Utility and Demand

• Individual and market demand
• Total and marginal utility
• Marginal utility theory
• Changes in price and income
• Consumer surplus
• The paradox of value

Water, Water, Everywhere

• We need water to live.
• Diamonds are nice, but we can live without them.
• Why is the price of water so low while the price of diamonds is so high?

Marginal Utility Theory

• The 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.

Household Consumption Choices

• Two factors determine a household's consumption choices:
  • Its budget constraint
  • Its preferences

Budget Constraint

• A 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 line.

Lisa's Consumption Possibilities

• Lisa 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.

The 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.

Lisa's Preferences

• How 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.

Utility is Abstract

• We 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.

Total Utility

• Total 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.

Lisa's Total Utility

• The 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.

Marginal Utility

• Marginal utility is the change in total utility resulting from a one-unit increase in the quantity of a good consumed.
• Marginal utility is the change in total utility per unit change in consumption.

Lisa's Marginal Utility

The marginal utility of seeing an additional movie is the increase in total utility. When Lisa views a fifth movie, her marginal utility is 25 units.

• Similarly, her marginal utility from drinking her fourth six-pack of soda is 28 units (181-153).

• As consumption of a good or service increases, the incremental satisfaction we get from consuming one more unit decreases.
• This decrease is called the principle of diminishing marginal utility.

Maximizing Utility

• A 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.

Lisa's Utility-Maximizing Combination

The Utility-Maximizing Choice

A 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.

Equalizing Marginal Utility per Dollar Spent

The 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.

Equalizing Marginal Utilities per Dollar Spent

Maximizing Total Utility

Total 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.

Lisa Maximizes Utility

• She spends all her income and

MUmovies/ Pmovies = MUsoda/ Psoda

• Equivalently:

MUmovies/MUsoda = Pmovies/ Psoda

Why the Marginal Utility Rule Maximizes Total Utility

If 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.

The Power of
Marginal Analysis

• The 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.

Units of Utility

• Using marginal utility means it is not necessary to worry about what units are used to measure total utility.

Predictions of Marginal Utility Theory

• What happens to Lisa's consumption of movies and soda when their prices change or when her income changes?
• Be sure to change only one factor at a time, keeping all other factors the same.

A Fall in the Price of Movies

• First, determine the combinations of movies and soda that can be bought at the new prices.
• Second, calculate the new marginal utilities per dollar spent.
• Third, determine the consumption of each good that makes the marginal utility per dollar equal and spends all of Lisa's income.

How Consumption Changes When Movie Prices Fall

• More movies are consumed.
• Less soda is consumed.
• Lisa substitutes movies for soda when the price of a movie falls.

A Movie Price Decrease Affects Lisa's Choice

A Rise in the Price of Soda

• Less soda is consumed.
• More movies are consumed.
• Lisa substitutes movies for soda when the price of soda rises.

A Soda Price Increase Affects Lisa's Choice

Predictions of Marginal Utility Theory

• When the price of a good rises, the quantity demanded of that good decreases.
• If the price of one good rises, the demand for another good that can serve as a substitute increases.
• These predictions correspond to the assumptions made in Chapter 4.

A Rise in Income

• Lisa's income increases from $30 to $42 a month
• The prices of movies and soda remain constant at $3 each
• Lisa's budget constraint shifts out; she can now afford more of each good.

Higher Income Means Greater Consumption

• Different preferences will produce different changes in consumption when income or prices change.
• A higher income always brings a larger consumption of a normal good.
• Higher income causes consumption of an inferior good to decrease.

Individual Demand and Market Demand

• The relationship between the total quantity demanded of a good and its price is called market demand.
• While marginal utility theory focuses on individual demand, its main purpose is to explain market demand.

From Individual Demand to Market Demand

• The relationship between quantity demanded of a good by a single individual and its price is called individual demand.
• The market demand curve is the horizontal sum of the individual demand curves.

Marginal Utility and
the Real World

• Marginal utility theory can be used to answer a wide range of questions about the real world.
• It tells us why the demand for CD players is price elastic while the demand for oil is price inelastic.
• Elasticity of demand is determined by how fast marginal utility declines.

Other Uses of
Marginal Utility Theory

• Marginal utility theory can be used to explain all household choices.
• One example is the allocation of time between work and leisure.

Criticisms of Marginal
Utility Theory

• Marginal utility theory helps us to understand the choices people make.
• It has been criticized because:
  • Utility can't be observed.
  • "People aren't that smart."

Utility Can't Be Observed

• This is a fact and, as such, cannot be disputed.
• We don't need to observe utility to use it.
• Utility theory helps us understand why people make the choices they make.

"People Aren't That Smart"

• Marginal utility theory makes predictions about choices--about what people decide to buy
• Even the very best pitchers don't understand why their curve ball moves the way it does. That doesn't keep them from using it!

Implications of
Marginal Utility Theory

• There are two important implications of marginal utility theory:
  • Consumer surplus
  • The paradox of value

Consumer Surplus and
the Gains from Trade

People can gain by specializing in the production of the things in which they have a comparative advantage and then trading with each other.

When Lisa exchanges her income for movies and soda, are the dollars she gives up worth more or less than the movies and soda she consumes?

Calculating
Consumer Surplus

• The value consumers place on a good is the maximum amount they would be willing to pay for it.
• The amount actually paid is its price, which is the same for all consumers.
• Consumer surplus is the difference between the value of a good and its price.

Diminishing Marginal Utility and Consumer Surplus

Diminishing marginal utility guarantees that the value a consumer places on a good is always greater than its price for some units of the good.

• A consumer always makes some consumer surplus.

Market Demand and Consumer Surplus

• Recall that the market demand curve is the sum of individual demand curves.
• Therefore, total consumer surplus is just the area between the market demand curve and the market price.

• Why are diamonds expensive while water is cheap?

The Utility of Water

• The total utility we get from water is enormous.
• However, since we use so much water, its marginal utility is very small.

The Utility of Diamonds

• The total utility we get from diamonds is small, especially compared to the utility we get from water.
• However, because we buy few diamonds, they have a high marginal utility.

Marginal Utilities and Prices

• Water has a low marginal utility and a low price.
• Diamonds have a high marginal utility and a high price.
• The marginal utility per dollar spent is the same for diamonds and water.