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Chapter 6 Consumer Choice Theory

©2002 South-Western College Publishing

• Key Concepts• Summary• Practice Quiz• Internet Exercises

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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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8642

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Diminishing Marginal Utility

MUMar

gina

l Util

ity

Q

9

161284

1 2 3 4

Total UtilityTU

Util

s

Q

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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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Marginal Utility of Diamonds

MUQ

Mar

gina

l Util

ity S

MUd

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Marginal Utility of Water

MUQ

Mar

gina

l Util

ityS

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

23

4

8

42

1

4

21

1/2

6

41

0

3

21/2

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 demand?• What is the income effect?• What is the substitution effect?• What does the substitution and Income effect prov

e?• 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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8642

1 2 3 4

Diminishing Marginal Utility

MUMar

gina

l Util

ity

Q

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161284

1 2 3 4

Total UtilityTU

Util

s

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 EquilibriumMU Z

price 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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END