Choice, Change, Challenge, and Opportunity

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UTILITY AND DEMAND How Household make choices
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CHAPTER
Dr. Gomis-Porqueras ECO 680
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Fundamentals of Consumer Choice
Limited income necessitates choice.
Consumers make choices purposefully. One good
can be substituted for another. Consumers must
make decisions without perfect information, but
knowledge and past experience will help.
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Household Choice in Output Markets
Every household must make three basic
decisions How much of each product, or output,
to demand. How much labor to supply. How much to
spend today and how much to save for the future.
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Household Consumption Choices

• A households consumption choices are determined
  by
• Consumption possibilities
• Preferences
• Consumption Possibilities
• A households consumption possibilities are
  constrained by its budget and the prices of the
  goods and services it buys.
• A budget line describes the limits to a
  households consumption choices.

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Consumption Possibilities

• The Budget Equation
• We can describe the budget line by using a budget
  equation
• The budget equation states the following
• Expenditure Income
• Call the price of soda PS, the quantity of soda
  QS, the price of a movie PM, the quantity of
  movies QM, and income Y.
• Lisas budget equation is
• PSQS PMQM Y.

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Consumption Possibilities

• PSQS PMQM Y
• Divide both sides of this equation by PS, to
  give
• QS (PM/PS)QM Y/PS
• Then subtract (PM/PS)QM from both sides of the
  equation to give
• QS Y/PS (PM/PS)QM
• The term Y/PS is Lisas real income in terms of
  soda.
• The term PM/PS is the relative price of a movie
  in terms of soda.

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Household Consumption Choices

• Figure 7.1 shows a budget line.

The household can afford all the points on or
below the budget line.
The household cannot afford the points beyond the
budget line.
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Household Consumption Choices

• Preferences
• A households preferences determine the benefits
  or satisfaction a person receives consuming a
  good or service.
• The 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 utility.
• Can we observe utility?

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Household Consumption Choices

• Figure 7.2(a) shows a total utility curve.

Total utility increases with the consumption of a
good or service.
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Consumer Preferences
The determining factors in consumer preferences
are frequently complex.
Consumer preferences are shaped by attitudes
toward time and risk. Advertising influences
consumer choice and preferences.
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Household Consumption Choices

• Marginal Utility
• Marginal utility is the change in total utility
  that results from a one-unit increase in the
  quantity of a good consumed.
• As the quantity consumed of a good increases, the
  marginal utility from consuming it decreases.
• We call this decrease in marginal utility as the
  quantity of the good consumed increases the
  principle of diminishing marginal utility.

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Household Consumption Choices

• Figure 7.2(b) illustrates diminishing marginal
  utility.

Utility is analogous to temperature. Both are
abstract concepts and both are measured in
arbitrary units.
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Utility, What Do You Really Mean?

• Utility is funny. I lived perfectly without a
  cell phone for years. After I got it, I did not
  feel all that much happier but if at this point
  in time it was taken away I would be worse off.
• Observation Our utility depends not only on what
  we are currently consuming, but also on what we
  are accustomed to consuming.
• Question If I were to take away your cell phone
  would you continue to feel worse or would your
  negative feelings diminish? Why?

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More on Utility My Favorite Example

• The Big Texan Steak Ranch and Opry in Amarillo
  Texas offers the following deal
• Eat the Big Texans famous 72oz. Steak dinner
  with all the trimmings in one hour and its
  FREE.
• Almost 35,000 people have tried and only 5,500
  have succeeded.
• Why?

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Preferences and Indifference Curves

• Lisa can sort all possible combinations of goods
  into three groups preferred, not preferred, and
  indifferent.
• An indifference curve joins all those points that
  Lisa says are just as good as C.

G is such a point. Lisa is indifferent between C
and G.
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Households Maximize Utility

• The key assumption of marginal utility theory is
  that the household chooses the consumption
  possibility that maximizes total utility.
• The Utility-Maximizing Choice
• We can find the utility-maximizing choice by
  looking at the total utility that arises from
  each affordable combination.
• Table 7.2 (page 153) shows an example of the
  utility-maximizing combination, which is called a
  consumer equilibrium.

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Maximizing Utility

• Equalizing Marginal Utility per Dollar Spent
• Using marginal analysis, a consumers total
  utility is maximized by following the rule
• Spend all available income and equalize the
  marginal utility per dollar spent on all goods.
• The marginal utility per dollar spent is the
  marginal utility from a good divided by its
  price.

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Maximizing Utility

• Call the marginal utility of movies MUM
• Call the marginal utility of soda MUS
• Call the price of movies PM
• Call the price of soda PS
• The marginal utility per dollar spent on movies
  is MUM/PM
• The marginal utility per dollar spent on soda is
  MUS/PS.

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Maximizing Utility

• If MUM/PM gt MUS/PS, then moving a dollar from
  soda to movies increases the total utility from
  movies by more than it decreases the total
  utility from soda, so total utility increases.

Only when MUM/PM MUS/PS, is it not possible to
reallocate the budget and increase total utility.
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Preferences and Indifference Curves

• Combing how we value the different goods and what
  we can afford we can determine our best choice

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Predictions of Marginal Utility Theory

• A Fall in the Price of a Movie
• When the price of a good falls the quantity
  demanded of that good increasesthe 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 consumed, MUM/PM gt MUS/PS.
  
• To restore consumer equilibrium (maximum total
  utility) the consumer increases the quantity of
  movies consumed to drive down the MUM and restore
  MUM/PM MUS/PS.

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Predictions of Marginal Utility Theory

• A change in the price of one good changes the
  demand for another good.
• Youve seen that if the price of a movie falls,
  MUM/PM rises, so before the consumer changes the
  quantities consumed, MUM/PM gt MUS/PS.
• To restore consumer equilibrium (maximum total
  utility) the consumer decreases the quantity of
  soda consumed to drive up the MUS and restore
  MUM/PM MUS/PS.

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Predictions

• Table 7.4 and Figure 7.4 illustrate these
  predictions.

A fall in the price of a movie increases the
quantity of movies demandeda movement along the
demand curve for movies,
and decreases the demand for sodaa shift of the
demand curve for soda.
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Predictions of Marginal Utility 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 consumed, MUS/PS lt MUM/PM.
  
• To restore consumer equilibrium (maximum total
  utility) the consumer decreases the quantity of
  soda consumed to drive up the MUS and increases
  the quantity of movies consumed to drive down
  MUM. These changes restore MUM/PM MUS/PS.

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Predictions
A rise in the price of soda decreases the
quantity of soda demandeda movement along the
demand curve for soda,

• and increases the demand for moviesa shift of
  the demand curve for movies.
• When income increases, the demand for a normal
  good increases.

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Income and Substitution Effects
Price changes affect households in two ways
The income effect Consumption changes because
purchasing power changes. The substitution
effect Consumption changes because opportunity
costs change.
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The Income Effect of a Price Change
When the price of a product falls, a consumer has
more purchasing power with the same amount of
income. When the price of a product rises, a
consumer has less purchasing power with the same
amount of income.
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The Substitution Effect of a Price Change
When the price of a product falls, that product
becomes more attractive relative to potential
substitutes. When the price of a product rises,
that product becomes less attractive relative to
potential substitutes.
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Income and Substitution Effects of a Price Change
Price of a good or service

Household is better off Income effect Household buys more

Opportunity cost of the good falls Substitution effect Household buys more

Household is worse off Income effect Household buys less

Opportunity cost of the good rises Substitution effect Household buys less

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Saving and Borrowing Present Versus Future
Consumption
Households can use present income to finance
future spending (i.e., save), or they can use
future funds to finance present spending (i.e.,
borrow).
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Saving and Borrowing Present Versus Future
Consumption
An increase in the interest rate also has
substitution and income effects, as follows

• Income effect Households will now earn more on
  all previous savings, so they will save less

• Substitution effect The opportunity cost of
  present consumption is now higher given the law
  of demand, the household will save more.

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Predictions of Marginal Utility Theory

• Individual Demand and Market Demand
• The market demand for a good is the relationship
  between the price of the good and total quantity
  demanded of that good.
• The individual demand for a good is the
  relationship between the price of the good and
  the quantity demanded by one person.
• Figure 7.6 on the next slide shows how we sum the
  individual demand curves to obtain the market
  demand.

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Predictions of Marginal Utility Theory
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Determinants of Demand

• Tastes, habits and fashions
• Advertising
• The availability and price of related goods
• Prices of substitutes
• Prices of complements
• Income
• Population
• Consumer expectations

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Classifying goods

• Income
• As income increases the demand for a normal
  good will increase.
• As income increases the demand for an inferior
  good will decrease.
• Prices of Related Goods
• When a fall in the price of one good reduces the
  demand for another good, the two goods are called
  substitutes.
• When a fall in the price of one good increases
  the demand for another good, the two goods are
  called complements.

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Can LeBron James Get You to Drink Powerade?
Firms must understand consumer behavior to
determine whether strategies such as using
celebrities in their advertising are likely to be
effective.
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Companies Respond to a Growing Hispanic Population
Firms are responding to the tastes of a growing
Hispanic population. Some Home Depot stores, for
example, include signs in both English and
Spanish.
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Example Winn-Dixie

• Methods of gathering Information
• -
• -
• Experiments they perform
• -
• -

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Why Supermarkets Need to Understand Substitutes
and Complements
COFFEE FROZENPIZZA HOTDOGS ICECREAM POTATOCHIPS REGULARCEREAL SPAGHETTISAUCE YOGURT
Varieties in FiveChicagoSupermarkets 391 337 128 421 285 242 194 288
VarietiesIntroducedin a 2-Year Period 113 109 47 129 93 114 70 107
Varieties Removedin a 2-Year Period 135 86 32 118 77 75 36 51
A supermarket shouldnt remove a slow-selling
soup from its shelves without researching whether
shoppers use that soup as a substitute or a
complement for another soup.
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Estimating and Predicting Demand

• Methods of collecting data
• Market observations
• seeing how demand has changed over time
• seeing how possible determinants of demand have
  changed over time
• using the information to estimate determinants of
  demand
• but past relationships may not hold in future!!!

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Estimating and Predicting Demand

• Methods of collecting data (cont.)
• Market surveys
• advantages
• conditions for accuracy of market surveys
• random sample
• clarity of the questions
• avoidance of leading questions
• truthful response
• stability of demand
• Market experiments