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© The McGraw-Hill Companies, 2008 Utility (2) Total utility of eating five slices of pizza is the total happiness we get from eating all pizzas. If you are talking about eating the first, second, third, etc. slices of pizza, we are talking about the marginal utility. As you consume more pizzas, the total utility increases, however, the marginal utility decreases.
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©The McGraw-Hill Companies, 2008
Chapter 5Consumer choice and demand
decisions
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 9th Edition, McGraw-Hill, 2008
PowerPoint presentation by Alex Tackie and Damian Ward
©The McGraw-Hill Companies, 2008
Utility (1)
• Utility is a measure of happiness.
• However, we cannot say that one apple can make me twice as happy as one banana. So, utility is not a cardinal measure.
• We can easily say that I like apple more than banana. This kind of measure is called an ordinal measure.
©The McGraw-Hill Companies, 2008
Utility (2)
• Total utility of eating five slices of pizza is the total happiness we get from eating all pizzas.
• If you are talking about eating the first, second, third, etc. slices of pizza, we are talking about the marginal utility.
• As you consume more pizzas, the total utility increases, however, the marginal utility decreases.
©The McGraw-Hill Companies, 2008
Example Qx TUx MUx0 01 10 102 18 83 24 64 28 45 30 26 30 07 28 -2
4
The total and marginal utility of good x.
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Why the Demand Curve is Downward Sloping
• When you consume a good little, the marginal utility of the extra unit is high. Therefore, you are willing to pay a higher amount for the additional unit.
• MWP is the inverse function of demand.
• As you consume more, the MU decreases.
5
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Optimal Consumption• The solution which gives the
maximum utility is as follows: On the margin, the marginal utility per lira you get should be equal for all goods.
6
MUX1 = MUX2
Px1 Px2
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Four key elements in consumer choice
• Consumer’s income
• Prices of goods
• Consumer preferences
• The assumption that consumers maximise utility
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Four key elements in consumer choice
• Consumer’s income
• Prices of goods
• Consumer preferences
• The assumption that consumers maximise utility
©The McGraw-Hill Companies, 2008
The budget line
• Income and prices together determine the combinations of the goods that the consumer can afford.
• The slope of the budget line is the ratio of the prices. (relative price)
• If the income increases, the budget line shifts parallel to the right.
Consider a student with abudget of £50 to spend on meals and films.
0
1
2
3
4
5
6
0 2 4 6 8 10 12
MealsFi
lms
AB
CD
EF
G
Price of meals is £5;price of films is £10.
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Modelling consumer preferences
• Assume the consumer prefers more to less.
• Compared with point a:– the consumer would
prefer to be to the north-east, e.g. at c
– but prefers a to such points as b to the south-west.
Quantityof meals
Qua
ntit y
of f
il ms
a
b
c
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Modelling consumer preferences (2)
• a is preferred to all points in the dominated region
• but the consumer would prefer any point in the preferred region to a
• points like d and e involve more of one good and less of the other compared with a.
Quantityof meals
Qua
ntit y
of f
il ms
ab
c
Preferredregion
Dominatedregion
e
d
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• An indifference curve like U2U2 shows all the consumption bundles that yield the same utility to the consumer– ICs slope downwards
(given our assumptions)
– their slope gets steadily flatter to the right
– ICs cannot intersect
Modelling consumer preferences (3)
Quantityof meals
Qua
ntity
of f
ilms
U2
U2
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Marginal Rate of Substitution.
The slope at any point on an indifference curve is the marginal rate of substitution.• It is the rate at which a consumer is willing
to trade one good for another.• It is the amount of one good that a consumer
requires as compensation to give up one unit of the other good.
• The MRS decreases as you consume more of that good. This is called decreasing MRS.
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The consumer’s choice
• The choice point is at C• where the budget line is
at a tangent to an IC• Points B and E are also
affordable• but give lower utility,• being on a lower IC.
U3
Quantity of meals
Qua
ntity
of f
ilms
U2
U2U1
U3U1
BL
C
E
B
The point at which utility is maximised is found by bringing together the indifference curves (U) and the budget line (BL)
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Adjustment to an income change
• A change in the consumer’s income shifts the budget line
• without changing the slope• The change in the pattern of consumer
choice depends on the nature of the two goods
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Normal goods
When both goods areNORMAL, an increasein income induces a newchoice point at C'
The quantity demandedof each good increases
U2
U1
Meals
Film
s
BL0
BL1
C
C'
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An inferior good and a normal good
When “meals” is an inferior goodthe increase in income takes theconsumer from C to C'The quantity of meals falls andthe quantity of films increases
Meals
Film
s
BL0
BL1
U2
U1
C
C'
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Adjustment to a price change
• An increase in the price of one good shifts the budget line
– altering its slope
– which reflects relative prices.
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An increase in the price of meals (1)
The increase in price of meals shifts the budget line from BL0 to BL1
The increase in price reduces purchasing power.Meals
Film
s
BL0BL1
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An increase in the price of meals (2)
Meals
Film
s
BL0BL1
U2
C
U1
E
The consumer moves from C to E as the price of meals rises
H
The overall effect is a reduction in quantity of meals demanded
Tracing out more of such points at different prices enables us to identify the Demand curve.
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Response to a price change
• The response to a price change comprises two effects:
• The SUBSTITUTION EFFECT– is the adjustment to the change in relative prices.
More Expensive: Buy less• THE INCOME EFFECT
– is the adjustment to the change in real income. Higher income, buy more of the normal goods, buy less of the inferior goods.
Total change in the consumption of the goods are determined by adding up these two effects.
©The McGraw-Hill Companies, 2008
Deriving the market demand curve
Market
24
then market demand at a price of £5 will be 24 units.
Quantity
Pric
e
The market demand curve is the horizontal sum of the individual demand curves
Consumer 1
5
11
If at a price of £5, consumer 1 demands 11 units
Consumer 2
13
and consumer 2 demands 13 units
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