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

1. The Logic of Individual Choice:The Foundation of Supply and Demand Chapter 8

2. Utility Theory and Individual Choice • Economists have an answer to the question of why people behave as they do — self interest. • Economists' analysis of individual choice does not deny individual differences.

3. Utility Theory and Individual Choice • Using the simple concept of self-interest, two things determine what people do: • The pleasure people get from doing or consuming something. • The price of doing or consuming that something.

4. Utility Theory and Individual Choice • Price is the market's tool to bring quantity supplied equal to the quantity demanded. • Changes in price provide incentives for people to change what they are doing.

5. Measuring Pleasure • Economists start with a proposition that individuals try to get as much pleasure as possible out of life. • The goods and services we consume provide value (satisfaction) to us.

6. Measuring Pleasure • Individuals want to maximize the amount of satisfaction they receive through consuming goods and services.

7. Measuring Pleasure • Economists use the concept of utility—the pleasure or satisfaction that one gets from consuming a good or service. • A util is a unit created by economists to “measure” utility.

8. Utility • Utility serves as the basis of economists' analysis of individual choice. • It is personal and individual. • Utility cannot be compared across individuals.

9. Total Utility • Total utility refers to the total satisfaction one gets from consuming a product.

10. Marginal Utility • Marginal utility refers to the satisfaction one gets from the consumption of one additional unit of a product above and beyond what on has consumed up to that point.

11. Total Utility and Marginal Utility • As additional units are consumed, marginal utility decreases while total utility increases. • When marginal utility is zero, total utility stops increasing. • Beyond this point, marginal utility is negative and total utility decreases.

12. Number of pizza slices Total utility Marginal utility 14 1 14 12 2 26 10 3 36 8 4 44 6 5 50 4 6 54 2 7 56 0 8 56 -2 9 54 Marginal and Total Utility, Fig. 8-1a, p 180

13. 16 70 14 60 12 Total utility Marginal utility 50 10 40 8 6 30 4 20 2 10 0 1 2 3 4 5 6 7 8 9 0 -2 1 2 3 4 5 6 7 8 9 Slices of pizza per hour Slices of pizza per hour Marginal and Total Utility, Fig. 8-1b and c, p 180 Total utility Marginal utility Utils Utils

14. Diminishing Marginal Utility • The principle of diminishing marginal utility states that, at some point, the marginal utility received from each additional unit of a good begins to decrease with each additional unit consumed.

15. Diminishing Marginal Utility • This principle does not say you do not enjoy consuming more of a good. • It only states that as you consume more of the good, you enjoy additional units less than you enjoyed the initial units.

16. Rational Choice and Marginal Utility • The analysis of rational choice begins with the premise that rational individuals want as much satisfaction as they can get from their available income. • Rationalmeans that people prefer more to less and will make choices that give them as much satisfaction as possible.

17. Rational Choices • In making choices, essentially what you are doing is buying units of utility. • Any choice (for the same amount of money) that does not give you as many units of utility as possible is an irrational choice.

18. Rational choices • Since you want to get the most for your money, you make those choices that have the highest units of utility per dollar spent.

19. Maximizing Utility • Total utility is maximized when marginal utility per dollar spent of two goods is equal.

20. Maximizing Utility • If: • Choose to consume an additional unit of good x.

21. Maximizing Utility • If: • Choose to consume an additional unit of good y.

22. Maximizing Utility • By substituting the marginal utilities and prices of goods into these formulas, you can always decide which good it makes more sense to consume. • Consume the one with the highest marginal utility per dollar.

23. Maximizing Utility and Equilibrium • When the ratios of the marginal utility to price of goods are equal, you are maximizing utility.

24. Maximizing Utility • If: • You’re in equilibrium. • You cannot increase your utility by adjusting your choices.

25. Hamburgers (P = $2) Ice Cream (P = $1) TU MU MU/P TU MU MU/P Q Q 0 0 0 0 29 29 10 20 1 1 20 29 17 17 12 6 2 2 32 46 3 7 6 7 3 3 38 53 1.5 3 3 3 4 4 56 41 0 0 1 1 5 5 41 57 -2.5 -5 0 0 6 6 57 36 -10 -4 -5 -4 7 7 53 26 Maximizing Utility, Table 8-1, p 182

26. Maximizing Utility, Table 8-2, p 183

27. Rational Choice and Marginal Utility • The same principle applies if more than two goods are consumed: • If MUx/Px > MUz/Pz, consume more of good x. • If MUy/Py > MUz/Pz, consume more of good y.

28. Rational Choice and Marginal Utility • The general utility-maximizing rule is that you are maximizing utility when the marginal utilities per dollar are equal across all goods you consume.

29. When you are maximizing utility. Rational Choice and Marginal Utility

30. Rational Choice and Marginal Utility • When this principle is met, the consumer is in equilibrium. • The cost per additional unit of utility is equal for all goods and the consumer is as well off as it is possible to be.

31. Rational Choice and Marginal Utility • The rule does not say that the rational consumer should consume a good until its marginal utility reaches zero. • Consumers do not have enough money to reach this point, as they face an income constraint.

32. Opportunity Cost • Opportunity cost is the benefit forgone of the next-best alternative. • It is essentially the marginal utility per dollar you forgo. • To say MUx/Px > MUy/Py is to say that the opportunity cost of not consuming good x is greater than the opportunity cost of not consuming good y. • So we consume x.

33. Opportunity Cost • When all the marginal utilities per dollar spent are equal, the opportunity cost of all the alternatives are equal.

34. Rational Choice and the Laws of Demand • The principle of rational choice leads to the law of demand. • When the price of a good goes up, the marginal utility per dollar from that good goes down and we demand less of it.

35. Rational Choice and the Law of Demand • Initially MUx/Px = MUy/Py • When the price of good y goes up, then MUx/Px > MUy/Py. • Our condition for maximizing utility is no longer satisfied. • So when the price of a good goes up, we would choose to consume less of that good.

36. Rational Choice and the Law of Demand • Our utility maximizing rule is no longer satisfied • We should now buy more of good x

37. Rational Choice and the Law of Demand • MUx decreases as we buy more x (diminishing marginal utility) and • MUy increases as we buy less of the good y • We are back at a point where MUx/Px = MUy/Py and we maximize utility (but we now consume less x and more y than before the price increase).

38. Rational Choice and the Law of Demand • Quantity demanded rises as price falls, other things constant. • Quantity demanded falls as price rises, other things constant.

39. Rational Choice and the Law of Demand • The above shows the relationship between marginal utility and the price we are willing to pay.

40. Rational Choice and the Law of Demand • Since our demand for a good is an expression of our willingness to pay for it, quantity demanded is related to marginal utility.

41. Maximizing Utility Using Indifference Curves • Economists often use graphic representation of the consumer’s choice. • The problem consists of two parts: • The budget constraint (or the income constraint) and • Indifference curves, which represent utility

42. Graphing the Budget Line • The budget constraint represents all the combinations of two goods that a person can afford to buy with given income. • The budget constraint is also called the income constraint, or budget line.

43. Jaz’s Budget Line • Jaz has $10 and buys chocolate and pop whose prices are $1 and $0.50 respectively.

44. Graphing the Budget Line, Fig. 8-2, p 187 Chocolate bars Slope= - Ppop/Pchocolate = - ½ Income = $10 10 8 6 4 2 0 2 4 6 8 10 12 14 16 18 20 22 Cans of pop

45. The Indifference Curve • An indifference curverepresents all the combinations of the two goods amongst which an individual is indifferent.

46. The Indifference Curve • Jaz is equally as well off (her utility is the same) from consuming bundles A, B, C, D or E.

47. Jaz’s Indifference Curve, Fig. 8-3a, p 188 Chocolate bars |Slope|= MUpop/MUchocolate bars = MRS of pop for chocolate bars 20 16 A 12 B Indifference curve C 8 D E U 4 0 2 4 6 8 10 12 14 16 18 20 22 Cans of pop

48. The Indifference Curve • The slope of the indifference curve is called the marginal rate of substitution (MRS) • The slope is bowed inward, indicating that MRS is decreasing as Jaz’s bundles contain more of the good on the horizontal axis.

49. The Indifference Curve • The reason for decreasing MRS is that as Jaz gets more and more of one good, she is willing to give up lots of it to get more of the relatively scarce good. |Slope| = MUpop/Muchocolate = MRS

50. A Map of Indifference Curves • The bundles of goods forming indifference curve U3 give Jaz higher utility than bundles along U2, • While the bundles of goods forming indifference curve U1 give Jaz less utility than bundles along U2.