Chapter 6 ECON4 William A. McEachern

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Consumer

Choice and

Demand

2

Utility Analysis• Utility

– Sense of pleasure, or satisfaction that comes from consumption

– Subjective• Assumption

– Taste are given– Tastes are relatively stable

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Utility Analysis• Total utility

– Total satisfaction you derive from consumption• Of consuming a particular good • Or from all consumption

• Marginal utility– Change in total utility from one-unit

change in consumption

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Law of Diminishing Marginal Utility

• Law of diminishing marginal utility– The more of a good consumed

• The smaller the increase in total utility• Other things constant

• Marginal utility from each additional unit– Declines as more is consumed

• Disutility– Negative marginal utility

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Measuring Utility• Units of utility

– Each person has a uniquely subjective utility scale

• Total utility– Sum of marginal utilities

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Exhibit 1

6

Utility Derived From Drinking Water After Running Four Miles

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Exhibit 2

7

Total Utility and Marginal Utility You Derive From Drinking Water After Running Four Miles

5 Glasses (8-ounce)43210

20

40

60

80

Tota

l util

ity

(a) Total utility

(b) Marginal utility

5 Glasses (8-ounce)4321

0

20

40

Mar

gina

l util

ity

Total utility, shown in panel (a), increases with each of the first four glasses of water consumed but by smaller and smaller amounts. The fifth glass causes total utility to fall, implying that marginal utility is negative, as shown in panel (b).

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Utility Maximization without Scarcity

• Free good– Increase consumption as long as

marginal utility is positive• Two free goods

– Increase consumption of each good– Until the marginal utility of each is 0

• Tastes, preferences

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Exhibit 3

9

Total and Marginal Utilities From Pizza and Movies

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Utility Maximization with Scarcity• Goods – not free• Tastes, preferences• Limited income• Maximize utility

– Equilibrium– Any affordable change will reduce utility

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Utility-Maximizing Conditions• Consumer 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

11

p m

p m

MU MU

p p

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MU and the Law of Demand• Exhibit 3

– Max U; budget = $40• Qp = 3; Pp = $8; one point on D curve

• (Qm = 4 ; Pm = $4)

• Price of pizza drops to $6, other things constant (Exhibit 4) – Max U; budget = $40

• Qp = 4; Pp = $6; second point on D curve

• (Qm = 4 ; Pm = $4)

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Exhibit 4

13

Total and Marginal Utilities From Pizza and Movies After the Price of Pizza Decreases From $8 to $6

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Exhibit 5

14

Demand for Pizza Generated From Marginal Utility

2

4

6

$8

Pric

e pe

r pi

zza

Pizzas per week3210 4

D

a

b

At a price of $8 per pizza, the consumer is in equilibrium when consuming three pizzas per week (point a). Marginal utility per dollar is the same for all goods consumed. If the price falls to $6, the consumer increases consumption to four pizzas (point b). Points a and b are two points on this consumer’s demand curve for pizza.

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Consumer Surplus• Marginal valuation

– The dollar value of the marginal utility derived from consuming each additional unit of a good

• Consumer surplus– Consumer bonus– Value of total utility minus total spending– Area under the demand curve, above the

price

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Exhibit 6

16

D

2

4

6

$8

Pric

e pe

r su

bs

7

5

3

1

Subs per month3210 4 5 6 7 8The first one is valued at $7, the second at $6, the third at $5, and the fourth at $4. The consumer values four at $22. Because the consumer pays $4 per sub, all four can be purchased for $16. The difference between what the consumer would have been willing to pay ($22) and what the consumer actually pays ($16) is called consumer surplus. When the price is $4, the consumer surplus is $6, as represented by the dark shaded area under the demand curve above $4. When the price of subs falls to $3, consumer surplus increases by $4, as reflected by the lighter shaded area.

Consumer Surplus From Sub SandwichesAt a given quantity of sub sandwiches, the height of the demand curve shows the value of the last one purchased. The area under the demand curve for a specific quantity shows the total value a consumer attaches to that quantity. At a price of $4, the consumer purchases four subs.

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Market Demand &Consumer Surplus

• Market demand 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

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Exhibit 7

18

Summing Individual Demand Curves to Derive the Market Demand for Sub Sandwiches

0 2 4 6

Pric

e

2

4

$6

dY

(a) Your demand

0 2 4

2

4

$6

dB

(b) Brittany’s demand

0 2Subs per month

2

4

$6

dC

(c) Chris’s demand

0 2 6 12

2

4

$6

dY+dB+dC=D

(d) Market demand

At a price of $4 per sub, you demand 4 per month, Brittany demands 2, and Chris demands 0. Quantity demanded at a price of $4 is 4+2+0=6 subs per month. At a lower price of $2, you demand 6, Brittany demands 4, Chris demands 2. Quantity demanded at a price of $2 is 12 subs. The market demand curve D is the horizontal sum of individual demand curves dY, dB, and dC.

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Exhibit 8

19

Market Demand and Consumer Surplus

0 Quantity per period

D1

$2

Pric

e pe

r un

it

Consumer surplus at a price of $2 is shown by the darker area. If the price falls to $1, consumer surplus increases to include the lighter area. At a zero price, consumer surplus increases to include the entire area under the demand curve.

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Role of Time in Demand• Consumption

– Money price– Time price

• Willing to pay premium for time-saving goods– Opportunity cost of time

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