Chapter 6: Consumer Choice Theory

If total utility from consuming two cups of coffee is 20 utils, and if the total utility from consuming three cups of coffee is 25 utils, then which of the following is the marginal utility of the third cup of coffee?

5

Utility

Ability or capacity of a good or service to be useful and give satisfaction to someone.

If a consumer wishes to maximize satisfaction given limited income and MUx/Px < MUy/Py then the consumer should: a. do nothing because she/he is in equilibrium. b. buy more of X and less of Y. c. buy more of Y and less of X. d. buy more of both X and Y. e. buy less of both X and Y.

C

What happens when the price of a good or service falls?

Consumer equilibrium no longer holds because the marginal utility per dollar for the good or service rises

Consumer equilibrium exists when: a. the marginal utility of each good and service consumed is equal. b. the total utility of each good and service consumed is equal. c. the marginal utility of each good and service consumed equals its price. d. ratio of marginal utility to price for all goods and services is equal.

D

What conclusion can we make regarding marginal utility per dollar?

If the marginal utility per last dollar spent on each good is equal and the entire budget is spent, total utility is maximized

marginal utility

The change in total utility from one additional unit of a good or service

If MUx/Px < MUy/Py, is the consumer in equilibrium, or should the consumer purchase more of X and less of Y, or vice versa?

The consumer is not in equilibrium. To get there, the consumer should purchase more of X and less of Y.

Why does the law of demand exist?

Ultimately because of the law of diminishing marginal utility. substitution effect, income effect, law of diminishing marginal utility

The subjective measure of the physical and mental satisfaction that is anticipated from consumption is called

Utility

When total utility is at a maximum, marginal utility is:

Zero

marginal utility

an additional amount of satisfaction

A util represents a unit of measurement for the:

happiness a person obtains from consuming a good

total utility

the total amount of satisfaction obtained from consumption of a good or service

Utility is defined as the:

sense of pleasure or satisfaction derived from consuming goods and services.

income effect

the change in the quantity demanded of a good that results from the effect of a change in the good's price on consumers' purchasing power

The term utility refers to the:

pleasure or satisfaction a consumer receives upon consuming a good.

Since water costs little and plane tickets are expensive, it must follow that when people choose their optimal quantities of water and plane tickets to purchase, the marginal utility they receive from the last plane ticket they buy is ______ than the marginal utility they receive from the last gallon of water they buy.

Greater

How is equilibrium restored?

To restore equilibrium, the consumer must increase consumption. As the quantity demanded increases, the marginal utility falls until equilibrium is again achieved.

How does consumer equilibrium relate to the law of demand?

The price falls, and the quantity demanded rises, as predicted by the law of demand.

Assume the consumption of just two goods, X and Y. Also assume the consumer is in equilibrium. What do you think would happen to consumer equilibrium given each of the following changes?

a. Income rises. (Because the consumer now has more to spend, the consumer will now purchase more of both X and Y. We are unable to determine exactly how much more of each good will be consumed. We would require more information to determine that (i.e. how much income rose, the marginal utility schedule and the price of goods X and Y)). b. The price of both X and Y double. (The amount of X and Y would both be cut in half.) c. The consumer now prefers X more and Y less. (This affects the marginal utility of both goods. The consumer will consume more of X and less of Y.)

Suppose you are interested in purchasing just ice cream and cake for an upcoming birthday party. Assume you have only $45 to spend, the price per cake is $10 and the price per package of ice cream is $5. You have estimated the utility (or satisfaction) from the consumption of cake and ice cream according to the following tables. ICE CREAM Quantity - Total Utility: 0 - 0 1 - 100 2 - 175 3 - 225 4 - 250 5 - 260 CAKE Quantity - Total Utility: 0 - 80 1 - 130 2 - 250 3 - 350 4 - 425 5 - 465 a. How many cakes and packages of ice cream should you purchase for the party? Why? b. Now suppose the price of cake falls to $7.50. Now how many cakes and packages of ice cream should you buy for the party? Why? c. How is the observed change in the quantity demanded of cake and the decrease in the price of cake related to the law of demand?

a. You should purchase 3 cakes and 3 packages of ice cream because this satisfies the algebraic formula for consumer equilibrium (i.e. this is the only quantity in which the marginal utility in relation to the price of both goods is equal). b. Now you should purchase 3 packages of ice cream and 4 cakes. c. The law of demand states there is an inverse relationship between the price and the quantity demanded. This was observed in this case. The law of demand exists because of the principle of rational choice.

If utility is not maximized, then:

some change in consumption will increase satisfaction

Suppose Charles has a monthly budget of $80 to spend on juice and cereal. Juice is priced at $4 per gallon, and cereal is priced at $2 per box. 1) If Charles spends his entire $80 on juice, he can buy ___ gallons of juice. 2) If he spends his entire $80 on cereal, he can buy ___ boxes of cereal. 3) What does the slope of Charles's budget line represent? 4) Suppose Charles receives an additional $20 from his grandmother on top of the $80 he already has and decides to dedicate this money to buy more juice and cereal. True or False: Charles faces the same tradeoff between juice and cereal.

1) 20 2) 40 (Since cereal is priced at $2 per box, if Charles spends $80 on cereal, he can buy $80/$2 per box=40 boxes of cereal.) 3) The opportunity cost of an additional gallon of juice in terms of boxes of cereal 4) True

What is consumer equilibrium?

A condition in which total utility cannot increase by spending more of a given budget on one good and spending less on another good (MU of good A/Price of good A) = (MU of good B/Price of good B) = (MU of good Z/Price of good Z) Example: (MU of Big Mac/Price of Big Mac) = (MU of milkshake/Price of milkshake) (4 utils/$2) = (4 utils/2)

How are the substitution and income effects related to the law of demand?

Because of a lower price people will buy more not only because the product is relatively less expensive (substitution effect), but also because of the increased purchasing power due to the price decrease (income effect).

If water is essential for life, while diamonds are not, then why is water cheaper than diamonds?

Because water is abundant, the marginal utility of water is low, and price reflects marginal utility, not total utility.

When the price of a normal good falls, then: a. both the income and substitution effects combine to cause the quantity demanded to increase. b. the substitution effect will cause people to buy more because the good is relatively less expensive. c. the income effect will cause people to buy more because of the increased purchasing power associated with the lower price. d. all of the above.

D

Which of the following statements is true? a. Total utility is the extra satisfaction from the consumption of a good or service. b. Marginal utility is the amount of satisfaction received from all the units of a good or service consumed. c. The law of diminishing marginal utility states that as more of a good or service is consumed total utility decreases. d. Consumer equilibrium is a combination of goods and services consumed which maximizes total utility from a given budget.

D

Why is water less expensive than diamonds?

Even though water provides individuals with more total utility, marginal utility determines the price one is willing to pay. Water is plentiful in most of the world, so its marginal utility is low and therefore one's willingness to pay for water is low. This follows the law of diminishing marginal utility.

Since juice costs little and high-definition televisions are expensive, it must follow that when people choose their optimal quantities of juice and high-definition televisions to purchase, the marginal utility they receive from the last gallon of juice they buy is ______ than the marginal utility they receive from the last high-definition television they buy.

Less

Suppose Latasha has to choose between purchasing high-definition televisions and juice. Which of the following is the utility-maximizing rule that Latasha should follow while choosing the optimal quantities of these two goods? (Note: In the answer options that follow, MU stands for "marginal utility.")

MU of Juice/Price of Juice = MU of HDTVs/Price of HDTVs

Suppose Kenji has to choose between purchasing jewelry and milk. Which of the following is the utility-maximizing rule that Kenji should follow while choosing the optimal quantities of these two goods? (Note: In the answer options that follow, MU stands for "marginal utility.") Which of the following is the utility-maximizing rule that Kenji should follow while choosing the optimal quantities of these two goods? (Note: In the answer options that follow, MU stands for "marginal utility.")

MU of Milk/Price of Milk = MU of Jewelry/Price of Jewelry

Balancing utility and price: Suppose Latasha has to choose between purchasing plane tickets and water. Which of the following is the utility-maximizing rule that Latasha should follow while choosing the optimal quantities of these two goods? (Note: In the answer options that follow, MU stands for "marginal utility.")

MU of Water/Price of Water = MU of Plane Tickets/Price of Plane Tickets

Utility Definitions

Nick is arguing with his girlfriend, Rosa. They have been going out for a little more than two years. Rosa says to him: "I'm leaving you, Nick. Get over it." Nick replies: "Are you saying that being single will make you happier than you've been with me? Speaking personally, I think the [TOTAL] utility we've had in this relationship was much more than you could have had if you'd been single this whole time!" Nick's use of the word "utility" rang a bell for Rosa, who had taken an economics class. "It's not that at all. We've had a fine time. It's that the [MARGINAL] utility I would get by continuing our relationship isn't worth it anymore." Nick replies: "I've never been dumped by someone citing the law of [DIMINISHING MARGINAL UTILITY] before. You're a piece of work, you know that?" Rosa doesn't hear. She has already walked off, leaving Nick feeling like something of a sunk cost.

substitution effect

The change in quantity demanded of a good or service caused by a change in its price relative to substitutes Example: Price of competing good Y rises --> Consumers switch from Y to good X --> Quantity of good X demanded increases.

What is the income effect?

The change in quantity demanded of a good or service caused by a change in real income (purchasing power) Example: Price of good X falls --> Real purchasing power increases --> Quantity of good X demanded increases.

Assume a two-good case, goods X and Y, and the consumer is initially in equilibrium. If the price of X declines then explain how a consumer will respond, and why, using the analysis introduced in this chapter. How is this related to the law of demand?

The consumer will purchase more of good X because the marginal utility in relation to the price of good X will now exceed that for good Y. As the consumer purchases more of good X and less of good Y, the consumer will be moving toward an equality between the ratio of the marginal utility of good X in relation to the price paid for good X and that for good Y. Eventually an equality between the two will be observed which defines consumer equilibrium, When we compare the old equilibrium with the new one, we observe more of good X being purchased. That is, because the price of good X fell, the consumer has found that in acting out of her own self-interest that more of X will be purchased. This is exactly what the law of demand predicts---when the price of a good falls, consumers will purchase more of the good.

Kevin has a so-called fruit budget, which he uses to buy only pears and avocados. Assume the price of pears decreases. Which of the following is an example of the income effect?

The decrease in the price of pears increases Kevin's real income, which enables Kevin to buy more fruits in general. (The income effect refers to the change in the quantity demanded of a good or service caused by a change in real income (or purchasing power). That is, when the price of pears decreases, Kevin's real income (or purchasing power) increases. This enables Kevin to buy more total pears and avocados. The income effect, together with the substitution effect, helps explain why individual demand curves slope downward.)

Which of the following best describes the economic concept of utility?

Utility measures the satisfaction, or pleasure, that people receive from consuming a good or service. The satisfaction, or pleasure, that people receive from consuming a good or service

Frances has a so-called fruit budget, which she uses to buy only apples and oranges. Assume the price of apples increases. Which of the following is an example of the income effect?

The increase in the price of apples decreases Frances's real income, which forces Frances to buy fewer fruits in general. (The income effect refers to the change in the quantity demanded of a good or service caused by a change in real income (or purchasing power). That is, when the price of apples increases, Frances's real income (or purchasing power) decreases. This forces Frances to buy fewer total apples and oranges. The income effect, together with the substitution effect, helps explain why individual demand curves slope downward.)

Amy has a so-called fruit budget, which she uses to buy only apricots and nectarines. Assume the price of apricots increases. Which of the following is an example of the substitution effect?

The increase in the price of apricots makes apricots relatively more expensive than nectarines, so Amy will buy fewer apricots and more nectarines. (The substitution effect refers to the change in the quantity demanded of a good or service caused by a change in its price relative to substitutes. That is, when the price of apricots increases, apricots become relatively more expensive than nectarines. Therefore, Amy will substitute away from the relatively more expensive apricots and toward the relatively less expensive nectarines. Amy will buy fewer apricots and more nectarines. The substitution effect, together with the income effect, helps explain why individual demand curves slope downward.)

law of diminishing marginal utility

The principle that the extra satisfaction provided by a good or service declines as people consume more in a given period

What is the marginal utility per dollar?

The ratio of the marginal utility of each good to its price

What conclusion can we make regarding the income effect and the substitution effect?

When the price of a normal good falls, the income effect and the substitution effect combine to cause the quantity demanded to increase.

The fact that a gallon of gasoline commands a higher market price than a gallon of water indicates that:

the marginal utility of gasoline is greater than the marginal utility of a gallon of water.

consumer equilibrium

when the ratio of the prices of goods is equal to the ratio of the marginal utilities (point at which the consumer can get the most satisfaction)

What are two alternative explanations of demand?

•Income effect •Substitution effect