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

Transcription

1 CHAPTER 10 The Logic of Individual Choice: The Foundation of Supply and Demand The theory of economics must begin with a correct theory of consumption. Stanley Jevons McGraw-Hill/Irwin Copyright 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

2 Utility Theory and Individual Choice Our behavior is motivated by rational selfinterest According to this theory, two things determine what people do: Utility which is the pleasure or satisfaction that people get from doing or consuming something The price of doing, or consuming, that something 10-2

3 Total Utility and Marginal Utility Utility = satisfaction Total utility is the total satisfaction one gets from consuming a product Marginal utility is the satisfaction you get from the consumption of one additional unit Utility is commonly measured in utils 10-3

4 Diminishing Marginal Utility The principle of diminishing marginal utility states that after some point, the marginal utility received from each additional unit of a good decreases with each additional unit consumed As additional units are consumed, marginal utility decreases, but total utility continues to increase 10-4

5 Application: Total Utility and Marginal Utility Number of Pizza Slices Total Utility Marginal Utility TU is increasing, but at some point decreases MU is decreasing as more units are consumed, but at some point becomes negative

6 Diminishing Marginal Utility When total utility is at a maximum, marginal utility is zero (remember this) Beyond this point, total utility decreases and marginal utility is negative McGraw-Hill/Irwin Colander, Economics 6

7 Total Utility Curve and Marginal Utility Curve Units of Utility Total Utility Curve Total utility reaches its maximum at 8 units Units of Utility Marginal Utility Curve Marginal utility is zero when it crosses the quantity axis. It demonstrates the law of diminishing marginal utility Q Q 10-7

8 Rational Choice and Marginal Utility The principle of rational choice states that people spend their money on those goods the give them the most marginal utility (MU) per dollar Consume another unit of X if: X MUY Consume another unit of Y if: MU P X MU P Y Y P Y MU P X X 10-8

9 Maximizing Utility and Equilibrium The utility maximizing rule states that when the ratios of the marginal utility to price of the two goods are equal, you are maximizing utility (and you are at equilibrium) If MU P X X MU P Y Y, you are maximizing utility MU=marginal utility and P=price 10-9

10 Maximizing Utility Big Macs (P = $2) Q TU MU MU/P Ice Cream (P = $1) Q TU MU MU/P Suppose you have $7 to spend. How will you spend it? (Refer to P ) 10-10

11 Maximizing Utility Using the chart, look for where the MU/P of both goods are equal (the utility maximizing rule) Then, see if those prices and quantities for each good sum to the amount of money you have to spend (in this case, $7) Big Macs: 2 ($2)=$4 Ice cream: 3($1)=$3 $7 McGraw-Hill/Irwin Colander, Economics 11

12 Extending the Principle of Rational Choice What if you were consuming three goods? You would consume them where the MU/P for all three goods is equal Utility is maximized when: MU P X X MU P Y Y MU P Z Z 10-12

13 Rational Choice and the Law of Demand When the price of a good increases, the marginal utility per dollar (MU/P) from it decreases, and we consume less of it By consuming less is the only way to increase marginal utility Remember, quantity demanded falls as price rises 10-13

14 Rational Choice and the Law of Demand When the price of a good decreases, the MU/P increases, and we consume more of it By consuming more, we decrease our marginal utility Remember, quantity demanded increases as price falls McGraw-Hill/Irwin Colander, Economics 14

15 Rational Choice and the Law of Demand: Income and Substitution Effects The inverse relationship between price and quantity demanded is due to the income and substitution effects The income effect is the reduction in quantity demanded when price increases 10-15

16 Rational Choice and the Law of Demand: Income and Substitution Effects The substitution effect is the reduction in quantity demanded when price increases You will substitute another good for the more expensive good Look at the Big Mac and ice cream example again McGraw-Hill/Irwin Colander, Economics 16

17 Income and Substitution Effects Suppose ice cream is now $2 You are given an extra $3 to make up for this price increase (so there is no income effect) How will your spending change (substitution effect)? Big Macs (P = $2) Q TU MU MU/P Ice Cream (P = $2) Q TU MU MU/P

18 Income and Substitution Effects In this case, you will substitute based on total utility, even though you were given $3 to compensate for the increase in the price of ice cream You will now buy 3 Big Macs and 2 ice creams McGraw-Hill/Irwin Colander, Economics 18

19 Why? Income and Substitution Effects We are looking for the greatest MU/P: We will consume the 1 st ice cream, the 1 st Big Mac, the 2 nd ice cream, the 2 nd Big Mac, and the 3 rd Big Mac Big Macs (P = $2) Q TU MU MU/P Ice Cream (P = $2) Q TU MU MU/P

20 Quantity of Tacos Utility and Consumer Surplus Tacos cost $2 and pizza costs $1. What is the consumer surplus if Mary consumes 3 tacos? Total Benefit of Tacos Quantity of Pizzas Total Benefit of Pizza 0 $0 0 $0 1 $6 1 $6 2 $10 2 $10 3 $12 3 $

21 Quantity of Tacos Utility and Consumer Surplus Tacos cost $2 and pizza costs $1. What is the consumer surplus if Mary consumes 3 tacos? Total Benefit of Tacos Quantity of Pizzas Total Benefit of Pizza 0 $0 0 $0 1 $6 1 $6 2 $10 2 $10 3 $12 3 $12 The total benefit of 3 tacos is $12. 3 tacos will cost Mary $6. CS= $12-$6= $

22 Quantity of Tacos Utility and Optimal Combination Tacos cost $2 and pizza costs $1. What is Mary s optimal combination if she has $7 to spend? Total Benefit of Tacos Quantity of Pizzas Total Benefit of Pizza 0 $0 0 $0 1 $6 1 $6 2 $10 2 $10 3 $12 3 $

23 Quantity of Tacos Total Benefit of Tacos Utility and Optimal Combination Tacos cost $2 and pizza costs $1. What is Mary s optimal combination if she has $7 to spend? MB of Tacos MU/P Tacos Quantity of Pizzas Total Benefit of Pizza MB of Pizza MU/P Pizza 0 $ $ $ $ $ $ $ $ First we need to calculate MB (MU) and MU/P. Find where the MU/P for tacos is equal to that for pizza. Her optimal quantity would be 2 tacos and 3 pizzas

24 Utility and Optimal Combination Tacos cost $2 and pizza now costs $2. What is Mary s optimal combination if she now has $8 to spend? Quantity of Tacos Total Benefit of Tacos MB of Tacos MU/P Tacos Quantity of Pizzas Total Benefit of Pizza MB of Pizza MU/P Pizza 0 $ $ $ $ $ $ $ $ Although Mary had an extra dollar to spend, her optimal quantity would be 2 tacos and 2 pizzas