Lecture 10

Utility and Demand
This Chapter
We have learned that demand is decided by preferences

• The marginal benefit of consumption depends on the what the consumer likes and dislikes
How can we derive marginal benefit and consumer demand from preferences?
• How is each specific demand curve determined?
How do our preferences end up deciding what we consume?

Consumption Choices
The choices you make as a buyer of goods and services are influenced by many
factors, which economists summarize as
• Consumption possibilities
• Preferences
Consumption Possibilities
Consumption possibilities are all the things that a consumer can afford to buy.
• We’ll study the consumption possibilities of Lisa, who buys only two goods: movies
and soda.
Consumption Choices
A Consumer’s Budget Line

Consumption possibilities are limited by income, the price of a movie, and
the price of soda.
When Lisa spends all of her income, she reaches the limits of her
consumption possibilities.
Lisa’s budget line shows the limits of her consumption possibilities.
Consumption Choices
Lisa has $40 to spend, the price of a movie is $8 and the price of soda is $4 a case.
Consumption Choices
Lisa can afford any of the

combinations at the points A to F.
Some goods are indivisible and must
be bought in whole units at the points
marked.
Other goods are divisible goods and
can be bought in any quantity.
The line through points A to F is
Lisa’s budget line.
Consumption Choices
The budget line is a constraint on

Lisa’s consumption choices.
Lisa can afford any point on her
budget line or inside it.
Lisa cannot afford any point outside
her budget line.
Looks familiar?
Consumption Choices
Changes in Consumption Possibilities

Consumption possibilities change when income or prices change.
• A rise in income shifts the budget line outward and leaves its slope unchanged.
Consumption possibilities expand.
• A rise in a price changes the slope of the line and shrinks consumption possibilities.
The budget line shows what is possible; the consumer's preferences determine
which possibility is chosen.
Consumption Choices
Preferences
The choice that Lisa makes depends on her preferences—her likes and dislikes.
Her benefit or satisfaction from consuming a good or service is called utility.
Total Utility
Total utility is the total benefit a person gets from the consumption of goods.
Generally, more consumption gives more total utility.
Consumption Choices
The table shows Lisa’s total utility

schedule.
Total utility from a good increases as
the quantity of the good increases.
For example, as Lisa sees more
movies in a month, her total utility
from movies increases.
Consumption Choices
Marginal Utility
Marginal utility from a good is the change in total utility that results from a
unit-increase in the quantity of the good consumed.
As the quantity consumed of a good increases, the marginal utility from it
decreases.
We call this decrease in marginal utility as the quantity of the good
consumed increases the principle of diminishing marginal utility.
Consumption Choices
The table shows how to calculate

Lisa’s marginal utility from her total
utility.
Marginal utility from a good decreases
as the quantity of the good increases.
For example, as the number of
movies seen in a month increases,
marginal utility from movies
decreases.
Consumption Choices
Figure (a) shows Lisa’s total utility

and marginal utility from soda.
Total utility from soda increases as
more soda is consumed.
The bars along the total utility curve
show the extra total utility (marginal
utility) from each additional case of
soda.
Consumption Choices
Graphing Liz’s Utility Schedule

Figure (b) illustrates diminishing
marginal utility.
As Lisa increases the quantity of soda
she drinks, her marginal utility from
soda diminishes.
Utility-Maximizing Choice
The key assumption is that the household chooses the consumption

possibility that maximizes total utility.
A Spreadsheet Solution
The direct way to find the utility-maximizing choice is to make a table in a
spreadsheet and do the calculations.
• Find the just-affordable combinations
• Find the total utility for each just-affordable combination
• The utility-maximizing combination is the consumer’s choice
Find the Just-Affordable

Combinations
Lisa has $40 a month to spend on
movies and soda.
The price of a movie is $8 and the
price of soda is $4 a case.
Each row of the table shows a
combination of movies and soda that
exhausts Lisa’s $40.
Find the Total Utility for Each Just-

Affordable Combination
When Lisa sees 1 movie and drinks 8
cases of soda a month, …
she gets 50 units of utility from the 1
movie and 248 units of utility from
the 8 cases of soda.
Her total utility is 298 units.
Consumer Equilibrium
Lisa chooses the combination that
gives her the highest total utility.
Lisa maximizes her total utility when
she sees 2 movies and drinks 6 cases
of soda a month.
Lisa gets 90 units of utility from the 2
movies and 315 units of utility from
the 6 cases of soda.
Consumer equilibrium is the

situation in which Lisa has allocated
all of her available income in the way
that maximizes her total utility, given
the prices of movies and soda.
Lisa’s consumer equilibrium is 2
movies and 6 cases of soda a month.
Another way to find the point…

What is the trade-off from B to C?
• 40 increase in total utility from 1
additional movie
• 23 decrease in total utility from 2 fewer
cases of soda
• Because 40 > 23, B is not the optimal
point of consumption.
Another way to find the point…

What is the trade-off from D to C?
• 32 decrease in total utility from 1 fewer
movie
• 42 increase in total utility from 2 more
cases of soda
• Because 42 > 32, D is not the optimal
point of consumption.
What condition should the optimal point of

consumption fulfill?
A more natural way of finding the consumer equilibrium is to use the idea of
choices made at the margin.
Choosing at the Margin
Having made a choice, would spending a dollar more or a dollar less on a
good bring more total utility?
Marginal utility is the increase in total utility that results from consuming
one more unit of the good.
The marginal utility per dollar is the marginal utility from a good that
results from spending one more dollar on it.
Marginal Utility per Dollar

The marginal utility per dollar equals the marginal utility from a good
divided by its price.
Calling the marginal utility from movies 𝑀𝑈𝑀 and the price of a movie 𝑃𝑀 ,
then the marginal utility per dollar from movies is 𝑀𝑈𝑀 /𝑃𝑀 .
Calling the marginal utility of soda 𝑀𝑈𝑆 and the price of soda 𝑃𝑆 , then the
marginal utility per dollar from soda is 𝑀𝑈𝑆 /𝑃𝑆 .
By comparing 𝑀𝑈𝑀 /𝑃𝑀 and 𝑀𝑈𝑆 /𝑃𝑆 , we can determine whether Lisa has
allocated her budget in the way that maximizes her total utility.
Utility-Maximizing Rule
A consumer’s total utility is maximized by following the rule:
• Spend all available income
• Equalize the marginal utility per dollar for all goods
In row B, 𝑀𝑈𝑆 /𝑃𝑆 < 𝑀𝑈𝑀 /𝑃𝑀 .

Lisa spends too much on soda and
too little on movies.
If Lisa spends less on soda and more

on movies,
𝑀𝑈𝑆 increases and 𝑀𝑈𝑀 decreases.
In row D, 𝑀𝑈𝑆 /𝑃𝑆 > 𝑀𝑈𝑀 /𝑃𝑀 .

Lisa spends too little on soda and too
much on movies.
If Lisa spends more on soda and less

on movies,
𝑀𝑈𝑆 decreases and 𝑀𝑈𝑀 increases.
In row C,
𝑀𝑈𝑆 /𝑃𝑆 = 𝑀𝑈𝑀 /𝑃𝑀 .
Lisa is maximizing utility.
Predictions of Marginal Utility
Theory
We can use marginal utility theory to make some predictions.
A Fall in the Price of a Movie
When the price of a good falls the quantity demanded of that good
increases—the demand curve slopes downward.
For example, if the price of a movie falls, we know that 𝑀𝑈𝑀 /𝑃𝑀 rises, so
before the consumer changes the quantities bought, 𝑀𝑈𝑀 /𝑃𝑀 > 𝑀𝑈𝑆 /𝑃𝑆 .
To restore consumer equilibrium (maximum total utility), the consumer
increases the movies seen to drive down the 𝑀𝑈𝑀 and restore 𝑀𝑈𝑀 /𝑃𝑀 =
𝑀𝑈𝑆 /𝑃𝑆 .
Theory
A change in the price of one good changes the demand for another good.
If the price of a movie falls, 𝑀𝑈𝑀 /𝑃𝑀 rises, …
so before the consumer changes the quantities consumed, 𝑀𝑈𝑀 /𝑃𝑀 >
𝑀𝑈𝑆 /𝑃𝑆 .
decreases the quantity of soda consumed to drive up the 𝑀𝑈𝑆 and restore
𝑀𝑈𝑀 /𝑃𝑀 = 𝑀𝑈𝑆 /𝑃𝑆 .
Theory
The table shows Lisa’s just-affordable
combinations when the price of a
movie is $4.
Before Lisa changes what she buys:
𝑀𝑈𝑀 /𝑃𝑀 > 𝑀𝑈𝑆 /𝑃𝑆 .
To maximize total utility, Lisa sees
more movies and drinks less soda.
Theory
The figure illustrates these predictions.
A fall in the price of a movie increases the quantity of
movies demanded—a movement along the demand
curve for movies, ...
and decreases the demand for soda—a shift of the
demand curve for soda.
Theory
A Rise in the Price of Soda
Now suppose the price of soda rises.
We know that 𝑀𝑈𝑆 /𝑃𝑆 falls, so before the consumer changes the quantities
bought, 𝑀𝑈𝑆 /𝑃𝑆 < 𝑀𝑈𝑀 /𝑃𝑀 .
decreases the quantity of soda consumed to drive up the 𝑀𝑈𝑆 and increases
the quantity of movies seen to drive down 𝑀𝑈𝑀 .
These changes restore 𝑀𝑈𝑀 /𝑃𝑀 = 𝑀𝑈𝑆 /𝑃𝑆 .
Theory
combinations when the price of soda
is $8 and the price of a movie is $4.
Before Lisa changes what she buys:
𝑀𝑈𝑆 /𝑃𝑆 < 𝑀𝑈𝑀 /𝑃𝑀 .
To maximize her total utility, Lisa
drinks less soda.
Theory
The figure illustrates these
predictions.
A rise in the price of soda decreases
the quantity of soda demanded—a
movement along the demand curve
for soda.
Theory
A Rise in Income
When income increases, the demand for a normal good increases.
Given the prices of movies and soda, when Lisa’s income increases from $40
to $56 a month, she buys more movies and more soda.
Movies and soda are normal goods.
Theory
combinations when she has $56 to
spend.
With $40 to spend, Lisa sees 6 movies
and drinks 4 cases of soda a month.
With $56 to spend, Lisa spends the
extra $16, so she buys more of both
goods.
She sees 8 movies and drinks 6 cases
of soda a month.
Theory
Example: the Music Industry
Maximizing Utility from Recorded Music

• In the 1970s, recorded music came on vinyl
discs in the 1970s.
• Cassettes gradually replaced vinyl, then
compact discs (CDs) gradually replaced
cassettes.
• Digital files downloaded to computers and
mobile devices replaced physical CDs.
• And now, downloads are in decline as
streaming takes off. (We don’t know the
quantity of files streamed.)
• The music that we buy isn’t just one good - it is several goods.
• Singles and albums are different goods; streams, downloads, physical discs are different goods.
• We get utility from the singles and albums that we buy.
• The more songs and albums we have, the more utility we get.
• Our marginal utility from songs and albums decreases as the quantity that we own increases.
• We also get utility from convenience.
• Downloaded music is more convenient to enjoy than CD
• Song for song, we get more utility from a digital song than we get from a song on a physical CD.
• When we decide how many singles and albums to stream, download, or buy on CDs,
We make the marginal utility per dollar from each type of music in each format equal.
• The market for downloads created consumer

surplus.
• In 2001, 100 million singles were bought at an
average price of $5, 2012, 1400 million singles
were bought at an average price of $1.20.
• We can infer the demand curve from the two
points, assuming demand is unchanged between
2001 and 2012 and is linear.
• What is the consumer surplus and what is
consumer’s expenditure on downloaded music?
• However, estimating consumer surplus is hard for

streaming music.
• Streaming is paid for with an upfront subscription.
• There is no price for each song!
• How to estimate consumer surplus?
• Assume demand is the same for downloaded music
and streaming music.
• After paying for subscription, price of an additional
streamed single is 0, and the quantity demanded is
where the demand curve hits the x-axis.
• Consumer surplus = the area of the whole triangle –
subscription expenditures

Lecture 10

Uploaded by

Copyright:

Available Formats

Lecture 10

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lecture 10

Uploaded by

Copyright:

Available Formats

Utility and Demand

We have learned that demand is decided by preferences

How do our preferences end up deciding what we consume?

A Consumer’s Budget Line

Lisa can afford any of the

The budget line is a constraint on

Changes in Consumption Possibilities

The table shows Lisa’s total utility

The table shows how to calculate

Figure (a) shows Lisa’s total utility

Graphing Liz’s Utility Schedule

The key assumption is that the household chooses the consumption

Find the Just-Affordable

Find the Total Utility for Each Just-

Consumer equilibrium is the

Another way to find the point…

Another way to find the point…

What condition should the optimal point of

Marginal Utility per Dollar

In row B, 𝑀𝑈𝑆 /𝑃𝑆 < 𝑀𝑈𝑀 /𝑃𝑀 .

If Lisa spends less on soda and more

In row D, 𝑀𝑈𝑆 /𝑃𝑆 > 𝑀𝑈𝑀 /𝑃𝑀 .

If Lisa spends more on soda and less

Maximizing Utility from Recorded Music

• The market for downloads created consumer

• However, estimating consumer surplus is hard for

You might also like