Chapter 8 The logic of individual choices

The logic of individual choices

1. © 2003 McGraw-Hill Ryerson Limited
The Logic of Individual The Logic of Individual
Choice:Choice:
The Foundation of The Foundation of
Supply and DemandSupply and Demand
Chapter 8Chapter 8

2. © 2003 McGraw-Hill Ryerson Limited.
8 - 2
Utility Theory and Utility Theory and
Individual ChoiceIndividual 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.

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Utility Theory and Utility Theory and
Individual ChoiceIndividual 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.

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Utility Theory and Utility Theory and
Individual ChoiceIndividual 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.

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Measuring PleasureMeasuring 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.

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

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Measuring PleasureMeasuring 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.

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

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Total UtilityTotal Utility
Total utility refers to the total
satisfaction one gets from consuming a
product.

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Marginal UtilityMarginal 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.

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Total Utility and Marginal Total Utility and Marginal
UtilityUtility
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.

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Number of
pizza slices
1
2
3
4
5
6
7
8
9
Total utility
14
26
36
44
50
54
56
56
54
Marginal utility
14
12
10
8
6
4
2
0
-2
Marginal and Total Utility, Marginal and Total Utility, Fig. Fig.
8-1a, p 1808-1a, p 180

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Total utility Marginal utility
Slices of pizza per hour
70
60
50
40
30
20
10
0
123456789
Slices of pizza per hour
16
14
12
10
8
6
4
2
0
-2
123456789
Marginal and Total Utility, Marginal and Total Utility, Fig. Fig.
8-1b and c, p 1808-1b and c, p 180
Total utility
Marginal utility
Utils Utils

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Diminishing Marginal Diminishing Marginal
UtilityUtility
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.

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Diminishing Marginal Diminishing Marginal
UtilityUtility
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.

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Rational Choice and Rational Choice and
Marginal UtilityMarginal 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.
Rational means that people prefer more
to less and will make choices that give
them as much satisfaction as possible.

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Rational ChoicesRational 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.

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Rational choicesRational 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.

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Maximizing UtilityMaximizing Utility
Total utility is maximized when marginal
utility per dollar spent of two goods is
equal.
y
y
x
x
P
MU

P
MU
=

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Maximizing UtilityMaximizing Utility
If:
y
y
x
x
P
MU

P
MU

Choose to consume an additional unit of good x.

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Maximizing UtilityMaximizing Utility
If:
y
y
x
x
P
MU

P
MU

Choose to consume an additional unit of good y.

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Maximizing UtilityMaximizing 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.

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Maximizing Utility and Maximizing Utility and
EquilibriumEquilibrium
When the ratios of the marginal utility to
price of goods are equal, you are
maximizing utility.

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Maximizing UtilityMaximizing Utility
If:
y
y
x
x
P
MU

P
MU

You’re in equilibrium.
You cannot increase your utility by
adjusting your choices.

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

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Maximizing Utility, Maximizing Utility, Table 8-2, p 183Table 8-2, p 183
Total $
spent
Purchase? MU/P MU
$1 1 ice cream cone 29 29
$2 2
nd
ice cream cone17 17
$4 1 hamburger 10 20
$5 3
rd
ice cream cone7 7
$7 2
nd
hamburger 6 12
$9 3
rd
hamburger 3 6
$10 4
th
ice cream cone3 3
Total utility =
94 utils

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Rational Choice and Rational Choice and
Marginal UtilityMarginal 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.

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Rational Choice and Rational Choice and
Marginal UtilityMarginal 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.

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Rational Choice and Rational Choice and
Marginal UtilityMarginal Utility
z
z
y
y
x
x
P
MU

P
MU

P
MU

When you are maximizing utility.

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Rational Choice and Rational Choice and
Marginal UtilityMarginal 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.

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Rational Choice and Rational Choice and
Marginal UtilityMarginal 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.

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Opportunity CostOpportunity 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.

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

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Rational Choice and the Rational Choice and the
Laws of DemandLaws 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.

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Rational Choice and the Law Rational Choice and the Law
of Demandof 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.

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

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Rational Choice and the Law Rational Choice and the Law
of Demandof 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).

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

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

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

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Maximizing Utility Using Maximizing Utility Using
Indifference CurvesIndifference 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

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Graphing the Budget LineGraphing 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.

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

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Graphing the Budget Line,Graphing the Budget Line, Fig. Fig.
8-2, p 1878-2, p 187
0
2
4
6
8
10
2 4 6 8 10 12 14 16 18 20 22
Chocolate bars
Cans of pop
Slope= - P
pop
/P
chocolate
= - ½
Income = $10

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The Indifference CurveThe Indifference Curve
An indifference curve represents all
the combinations of the two goods
amongst which an individual is
indifferent.

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

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

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The Indifference CurveThe 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.

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The Indifference CurveThe 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| = MU
pop/Mu
chocolate = MRS

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A Map of Indifference A Map of Indifference
CurvesCurves
The bundles of goods forming
indifference curve U
3
give Jaz higher
utility than bundles along U
2,
While the bundles of goods forming
indifference curve U
1 give Jaz less utility
than bundles along U
2.

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A Map of Indifference A Map of Indifference
Curves,Curves, Fig. 8-3b, p 188 Fig. 8-3b, p 188
0
4
8
12
16
20
2 4 6 8 10 12 14 16 18 20 22
Chocolate bars
Cans of pop
U
2
A
B
C
D
E
U
1
U
3

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Combining Indifference Combining Indifference
Curves and Budget LineCurves and Budget Line
The goal for a consumer is to get as
high on an indifference curve as
possible, given her income constraint.
More is preferred to less.

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Combining Indifference Combining Indifference
Curves and Budget Line,Curves and Budget Line, Fig. 8-4, p Fig. 8-4, p
189189
0
4
8
12
16
20
2 4 6 8 10 12 14 16 18 20 22
Chocolate bars
Cans of pop
U2
U
1
U
3
Slope= -MU
pop/Mu
chocolate bars
Slope= -P
pop
/P
chocolate bars
D
C
G
K

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Combining Indifference Combining Indifference
Curves and Budget LineCurves and Budget Line
At the point D, Jaz maximizes her utility
when:
MU
pop/Mu
chocolate bars = P
pop/P
chocolate bars

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Combining Indifference Combining Indifference
Curves and Budget LineCurves and Budget Line
In other words, utility is maximized
when the slopes of the budget
constraint and the indifference curve are
equal.

56. © 2003 McGraw-Hill Ryerson Limited
The Logic of Individual The Logic of Individual
Choice:Choice:
The Foundation of The Foundation of
Supply and DemandSupply and Demand
End of Chapter 8End of Chapter 8