CChapter 5hapter 5

Marginal Utility and Consumer Choice

© 2002 South-Western

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Economic PrinciplesEconomic Principles

• Total Utility and Marginal Utility

• Law of Diminishing Marginal Utility

• Relationship Between the Law of Demand and the Marginal-Utility-To-Price Ratio

• Consumer Surplus

• Difficulties with Interpersonal Comparison of Utility

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What is Marginal What is Marginal Utility?Utility?

Util:

• It is a hypothetical unit used to measure how much utility a person

obtains from consuming a good.

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What is Marginal What is Marginal Utility?Utility?

Utility measures the satisfaction or enjoyment a person obtains from consuming a good.

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What is Marginal What is Marginal Utility?Utility?

Law of Diminishing Marginal Utility:

• It is the idea that as more of a good is consumed, the utility a person derives

from each additional unit diminishes.

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What is Marginal What is Marginal Utility?Utility?

The implication of someone experiencing increasing marginal utility for pizza slices is:

• The next slice of pizza would generate

higher marginal utility than the one before.

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What is Marginal What is Marginal Utility?Utility?

The implication of someone experiencing increasing marginal utility for pizza slices is:

• When his stomach is full to bursting from eating so much pizza, the marginal utility from eating yet another slice would be

higher than for any of the preceding slices.

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What is Marginal What is Marginal Utility?Utility?

The implication of someone experiencing increasing marginal utility for pizza slices is:

• It is not clear that someone could survive having increasing marginal utility!

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What is Marginal What is Marginal Utility?Utility?

It possible for marginal utility to become negative.

• For example, if you overeat and feel ill, then the marginal utility for the

last bit of food you ate is negative.

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What is Marginal What is Marginal Utility?Utility?

A rational consumer will not knowingly pay to buy a unit of a good that generates negative marginal utility.

• Presumably something else could be bought that generates positive marginal utility. • Buying something that generates negative marginal utility is not consistent with utility maximization.

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EXHIBIT 1 TOTAL UTILITY AND MARGINAL UTILITY DERIVED FROM CONSUMING T-BONE STEAKS (UTILS)

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Exhibit 1: Total Utility and Exhibit 1: Total Utility and Marginal Utility Derived From Marginal Utility Derived From

Consuming T-Bone Steaks Consuming T-Bone Steaks (Utils)(Utils)

If marginal utility is declining, but is still positive, total utility is:

• Total utility increases as long as

marginal utility is positive.

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Exhibit 1: Total Utility and Exhibit 1: Total Utility and Marginal Utility Derived From Marginal Utility Derived From

Consuming T-Bone Steaks Consuming T-Bone Steaks (Utils)(Utils)

If marginal utility is declining, but is still positive, total utility is:

• In Exhibit 1, total utility reaches its maximum at five t-bone steaks. Consuming more than five steaks will reduce total utility.

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EXHIBIT 2A TOTAL AND MARGINAL UTILITY

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EXHIBIT 2B TOTAL AND MARGINAL UTILITY

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Exhibit 2: Total and Exhibit 2: Total and Marginal UtilityMarginal Utility

In Exhibit 2, the curves in Panel a and b represent:

• The curve in Panel a is the total utility curve for T-bone steaks.

• Panel a depicts the number of utils, or the amount of utility, a person gains from consuming a certain number of steaks.

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Exhibit 2: Total and Exhibit 2: Total and Marginal UtilityMarginal Utility

In Exhibit 2, the curves in Panel a and b represent:

• Total utility peaks at 81 utils, or 5 steaks. Each steak consumed beyond 5 reduces total utility.

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Exhibit 2: Total and Exhibit 2: Total and Marginal UtilityMarginal Utility

In Exhibit 2, the curves in Panel a and b represent:

• The curve in Panel b is the marginal utility curve for T-bone steaks.

• The curve depicts the change in total utility a person derives from consuming each additional steak.

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Exhibit 2: Total and Exhibit 2: Total and Marginal UtilityMarginal Utility

In Exhibit 2, the curves in Panel a and b represent:

• When marginal utility is zero, total utility is maximized.

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What is Marginal What is Marginal Utility?Utility?

If water is necessary for life, then the market price of water so much lower than for diamonds because:

• Market price reflects marginal utility,

not total utility. • Due to the law of diminishing marginal utility and the abundance of water, the marginal utility of water is lower than for diamonds.

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What is Marginal What is Marginal Utility?Utility?

A hypothetical circumstance in which the marginal utility of water might exceed the marginal utility of a diamond:

• If you are lost in the desert and are severely dehydrated, then your marginal utility for a gallon of water might exceed

your marginal utility for a diamond.

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French Cuisine and French Cuisine and Marginal UtilityMarginal Utility

Many courses, each with small portions of food (French cuisine), may generate more utility than one course with a large portion of food because:

• One large portion will drive down marginal

utility. • Marginal utility is high for the whole meal.

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EXHIBIT 3 MARGINAL UTILITIES OF CLOTHES AND AMUSEMENT GOODS (UTILS)

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Exhibit 3: Marginal Utilities of Exhibit 3: Marginal Utilities of Clothes and Amusement Goods Clothes and Amusement Goods

(Utils)(Utils)

Based on the utility data in Exhibit 3, a rational consumer will select the best combination of clothes and amusement goods:

• By sequentially picking units of clothing and amusement goods that generate the largest MU/P.

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EXHIBIT 4 MARGINAL-UTILITY-TO-PRICE RATIOS OF CLOTHES AND AMUSEMENT GOODS (MU/P)

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Exhibit 4: Marginal-Utility-to-Exhibit 4: Marginal-Utility-to-Price Ratios of Clothes and Price Ratios of Clothes and Amusement Goods Amusement Goods (MU/P)(MU/P)

If a unit of clothes and amusement goods both cost $10, and if you have $80 to spend, the rational consumer will spend her money:

• MU/P is equal when three units of clothes and five units of amusement goods are purchased (MU/P = 1.4).

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Marginal-Utility-to-Marginal-Utility-to-Price RatioPrice Ratio

Marginal-utility-to-price ratio:

• The ratio is calculated by dividing the marginal utility of a good by the

price of the good -- MU/P.

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Marginal-Utility-to-Marginal-Utility-to-Price RatioPrice Ratio

The MU/P equalization principle:

• A person’s total utility is maximized when the ratios of marginal utility to price for the last unit of each of the goods consumed are equal.

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Marginal-Utility-to-Marginal-Utility-to-Price RatioPrice Ratio

The MU/P equalization principle:

• MU/P measures marginal utility per dollar spent.

• Total utility will be maximized (within the constraints of a limited budget) when each individual purchase generates the largest possible MU/P.

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Marginal-Utility-to-Marginal-Utility-to-Price RatioPrice Ratio

The MU/P equalization principle:

• A rational and fully-informed consumer will always shift a dollar from a good whose MU/P is lower to one whose MU/P is higher, if such a

shift is possible.

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Marginal-Utility-to-Marginal-Utility-to-Price RatioPrice Ratio

The MU/P equalization principle:

• The principle is based on consumer behavior.

• Consumers will always arrange their sequence of choices among goods starting with the highest MU/P and running down to exhaust an expenditure budget.

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Marginal-Utility-to-Marginal-Utility-to-Price RatioPrice Ratio

The MU/P equalization principle:• The consumer choice process is in equilibrium when:

• There is no longer any incentive for the consumer to rearrange her purchases.• The MU/P is equal for the last unit of each good or service consumed.

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EXHIBIT 5 COMPARING MU/Ps AFTER A 20-PERCENT- OFF SALE ON CLOTHES

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Exhibit 5: Comparing Exhibit 5: Comparing MU/PsMU/Ps After a 20 Percent Off Sale on After a 20 Percent Off Sale on

ClothesClothes

The MU/P of clothes changes when there is a 20 percent off sale on clothes by:

• MU/P for each unit of clothing rises when price is reduced by 20 percent.• This will cause a rational consumer to consume more clothes.

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EXHIBIT 6 COMPARING MU/Ps AFTER A 50-PERCENT- OFF SALE ON CLOTHES

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Exhibit 6: Comparing Exhibit 6: Comparing MU/PsMU/Ps After a 50 Percent Off Sale on After a 50 Percent Off Sale on

ClothesClothes

An additional reduction in the price of clothing will change all of the MU/Ps for clothing, and thus change a rational consumer’s consumption of clothing.

• If the price of clothes falls again, from $8 to $5, the quantity of clothing demanded increases from four to six units.

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EXHIBIT 7 THE DEMAND CURVE FOR CLOTHES

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Exhibit 7: The Demand Curve for Exhibit 7: The Demand Curve for ClothesClothes

When the price of clothing falls from $10 to $8 to $5, which of the following occurs:

• Quantity demanded remains the same.

• Quantity demanded falls from 6 to 4 to 3.

• Quantity demanded rises from 3 to 4 to 6.

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Exhibit 7: The Demand Curve for Exhibit 7: The Demand Curve for ClothesClothes

When the price of clothing falls from $10 to $8 to $5, which of the following occurs:

• Quantity demanded remains the same.

• Quantity demanded falls from 6 to 4 to 3.

• Quantity demanded rises from 3 to 4 to 6.

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MU/P Equalization MU/P Equalization Principle and the Law Principle and the Law

of Demandof DemandChanges in the marginal-utility-to-price ratio are caused by:

• A change in the marginal utility of a good or a change in the price of a good changes the marginal-utility-to-price ratio, and therefore changes quantity demanded.

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MU/P Equalization MU/P Equalization Principle and the Law Principle and the Law

of Demandof DemandThe relationship between the MU/P Principle and the Law of Demand:

• If the price of a good falls:

• MU/P rises.

• The rational consumer will increase her consumption of that good.• Increase in quantity demanded (movement along the demand curve).

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MU/P Equalization MU/P Equalization Principle and the Law Principle and the Law

of Demandof DemandThe relationship between the MU/P Principle and the Law of Demand:

• If consumer preference for a good decreases:

• MU/P declines.

• The rational consumer will reduce consumption.• The demand curve shifts to the left (since consumer preference is a non-price factor).

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MU/P Equalization MU/P Equalization Principle and the Law Principle and the Law

of Demandof DemandThe relationship between the MU/P Principle and the Law of Demand:

• If consumer income increases:

• The consumer can pursue a lower MU/P.

• The consumer can afford to increase consumption.• An increase in the demand for normal goods.

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MU/P Equalization MU/P Equalization Principle and the Law Principle and the Law

of Demandof Demand

A downward-sloping demand curve is consistent with the law of diminishing marginal utility.

• Diminishing marginal utility means that MU/P declines as quantity consumed increases.

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MU/P Equalization MU/P Equalization Principle and the Law Principle and the Law

of Demandof Demand

A downward-sloping demand curve is consistent with the law of diminishing marginal utility.

• A consumer’s willingness-to-pay falls as quantity consumed increases.

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Are White Rats Are White Rats Rational Consumers?Rational Consumers?

There is evidence that lab rats make consumer choices based on MU/P.

• Economists Battalio and Kagel found that white lab rats respond to price and income changes in a manner consistent with economic theory.

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The The MU/PMU/P Guide to Guide to Auction BiddingAuction Bidding

MU/P can help guide auction bidding:

• If a particular MU/P is guaranteed by buying something outside of the auction, and if the marginal utility from the auction good is known, then you can figure out your maximum auction price.

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Creating Consumer Creating Consumer SurplusSurplus

Consumer surplus:

• The difference between the maximum price a person would be willing to pay for a good or service, and the price the person actually pays.

• Most consumers receive some consumer

surplus from a transaction.

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Creating Consumer Creating Consumer SurplusSurplus

When market price falls, consumer surplus increases.

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Creating Consumer Creating Consumer SurplusSurplus

If the price of a good is greater than amount a consumer is willing to pay for that good, the consumer surplus will be negative if the consumer buys the good.

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Creating Consumer Creating Consumer SurplusSurplus

A rational consumer will not purchase a good that generates negative consumer surplus.

• A rational consumer will prefer zero consumer surplus (no purchase) to negative consumer surplus.

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EXHIBIT 8 THE MARKET FOR HORSEBACK RIDING

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Exhibit 8: The Market for Exhibit 8: The Market for Horseback RidingHorseback Riding

Exhibit 8 depicts the demand and supply curves for horseback riding. The concept of consumer surplus applies to horseback riding:• At a price of $6, all consumers with a willingness-to-pay value of $6 or more will purchase a horseback ride.

• These consumers receive consumer surplus.

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Exhibit 8: The Market for Exhibit 8: The Market for Horseback RidingHorseback Riding

Exhibit 8 depicts the demand and supply curves for horseback riding. The concept of consumer surplus applies to horseback riding:

• Some consumer may be willing to pay $10 for a horseback ride.

• This consumer will receive $(10-6) = $4 of consumer surplus.

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Exhibit 8: The Market for Exhibit 8: The Market for Horseback RidingHorseback Riding

Exhibit 8 depicts the demand and supply curves for horseback riding. The concept of consumer surplus applies to horseback riding:

• A consumer who has a willingness-to-pay value less than $6:

• A rational consumer will not choose to purchase a ride.

• This consumer has a negative consumer surplus.

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EXHIBIT 9 CONSUMER SURPLUS ON THE HORSEBACK-RIDING MARKET

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Exhibit 9: Consumer Exhibit 9: Consumer Surplus on the Surplus on the

Horseback-Riding MarketHorseback-Riding MarketKim’s consumer surplus from horseback riding is:

• $(15-6) for the first ride.

• $(12-6) for the second ride.

• $(9-6) for the third ride.

• $(6-6) for the fourth ride.

• These sum to $(9+6+3+0) = $18.

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Exhibit 9: Consumer Exhibit 9: Consumer Surplus on the Surplus on the

Horseback-Riding MarketHorseback-Riding MarketTony’s consumer surplus from horseback riding is:

• $(10-6) for the first ride.

• $(8-6) for the second ride.

• $(6-6) for the fourth ride.

• These sum to $(4+2+0) = $6.

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Exhibit 9: Consumer Exhibit 9: Consumer Surplus on the Surplus on the

Horseback-Riding MarketHorseback-Riding MarketRandy’s consumer surplus from horseback riding is:

• $(9-6) for the first ride.

• $(6-6) for the fourth ride.

• These sum to $(3+0) = $3.

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Exhibit 9: Consumer Exhibit 9: Consumer Surplus on the Surplus on the

Horseback-Riding MarketHorseback-Riding MarketIf Kim, Tony and Randy represent the entire market demand for horseback riding, the total consumer surplus is:

• $18 (Kim) + $6 (Tony) + $3 (Randy)

= $27 in consumer surplus

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Interpersonal Interpersonal Comparisons of Comparisons of

UtilityUtility

An interpersonal comparison of utility:

• It is a comparison of the marginal utilities that different people derive from a good or a dollar.

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Interpersonal Interpersonal Comparisons of Comparisons of

UtilityUtilityIs it actually possible to compare the satisfaction that different people derive from a good or a dollar?

• It is not possible to make an exact comparison of different peoples’ utility.

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Interpersonal Interpersonal Comparisons of Comparisons of

UtilityUtilityIs it actually possible to compare the satisfaction that different people derive from a good or a dollar?

• Policies such as those aimed at poverty alleviation rely on society being able to make approximate or reasonable comparisons of

utility across different people.