Exploring Consumer Choice Theories and Utility Analysis

1. Chapter 20 – Consumer Choice There have been shifts in air travel away from facilities located in larger metro areas. San Francisco International Airport saw a decline in air passenger traffic, while Oakland International Airport had a gain. At Cleveland Hopkins International Airport passenger volume also fell, while Ohio’s Akron-Canton Airport saw volume rise.

2. Learning Objectives • Distinguish between total utility and marginal utility • Discuss why marginal utility at first rises but ultimately tends to decline as a person consumes more of a good or service • Explain why an individual’s optimal choice of how much to consume of each good or service entails equalizing the marginal utility per dollar spent across all goods and services

3. Learning Objectives • Describe the substitution effect of a price change on the quantity demanded of a good or service • Understand how the real-income effect of a price change affects the quantity demanded a good or service • Evaluate why the price of diamonds is so much higher than the price of water even though people cannot survive long without water

4. Did You Know That... • There has been a proliferation of choices at U.S. grocery stores, which now stock an average of 40,000 items? • One way of deriving the law of demand involves an analysis of the logic of consumer choice in a world of limited resources? • In this chapter we discuss what is called utility analysis.

5. Utility Theory • Utility • The want-satisfying power of a good or service • Utility Analysis • The analysis of consumer decision making based on utility maximization • Util • A representative unit by which utility is measured

6. Change in total utility Marginal utility = Change in number of units consumed Utility Theory • Marginal Utility • The change in total utility due to a one-unit change in the quantity of a good or service consumed

7. Graphical Analysis • We can appreciate total and marginal utility by using graphical analysis.

8. Figure 20-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (a)

9. Figure 20-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (b)

10. Figure 20-1 Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panel (c)

11. Figure 20-1Total and Marginal Utility of Downloading and Listening to Digital Music Albums, Panels (b) and (c) Total utility is maximized... …where marginal utility equals zero.

12. Graphical Analysis • Observations • Marginal utility falls as more is consumed. • Marginal utility equals zero when total utility is at its maximum.

13. Example: The High Cost of Certain Sources of Negative Marginal Utility • Conventional wisdom says that it is impossible to put a price tag on happiness. • Economists usually attempt to attach dollar values to economic goods. • What is the amount of compensation required for economic “bads?”

14. Diminishing Marginal Utility • Diminishing Marginal Utility • The principle that as more of any good or service is consumed, its extra benefit declines • Increases in total utility from consumption of a good or service become smaller and smaller as more is consumed during a given time period.

15. Example: Newspaper Vending Machines versus Candy Vending Machines • How many people take more than one paper from the vending machine? • Why not dispense candy the same way? • The answer is found in the concept of diminishing marginal utility.

16. Optimizing Consumption Choices • Consumer Optimum • A choice of a set of goods and services that maximizes the level of satisfaction for each consumer, subject to limited income

17. Table 20-1 Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26

18. Table 20-1 Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26

19. Table 20-1 Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26

20. Optimizing Consumption Choices • A consumer’s money income should be allocated so that the last dollar spent on each good purchased yields the same amount of marginal utility (when all income is spent), because this rule yields the largest possible total utility.

21. Optimizing Consumption Choices • A little math • The rule of equal marginal utilities per dollar spent • A consumer maximizes personal satisfaction when allocating money income in such a way that the last dollars spent on good A, good B, good C, and so on, yield equal amounts of marginal utility.

22. MU of good A MU of good B MU of good Z = = ... = Price of good A Price of good B Price of good Z Optimizing Consumption Choices • A little math • The rule of equal marginal utilities per dollar spent

23. MUd 36.5 Qd = 4 = 7.3 = Pd 5 MUs 22 Qs = 2 = 7.3 = Ps 3 How a Price Change Affects Consumer Optimum Recall from Table 20-1 Income = $26

24. Assume Price of Music Falls to $4 MUd 36.5 Qd = 4 = 9.125 = Pd 4 MUs 22 Qs = 2 = 7.3 = Ps 3 How a Price Change Affects Consumer Optimum

25. Assume Price of Music Falls to $4 Now > Result Buy more downloads and MUd falls MUd MUs Pd Ps How a Price Change Affects Consumer Optimum

26. How a Price Change Affects Consumer Optimum • Consumption decisions are summarized in the law of demand • The amount purchased is inversely related to price. • A consumer’s response to a price change • At higher consumption rate, marginal utility falls.

27. Figure 20-3 Digital Music Download Prices and Marginal Utility

28. How a Price Change Affects Consumer Optimum • The Substitution Effect • The tendency of people to substitute cheaper commodities for more expensive commodities

29. How a Price Change Affects Consumer Optimum • The Principle of Substitution • Consumers and producers shift away from goods and resources that become priced relatively higher in favor of goods and resources that are now priced relatively lower.

30. How a Price Change Affects Consumer Optimum • Purchasing Power • The value of money for buying goods and services

31. How a Price Change Affects Consumer Optimum • Real-Income Effect • The change in people’s purchasing power that occurs when, other things being constant, the price of one good that they purchase changes • When that price goes up (down), real income, or purchasing power, falls (increases).

32. The Demand Curve Revisited • Question • How is the demand curve derived? • Answer • By presuming income, tastes, expectations, and the price of related goods are not changing as the price of the good changes

33. The Demand Curve Revisited • Marginal utility, total utility, and the diamond-water paradox • Water is essential to life but cheap. • Diamonds are not essential to life but expensive.

34. Figure 20-4 The Diamond-Water Paradox

35. Issues and Applications: The Upside of Taking Off from a Less Convenient Airport • According to the principle of substitution, people shift away from consuming items that become priced relatively higher in favor of items that are now priced relatively lower. • In recent years, the principle of substitution has applied to the services offered by several major airports. • Many consumers of air travel are choosing to drive some distance before they depart to their ultimate destinations by plane.

36. Issues and Applications: The Upside of Taking Off from a Less Convenient Airport • Weighing relative marginal utilities and prices • Opting to avoid hassles that reduce marginal utility • Responding to price changes

37. Table 20-3 Selected Substitute Airport Pairs in the United States

38. Summary Discussionof Learning Objectives • Total utility versus marginal utility • Total utility is total satisfaction from consumption. • Marginal utility is the additional satisfaction from consuming an additional unit. • Law of diminishing marginal utility • Marginal utility ultimately declines as a person consumes more and more of a good or service.

39. Summary Discussionof Learning Objectives • The consumer optimum • Occurs when the marginal utility per dollar spent on the last unit consumed is equalized • The substitution effect of a price change • A person will substitute among goods by buying less of a good when its price increases.

40. Summary Discussionof Learning Objectives • The real-income effect of a price change • A price change affects the purchasing power of an individual’s available income. • Why the price of diamonds exceeds the price of water even though people cannot long survive without water • Marginal utility, not total utility, determines how much people are willing to pay.