McGraw-Hill/Irwin Copyright 2006 by The McGraw-Hill Companies, Inc. All rights reserved.

THE LOGIC OF THE LOGIC OF INDIVIDUAL INDIVIDUAL

CHOICE: THE CHOICE: THE FOUNDATION OF FOUNDATION OF

DEMAND AND DEMAND AND SUPPLYSUPPLY

Chapter 8Chapter 8

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8-2

Today’s lecture will:Today’s lecture will:• Discuss the principle of diminishing marginal

utility.• Talk about the principle of rational choice.• Explain the relationship between marginal

utility and price when a consumer is maximizing total utility.• Explain how the principle of rational choice

accounts for the laws of supply and demand.

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8-3

Today’s lecture will:Today’s lecture will:

• Explain why economists can believe there are many explanations of individual choice, but nonetheless focus on self-interest.• Name three assumptions of the

theory of choice and discuss why they may not reflect reality.

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8-4

Utility Theory and Utility Theory and Individual ChoiceIndividual Choice

• According to economists, our behavior is motivated by rational self interest.• According to this theory, 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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8-5

Total Utility and Total Utility and Marginal UtilityMarginal Utility

• Utility is the pleasure or satisfaction that one expects to get from consuming a good or service.• Total utility is the satisfaction one gets

from one’s consumption of a product.• Marginal utility is the satisfaction you get

from the consumption of one additional unit of the product above what you have consumed up to that point.

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8-6

Diminishing Marginal UtilityDiminishing Marginal Utility• The principle of diminishing marginal utility –

after some point, the marginal utility received from each additional unit of a good decreases with each additional unit consumed. As additional units are consumed, marginal utility

decreases, but total utility continues to increase. When total utility is at a maximum, marginal

utility is zero. Beyond this point, total utility decreases and

marginal utility is negative.

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8-7

Marginal and Total UtilityMarginal and Total UtilityNumber of

pizza slices

123456789

Total utility

142636445054565654

Marginal utility

14121086420-2

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8-8

Marginal Marginal and and Total Total UtilityUtility

Total utility

Q

70605040302010

0 1 2 3 4 5 6 7 8 9

Total utility

Marginal utility

16141210

86420

-2 1 2 3 4 5 6 7 8 9

Marginal utility

Q

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8-9

Rational Choice and Rational Choice and Marginal UtilityMarginal Utility

• Rational individuals want as much satisfaction as they can get from their income.• According to the basic principle of rational

choice you should spend your money on those goods that give you the most marginal utility per dollar.• Any choice that does not give you as many

units of utility as possible for the same amount of money is an irrational choice.

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8-10

The Principle of The Principle of Rational ChoiceRational Choice

• Consume another unit of x if:

Y

Y

X

X

PMU

PMU

• Consume another unit of y if:

Y

Y

X

X

PMU

PMU

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8-11

Maximizing UtilityMaximizing Utility

Q

01234567

TU

020344447474232

MU

201410

30

-5-10

MU/P

1075

1.50

-2.5-5

Q

01234567

TU

029465355565652

MU

2917

7210

-4

MU/P

2917

7210

-4

Big Macs (P = $2) Ice Cream (P = $1)

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8-12

Maximizing Utility and Maximizing Utility and EquilibriumEquilibrium

•Utility is maximized and equilibrium reached when:

Y

Y

X

X

PMU

PMU

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8-13

Extending the Principle of Extending the Principle of Rational ChoiceRational Choice

• Utility is maximized when:

Z

Z

Y

Y

X

X

PMU

PMU

PMU

• 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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8-14

Rational Choice and the Law of Rational Choice and the Law of DemandDemand

• When the price of a good goes up, the marginal utility per dollar (MU/$) from it goes down, and we consume less of it and its marginal utility increases. Quantity demanded falls as price rises.

• When the price of a good decreases, the MU/$ increases, and we consume more of it and its marginal utility decreases. Quantity demanded increases as price falls.

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8-15

The Law of SupplyThe Law of Supply• The higher the

wage, the higher the marginal utility of the goods you can get for the wage.• This gives an

upward sloping supply curve.

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8-16

Opportunity CostOpportunity Cost• Opportunity cost is the benefit forgone of

the next-best alternative.• In the context of utility, it is the marginal

utility per dollar you forgo from the consumption of the next-best alternative.• If the MUX/PX > MUY/PY, 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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8-17

Applying the Theory of Choice Applying the Theory of Choice to the Real Worldto the Real World

• There are limits on the assumptions underlying the theory of rational decision making.• Those assumptions are:

Decision making is costless Tastes are given Individuals maximize utility

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8-18

The Cost of Decision MakingThe Cost of Decision Making• The cost of deciding among hundreds of

possible choices lead us to do something irrational.• Most people may use bounded rationality –

rationality based on rules of thumb. “You get what you pay for” –the implication that

high price equals high quality “Follow the leader” – leads to focal point equilibria

– a set of goods is consumed because they have become focal points to which people have gravitated.

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8-19

Given TastesGiven Tastes• Implicit in the theory of rational

choice is that utility functions are given, not shaped by society.• Tastes are often significantly

influenced by society.• Conspicuous consumption – the

consumption of goods not for one’s direct pleasure, but to show off to others.

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8-20

Individuals Maximize Utility Individuals Maximize Utility

• People may not behave rationally in practice. • The ultimatum game shows that

people care about fairness as well as income.• According to the status quo bias,

individuals’ actions are influenced by what the current situation is.

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8-21

SummarySummary• Total utility is the satisfaction

obtained from consuming a product.• Marginal utility is the satisfaction

obtained from consuming one additional unit of a product.• The principle of diminishing marginal

utility states that after some point, the marginal utility of consuming more of the good will fall.

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8-22

SummarySummary• Utility is maximized and equilibrium

reached when:

Y

Y

X

X

PMU

PMU

Unless MUX/PX= MUY/PY, an individual canrearrange his or her consumption to in-crease total utility.

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8-23

SummarySummary• Opportunity cost is the marginal utility per

dollar one forgoes from the consumption of the next-best alternative.• The laws of demand and supply can be

derived from the principle of rational choice.• If the price of a good increases, you will

decrease consumption of that good so that its marginal utility increases.• If your wage rises, the marginal utility of the

goods you can buy with your wage will rise and you will work more to maximize utility.

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8-24

The following table shows your total utility from consuming sodas andgrilled cheese sandwiches.

Sandwiches SodasQ TU MU MU/$ Q TU MU MU/$0 0 0 01 27 ____ ____ 1 8 ____ ____

2 51 ____ ____ 2 15 ____ ____

3 69 ____ ____ 3 21 ____ ____

Review Question 8-1 Find the marginal utility for grilled cheese sandwiches and sodas.Review Question 8-2 Suppose that sandwiches cost $3 each and theprice sodas is $1. Find the marginal utility per dollar for sodas andsandwiches. How many of each will you buy if you have $8 to spendand you want to maximize your total utility?

27 9

24

6

8

6

78

18 6

7

8

If you buy 2 sandwiches and 2 sodas you will maximize utility.