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

Chapter 21 - Consumer Choice 1

 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

Chapter 21 - Consumer Choice 2

 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.

Chapter 21 - Consumer Choice 3

 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

Chapter 21 - Consumer Choice 4

 Utility Theory
 Marginal Utility
– The change in total utility due to a one-unit
change in the quantity of a good or service
consumed

Change in total utility

Marginal utility =
Change in number of units consumed

Chapter 21 - Consumer Choice 5

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

Chapter 21 - Consumer Choice 6

 Total and Marginal Utility
of Downloading and Listening to Digital
Music Albums

Chapter 21 - Consumer Choice 7

 Total and Marginal Utility
of Downloading and Listening to Digital
Music Albums

Chapter 21 - Consumer Choice 8

 Total and Marginal Utility
of Downloading and Listening to Digital
Music Albums

Chapter 21 - Consumer Choice 9

 Total and Total utility is
maximized...

Marginal Utility
of Downloading
and Listening
to Digital
…where marginal
utility equals zero.

Music Albums

Chapter 21 - Consumer Choice 10

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

Chapter 21 - Consumer Choice 11

 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?”

Chapter 21 - Consumer Choice 12

 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.

Chapter 21 - Consumer Choice 13

 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.

Chapter 21 - Consumer Choice 14

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

Chapter 21 - Consumer Choice 15

Total and Marginal Utility from Consuming
Music Album Downloads and Sandwiches on
an Income of $26

Chapter 21 - Consumer Choice 16

Total and Marginal Utility from Consuming
Music Album Downloads and Sandwiches on
an Income of $26

Chapter 21 - Consumer Choice 17

Total and Marginal Utility from Consuming
Music Album Downloads and Sandwiches on
an Income of $26

Chapter 21 - Consumer Choice 18

 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.

Chapter 21 - Consumer Choice 19

 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.

Chapter 21 - Consumer Choice 20

 Optimizing Consumption
Choices
 A little math
– The rule of equal marginal utilities per dollar
spent

MU of good A MU of good B MU of good Z

= = ... =
Price of good A Price of good B Price of good Z

Chapter 21 - Consumer Choice 21

How a Price Change Affects
Consumer Optimum
Recall from Table 20-1 Income = $26

MUd 36.5
Qd = 4 = = 7.3
Pd 5

MUs 22
Qs = 2 = = 7.3
Ps 3

Chapter 21 - Consumer Choice 22

How a Price Change Affects
Consumer Optimum
Assume Price of Music Falls to $4

MUd 36.5
Qd = 4 = = 9.125
Pd 4

MUs 22
Qs = 2 = = 7.3
Ps 3

Chapter 21 - Consumer Choice 23

How a Price Change Affects
Consumer Optimum
Assume Price of Music Falls to $4

MUd MUs
Now >
Pd Ps

Result Buy more downloads

and MUd falls

Chapter 21 - Consumer Choice 24

 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.

Chapter 21 - Consumer Choice 25

Digital Music Download Prices
and Marginal Utility

Chapter 21 - Consumer Choice 26

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

Chapter 21 - Consumer Choice 27

 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.

Chapter 21 - Consumer Choice 28

 How a Price Change Affects
Consumer Optimum
 Purchasing Power
– The value of money for buying goods
and services

Chapter 21 - Consumer Choice 29

 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).

Chapter 21 - Consumer Choice 30

 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

Chapter 21 - Consumer Choice 31

 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.

Chapter 21 - Consumer Choice 32

The Diamond-Water Paradox

Chapter 21 - Consumer Choice 33

 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.
Chapter 21 - Consumer Choice 34
 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

Chapter 21 - Consumer Choice 35

Selected Substitute Airport
Pairs in the United States

Chapter 21 - Consumer Choice 36

 Summary Discussion
of 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.
Chapter 21 - Consumer Choice 37
 Summary Discussion
of 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.

Chapter 21 - Consumer Choice 38

 Summary Discussion
of 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.

Chapter 21 - Consumer Choice 39