Chapter 8- Utility and Demand

Econ 101 Chapter 8: Utility and Demand Maximizing Utility Utility: the benefit or satisfaction that a person gets from the consumption of goods and services To understand how people’s choices maximize utility, we distinguish between two concepts:  Total utility  Marginal utility Total Utility: the total benefit a person gets from the consumption of all the different goods and services  Depends on level of consumption Marginal Utility: the change in total utility that results from a one-unit increase in the quantity of a good consumed  The marginal utility appear midway between the quantities of a good because it is the change in the quantity she buys which produces the marginal utility  Marginal utility is positive, but it diminishes as the quantity consumed of a good increases Positive Marginal Utility  Goods and services that people value all have positive marginal utility  Total utility increases as the quantity consumed increases  Some objects and activities can generate negative marginal utility  E.g. hard labour & polluted air Diminishing Marginal Utility  Diminishing marginal utility: The tendency for marginal utility to decrease as the consumption of a good increase Graphically  As more of a good is consumed, the total utility curve slopes upwards  As more of a good is consumed, the marginal utility curve slopes downwards The Utility-Maximizing Choice  Most direct way of finding the quantities that maximize utility is to make a spreadsheet  Combination which adds up to the highest of the total quantities of two goods =maximization  Consumer equilibrium: a situation in which a consumer has allocated all of his or her available income in the way that maximizes his or her total utility, given the prices of the goods and services Econ 101  Simpler way of finding a consumer equilibrium uses the idea that choices are made at the margin Choosing at the Margin  A consumer’s total utility is maximized by following the rule:  Spend all the available income  Equalize the marginal utility per dollar for all goods Spend All the Available Income  Because more consumption brings more utility, only those choices that exhaust income can maximize utility Equalize Marginal Utility per Dollar  Since marginal utility is the increase in total utility from consuming one more unit of good, the marginal utility per dollar is the marginal utility from a good obtained by spending one more dollar on that good The Basic Idea  Basic idea behind the utility maximizing rule is to move dollars from good A to good B if doing so increases the utility from good A by more than it decreases the utility from good B  Possible if the marginal utility per dollar from good A exceeds the marginal utility per dollar from good B  Since buying more of good A decreases it marginal utility and buying less of good B increases its marginal utility, by moving dollars from good A to good B, total utility rises, the gap between the marginal utilities per dollar gets smaller  As a gap exists-so long as the marginal utility per good from good A exceeds that from good B, total utility can be increased by spending more on A and less on B  When the two marginal utilities per dollar equal, the total utility cannot be increased further  Utility is maximized Marginal Calculation  Marginal utility per dollar = Marginal utility numbers for each quantity of each good Price of the good Too Few A and too Much B  If person consumes 1 A and 8 B, her marginal utility per dollar from A exceeds her marginal utility per dollar from B  So, if she spent an extra dollar on A and a dollar less on B, her total utility would increase Econ 101 Too Much A and too Little B  If person consumes 1 A and 4 B, her marginal utility from B exceeds her marginal utility from A  So, if she spent an extra dollar on B and a dollar less on A, her total utility would increase The Power of Marginal Analysis  Rule: If the marginal utility per dollar from A exceeds the marginal utility per dollar from B, consume more A and less B; if the marginal utility per dollar from B exceeds the marginal utility per dollar from A, consume more B and less A  More generally, if the marginal gain from an action exceeds the marginal loss, take the action Units of Utility  In maximizing total utility by making the marginal utility per dollar equal for all goods, the units in which utility is measured do not matter  We can figure out a person’s preferences by observing what she buys at various prices: 1. Marginal utility per dollar from A is: MU /A A 2. Marginal utility per dollar from B is: MU /B B 3. Person maximizes utility when: MU /P =AMUA/P B B 4. Multiply both sides by P AMU = MUAX (P PB) A/ B Example: MU = PU X (4M8) MU =PMU X 0M5 1 = 2 X 0.5  For every increase in marginal utility for MU , the marginal utility for MU is P M that amount X 0.5 1 = 1 Econ 101 Predictions of Marginal Utility Theory  Marginal utility theory predicts the law of demand  Predicts that a fall in the price of a substitute of a good decreases the demand for the good and that for a normal good, a rise in income increases demand A Fall in the Price of A With No Change in Income (if consuming 2 A and 4 B maximizes utility)  How does a person change their buying plans? Finding the New Quantities of A and B  Effect of a fall in price on A on the quantities of A and B a person consumes in a three-step calculation: 1 Determine the just-affordable combinations of A and B at the new prices 2 Calculate the new marginal utilities per dollar from the good whose price has changed 3 Determine the quantities of A and B that make their marginal utilities per dollar equal Affordable Combinations  Lower price of A means that a person can afford more A or B New Marginal Utilities per Dollar from Movies  Person’s preferences don’t change just because a price has changed  Therefore, a person’s marginal utilities are the same as those from the regular price  However, the marginal utility per dollar from A changes o Marginal utility numbers for each quantity of each good/ Lowered price of the good Equalizing the Marginal Utilities per Dollar A ($4 each) B ($4 each) Quantity Marginal Marginal utility Quantity Marginal Marginal utility Utility per dollar Utility per dollar 4 28 7.00 6 20 5.00 5 26 6.50 5 22 5.50 6 24 6.00 4 24 6.00 7 22 5.50 3 36 9.00 8 20 5.00 2 48 12.00 Bolded=maximized utility  A person’s increased purchases of A results from:  Substitution effect- she substitutes the now lower priced A for B  Income effect- She can afford more A Econ 101 A Change in the Quantity Demanded  Since the price of A decreased, a person has increased their quantity demanded, meaning that they plan to consume more of A at a given period of time  The demand curve traces the quantities that maximize utility at each price with all other influences remaining the same  Utility maximizing choices generate a downward-sloping demand curve  Utility maximization with diminishing marginal utility implies the law of demand A Change in Demand  A person who decides to decrease the quantity of B that they consume in a given period is the change demand for B Change in demand is illustrated by a shift of a demand curve A Rise in the Price of B With No Change in Income  Assume price of A is $4 and price of B raised from $4 to $8  How does a person change their buying plans?  Answer can be founded by repeating the three-step process  A person will decrease their purchases of B resulting:  Income effect-she can afford fewer cases and she buys fewer cases  However, she buys the same quantity of A A Person’s Demand for B  Despite the demand for B, a person has the same demand for A  This outcome does not always occurresult of person’s utili