrium When the ratios of the marginal utility to
price of goods are equal, you are maximizing utility.
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Maximizing UtilityMaximizing Utility
If:
y
y
x
x
P
MU
P
MU
You’re in equilibrium. You cannot increase your utility by
adjusting your choices.
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Maximizing Utility, Maximizing Utility, Table 8-1, Table 8-1,
p 182p 182
Q
01234567
TU
020323841413626
MU
2012
630
-5-10
MU/P
1063
1.50
-2.5-5
Q
01234567
TU
029465356575753
MU
2917
7310
-4
MU/P
2917
7310
-4
Hamburgers (P = $2) Ice Cream (P = $1)
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Maximizing Utility, Maximizing Utility, Table 8-2, Table 8-2,
p 183p 183
Total $ spent
Purchase? MU/P MU
$1 1 ice cream cone 29 29
$2 2nd ice cream cone 17 17
$4 1 hamburger 10 20
$5 3rd ice cream cone 7 7
$7 2nd hamburger 6 12
$9 3rd hamburger 3 6
$10 4th ice cream cone 3 3
Total utility = 94 utils
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Rational Choice and Rational Choice and Marginal UtilityMarginal Utility The same principle applies if more than
two goods are consumed: If MUx/Px > MUz/Pz, consume more of
good x. If MUy/Py > MUz/Pz, consume more of
good y.
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Rational Choice and Rational Choice and Marginal UtilityMarginal Utility The general utility-maximizing rule is
that you are maximizing utility when the marginal utilities per dollar are equal across all goods you consume.
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Rational Choice and Rational Choice and Marginal UtilityMarginal Utility
z
z
y
y
x
x
P
MU
P
MU
P
MU
When you are maximizing utility.
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Rational Choice and Rational Choice and Marginal UtilityMarginal Utility When this principle is met, the
consumer is in equilibrium. The cost per additional unit of utility is
equal for all goods and the consumer is as well off as it is possible to be.
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Rational Choice and Rational Choice and Marginal UtilityMarginal Utility The rule does not say that the rational
consumer should consume a good until its marginal utility reaches zero.
Consumers do not have enough money to reach this point, as they face an income constraint.
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Opportunity CostOpportunity Cost
Opportunity cost is the benefit forgone of the next-best alternative. It is essentially the marginal utility per
dollar you forgo. To say MUx/Px > MUy/Py is to say that the
opportunity cost of not consuming good x is greater than the opportunity cost of not consuming good y.
So we consume x.
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Opportunity CostOpportunity Cost
When all the marginal utilities per dollar spent are equal, the opportunity cost of all the alternatives are equal.
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Rational Choice and the Rational Choice and the Laws of DemandLaws of Demand The principle of rational choice leads to
the law of demand. When the price of a good goes up, the
marginal utility per dollar from that good goes down and we demand less of it.
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Rational Choice and the Rational Choice and the Law of DemandLaw of Demand Initially MUx/Px = MUy/Py When the price of good y goes up, then
MUx/Px > MUy/Py. Our condition for maximizing utility is no
longer satisfied. So when the price of a good goes up, we
would choose to consume less of that good.
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Rational Choice and the Rational Choice and the Law of DemandLaw of Demand Our utility maximizing rule is no longer
satisfied We should now buy more of good x
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Rational Choice and the Rational Choice and the Law of DemandLaw of Demand MUx decreases as we buy more x
(diminishing marginal utility) and MUy increases as we buy less of the
good y We are back at a point where MUx/Px =
MUy/Py and we maximize utility (but we now consume less x and more y than before the price increase).
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Rational Choice and the Rational Choice and the Law of DemandLaw of Demand Quantity demanded rises as price falls,
other things constant.
Quantity demanded falls as price rises, other things constant.
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Rational Choice and the Rational Choice and the Law of DemandLaw of Demand The above shows the relationship
between marginal utility and the price we are willing to pay.
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Rational Choice and the Rational Choice and the Law of DemandLaw of Demand Since our demand for a good is an
expression of our willingness to pay for it, quantity demanded is related to marginal utility.
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Maximizing Utility Maximizing Utility Using Indifference Using Indifference CurvesCurves Economists often use graphic
representation of the consumer’s choice.
The problem consists of two parts: The budget constraint (or the income
constraint) and Indifference curves, which represent
utility
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Graphing the Budget Graphing the Budget LineLine The budget constraint represents all
the combinations of two goods that a person can afford to buy with given income.
The budget constraint is also called the income constraint, or budget line.
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Jaz’s Budget LineJaz’s Budget Line
Jaz has $10 and buys chocolate and pop whose prices are $1 and $0.50 respectively.
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Graphing the Budget Graphing the Budget Line,Line, Fig. 8-2, p 187 Fig. 8-2, p 187
0
2
4
6
8
10
2 4 6 8 10 12 14 16 18 20 22
Chocolate bars
Cans of pop
Slope= - Ppop/Pchocolate
= - ½Income = $10
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The Indifference CurveThe Indifference Curve
An indifference curve represents all the combinations of the two goods amongst which an individual is indifferent.
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The Indifference CurveThe Indifference Curve
Jaz is equally as well off (her utility is the same) from consuming bundles A, B, C, D or E.
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Jaz’s Indifference Jaz’s Indifference Curve,Curve, Fig. 8-3a, p 188 Fig. 8-3a, p 188
0
4
8
12
16
20
2 4 6 8 10 12 14 16 18 20 22
Chocolate bars
Cans of pop
|Slope|= MUpop/MUchocolate bars
= MRS of pop for chocolate bars
U
ABC
DE
Indifference curve
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The Indifference CurveThe Indifference Curve
The slope of the indifference curve is called the marginal rate of substitution (MRS)
The slope is bowed inward, indicating that MRS is decreasing as Jaz’s bundles contain more of the good on the horizontal axis.
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The Indifference CurveThe Indifference Curve
The reason for decreasing MRS is that as Jaz gets more and more of one good, she is willing to give up lots of it to get more of the relatively scarce good.
|Slope| = MUpop/Muchocolate = MRS
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A Map of Indifference A Map of Indifference CurvesCurves The bundles of goods forming
indifference curve U3 give Jaz higher utility than bundles along U2,
While the bundles of goods forming indifference curve U1 give Jaz less utility than bundles along U2.
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A Map of Indifference A Map of Indifference Curves,Curves, Fig. 8-3b, p 188 Fig. 8-3b, p 188
0
4
8
12
16
20
2 4 6 8 10 12 14 16 18 20 22
Chocolate bars
Cans of pop
U2
ABC
DE
U1
U3
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Combining Indifference Combining Indifference Curves and Budget LineCurves and Budget Line The goal for a consumer is to get as
high on an indifference curve as possible, given her income constraint.
More is preferred to less.
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Combining Indifference Combining Indifference Curves and Budget Curves and Budget Line,Line, Fig. 8-4, p 189 Fig. 8-4, p 189
0
4
8
12
16
20
2 4 6 8 10 12 14 16 18 20 22
Chocolate bars
Cans of pop
U2
U1
U3
Slope= -MUpop/Muchocolate bars
Slope= -Ppop/Pchocolate barsD
CG
K
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Combining Indifference Combining Indifference Curves and Budget LineCurves and Budget Line At the point D, Jaz maximizes her utility
when:
MUpop/Muchocolate bars = Ppop/Pchocolate bars
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Combining Indifference Combining Indifference Curves and Budget LineCurves and Budget Line In other words, utility is maximized
when the slopes of the budget constraint and the indifference curve are equal.
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The Logic of The Logic of Individual Choice:Individual Choice:The Foundation of The Foundation of
Supply and DemandSupply and Demand
End of Chapter 8End of Chapter 8