The Logic of Individual Choice:The Foundation of Supply and Demand ppt

Utility Theory and Individual Choice  A good beginning in understanding individual choice is to focus on the rational part of people's behavior... Total Utility and Marginal Utility  A

Individual Choice:

The Foundation of

Supply and Demand

Chapter 8

Utility Theory and

Individual 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.

Utility Theory and

Individual Choice

 A good beginning in understanding

individual choice is to focus on the

rational part of people's behavior

Utility Theory and

Individual Choice

 Using the simple concept of

self-interest, two things determine what

Utility Theory and

Individual 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

Measuring 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

Measuring Pleasure

 Individuals want to maximize the

amount of satisfaction they receive

through consuming goods and services

Measuring 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

 Utility serves as the basis of

economists' analysis of individual

choice

 It is personal and individual

 Utility cannot be compared across

individuals

Total Utility

 Total utility refers to the total

satisfaction one gets from consuming a product

Marginal 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

Total Utility and

Marginal 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.

Number of

pizza slices

1 2 3 4 5 6 7

Total utility

14 26 36 44 50 54 56

Marginal utility

14 12 10 8 6 4 2

Marginal and Total

Total utility Marginal utility

Marginal and Total

Total utility Marginal utility

Diminishing Marginal

Utility

 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

Diminishing Marginal

Utility

 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.

Rational Choice and

Marginal 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

Rational 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

P

MU P

MU

=



 Choose to consume an additional unit of good x.



 Choose to consume an additional unit of good y.

Maximizing 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

Maximizing Utility and

Equilibrium

 When the ratios of the marginal utility to price of goods are equal, you are

maximizing utility

Maximizing Utility, Table 8-1,

MU

20 12 6 3 0 -5

MU/P

10 6 3 1.5 0 -2.5

Q

0 1 2 3 4 5 6

TU

0 29 46 53 56 57 57

MU

29 17 7 3 1 0

MU/P

29 17 7 3 1 0

Hamburgers (P = $2) Ice Cream (P = $1)

Maximizing Utility, Table 8-2,

p 183

Total $

spent Purchase? MU/P MU

Rational Choice and

Rational Choice and

Marginal 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

Rational Choice and

Marginal Utility

z

z y

y x

x

P

MU

P

MU

Rational Choice and

Marginal 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

Rational Choice and

Marginal 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

Opportunity 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.

Opportunity Cost

 When all the marginal utilities per dollar spent are equal, the opportunity cost of all the alternatives are equal

Rational Choice and the Laws 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.

Rational Choice and the Law 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.

Rational Choice and the Law of Demand

 Our utility maximizing rule is no longer

satisfied

 We should now buy more of good x

Rational Choice and the Law 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

Rational Choice and the Law of Demand

 Quantity demanded rises as price falls,

other things constant

 Quantity demanded falls as price rises, other things constant

Rational Choice and the Law of Demand

 The above shows the relationship

between marginal utility and the price

we are willing to pay

Rational Choice and the Law 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

Choice to the Real

World

 There are limits on the assumptions

underlying the theory of rational

decision-making

The Cost of Decision

Making

 In reality, people make hundreds of

choices every day

 It is difficult to believe that we are going

to apply principles of rational choice to

all those decisions

The Cost of Decision

Making

 Some decisions are difficult to make

because we lack information, or there is some uncertainty involved, or it is a

complex decision

 Each decision requires us to use our

limited cognitive ability to receive,

process, store and retrieve information

The Cost of Decision

Making

 A number of economists believe that

most people use bounded rationality to

make their decisions rather than using

the rational choice model

 Bounded rationality means rationality

adjusted for our limitations

The Cost of Decision

Making

 We employ a variety of simple rules to

make some of our decisions:

 Price conveys information

 Follow the leader

 Habit

 Custom

Price Conveys

Information

 Higher priced goods tend to be better

than lower-priced goods

 We can use this simple rule to make a quick decision – we rely on price to

convey information about quality.

Follow the Leader

 Sometimes we just do what others are

doing

 Clothes manufacturers try to exploit

this decision rule with their

advertising efforts by convincing us

that “everyone” is wearing a

particular style.

 Habit explains a lot of our choices

 We did the marginal utility calculation

some time ago and we continue with the same choice

 We rely on our previous judgment.

 Employing the rule of custom can ease

the burden of decision making

Using Indifference

Curves

 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

Graphing the Budget

Line

 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

Jaz’s Budget Line

 Jaz has $10 and buys chocolate and

pop whose prices are $1 and $0.50

respectively

Graphing the Budget

The Indifference Curve

 An indifference curve represents all

the combinations of the two goods

amongst which an individual is

indifferent

The Indifference Curve

 Jaz is equally as well off (her utility is

the same) from consuming bundles A,

B, C, D or E

E

Indifference curve

The 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

The 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

A Map of Indifference

Curves

 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

E

U1

U3

Combining Indifference Curves 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

Curves and Budget

Slope= -MUpop/Muchocolate bars

Slope= -Ppop/Pchocolate bars

D

C

G

K

Combining Indifference Curves and Budget Line

 At the point D, Jaz maximizes her utility when:

Combining Indifference Curves and Budget Line

 In other words, utility is maximized

when the slopes of the budget

constraint and the indifference curve are equal

Individual Choice:

The Foundation of

Supply and Demand

End of Chapter 8