Marginal Utility Theory The purpose of marginal utility theory is to explain an individual households demand Marginal utility theory predicts that individual demand curves slope downward Therefore market demand curves must also slope downward ID: 1027779
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1. CHAPTERS 8Utility and Demand
2. Marginal Utility TheoryThe purpose of marginal utility theory is to explain an individual household’s demand.Marginal utility theory predicts that individual demand curves slope downward.Therefore, market demand curves must also slope downward.
3. Household Consumption ChoicesTwo factors determine a household’s consumption choices:Its budget constraint (how much money it has to spend and the prices of each good or service it buys)Its preferences (how much it likes each good relative to others)
4. Budget ConstraintA household’s consumption choices are constrained by its income and by the prices of the goods and services it buys.The limits to a household’s consumption choices are described by its budget constraint or sometimes called its budget line.
5. Example - Lisa’s Consumption PossibilitiesLisa has $30 per month to spend on movies and soda.Movies cost $6 each. If she spends her entire budget on movies, she can see 5 per month.Soda costs $3 per six-pack. If she spends her entire budget on soda, she can drink 10 six-packs a month.
6. Movies ($6) Soda ($3) Expenditure ExpenditurePossibility Q (dollars) Q (dollars) a 0 0 10 30 b 1 6 8 24 c 2 12 6 18 d 3 18 4 12 e 4 24 2 6 f 5 30 0 0Consumption Possibilities
7. Consumption PossibilitiesMovies (per month)0 1 2 3 4 5246810Soda (six-packs per month)abcdef
8. Consumption PossibilitiesMovies (per month)0 1 2 3 4 5246810abcdefSoda (six-packs per month)Each point on line exhausts the entire $30 budget
9. AffordableConsumption PossibilitiesMovies (per month)0 1 2 3 4 5246810abcdefUnaffordableSoda (six-packs per month)
10. PreferencesThe combination of goods and services a person chooses to consume from the available choices on the budget line is determined by their likes and dislikes — their preferences.The satisfaction a person gets from consumption is called utility.
11. Lisa’s PreferencesHow Lisa spends her $30 per month depends on her preferences for movies and soda. Each additional movie or soda she consumes increases her total utility.
12. Utility Is an Abstract ConceptWe cannot directly observe values for utility.However, each of us knows what we like and what we dislike.We will consume more of the goods and services we like and less of those we dislike.
13. Total UtilityTotal utility is the total benefit or satisfaction that a person gets from the consumption of goods and services.Total utility depends on the level of consumption — more consumption generally increases total utility.
14. Lisa’s Total UtilityThe more movies Lisa sees each month, the greater her total utility from movies.The more soda Lisa drinks each month, the greater her total utility from soda.
15. Marginal UtilityMarginal utility is the change in total utility resulting from a one-unit increase in the quantity of a good consumed.
16. Total Utility and Marginal UtilityQuantity Total utility Marginal utility 0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250Movies -
17. Total Utility and Marginal UtilityQuantity Total utility Marginal utilityMovies -50 0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
18. Total Utility and Marginal UtilityQuantity Total utility Marginal utilityMovies -5038 0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
19. Total Utility and Marginal UtilityQuantity Total utility Marginal utilityMovies -503833 0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
20. Total Utility and Marginal UtilityQuantity Total utility Marginal utilityMovies -50383329 0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
21. Total Utility and Marginal UtilityQuantity Total utility Marginal utilityMovies -5038332925 0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
22. Total Utility and Marginal UtilityQuantity Total utility Marginal utilityMovies -503833292521 0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
23. Total Utility and Marginal UtilityQuantity Total utility Marginal utilityMovies -50383329252118 0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
24. Total Utility and Marginal UtilityQuantity Total utility Marginal utilityMovies -5038332925211815 0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
25. Total Utility and Marginal UtilityQuantity Total utility Marginal utilityMovies -503833292521181512 0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
26. Total Utility and Marginal UtilityQuantity Total utility Marginal utilityMovies -503833292521181512 9 0 0 1 50 2 88 3 121 4 150 5 175 6 196 7 214 8 229 9 24110 250
27. Diminishing Marginal UtilityAs consumption of a good or service increases, the incremental (or marginal) satisfaction we get from consuming one more unit decreases.This decrease is called the principle of diminishing marginal utility.
28. Total Utility and Marginal Utility0 1 2 3 4 5Units of utility 50 501001502000 1 2 3 4 5Quantity (movies per month)Units of utilityQuantity (movies per month)
29. 0 1 2 3 4 5 50 501001502000 1 2 3 4 5Quantity (movies per month)Units of utilityTotalutilityQuantity (movies per month)Total Utility and Marginal UtilityUnits of utility
30. 500 1 2 3 4 5 50 501001502000 1 2 3 4 5Quantity (movies per month)Units of utilityIncreasingtotal utility...TotalutilityQuantity (movies per month)Total Utility and Marginal UtilityUnits of utility
31. 38500 1 2 3 4 5 50…and diminishingmarginal utility 501001502000 1 2 3 4 5Quantity (movies per month)Units of utilityIncreasingtotal utility...TotalutilityQuantity (movies per month)Total Utility and Marginal UtilityUnits of utility
32. 3338500 1 2 3 4 5 50…and diminishingmarginal utility 501001502000 1 2 3 4 5Quantity (movies per month)Units of utilityIncreasingtotal utility...TotalutilityQuantity (movies per month)Total Utility and Marginal UtilityUnits of utility
33. 293338500 1 2 3 4 5 50…and diminishingmarginal utility 501001502000 1 2 3 4 5Quantity (movies per month)Units of utilityIncreasingtotal utility...TotalutilityQuantity (movies per month)Total Utility and Marginal UtilityUnits of utility
34. 25293338500 1 2 3 4 5 50…and diminishingmarginal utility 501001502000 1 2 3 4 5Quantity (movies per month)Units of utilityIncreasingtotal utility...TotalutilityQuantity (movies per month)Total Utility and Marginal UtilityUnits of utility
35. 25293338500 1 2 3 4 5 50…and diminishingmarginal utilityMarginalutility 501001502000 1 2 3 4 5Quantity (movies per month)Units of utilityIncreasingtotal utility...TotalutilityQuantity (movies per month)Total Utility and Marginal UtilityUnits of utility
36. Total Utility and Marginal UtilityQuantity Total utility Marginal utility Soda - 0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
37. Total Utility and Marginal UtilityQuantity Total utility Marginal utility Soda -75 0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
38. Total Utility and Marginal UtilityQuantity Total utility Marginal utility Soda -7542 0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
39. Total Utility and Marginal UtilityQuantity Total utility Marginal utility Soda -754236 0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
40. Total Utility and Marginal UtilityQuantity Total utility Marginal utility Soda -75423628 0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
41. Total Utility and Marginal UtilityQuantity Total utility Marginal utility Soda -7542362825 0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
42. Total Utility and Marginal UtilityQuantity Total utility Marginal utility Soda -754236282519 0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
43. Total Utility and Marginal UtilityQuantity Total utility Marginal utility Soda -75423628251918 0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
44. Total Utility and Marginal UtilityQuantity Total utility Marginal utility Soda -7542362825191817 0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
45. Total Utility and Marginal UtilityQuantity Total utility Marginal utility Soda -754236282519181716 0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
46. Total Utility and Marginal UtilityQuantity Total utility Marginal utility Soda -75423628251918171615 0 0 1 75 2 117 3 153 4 181 5 206 6 225 7 243 8 260 9 27610 291
47. Maximizing UtilityA household’s income and the prices it faces limit the total utility it can obtain.We assume that households consume the quantities of goods and services that maximize total utility.People must make hard choices because wants exceed resources.
48. The Utility-maximizing ChoiceA consumer equilibrium is a situation in which a consumer has allocated his or her income in the way that, given the prices of goods and services, maximizes his or her total utility.
49. Lisa's Affordable Combinations Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per montha 0 0 291 10b 1 50 260 8c 2 88 225 6d 3 121 181 4e 4 150 117 2f 5 175 0 0
50. Lisa's Affordable Combinations Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per montha 0 0 291 291 10b 1 50 260 8c 2 88 225 6d 3 121 181 4e 4 150 117 2f 5 175 0 0
51. Lisa's Affordable Combinations Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per montha 0 0 291 291 10b 1 50 310 260 8c 2 88 225 6d 3 121 181 4e 4 150 117 2f 5 175 0 0
52. Lisa's Affordable Combinations Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per montha 0 0 291 291 10b 1 50 310 260 8c 2 88 313 225 6d 3 121 181 4e 4 150 117 2f 5 175 0 0
53. Lisa's Affordable Combinations Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per montha 0 0 291 291 10b 1 50 310 260 8c 2 88 313 225 6d 3 121 302 181 4e 4 150 117 2f 5 175 0 0
54. Lisa's Affordable Combinations Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per montha 0 0 291 291 10b 1 50 310 260 8c 2 88 313 225 6d 3 121 302 181 4e 4 150 267 117 2f 5 175 0 0
55. Lisa's Affordable Combinations Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per montha 0 0 291 291 10b 1 50 310 260 8c 2 88 313 225 6d 3 121 302 181 4e 4 150 267 117 2f 5 175 175 0 0
56. Lisa's Affordable Combinations Movies Soda Total utility Quantity from movies Six-packs per month Total utility and soda Total utility per montha 0 0 291 291 10b 1 50 310 260 8c 2 88 313 225 6d 3 121 302 181 4e 4 150 267 117 2f 5 175 175 0 0
57. Equalizing Marginal Utility Per Dollar SpentThe allocation that maximizes total utility will also make the marginal utility per dollar spent on each good equal for all goods.The marginal utility per dollar spent is the marginal utility obtained from the last unit of a good consumed divided by the price of the good.
58. Maximizing Total UtilityTotal utility is maximized when all the consumer’s income is spent and when the marginal utility per dollar spent is equal for all goods.If all income is not spent, utility could be improved by spending more. Therefore, the consumer will spend all income.
59. Lisa Maximizes UtilityShe spends all her income andMUmovies/ Pmovies = MUsoda/ PsodaEquivalently:MUmovies/MUsoda = Pmovies/ Psoda
60. Equalizing Marginal Utilities Per Dollar Spenta 0 0 - 10 15 b 1 50 8 17 c 2 38 6 19 d 3 33 4 28 e 4 29 2 42 f 5 25 0 0 - Movies ($6 each) Soda ($3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
61. Equalizing Marginal Utilities Per Dollar Spenta 0 0 - 10 15 b 1 50 8.33 8 17 c 2 38 6 19 d 3 33 4 28 e 4 29 2 42 f 5 25 0 0 - Movies ($6 each) Soda ($3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
62. Equalizing Marginal Utilities Per Dollar Spenta 0 0 - 10 15 b 1 50 8.33 8 17 c 2 38 6.33 6 19 d 3 33 4 28 e 4 29 2 42 f 5 25 0 0 - Movies ($6 each) Soda ($3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
63. Equalizing Marginal Utilities per Dollar Spenta 0 0 - 10 15 b 1 50 8.33 8 17 c 2 38 6.33 6 19 d 3 33 5.50 4 28 e 4 29 2 42 f 5 25 0 0 - Movies ($6 each) Soda ($3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
64. Equalizing Marginal Utilities Per Dollar Spenta 0 0 - 10 15 b 1 50 8.33 8 17 c 2 38 6.33 6 19 d 3 33 5.50 4 28 e 4 29 4.83 2 42 f 5 25 0 0 - Movies ($6 each) Soda ($3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
65. Equalizing Marginal Utilities Per Dollar Spenta 0 0 - 10 15 b 1 50 8.33 8 17 c 2 38 6.33 6 19 d 3 33 5.50 4 28 e 4 29 4.83 2 42 f 5 25 4.17 0 0 - Movies ($6 each) Soda ($3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
66. Equalizing Marginal Utilities Per Dollar Spenta 0 0 - 10 15 5.00b 1 50 8.33 8 17 c 2 38 6.33 6 19 d 3 33 5.50 4 28 e 4 29 4.83 2 42 f 5 25 4.17 0 0 - Movies ($6 each) Soda ($3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
67. Equalizing Marginal Utilities Per Dollar Spenta 0 0 - 10 15 5.00b 1 50 8.33 8 17 5.67c 2 38 6.33 6 19 d 3 33 5.50 4 28 e 4 29 4.83 2 42 f 5 25 4.17 0 0 - Movies ($6 each) Soda ($3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
68. Equalizing Marginal Utilities Per Dollar Spenta 0 0 - 10 15 5.00b 1 50 8.33 8 17 5.67c 2 38 6.33 6 19 6.33d 3 33 5.50 4 28 e 4 29 4.83 2 42 f 5 25 4.17 0 0 - Movies ($6 each) Soda ($3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
69. Equalizing Marginal Utilities Per Dollar Spenta 0 0 - 10 15 5.00b 1 50 8.33 8 17 5.67c 2 38 6.33 6 19 6.33d 3 33 5.50 4 28 9.33e 4 29 4.83 2 42 f 5 25 4.17 0 0 - Movies ($6 each) Soda ($3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
70. Equalizing Marginal Utilities Per Dollar Spenta 0 0 - 10 15 5.00b 1 50 8.33 8 17 5.67c 2 38 6.33 6 19 6.33d 3 33 5.50 4 28 9.33e 4 29 4.83 2 42 14.00f 5 25 4.17 0 0 - Movies ($6 each) Soda ($3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
71. Equalizing Marginal Utilities Per Dollar Spenta 0 0 - 10 15 5.00b 1 50 8.33 8 17 5.67c 2 38 6.33 6 19 6.33d 3 33 5.50 4 28 9.33e 4 29 4.83 2 42 14.00f 5 25 4.17 0 0 - Movies ($6 each) Soda ($3 per six-pack) Marginal Marginal utility utility Marginal per dollar Marginal per dollar Quantity utility spent Quantity utility spent
72. Lisa Maximizes UtilityShe spends all her income andMUmovies/ Pmovies = MUsoda/ Psoda (38/6) = (19/3) = 6.33Equivalently:MUmovies/MUsoda = Pmovies/ Psoda (38/19) = (6/3) = 2
73. Why the Marginal Utility Rule Maximizes Total UtilityCase IIf the ratio of marginal utility to price is higher for movies than for soda, Lisa can increase total utility by consuming less soda and more movies.If MUmovies/ Pmovies > MUsoda/ Psoda then the next movie provides more satisfaction per dollar than a soda.
74. Why the Marginal Utility Rule Maximizes Total UtilityCase IIIf the ratio of marginal utility to price is lower for movies than for soda, Lisa can increase total utility by consuming more soda and less movies.If MUmovies/ Pmovies < MUsoda/ Psoda then the next soda provides more satisfaction per dollar than a movie.
75. Equalizing Marginal Utilities Per Dollar SpentMoviesSodaPossibility0 1 2 3 4 510 8 6 4 2 0a b c d e f4.008.33 12.0016.006.335.67Marginal utility per dollar spent(units of utility per dollar)
76. Equalizing Marginal Utilities Per Dollar SpentMoviesSodaPossibility0 1 2 3 4 510 8 6 4 2 0a b c d e f4.008.33 12.0016.006.335.67Marginal utility per dollar spent(units of utility per dollar)MUm Pm
77. Equalizing Marginal Utilities Per Dollar SpentMoviesSodaPossibility0 1 2 3 4 510 8 6 4 2 0a b c d e f4.008.33 12.0016.006.335.67MUs PsMUm PmMarginal utility per dollar spent(units of utility per dollar)
78. Equalizing Marginal Utilities Per Dollar SpentMoviesSodaPossibility0 1 2 3 4 510 8 6 4 2 0a b c d e f4.008.33 12.0016.006.335.67MUs PsMUm PmMaximumtotal utilityCase IIUtility gainfrom moresoda and fewer moviesCase IUtility gainfrom moremovies and less sodaMarginal utility per dollar spent(units of utility per dollar)
79. Consuming Only SodasMoviesSodaPossibility0 1 2 3 4 510 8 6 4 2 0a b c d e fMUs PsMUm PmMarginal utility per dollar spent(units of utility per dollar)
80. Consuming Only MoviesMoviesSodaPossibility0 1 2 3 4 510 8 6 4 2 0a b c d e fMUs PsMUm PmMarginal utility per dollar spent(units of utility per dollar)
81. The Power ofMarginal AnalysisThe method we have used to maximize Lisa’s utility is an example of marginal analysis.By comparing marginal gain with marginal loss, we can guarantee that total utility is maximized.
82. New Ways of Explaining Consumer ChoicesBehavioral EconomicsBehavioral economics studies the ways in which limits on the human brain’s ability to compute and implement rational decisions influence economic behavior—both the decisions that people make and the consequences of those decisions for the way markets work.There are three impediments to rational choice: Bounded rationalityBounded willpowerBounded self-interest
83. New Ways of Explaining Consumer ChoicesBounded RationalityBounded rationality is rationality that is limited by the computing power of the human brain. Faced with uncertainty, consumers cannot rationally make choices and instead rely on other decision-making methods such as rules of thumb, listening to the views of others, or gut instinct.
84. New Ways of Explaining Consumer ChoicesBounded WillpowerBounded will-power is the less-than-perfect willpower that prevents us from making a decision that we know, at the time of implementing the decision, we will later regret.
85. New Ways of Explaining Consumer ChoicesBounded Self-InterestBounded self-interest is the limited self-interest that sometimes results in suppressing our own interests to help others. Main applications are in finance where uncertainty is the key factor and savings where future is the key factor.
86. New Ways of Explaining Consumer ChoicesOne behavior observed by behavioral economists is more general and might affect your choices.The Endowment Effect The endowment effect is the tendency for people to value something more highly simply because they own it.
87. New Ways of Explaining Consumer ChoicesNeuroeconomicsNeuroeconomics is the study of the activity of the human brain when a person makes an economic decision.Different decisions appear to activate different areas of the brain. Some decisions are madeIn the pre-frontal cortex where memories are stored and data analyzed and where decisions might be deemed rational. In the hippocampus where memories of anxiety and fear are stored and where decisions might be deemed irrational.
88. New Ways of Explaining Consumer ChoicesControversyShould economics focus on explaining the decisions we observe or should it focus on what goes on inside people’s heads?This is the controversy.For most economists, the goal of economics is to explain the decisions that we observe people make, and not to explain what goes on inside people’s heads.