Marg Util Powerpoint

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CChapter 5hapter 5Marginal Utility Marginal Utility and Consumer and Consumer

ChoiceChoice

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2Gottheil - Principles of Economics, 4e

Economic PrinciplesEconomic Principles

Total utility and marginal utilityLaw of diminishing marginal utilityRelationship between the law of demand and the marginal-utility-to-price ratioConsumer surplusDifficulties with interpersonal comparison of utility

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What is Marginal What is Marginal Utility?Utility?

Util

• It is a hypothetical unit used to measure how much utility a person obtains from consuming a good.

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Utility measures the satisfaction or enjoyment a person obtains from consuming a good.

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Law of Diminishing Marginal Utility

• It is the idea that as more of a good is consumed, the utility a person derives from each additional unit diminishes.


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The implication of someone experiencing increasing marginal utility for pizza slices is:• The next slice of pizza would generate higher marginal utility than the one before.


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The implication of someone experiencing increasing marginal utility for pizza slices is:• When his stomach is full to bursting from eating so much pizza, the marginal utility from eating yet another slice would be higher than for any of the preceding slices.


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The implication of someone experiencing increasing marginal utility for pizza slices is:• It is not clear that someone could survive having increasing marginal utility!


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It possible for marginal utility to become negative.• For example, if you overeat and feel ill, then the marginal utility for the last bit of food you ate is negative.


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Economics, 4e

A rational consumer will not knowingly pay to buy a unit of a good that generates negative marginal utility.• Presumably something else could be bought that generates positive marginal utility. • Buying something that generates negative marginal utility is not consistent with utility maximization.


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Economics, 4e

EXHIBIT 1 TOTAL UTILITY AND MARGINAL UTILITY DERIVED FROM CONSUMING T-BONE STEAKS (UTILS)

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Economics, 4e

Exhibit 1: Total Utility and Exhibit 1: Total Utility and Marginal Utility Derived From Marginal Utility Derived From

Consuming T-Bone Steaks Consuming T-Bone Steaks (utils)(utils)If marginal utility is declining,

but is still positive, total utility is:• Total utility increases as long as marginal utility is positive.

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Economics, 4e

If marginal utility is declining, but is still positive, total utility is:• In Exhibit 1, total utility reaches its maximum at five t-bone steaks. Consuming more than five steaks will reduce total utility.

Exhibit 1: Total Utility and Exhibit 1: Total Utility and Marginal Utility Derived Marginal Utility Derived From Consuming T-Bone From Consuming T-Bone

Steaks (utils)Steaks (utils)

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EXHIBIT 2A TOTAL AND MARGINAL UTILITY

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EXHIBIT 2B TOTAL AND MARGINAL UTILITY

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Exhibit 2: Total and Exhibit 2: Total and Marginal UtilityMarginal Utility

In Exhibit 2, the curves in Panel a and b represent:• The curve in Panel a is the total utility curve for T-bone steaks.• Panel a depicts the number of utils, or the amount of utility, a person gains from consuming a certain number of steaks.

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Economics, 4e

In Exhibit 2, the curves in Panel a and b represent:• Total utility peaks at 81 utils, or 5 steaks. Each steak consumed beyond 5 reduces total utility.


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Economics, 4e

In Exhibit 2, the curves in Panel a and b represent:• The curve in Panel b is the marginal utility curve for T-bone steaks. • The curve depicts the change in total utility a person derives from consuming each additional steak.


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Economics, 4e

In Exhibit 2, the curves in Panel a and b represent:• When marginal utility is zero, total utility is maximized.


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Economics, 4e

What Is Marginal What Is Marginal Utility?Utility?

If water is necessary for life, then the market price of water so much lower than for diamonds because:• Market price reflects marginal utility, not total utility. • Due to diminishing marginal utility and the abundance of water, the marginal utility of water is lower than for diamonds.

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Economics, 4e

A hypothetical circumstance in which the marginal utility of water might exceed the marginal utility of a diamond:• If you are lost in the desert and are severely dehydrated, then your marginal utility for a gallon of water might exceed your marginal utility for a diamond.


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Economics, 4e

French Cuisine and French Cuisine and Marginal UtilityMarginal UtilityMany courses, each with small

portions of food (French cuisine), may generate more utility than one course with a large portion of food because:• One large portion will drive down marginal utility. • Marginal utility is high for the whole meal.

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Economics, 4e

EXHIBIT 3 MARGINAL UTILITIES OF CLOTHES AND AMUSEMENT GOODS (UTILS)

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Economics, 4e

Exhibit 3: Marginal Utilities of Exhibit 3: Marginal Utilities of Clothes Clothes

and Amusement Goods (Utils)and Amusement Goods (Utils)Based on the utility data in Exhibit 3, a rational consumer will select the best combination of clothes and amusement goods:• By sequentially picking units of clothing and amusement goods that generate the largest MU/P.

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Economics, 4e

EXHIBIT 4 MARGINAL-UTILITY-TO-PRICE RATIOS OF CLOTHES AND AMUSEMENT GOODS (MU/P)

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Exhibit 4: Marginal-Utility-to-Price Exhibit 4: Marginal-Utility-to-Price Ratios of Clothes and Amusement Ratios of Clothes and Amusement

Goods Goods (MU/P)(MU/P)If a unit of clothes and amusement goods both cost $10, and if you have $80 to spend, the rational consumer will spend her money:• MU/P is equal when three units of clothes and five units of amusement goods are purchased (MU/P = 1.4).

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Economics, 4e

Marginal-Utility-to-Marginal-Utility-to-Price RatioPrice Ratio

Marginal-utility-to-price ratio

• The ratio is calculated by dividing the marginal utility of a good by the price of the good—MU/P.

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The MU/P equalization principle

• A person’s total utility is maximized when the ratios of marginal utility to price for the last unit of each of the goods consumed are equal.

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The MU/P equalization principle:

• MU/P measures marginal utility per dollar spent.

• Total utility will be maximized (within the constraints of a limited budget) when each individual purchase generates the largest possible MU/P.

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Economics, 4e



• A rational and fully-informed consumer will always shift a dollar from a good whose MU/P is lower to one whose MU/P is higher, if such a shift is possible.

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• The principle is based on consumer behavior.• Consumers will always arrange their sequence of choices among goods starting with the highest MU/P and running down to exhaust an expenditure budget.

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• The consumer choice process is in equilibrium when:• There is no longer any incentive for the consumer to rearrange her purchases.• The MU/P is equal for the last unit of each good or service consumed.

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Economics, 4e

EXHIBIT 5 COMPARING MU/Ps AFTER A 20-PERCENT- OFF SALE ON CLOTHES

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Economics, 4e

Exhibit 5: Comparing Exhibit 5: Comparing MU/PsMU/Ps After a 20 Percent After a 20 Percent

Off Sale on ClothesOff Sale on ClothesThe MU/P of clothes changes when there is a 20 percent off sale on clothes by:• MU/P for each unit of clothing rises when price is reduced by 20 percent.• This will cause a rational consumer to consume more clothes.

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Economics, 4e

EXHIBIT 6 COMPARING MU/Ps AFTER A 50-PERCENT- OFF SALE ON CLOTHES

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Economics, 4e

Exhibit 6: Comparing Exhibit 6: Comparing MU/PsMU/Ps After a 50 Percent After a 50 Percent

Off Sale on ClothesOff Sale on ClothesAn additional reduction in the price of clothing will change all of the MU/Ps for clothing, and thus change a rational consumer’s consumption of clothing.• If the price of clothes falls again, from $8 to $5, the quantity of clothing demanded increases from four to six units.

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Economics, 4e

EXHIBIT 7 THE DEMAND CURVE FOR CLOTHES

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Exhibit 7: The Demand Exhibit 7: The Demand CurveCurve

for Clothesfor ClothesWhen the price of clothing falls from $10 to $8 to $5, which of the following occurs:• Quantity demanded remains the same.

• Quantity demanded falls from 6 to 4 to 3.

• Quantity demanded rises from 3 to 4 to 6.

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Economics, 4e

Exhibit 7: The Demand Exhibit 7: The Demand CurveCurve

for Clothesfor ClothesWhen the price of clothing falls from $10 to $8 to $5, which of the following occurs:• Quantity demanded remains the same.

• Quantity demanded falls from 6 to 4 to 3.

• Quantity demanded rises from 3 to 4 to 6.

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Economics, 4e

MU/P Equalization MU/P Equalization Principle and the Law Principle and the Law

of Demandof DemandChanges in the marginal-utility-to-price ratio are caused by:• A change in the marginal utility of a good or a change in the price of a good changes the marginal-utility-to-price ratio, and therefore changes quantity demanded.

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Economics, 4e


of Demandof DemandThe relationship between the MU/P Principle and the Law of Demand:If the price of a good falls:• MU/P rises.• The rational consumer will increase her consumption of that good.• Increase in quantity demanded (movement along the demand curve).

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of Demandof DemandThe relationship between the MU/P Principle and the Law of Demand:If consumer preference for a good decreases:• MU/P declines.• The rational consumer will reduce consumption.• The demand curve shifts to the left (since consumer preference is a nonprice factor).

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Economics, 4e


of Demandof DemandThe relationship between the MU/P Principle and the Law of Demand:If consumer income increases:• The consumer can pursue a lower MU/P.• The consumer can afford to increase consumption.• An increase in the demand for normal goods.

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Economics, 4e


of Demandof DemandA downward-sloping demand curve is consistent with the law of diminishing marginal utility.• Diminishing marginal utility means that MU/P declines as quantity consumed increases.

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Economics, 4e


of Demandof DemandA downward-sloping demand curve is consistent with the law of diminishing marginal utility.• A consumer’s willingness-to-pay falls as quantity consumed increases.

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Economics, 4e

Are White Rats Are White Rats Rational Consumers?Rational Consumers?There is evidence that lab rats make consumer choices based on MU/P.

• Economists Battalio and Kagel found that white lab rats respond to price and income changes in a manner consistent with economic theory.

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Economics, 4e

The The MU/PMU/P Guide to Guide to Auction BiddingAuction Bidding

MU/P can help guide auction bidding:• If a particular MU/P is guaranteed by buying something outside of the auction, and if the marginal utility from the auction good is known, then you can figure out your maximum auction price.

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Economics, 4e

Creating Consumer Creating Consumer SurplusSurplus

Consumer surplus

• The difference between the maximum price a person would be willing to pay for a good or service, and the price the person actually pays. • Most consumers receive some consumer surplus from a transaction.

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Economics, 4e


When market price falls, consumer surplus increases.

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Economics, 4e


If the price of a good is greater than amount a consumer is willing to pay for that good, the consumer surplus will be negative if the consumer buys the good.

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Economics, 4e


A rational consumer will not purchase a good that generates negative consumer surplus.• A rational consumer will prefer zero consumer surplus (no purchase) to negative consumer surplus.

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EXHIBIT 8 THE MARKET FOR HORSEBACK RIDING

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Economics, 4e

Exhibit 8: The Market forExhibit 8: The Market forHorseback RidingHorseback Riding

Exhibit 8 depicts the demand and supply curves for horseback riding. The concept of consumer surplus applies to horseback riding:• At a price of $6, all consumers with a willingness-to-pay value of $6 or more will purchase a horseback ride.• These consumers receive consumer surplus.

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Economics, 4e

Exhibit 8 depicts the demand and supply curves for horseback riding. The concept of consumer surplus applies to horseback riding:• Some consumer may be willing to pay $10 for a horseback ride.• This consumer will receive $(10 - 6) = $4 of consumer surplus.

Exhibit 8: The Market Exhibit 8: The Market for Horseback Ridingfor Horseback Riding

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Exhibit 8 depicts the demand and supply curves for horseback riding. The concept of consumer surplus applies to horseback riding:A consumer who has a willingness-to-pay value less than $6:

• Will not choose to purchase a ride (a rational consumer).

• Has a negative consumer surplus.

Exhibit 8: The Market Exhibit 8: The Market for Horseback Ridingfor Horseback Riding

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Economics, 4e

EXHIBIT 9 CONSUMER SURPLUS ON THE HORSEBACK-RIDING MARKET

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Exhibit 9: Consumer Exhibit 9: Consumer Surplus on the Horseback-Surplus on the Horseback-

Riding MarketRiding MarketKim’s consumer surplus from horseback riding is:• $(15 - 6) for the first ride.

• $(12 - 6) for the second ride.• $(9 - 6) for the third ride.• $(6 - 6) for the fourth ride.• These sum to $(9 + 6 + 3 + 0) = $18.

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Economics, 4e


Riding MarketRiding MarketTony’s consumer surplus from horseback riding is:• $(10 - 6) for the first ride.• $(8 - 6) for the second ride.• $(6 - 6) for the fourth ride.• These sum to $(4 + 2 + 0) = $6.

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Economics, 4e


Riding MarketRiding MarketRandy’s consumer surplus from horseback riding is:• $(9 - 6) for the first ride.• $(6 - 6) for the fourth ride.• These sum to $(3 + 0) = $3.

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Economics, 4e


Riding MarketRiding MarketIf Kim, Tony and Randy represent the entire market demand for horseback riding, the total consumer surplus is:• $18 (Kim) + $6 (Tony) + $3 (Randy)

= $27 in consumer surplus

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Economics, 4e

Interpersonal Interpersonal ComparisonsComparisons

of Utilityof UtilityAn interpersonal comparison of utility• It is a comparison of the marginal utilities that different people derive from a good or a dollar.

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Economics, 4e


of Utilityof UtilityIs it actually possible to compare the satisfaction that different people derive from a good or a dollar?• It is not possible to make an exact comparison of different peoples’ utility.

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Economics, 4e


of Utilityof UtilityIs it actually possible to compare the satisfaction that different people derive from a good or a dollar?• Policies such as those aimed at poverty alleviation rely on society being able to make approximate or reasonable comparisons of utility across different people.

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Marg Util Powerpoint