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06 consumer choice theory

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06 consumer choice theory

  1. 1. Chapter 6Consumer Choice Theory • Key Concepts • Summary • Practice Quiz • Internet Exercises ©2000 South-Western College Publishing 1
  2. 2. In this chapter, you will learn to solve these economic puzzles: When ordering Big Macs,Under what conditions might Do white ratspizza, pay milkshakes, obey and you be willing to the otherlaw of demand? you $10,000 forhow can of goods, a gallon water and 1the highest one- obtain cent for a possible diamond? carat satisfaction? 2
  3. 3. What is Util?A hypothetical unit used to measure how much utility a person obtains from consuming a good 3
  4. 4. What is Utility?The satisfaction, or pleasure, that people receive from consuming a good or service 4
  5. 5. What is Total Utility?The amount of satisfaction received from all the units of a good or service consumed 5
  6. 6. Why does a consumerbuy one bundle of goods, rather than another? Consumers make one choice over another depending on their marginal utility 6
  7. 7. What is Marginal Utility?The change in total utility from one additional unit of a good or service 7
  8. 8. 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 8
  9. 9. Diminishing Marginal Utility8 Marginal Utility642 MU Q 1 2 3 4 9
  10. 10. Total Utility16 Utils TU128 4 Q 1 2 3 4 10
  11. 11. When is Total Utility maximized?When the marginal utility per dollar of each good is equal and the entire budget is spent 11
  12. 12. 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 12
  13. 13. Even though water provides a greater utility than diamonds, why arediamonds more expensive? Water is plentiful in most of the world, so its marginal utility is low 13
  14. 14. Marginal Utility of Diamonds8 Marginal Utility S64 MUd2 MU Q 1 2 3 4 14
  15. 15. Marginal Utility of Water8 Marginal Utility S642 MUw MU Q 1 2 3 4 15
  16. 16. Marginal Utility for Big Macs andMilkshakes (utils per day) ($2 each) BIG MACS MILKSHAKESQuantity MU MU/P MU MU/P 1 8 4 6 3 2 4 2 4 2 3 2 1 1 1/2 4 1 1/2 0 0 16
  17. 17. Consumer Equilibrium MU A MU B MU Zprice A = price B = price Z 17
  18. 18. Consumer Equilibrium Price of Big Mac = $2MU of Big Mac MU of milkshakeprice of Big Mac = price of milkshake 4 utils 4 utils $2 = $2 18
  19. 19. What happens if theprice of a Big Mac falls to $1 and upsets theprevious equilibrium? 19
  20. 20. Consumer Equilibrium Price of Big Mac = $1 MU of Big Mac MU of milkshakeprice of Big Mac >price of milkshake 4 utils > 4 utils $1 $2 20
  21. 21. 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 21
  22. 22. 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 22
  23. 23. What are two alternativeexplanations of demand? Income effect Substitution effect 23
  24. 24. What is the Income effect?The change in quantity demanded of a good or service caused by a change in real income (purchasing power) 24
  25. 25. What does the Income effect show?As prices decline, your real income increases, increasing your buying power, so you buy more units, ceteris paribus 25
  26. 26. What is the Substitution effect?The change in quantity demanded of a good or service caused by the change in its price relative to substitutes 26
  27. 27. What does theSubstitution 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 27
  28. 28. What does theSubstitution 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 28
  29. 29. What is a Normal Good? A good that consumers will buy more of as their incomes increase 29
  30. 30. What is an Inferior Good?A good that consumers will buy less of as their incomes increase 30
  31. 31. Key Concepts 31
  32. 32. Key Concepts• What is Util?• What is Utility?• What is Total Utility?• What is Marginal Utility?• What is the Law of Diminishing Marginal U• When is Total Utility maximized?• What is Consumer Equilibrium? 32
  33. 33. Key Concepts cont.• What are two alternative explanations of dem• What is the Income effect?• What is the Substitution effect?• What does the Substitution and Income effec• What is a Normal Good?• What is an Inferior Good? 33
  34. 34. Summary 34
  35. 35. Utility is the satisfaction orpleasure derived from consumptionof a good or service. Actualmeasurement of utility isimpossible, but economists assumeit can be measured by a fictitiousunit called the util. 35
  36. 36. Total utility is the total level ofsatisfaction derived from all units ofa good or service consumed.Marginal utility is the change intotal utility from a one unit changein the quantity of a good or serviceconsumed. 36
  37. 37. Diminishing Marginal Utility8 Marginal Utility642 MU Q 1 2 3 4 37
  38. 38. Total Utility16 Utils TU128 4 Q 1 2 3 4 38
  39. 39. The law of diminishingmarginal utility states thatmarginal utility of a good orservice eventually declines asconsumption increases. 39
  40. 40. Consumer equilibrium is thecondition of reaching themaximum level of satisfaction,given a budget, when the marginalutility per dollar spent on eachgood purchased is equal. 40
  41. 41. Consumer equilibrium and thelaw of diminishing marginal utilitycan be used to derive a downward-sloping demand curve. When theprice of a good falls, consumerequilibrium no longer holds becausethe marginal utility the marginalutility per dollar for the good rises. 41
  42. 42. To restore equilibrium, theconsumer must increaseconsumption. As the quantitydemanded increases, the marginalutility falls until equilibrium isagain achieved. Thus, the price fallsand the quantity demanded rises, aspredicted by the law of demand 42
  43. 43. Consumer Equilibrium MU A MU B MU Zprice A = price B = price Z 43
  44. 44. The income effect and thesubstitution effect arecomplementary explanations for thelaw of demand. When the pricechanges, these effects work incombination to change in thequantity demanded in the oppositedirections. 44
  45. 45. As the price falls, realpurchasing power increases,causing an increase in theconsumer’s willingness and abilityto purchase a good or service. Thisis the income effect. Also, as theprice falls, the consumer substitutesthe cheaper the cheaper good forother goods that are now relativelymore expensive. This is thesubstitution effect. 45
  46. 46. If the marginal utility per lastdollar spend on each good is equaland the entire budget is spent, totalutility is maximized. 46
  47. 47. When the price of a normal goodfalls, the income effect and thesubstitution effect combine to causethe quantity demanded to increase. 47
  48. 48. Chapter 6 Quiz ©2000 South-Western College Publishing 48
  49. 49. 1. As an individual consumes more of a given good, the marginal utility of that good to the consumer a. rises at an increasing rate. b. rises at a decreasing rate. c. falls. d. rises.C. As a consumer consumes more and more of anything, the satisfaction received on the last unit becomes less and less with each unit. 49
  50. 50. 2. The amount of added utility that a consumer gains from the consumption of one more unit of a good is called a. incremental utility. b. total utility. c. diminishing utility. d. marginal utility.D. The word “margin” means that last unit or the last increment. 50
  51. 51. 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 will a. 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.A. As more units of food are purchased, the marginal utility diminishes, while that of compact discs remains the same. 51
  52. 52. 4. Rational consumers will continue to consume two goods until a. 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.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. 52
  53. 53. 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. D. In terms of satisfaction, the two goods become identical at the point of equilibrium. 53
  54. 54. 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 the a. 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. D. At this point, the ratio of utils to price is the same. 54
  55. 55. 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.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. 55
  56. 56. 8. A state of consumer equilibrium for goods consumed prevails when the a. 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.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. 56
  57. 57. 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.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. 57
  58. 58. Total Utility for Multiplex Tickets, Video Rentals, and Popcorn Total Utility Total Utility Total Utility from Multiplex from Video from Popcorn Tickets Rentals1 movie (30 utils) 1 video (14 utils) 1 bag (8 utils)2 movies (54 utils) 2 videos (24 utils) 2 bags (13 utils)3 movies (72 utils) 3 videos (30 utils) 3 bags (15 utils)4 movies (84 utils) 4 videos (32 utils) 4 bags (16 utils) Exhibit 4 58
  59. 59. 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.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. 59
  60. 60. 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. B. 67 total utils are achieved with this combination, a yields 60 utils, c yields 60 utils and d yields 54 utils. 60
  61. 61. Internet ExercisesClick on the picture of the book, choose updates by chapter for the latest internet exercises. 61
  62. 62. END 62

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