Chapter 5. Consumer Choice

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Chapter 5. Consumer Choice

• Utility
• Consumer surplus
• Budget Constraints
• Indifference Curves

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I. Utility Analysis

• what is utility?
• benefit you get from consuming a good
• determined by your tastes/preferences
• (assume these are stable)

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total utility (TU)

• total benefit from consuming good
• example
• total benefit from 3 cookies

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• TU increases as consumption increases, to a point

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marginal utility (MU)

• change in TU from
• consuming one more of a good
• example
• how much MORE utility from
• an additional pack of gum?

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change in TU from 0 to 1 cookie
MU of 1st cookie

change in TU from 1 cookie to 2 cookies

MU of 2nd cookie
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diminishing marginal utility

• MU falls as consumption rises
• get sick of cookies

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MU of 1st cookie

MU of 2nd cookie
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TU rises at slower and slower rate
as MU declines
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How to maximize TU?

• use available budget
• equalize MU/ across goods
• Huh?

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• chose combination of cookies and milk where

price of cookies
price of milk
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why?

• chose combo of 6 cookies, 1 milk
• suppose MU/1 of cookies 4,
• MU/1 of milk 15
• by consuming fewer cookies, more milk
• I would add more to my TU

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TU vs. MU

• Diamond-Water paradox
• 10,000
• one carat diamond
• 5 million gallons of tap water

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why?

• TU of water is greater than TU of diamonds
• water is essential for life
• BUT water is abundant, diamonds are rarer
• MU of last diamond is higher
• MU determines value

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MU and demand

• MU declines as consumption rises
• willing to pay less for each additional unit
• downward sloping demand

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example pizza
for 2nd pizza
for 4th pizza
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II. Consumer Surplus

• difference between what you pay for a good,
• any what you are WILLING to pay for a good

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example

• market price pizza 10
• my marginal value of 3rd pizza this week 12
• my consumer surplus 2

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my demand curve
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area between D and price of pizza
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III. The Budget Line

• given
• consumers budget
• prices
• draw a line representing choices
• consumption possibilities

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example

• 2 goods milk cookies
• bottle of milk 1
• cookie .50
• daily budget 4

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possible combinations
0 2 4 6 8
4 3 2 1 0
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budget line
cookies
milk
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budget line
cookies
Unaffordable
Affordable
milk
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what if prices change?

• changes slope of budget line
• suppose cookies 1

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budget line
cookies
milk
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what if budget changes

• budget line shifts
• suppose budget 5

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cookies
milk
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IV. Indifference Curves

• (appendix)
• alternative way to show utility
• curve shows combo of goods
• that deliver same total utility

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example milk and cookies
cookies
Every point on curve has same total utility
milk
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TU is higher as curve shifts right
cookies
milk
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consumer equilibrium

• maximize TU
• stay on budget

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consumer equilibrium
best affordable point
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consumer equilibrium
best affordable point
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sum it up

• consumer decisions based on
• preferences
• budget constraint
• consumer decisions made at the margin
• marginal benefit of one more
• compared to price of one more