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Chapter 6 Consumer Choice Theory

©2000 South-Western College Publishing

• Key Concepts• Summary• Practice Quiz• Internet Exercises

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In this chapter, you will learn to solve these economic puzzles:

Under what conditions might you be willing to pay

$10,000 for a gallon of water and 1 cent for a one-

carat diamond?

When ordering Big Macs, milkshakes, pizza, and

other goods, how can you obtain the highest

possible satisfaction?

Do white rats obey the law of demand?

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What is Util?A hypothetical unit used

to measure how much utility a person obtains from consuming a good

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What is Utility?The satisfaction, or

pleasure, that people receive from consuming a good or service

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What is Total Utility?The amount of satisfaction

received from all the units of a good or service consumed

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Why does a consumer buy one bundle of goods,

rather than another?Consumers make one

choice over another depending on their marginal utility

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What is Marginal Utility?The change in total utility

from one additional unit of a good or service

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What is the Law of Diminishing

Marginal Utility?The principle that the

extra satisfaction of a good or service declines as people consume more in a given period

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8

6

4

2

1 2 3 4

Diminishing Marginal Utility

MUMar

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al U

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Q

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16

12

8

4

1 2 3 4

Total Utility

TUU

tils

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When is Total Utility maximized?

When the marginal utility per dollar of each good is equal and the entire budget is spent

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What isConsumer Equilibrium?A condition in which total

utility cannot increase by spending more of a given budget on one good and spending less on another good

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Even though water provides a greater utility than diamonds, why are

diamonds more expensive?Water is plentiful in most

of the world, so its marginal utility is low

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8

6

4

2

1 2 3 4

Marginal Utility of Diamonds

MUQ

Mar

gin

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tili

ty S

MUd

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8

6

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1 2 3 4

Marginal Utility of Water

MUQ

Mar

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MUw

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Marginal Utility for Big Macs and Milkshakes (utils per day) ($2 each)

Quantity MU MU/P MU MU/P

1

2

3

4

8

4

2

1

4

2

1

1/2

6

4

1

0

3

2

1/2

0

BIG MACS MILKSHAKES

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MU Aprice A

MU Bprice B

Consumer Equilibrium

MU Zprice Z= =

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MU of Big Macprice of Big Mac

MU of milkshakeprice of milkshake

Consumer Equilibrium Price of Big Mac = $2

4 utils$2

4 utils$2 =

=

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What happens if the price of a Big Mac falls

to $1 and upsets the previous equilibrium?

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MU of Big Macprice of Big Mac

>MU of milkshakeprice of milkshake

Consumer Equilibrium Price of Big Mac = $1

4 utils$1

4 utils$2

>

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What happens to the number of Big Macs bought when the price drops?

To restore maximum total utility, the consumer spends more on Big Macs

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What does this discussion of Utility reveal?

The law of demand, that is, as the price of a good declines, consumers will buy more units of the good, and vice versa

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What are two alternative explanations of demand?

Income effect Substitution effect

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What is theIncome effect?

The change in quantity demanded of a good or service caused by a change in real income (purchasing power)

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What does the Income effect show?

As prices decline, your real income increases, increasing your buying power, so you buy more units, ceteris paribus

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What is theSubstitution effect?

The change in quantity demanded of a good or service caused by the change in its price relative to substitutes

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What does the Substitution effect show?Suppose the price of a Pepsi

falls and the price of a Coke remains unchanged; you will buy more Pepsi, because relatively, it is less expensive than Coke

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What does the Substitution and Income

effect prove?The law of demand, that is,

as the price of a good declines, consumers will buy more units of the good, and vice versa

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What is a Normal Good?A good that consumers

will buy more of as their incomes increase

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What is anInferior Good?

A good that consumers will buy less of as their incomes increase

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Key Concepts

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• What is Util?

• What is Utility?

• What is Total Utility?

• What is Marginal Utility?

• What is the Law of Diminishing Marginal Utility?

• When is Total Utility maximized?

• What is Consumer Equilibrium?

Key Concepts

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Key Concepts cont.• What are two alternative explanations of d

emand?

• What is the Income effect?

• What is the Substitution effect?

• What does the Substitution and Income effect prove?

• What is a Normal Good?

• What is an Inferior Good?

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Summary

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Utility is the satisfaction or pleasure derived from consumption of a good or service. Actual measurement of utility is impossible, but economists assume it can be measured by a fictitious unit called the util.

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Total utility is the total level of satisfaction derived from all units of a good or service consumed. Marginal utility is the change in total utility from a one unit change in the quantity of a good or service consumed.

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8

6

4

2

1 2 3 4

Diminishing Marginal Utility

MUMar

gin

al U

tili

ty

Q

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16

12

8

4

1 2 3 4

Total Utility

TUU

tils

Q

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The law of diminishing marginal utility states that marginal utility of a good or service eventually declines as consumption increases.

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Consumer equilibrium is the condition of reaching the maximum level of satisfaction, given a budget, when the marginal utility per dollar spent on each good purchased is equal.

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Consumer equilibrium and the law of diminishing marginal utility can be used to derive a downward-sloping demand curve. When the price of a good falls, consumer equilibrium no longer holds because the marginal utility the marginal utility per dollar for the good rises.

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To restore equilibrium, the consumer must increase consumption. As the quantity demanded increases, the marginal utility falls until equilibrium is again achieved. Thus, the price falls and the quantity demanded rises, as predicted by the law of demand

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MU Aprice A

MU Bprice B

Consumer Equilibrium

MU Zprice Z= =

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The income effect and the substitution effect are complementary explanations for the law of demand. When the price changes, these effects work in combination to change in the quantity demanded in the opposite directions.

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As the price falls, real purchasing power increases, causing an increase in the consumer’s willingness and ability to purchase a good or service. This is the income effect. Also, as the price falls, the consumer substitutes the cheaper the cheaper good for other goods that are now relatively more expensive. This is the substitution effect.

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If the marginal utility per last dollar spend on each good is equal and the entire budget is spent, total utility is maximized.

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When the price of a normal good falls, the income effect and the substitution effect combine to cause the quantity demanded to increase.

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Chapter 6 Quiz

©2000 South-Western College Publishing

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C. As a consumer consumes more and more of anything, the satisfaction received on the last unit becomes less and less with each unit.

1. As an individual consumes more of a given good, the marginal utility of that good to the consumera. rises at an increasing rate.b. rises at a decreasing rate.c. falls.d. rises.

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D. The word “margin” means that last unit or the last increment.

2. The amount of added utility that a consumer gains from the consumption of one more unit of a good is calleda. incremental utility. b. total utility. c. diminishing utility. d. marginal utility.

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A. As more units of food are purchased, the marginal utility diminishes, while that of compact discs remains the same.

3. A certain consumer buys only food and compact discs. If the quantity of food bought increases, while that of compact discs remains the same, the marginal utility of food willa. fall relative to the marginal utility of

compact discs.b. rise relative to the marginal utility of

compact discs.c. rise, but not as fast as the marginal utility

of compact discs falls.d. fall, but not as fast as the marginal utility

of compact discs falls.

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A. If a consumer can raise his/her marginal utility by purchasing more of a good, more units of that good will be purchased. At the point that marginal utility cannot be increased by purchasing more units of either good, the consumer will stop purchasing.

4. Rational consumers will continue to consume two goods untila. the marginal utility per dollar’s worth of

the two goods is the same.b. the marginal utility is the same for each

good.c. the prices of the two goods are equal.d. the prices of the two goods are unequal.

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D. In terms of satisfaction, the two goods become identical at the point of equilibrium.

5. Assume a person’s consumption of just the right amounts of pork and chicken is in equilibrium. We can conclude that the a. marginal utility of pork must equal the

marginal utility of chicken.b. price of pork must equal the price of

chicken.c. ratio of marginal cost to price must be the

same in both the pork and the chicken markets.

d. ratio of marginal utility to price must be the same for pork and chicken.

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D. At this point, the ratio of utils to price is the same.

6. Assume an individual consumes only milk and doughnuts, and he/she has arranged consumption so that the last glass of milk yields 12 utils and the last doughnut 6 utils. If the price of milk is $1 per glass and the price of a doughnut is $.50, we can conclude that thea. consumer should consume less milk and

more doughnuts.b. price of milk is too high relative to

doughnuts.c. consumer should consume more milk and

fewer doughnuts.d. consumer is in equilibrium.

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C. When the ratio of utils to price is the same for two goods, the consumer cannot increase his/her satisfaction by buying more of either.

7. Suppose an individual consumes pizza and cola. To reach consumer equilibrium, the individual must consume pizza and cola so that the a. price paid for the two goods is the same.b. marginal utility of the two goods is equal.c. ratio of marginal utility to price is the

same for both goods.d. ratio of marginal utility of cola to

marginal utility of pizza is 1.

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B. When the marginal utility of two goods is the same, the consumer cannot increase his/her level of satisfaction by purchasing more of either good.

8. A state of consumer equilibrium for goods consumed prevails when thea. marginal utility of all goods is the same.b. marginal utility per dollar’s worth of two

goods is the same.c. price of two goods is the same.d. marginal cost per dollar spent on two

goods is the same.

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A. When prices decline the purchasing power of the consumer increases, and vice versa. Therefore, a change in prices has the same effect on the buying power of the consumer as if his/her income had changed.

9. The change in quantity demanded resulting from a change in purchasing power is known as the a. income effect.b. substitution effect.c. law of demand.d. consumer equilibrium effect.

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Total Utility for Multiplex Tickets, Video Rentals, and Popcorn

1 movie (30 utils)

2 movies (54 utils)

3 movies (72 utils)

4 movies (84 utils)

1 bag (8 utils)

2 bags (13 utils)

3 bags (15 utils)

4 bags (16 utils)

1 video (14 utils)

2 videos (24 utils)

3 videos (30 utils)

4 videos (32 utils)

Total Utility from Multiplex

Tickets

Total Utility from Video

Rentals

Total Utility from Popcorn

Exhibit 4

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A. If the total utility for 2 videos is 24 utils and the total utility for 3 videos is 30 utils, the additional utils added by the third video is 6.

10. In exhibit 4, assume Multiplex tickets cost $6 each, video rentals cost $2 each, and bags of popcorn cost $1 each. What is the marginal utility of renting a third video? a. 6 utils.b. 8 utils.c. 10 utils.d. 30 utils.

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B. 67 total utils are achieved with this combination, a yields 60 utils, c yields 60 utils and d yields 54 utils.

11. In exhibit 4, assume Multiplex tickets cost $6 each, video rentals cost $2 each, and bags of popcorn cost $1 each. Suppose the consumer has $12 per week to spend on Multiplex tickets, video rentals, and popcorn. What combination of goods will give the consumer the most utility? a. 1 movie, 3 videos, and no popcorn.b. 1 movie, 2 videos, and 2 bags of popcorn.c. 1 movie, 1 video, and 4 bags of popcorn.d. 2 movies, no video, and no bags of popcorn.

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