Micro

McEachern ECON 2010-

2011

Designed by
Amy McGuire, B-books, Ltd.
CHAPTER
6 Consumer Choice
and Demand

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 1
 Utility Analysis

 Utility
 Satisfaction derived from
consumption
 Subjective
 Assumption
 Tastes are given
 Tastes are
relatively stable

LO1
Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 2
 The Law of Diminishing
Marginal Utility
 Total utility
 Total satisfaction
 Marginal utility
 Change in total
utility from
one-unit change
in consumption

LO1
Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 3
 The Law of Diminishing
Marginal Utility
 The more of a good consumed
 The smaller the increase in total utility
 Marginal utility from each additional unit
 Declines as more is consumed
 Disutility
 Negative marginal utility
 “Been there; done that”

LO1
Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 4
 LO2 Measuring Utility

 Units of utility
 Each person has a
uniquely subjective
utility scale
 Total utility
 Sum of marginal
utilities

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 5
LO2
Utility Derived from Drinking
Water After Jogging Four Miles
Exhibit 1

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 6
LO2 Exhibit 2
Total Utility and Marginal Utility You Derive from
Drinking Water after Jogging Four Miles
(a) Total utility (b) Marginal utility
80

Marginal utility
Total utility

60
40
40
20
20
0

0 1 2 3 4 5 1 2 3 4 5
Glasses (8-ounce) Glasses (8-ounce)

Total utility increases with each of the

first 4 glasses of water consumed but Marginal utility declines
by smaller and smaller amounts MU of the 5th glass is negative
The 5th glass causes TU to fall

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 7
 Utility Maximization
LO 2
Without Scarcity

 Free good
 Increase
consumption as
marginal utility is
positive
 Two free goods
 Until the marginal
utility of each is 0
 Tastes, preferences

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 8
LO2 Exhibit 3
Total and Marginal Utilities from
Pizza and Videos

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 9
 Utility Maximization
LO 2
With Scarcity

 Goods – not free

 Tastes, preferences
 Limited income
 Maximize utility
 Equilibrium
 Any affordable
change will reduce
utility

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 10
 Utility-Maximizing
LO 2
Conditions

 Equilibrium
 There is no way to increase utility by
reallocating the budget
 Last $ spent on each good yields the same
marginal utility
 Higher-priced goods must yield more
marginal utility than lower-price goods

MU p MU v

pp pv
Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 11
LO2 Water, Water, Everywhere
 Diamonds
 Not a necessity; expensive;
Case Study
relatively scarce
 Water
 Necessity; cheap; abundant
 Diamonds-Water paradox
 TUwater >TUdiamonds
 Last gallon of water MUwater
very low
 Last diamond MUdiamond high
 Pdiamond > Pwater

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 12
LO3 Exhibit 4
Total and Marginal Utilities from
Pizza and Videos After the Price of
Pizza Decreases from $8 to $6

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 13
 Marginal Utility and
LO 2
the Law of Demand

 Exhibit 3
 Max U; budget = $40
 Qp = 3; Pp = $8; one point on D curve
 (Qv = 4 ; Pv = $4)
 Price of pizza drops to $6, other things constant
 Max U; budget = $40
 Qp = 4; Pp = $8; second point on D curve
 (Qv = 4 ; Pv = $4)

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 14
LO3 Exhibit 5
Demand for Pizza Generated from
Marginal Utility

$8 a
P=$8, consumer equilibrium at Q=3
MU per $ is the same for all goods
6 b
Price per pizza

consumed

4 P=$6, consumer equilibrium at Q=4

2 D

0 1 2 3 4 Pizzas per week

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 15
 Consumer Surplus

– Value of a good purchased must at least

equal the P
 D curve
– Marginal valuation
 Consumer surplus
– Consumer bonus
– Value of total utility minus total spending
– Area under D, above P

LO3
Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 16
LO3 Exhibit 6
Consumer Surplus from Sub Sandwiches
$8 At P=$4:
•1st sub valued at $7
7
Price per subs

•2nd sub valued at $6

6
•3rd sub valued at $5
5 •4th sub valued at $4
4 •Willing to pay $22 for 4 subs
3 •Pays only $16 for 4 subs
2 •Consumer surplus
1 $22-$16 = $6
D

0 1 2 3 4 5 6 7 8 Subs per
month
When P drops to $3, consumer surplus increases by $4
Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 17
 Market D and
Consumer Surplus
 Market D curve
– Horizontal sum of individual D curves
– Total quantity demanded, per period, by all
consumers, at various prices
 Consumer surplus for the market
– Amount consumers are willing to pay minus
amount they pay
– Net benefit for consumers
– Economic welfare

LO3
Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 18
LO3 Exhibit 7
Summing Individual Demand Curves to Derive
Market Demand for Sub Sandwiches
(a) You (b) Brittany (c) Chris (d) Market demand
for subs
$6 $6 $6 $6
Price

4 4 4 4 dY+dB+dC=D

2 2 2 2

dY dB dC

0 2 4 6 0 2 4 0 2 0 2 6 12
Subs per month

Market demand curve is the horizontal sum of individual demand curves

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 19
LO3 Market Demand and
Consumers Surplus

Consumer surplus at a price of $2

Exhibit 8

is shown by the blue area.

Price per unit

If the price falls to $1, consumer

surplus increases to include the
green area.

At a zero price, consumer surplus

increases to the entire area under
the D curve.
$2
1 D

0 Quantity per period

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 20
LO3 The Marginal Value of Free Medical Care
 Free medical care
 Consumed until
Case Study
marginal utility = 0
 High marginal cost to
taxpayers
 Waste, fraud, abuse
 Less incentive for
healthy behavior
 Charge $1 per doctor visit
 Reduce cost to
taxpayers

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 21
 Role of Time in Demand

 Consumption
– Money price
– Time price
 Willing to pay premium for time-saving goods

LO4
Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 22
 Indifference Curves and
Utility Maximization
Appendix

 Indifference curve
– Combinations of goods
– Same total utility
– Slope downward to right
– Convex to origin

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 23
 An Indifference Curve

An indifference curve (I) shows all

combinations of two goods that
Video rentals per week
Exhibit A

10
provide a particular consumer with
8 a the same total utility.

Indifference curve:
5 • negative slope
4 b • convex to origin
3 c
2 d
I

0 1 2 3 4 5 10
Pizzas per week

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 24
 Indifference Curves and
Utility Maximization
Appendix

 Marginal rate of substitution MRS

– Willingness to trade
– Slope of indifference curve
 Law of diminishing MRS
– Diminishing slope of I curve

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 25
 Indifference Curves and
Utility Maximization
Appendix

 Indifference map
– Graphical representation of consumer’s
tastes
– Each I: different utility levels
– The further indifference curve from origin
• The higher the utility
• More of both goods

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 26
 Exhibit B
An Indifference Map
Indifference curves I1 through
Video rentals per week

10 I4 are examples from a

consumer’s particular
indifference map.

Indifference curves farther

5 from origin depict higher
I4 levels of utility.
I3
I2
I1
A line intersects each higher
indifference curve, reflecting
more of both goods.
0 5 10
Pizzas per week

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 27
 Exhibit C
Indifference Curves Do Not Intersect
Video rentals per week

If indifference curves crossed (i)

every point on I and every point on
I’ would have to reflect the same
k level of utility as i.

j k: more pizzas and videos

i
than j; higher utility than j
I’
I

0 Pizzas per week

Indifference curves cannot intersect
Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 28
 Indifference Curves and
Utility Maximization
Appendix

 The budget line

– Combinations of goods
– Able to buy
– Consumption possibilities frontier
 Slope of budget line:

I / pv p p
 
I / p p pv

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 29
LO4 Exhibit D
A Budget Line
Budget line: all combinations of pizza and videos that
Video rentals per week

10 can be purchased at fixed prices with a given income.

Slope = -pp / pv = -$8/$4 = -2

5
Slope = -2: the price of 1 pizza is 2 videos.

0 5 10
Pizzas per week

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 30
 Indifference Curves and
Utility Maximization
Appendix

 Consumer equilibrium at the tangency

– Maximize utility
– Indifference curve tangent to budget line

 pp
MRS  
pv  MU p MU v
 
MU p  p p pv
MRS 
MU v 

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 31
LO4 Exhibit E
Utility Maximization
Video rentals per week

10 A consumer’s utility is maximized at

point e, where indifference curve I2 is
a
tangent to the budget line.

5
e
4
I3
I2
I1

0 3 5 10
Pizzas per week

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 32
 Indifference Curves and
Utility Maximization
Appendix

 Effects of a change in price

– Derive the D curve
 Income effect
 Substitution effect

Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 33
LO4 Exhibit F
Effect of a Drop in the Price of Pizza
(a) (b)
10
Video rentals per week

Price per pizza

5 e
e” $8
4 e”
e 6
I I” D

0 3 4 5 6.67 0 3 4
Pizzas per week Pizzas per week

A reduction in the price of pizza A drop in price of pizza increases

rotates the budget line rightward. quantity demanded.
The consumer is back in equilibrium
at point e” along the new budget line.
Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 34
 LO4 Exhibit G
Substitution and Income Effects of a Drop in the
Price of Pizza from $8 to $4
Video rentals per week

10
A reduction in the price of pizza moves the
consumer from e to e*.

C Substitution effect: e to e’; consumer’s reaction

e*
5 to a change in relative prices along the
e
4 original indifference curve.
I*
e’
Income effect: e’ to e*; moves the
I
consumer to a higher indifference
curve at the new relative price ratio.
0 3 4 5 F 10
Pizzas per week
Substitution Income
effect effect
Chapter 6 Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 35