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Consumer Choice - Economics.docx

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Department
Economics
Course
ECO1104
Professor
Robert Brown
Semester
Fall

Description
Chapter 7 This chapter provides a more detailed examination of the theory of consumer choice. The theory of demand is derived from this theory of choice. Utility The economic theory of choice is based on the concept of utility. Utility is defined as the level of happiness or satisfaction associated with alternative choices. Economists assume that when individuals are faced with a choice of feasible alternatives, they will always select the alternative that provides the highest level of utility. Total and marginal utility The total utility associated with a good is the level of happiness derived from consuming the good. Marginal utility is a measure of the additional utility that is received when an additional unit of the good is consumed. The table below illustrates the relationship that exists between total and marginal utility associated with an individual's consumption of pizza (in a given time period). # of slices Total utility Marginal utility 0 0 - 1 70 70 2 110 40 3 130 20 4 140 10 5 145 5 6 140 -5 As the table above indicates, the marginal utility associated with an additional slice of pizza is just the change in the level of total utility that occurs when one more slice of pizza is consumed. Note, for example, that the marginal utility of the third slice of pizza is 20 since total utility increases by 20 units (from 110 to 130) when the third slice of pizza is consumed. More generally, marginal utility can be defined as: The table above also illustrates a phenomena known as the law of diminishing marginal utility. This law states that marginal utility declines as more of a particular good is consumed in a given time period, ceteris paribus. In the example above, the marginal utility of additional slices of pizza declines as more pizza is consumed (in this time period). In this example, the marginal utility of pizza consumption becomes negative when the 6th slice of pizza is consumed. Note, though, that even though the marginal utility from pizza consumption declines, total utility still increases as long as marginal utility is positive. Total utility will decline only if marginal utility is negative. This law of diminishing marginal utility is believed to occur for virtually all commodities. A bit of introspection should confirm the general applicability of this principle. Diamond-water paradox In The Wealth of Nations (1776), Adam Smith attempted to formulate a theory of value that explained why different commodities had different market values. In this attempt, however, he encountered a problem that has come to be called the "diamond-water" paradox. The paradox occurs because water is essential for life and has a low market price (often a price of zero) while diamonds are not as essential yet have a very high market price. To resolve this issue, Smith proposed two concepts of value: value in use and value in exchange. Diamonds have a low value in use but a high value in exchange while water has a high value is use but a low value in exchange. Smith argued that economists could explain the exchange value of a commodity by the amount of labor required to produce the commodity. (This "labor theory of value" later served as the basis for much of Marx's critique of capitalism.) Smith did not propose a theory to explain the use value of a commodity. Marginal analysis, however, allows us to explain both value in use and value in exchange. The diagram below contains marginal utility curves for both diamonds and water. Because individuals consume a large volume of water, the marginal utility of an additional unit of water is relatively low. Since few diamonds are consumed, the marginal utility of an additional diamond is relatively high. Total utility can be derived by adding up the marginal utilities associated with each unit of the good. A bit of reflection should convince you that total utility can be measured by the area under the marginal utility curve. The shaded areas in the diagram below provide a measure of the total utility associated with the consumption of water and diamonds. Note that the total utility from water is very high (since a large volume of water is consumed) while the total utility received from diamonds is relatively low (because few diamonds are consumed). These concepts of total and marginal utility can be used to resolve Adam Smith's diamond-water paradox. When Adam Smith was referring to "value in use," he was actually referring to the concept of total utility. Exchange value, on the other hand, is tied to how much someone is willing to pay for an additional unit of the commodity. Because diamonds are expensive, individuals consume few diamonds and the marginal utility of an additional diamond is relatively high. Since water is not very costly to acquire, people consume more water. At this high level of consumption, the marginal utility of an additional unit of water is relatively low. The price that someone is willing to pay for an additional unit of a good is related to its marginal utility. Because the marginal utility of an additional diamond is higher than the marginal utility associated with an additional glass of water, diamonds have a higher value in exchange. Consumer equilibrium How can the concept of marginal utility be used to explain consumer choice? As noted above, economists assume that when an individual is faced with a choice among feasible alternatives, he or she will select the alternative that provides the highest level of utility. Suppose that an individual has a given income that can be spent on alternative combinations of goods and services. A utility maximizing consumer will select the bundle of goods at which the following two conditions are satisfied: 1. MU /PA= AU /P = B..B= MU /P , fZr Zll commodities (A-Z), and 2. all income is spent. The first of these conditions requires that the marginal utility per dollar of spending be equated for all commodities. To see why this condition must be satisfied, suppose that the condition is violated. In particular, let's assume that the marginal utility resulting from the last dollar spent on good X equals 10 while the marginal utility received from the last dollar spent on good Y equals 5. Since an additional dollar spent on good X provides more additional utility than the last dollar spent on good Y, a utility-maximizing individual would spend more on good X and less on good Y. Spending $1 less on good Y lowers utility by 5 units, but an additional dollar spent on good X raises utility by 10 units in this example. Thus, the transfer of $1 in spending from good Y to good X provides this person with a net gain of 10 units of utility. As more is spent on good Y and less on good X, though, the marginal utility of good Y will fall relative to the marginal utility of good X. This person will keep spending more on good Y and less on good X, though, until the marginal utility of the last dollar spent on good Y is the same as the marginal utility of the last dollar spent on good X. The first condition listed above is sometimes referred to as the "equimarginal principle." The reason for the assumption that all income is spent is because this relatively simple model is a single-period model in which there is no possibility of saving or borrowing (since there are no future periods in this simple model). Of course, a more detailed model can be constructed which includes such possibili
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