Chapter 6: Consumer Choice Theory

Chapter 6 Consumer Choice Theory©2000 South-Western College Publishing Key Concepts Summary Practice Quiz Internet Exercises1In this chapter, you will learn to solve these economic puzzles:Under what conditions might you be willing to pay $10,000 for a gallon of water and 1 cent for a one-carat diamond?When ordering Big Macs, milkshakes, pizza, and other goods, how can you obtain the highest possible satisfaction?Do white rats obey the law of demand?2What is Util?A hypothetical unit used to measure how much utility a person obtains from consuming a good3What is Utility?The satisfaction, or pleasure, that people receive from consuming a good or service4What is Total Utility?The amount of satisfaction received from all the units of a good or service consumed5Why does a consumer buy one bundle of goods, rather than another?Consumers make one choice over another depending on their marginal utility6What is Marginal Utility?The change in total utility from one additional unit of a good or service7What is the Law of Diminishing Marginal Utility?The principle that the extra satisfaction of a good or service declines as people consume more in a given period886421234Diminishing Marginal UtilityMUMarginal UtilityQ91612841234Total UtilityTUUtilsQ10When is Total Utility maximized?When the marginal utility per dollar of each good is equal and the entire budget is spent11What isConsumer Equilibrium?A condition in which total utility cannot increase by spending more of a given budget on one good and spending less on another good12Even though water provides a greater utility than diamonds, why are diamonds more expensive?Water is plentiful in most of the world, so its marginal utility is low1386421234Marginal Utility of DiamondsMUQMarginal UtilitySMUd1486421234Marginal Utility of WaterMUQMarginal UtilitySMUw15Marginal Utility for Big Macs and Milkshakes (utils per day) ($2 each)QuantityMUMU/PMUMU/P123484214211/26410321/20BIG MACSMILKSHAKES16MU Aprice A MU Bprice BConsumer EquilibriumMU Zprice Z==17MU of Big Macprice of Big Mac MU of milkshakeprice of milkshakeConsumer Equilibrium Price of Big Mac = $24 utils$2 4 utils$2 ==18What happens if the price of a Big Mac falls to $1 and upsets the previous equilibrium?19MU of Big Macprice of Big Mac >MU of milkshakeprice of milkshakeConsumer Equilibrium Price of Big Mac = $14 utils$1 4 utils$2 >20What happens to the number of Big Macs bought when the price drops? To restore maximum total utility, the consumer spends more on Big Macs21What does this discussion of Utility reveal?The law of demand, that is, as the price of a good declines, consumers will buy more units of the good, and vice versa22What are two alternative explanations of demand?Income effect Substitution effect23What is theIncome effect?The change in quantity demanded of a good or service caused by a change in real income (purchasing power)24What does the Income effect show?As prices decline, your real income increases, increasing your buying power, so you buy more units, ceteris paribus25What is theSubstitution effect?The change in quantity demanded of a good or service caused by the change in its price relative to substitutes26What does the Substitution effect show?Suppose the price of a Pepsi falls and the price of a Coke remains unchanged; you will buy more Pepsi, because relatively, it is less expensive than Coke27What does the Substitution and Income effect prove?The law of demand, that is, as the price of a good declines, consumers will buy more units of the good, and vice versa28What is a Normal Good?A good that consumers will buy more of as their incomes increase29What is anInferior Good?A good that consumers will buy less of as their incomes increase30Key Concepts31What is Util?What is Utility?What is Total Utility?What is Marginal Utility?What is the Law of Diminishing Marginal Utility?When is Total Utility maximized?What is Consumer Equilibrium?Key Concepts32Key Concepts cont.What are two alternative explanations of demand?What is the Income effect?What is the Substitution effect?What does the Substitution and Income effect prove?What is a Normal Good?What is an Inferior Good?33Summary34 Utility is the satisfaction or pleasure derived from consumption of a good or service. Actual measurement of utility is impossible, but economists assume it can be measured by a fictitious unit called the util.35 Total utility is the total level of satisfaction derived from all units of a good or service consumed. Marginal utility is the change in total utility from a one unit change in the quantity of a good or service consumed. 3686421234Diminishing Marginal UtilityMUMarginal UtilityQ371612841234Total UtilityTUUtilsQ38 The law of diminishing marginal utility states that marginal utility of a good or service eventually declines as consumption increases. 39 Consumer equilibrium is the condition of reaching the maximum level of satisfaction, given a budget, when the marginal utility per dollar spent on each good purchased is equal. 40 Consumer equilibrium and the law of diminishing marginal utility can be used to derive a downward-sloping demand curve. When the price of a good falls, consumer equilibrium no longer holds because the marginal utility the marginal utility per dollar for the good rises. 41 To restore equilibrium, the consumer must increase consumption. As the quantity demanded increases, the marginal utility falls until equilibrium is again achieved. Thus, the price falls and the quantity demanded rises, as predicted by the law of demand42MU Aprice A MU Bprice BConsumer EquilibriumMU Zprice Z==43 The income effect and the substitution effect are complementary explanations for the law of demand. When the price changes, these effects work in combination to change in the quantity demanded in the opposite directions. 44 As the price falls, real purchasing power increases, causing an increase in the consumer’s willingness and ability to purchase a good or service. This is the income effect. Also, as the price falls, the consumer substitutes the cheaper the cheaper good for other goods that are now relatively more expensive. This is the substitution effect. 45 If the marginal utility per last dollar spend on each good is equal and the entire budget is spent, total utility is maximized. 46 When the price of a normal good falls, the income effect and the substitution effect combine to cause the quantity demanded to increase. 47 Chapter 6 Quiz©2000 South-Western College Publishing48C. As a consumer consumes more and more of anything, the satisfaction received on the last unit becomes less and less with each unit.1. As an individual consumes more of a given good, the marginal utility of that good to the consumera. rises at an increasing rate.b. rises at a decreasing rate.c. falls.d. rises.49D. The word “margin” means that last unit or the last increment.2. The amount of added utility that a consumer gains from the consumption of one more unit of a good is calleda. incremental utility. b. total utility. c. diminishing utility. d. marginal utility. 50A. As more units of food are purchased, the marginal utility diminishes, while that of compact discs remains the same.3. A certain consumer buys only food and compact discs. If the quantity of food bought increases, while that of compact discs remains the same, the marginal utility of food willa. fall relative to the marginal utility of compact discs.b. rise relative to the marginal utility of compact discs.c. rise, but not as fast as the marginal utility of compact discs falls.d. fall, but not as fast as the marginal utility of compact discs falls.51A. If a consumer can raise his/her marginal utility by purchasing more of a good, more units of that good will be purchased. At the point that marginal utility cannot be increased by purchasing more units of either good, the consumer will stop purchasing.4. Rational consumers will continue to consume two goods untila. the marginal utility per dollar’s worth of the two goods is the same.b. the marginal utility is the same for each good.c. the prices of the two goods are equal.d. the prices of the two goods are unequal.52D. In terms of satisfaction, the two goods become identical at the point of equilibrium.5. Assume a person’s consumption of just the right amounts of pork and chicken is in equilibrium. We can conclude that the a. marginal utility of pork must equal the marginal utility of chicken.b. price of pork must equal the price of chicken.c. ratio of marginal cost to price must be the same in both the pork and the chicken markets.d. ratio of marginal utility to price must be the same for pork and chicken.53D. At this point, the ratio of utils to price is the same.6. Assume an individual consumes only milk and doughnuts, and he/she has arranged consumption so that the last glass of milk yields 12 utils and the last doughnut 6 utils. If the price of milk is $1 per glass and the price of a doughnut is $.50, we can conclude that thea. consumer should consume less milk and more doughnuts.b. price of milk is too high relative to doughnuts.c. consumer should consume more milk and fewer doughnuts.d. consumer is in equilibrium.54C. When the ratio of utils to price is the same for two goods, the consumer cannot increase his/her satisfaction by buying more of either.7. Suppose an individual consumes pizza and cola. To reach consumer equilibrium, the individual must consume pizza and cola so that the a. price paid for the two goods is the same.b. marginal utility of the two goods is equal.c. ratio of marginal utility to price is the same for both goods.d. ratio of marginal utility of cola to marginal utility of pizza is 1.55B. When the marginal utility of two goods is the same, the consumer cannot increase his/her level of satisfaction by purchasing more of either good.8. A state of consumer equilibrium for goods consumed prevails when thea. marginal utility of all goods is the same.b. marginal utility per dollar’s worth of two goods is the same.c. price of two goods is the same.d. marginal cost per dollar spent on two goods is the same.56A. When prices decline the purchasing power of the consumer increases, and vice versa. Therefore, a change in prices has the same effect on the buying power of the consumer as if his/her income had changed.9. The change in quantity demanded resulting from a change in purchasing power is known as the a. income effect.b. substitution effect.c. law of demand.d. consumer equilibrium effect.57Total Utility for Multiplex Tickets, Video Rentals, and Popcorn1 movie (30 utils)2 movies (54 utils)3 movies (72 utils)4 movies (84 utils)1 bag (8 utils) 2 bags (13 utils) 3 bags (15 utils) 4 bags (16 utils)1 video (14 utils)2 videos (24 utils)3 videos (30 utils)4 videos (32 utils)Total Utility from Multiplex TicketsTotal Utility from Video RentalsTotal Utility from PopcornExhibit 458A. If the total utility for 2 videos is 24 utils and the total utility for 3 videos is 30 utils, the additional utils added by the third video is 6. 10. In exhibit 4, assume Multiplex tickets cost $6 each, video rentals cost $2 each, and bags of popcorn cost $1 each. What is the marginal utility of renting a third video? a. 6 utils.b. 8 utils.c. 10 utils.d. 30 utils.59B. 67 total utils are achieved with this combination, a yields 60 utils, c yields 60 utils and d yields 54 utils.11. In exhibit 4, assume Multiplex tickets cost $6 each, video rentals cost $2 each, and bags of popcorn cost $1 each. Suppose the consumer has $12 per week to spend on Multiplex tickets, video rentals, and popcorn. What combination of goods will give the consumer the most utility? a. 1 movie, 3 videos, and no popcorn.b. 1 movie, 2 videos, and 2 bags of popcorn.c. 1 movie, 1 video, and 4 bags of popcorn.d. 2 movies, no video, and no bags of popcorn.60Internet ExercisesClick on the picture of the book, choose updates by chapter for the latest internet exercises.61END62