Kinh tế học vĩ mô - Chapter 8: The logic of individual choice: the foundation of supply and demand

The Logic of Individual Choice:The Foundation of Supply and DemandChapter 8Utility Theory and Individual ChoiceEconomists have an answer to the question of why people behave as they do — self interest.Economists' analysis of individual choice does not deny individual differences.Utility Theory and Individual ChoiceA good beginning in understanding individual choice is to focus on the rational part of people's behavior.Utility Theory and Individual ChoiceUsing the simple concept of self-interest, two things determine what people do:The pleasure people get from doing or consuming something.The price of doing or consuming that something.Utility Theory and Individual ChoicePrice is the market's tool to bring quantity supplied equal to the quantity demanded.Changes in price provide incentives for people to change what they are doing.Measuring PleasureEconomists start with a proposition that individuals try to get as much pleasure as possible out of life.The goods and services we consume provide value (satisfaction) to us.Measuring PleasureIndividuals want to maximize the amount of satisfaction they receive through consuming goods and services.Measuring PleasureEconomists use the concept of utility—the pleasure or satisfaction that one gets from consuming a good or service.A util is a unit created by economists to “measure” utility.UtilityUtility serves as the basis of economists' analysis of individual choice. It is personal and individual. Utility cannot be compared across individuals.Total UtilityTotal utility refers to the total satisfaction one gets from consuming a product.Marginal UtilityMarginal utility refers to the satisfaction one gets from the consumption of one additional unit of a product above and beyond what on has consumed up to that point.Total Utility and Marginal UtilityAs additional units are consumed, marginal utility decreases while total utility increases.When marginal utility is zero, total utility stops increasing.Beyond this point, marginal utility is negative and total utility decreases.Number of pizza slices123456789Total utility 142636445054565654Marginal utility14121086420-2Marginal and Total Utility, Fig. 8-1a, p 180Total utilityMarginal utilitySlices of pizza per hour706050403020100123456789Slices of pizza per hour1614121086420-2123456789Marginal and Total Utility, Fig. 8-1b and c, p 180Total utilityMarginal utility UtilsUtilsDiminishing Marginal UtilityThe principle of diminishing marginal utility states that, at some point, the marginal utility received from each additional unit of a good begins to decrease with each additional unit consumed. Diminishing Marginal UtilityThis principle does not say you do not enjoy consuming more of a good.It only states that as you consume more of the good, you enjoy additional units less than you enjoyed the initial units.Rational Choice and Marginal UtilityThe analysis of rational choice begins with the premise that rational individuals want as much satisfaction as they can get from their available income.Rational means that people prefer more to less and will make choices that give them as much satisfaction as possible.Rational ChoicesIn making choices, essentially what you are doing is buying units of utility.Any choice (for the same amount of money) that does not give you as many units of utility as possible is an irrational choice.Rational choicesSince you want to get the most for your money, you make those choices that have the highest units of utility per dollar spent.Maximizing UtilityTotal utility is maximized when marginal utility per dollar spent of two goods is equal.Maximizing UtilityIf:Choose to consume an additional unit of good x.Maximizing UtilityIf:Choose to consume an additional unit of good y.Maximizing UtilityBy substituting the marginal utilities and prices of goods into these formulas, you can always decide which good it makes more sense to consume.Consume the one with the highest marginal utility per dollar.Maximizing Utility and EquilibriumWhen the ratios of the marginal utility to price of goods are equal, you are maximizing utility.Maximizing UtilityIf:You’re in equilibrium.You cannot increase your utility by adjusting your choices.Maximizing Utility, Table 8-1, p 182Q01234567TU020323841413626MU2012630-5-10MU/P10631.50-2.5-5Q01234567TU029465356575753MU29177310-4MU/P29177310-4Hamburgers (P = $2)Ice Cream (P = $1)Maximizing Utility, Table 8-2, p 183Total $ spentPurchase?MU/PMU$11 ice cream cone2929$22nd ice cream cone1717$41 hamburger1020$53rd ice cream cone77$72nd hamburger612$93rd hamburger36$104th ice cream cone33Total utility = 94 utilsRational Choice and Marginal UtilityThe same principle applies if more than two goods are consumed:If MUx/Px > MUz/Pz, consume more of good x.If MUy/Py > MUz/Pz, consume more of good y.Rational Choice and Marginal UtilityThe general utility-maximizing rule is that you are maximizing utility when the marginal utilities per dollar are equal across all goods you consume.Rational Choice and Marginal UtilityWhen you are maximizing utility.Rational Choice and Marginal UtilityWhen this principle is met, the consumer is in equilibrium.The cost per additional unit of utility is equal for all goods and the consumer is as well off as it is possible to be.Rational Choice and Marginal UtilityThe rule does not say that the rational consumer should consume a good until its marginal utility reaches zero.Consumers do not have enough money to reach this point, as they face an income constraint. Opportunity CostOpportunity cost is the benefit forgone of the next-best alternative.It is essentially the marginal utility per dollar you forgo.To say MUx/Px > MUy/Py is to say that the opportunity cost of not consuming good x is greater than the opportunity cost of not consuming good y.So we consume x.Opportunity CostWhen all the marginal utilities per dollar spent are equal, the opportunity cost of all the alternatives are equal.Rational Choice and the Laws of DemandThe principle of rational choice leads to the law of demand.When the price of a good goes up, the marginal utility per dollar from that good goes down and we demand less of it.Rational Choice and the Law of DemandInitially MUx/Px = MUy/Py When the price of good y goes up, then MUx/Px > MUy/Py.Our condition for maximizing utility is no longer satisfied. So when the price of a good goes up, we would choose to consume less of that good.Rational Choice and the Law of DemandOur utility maximizing rule is no longer satisfiedWe should now buy more of good x Rational Choice and the Law of DemandMUx decreases as we buy more x (diminishing marginal utility) and MUy increases as we buy less of the good yWe are back at a point where MUx/Px = MUy/Py and we maximize utility (but we now consume less x and more y than before the price increase).Rational Choice and the Law of DemandQuantity demanded rises as price falls, other things constant.Quantity demanded falls as price rises, other things constant.Rational Choice and the Law of DemandThe above shows the relationship between marginal utility and the price we are willing to pay.Rational Choice and the Law of DemandSince our demand for a good is an expression of our willingness to pay for it, quantity demanded is related to marginal utility.Applying the Theory of Choice to the Real WorldThere are limits on the assumptions underlying the theory of rational decision-making.The Cost of Decision MakingIn reality, people make hundreds of choices every day.It is difficult to believe that we are going to apply principles of rational choice to all those decisions.The Cost of Decision MakingSome decisions are difficult to make because we lack information, or there is some uncertainty involved, or it is a complex decision.Each decision requires us to use our limited cognitive ability to receive, process, store and retrieve information.The Cost of Decision MakingA number of economists believe that most people use bounded rationality to make their decisions rather than using the rational choice model.Bounded rationality means rationality adjusted for our limitations.The Cost of Decision MakingWe employ a variety of simple rules to make some of our decisions:Price conveys informationFollow the leaderHabitCustomPrice Conveys InformationHigher priced goods tend to be better than lower-priced goods.We can use this simple rule to make a quick decision – we rely on price to convey information about quality.Follow the LeaderSometimes we just do what others are doing.Clothes manufacturers try to exploit this decision rule with their advertising efforts by convincing us that “everyone” is wearing a particular style.HabitHabit explains a lot of our choices. We did the marginal utility calculation some time ago and we continue with the same choice.We rely on our previous judgment.CustomEmploying the rule of custom can ease the burden of decision making.Maximizing Utility Using Indifference CurvesEconomists often use graphic representation of the consumer’s choice.The problem consists of two parts:The budget constraint (or the income constraint) andIndifference curves, which represent utilityGraphing the Budget LineThe budget constraint represents all the combinations of two goods that a person can afford to buy with given income.The budget constraint is also called the income constraint, or budget line.Jaz’s Budget LineJaz has $10 and buys chocolate and pop whose prices are $1 and $0.50 respectively.Graphing the Budget Line, Fig. 8-2, p 1870246810 2 4 6 8 10 12 14 16 18 20 22 Chocolate barsCans of popSlope= - Ppop/Pchocolate = - ½Income = $10The Indifference CurveAn indifference curve represents all the combinations of the two goods amongst which an individual is indifferent.The Indifference CurveJaz is equally as well off (her utility is the same) from consuming bundles A, B, C, D or E.Jaz’s Indifference Curve, Fig. 8-3a, p 188048121620 2 4 6 8 10 12 14 16 18 20 22 Chocolate barsCans of pop|Slope|= MUpop/MUchocolate bars = MRS of pop for chocolate barsUABCDEIndifference curveThe Indifference CurveThe slope of the indifference curve is called the marginal rate of substitution (MRS)The slope is bowed inward, indicating that MRS is decreasing as Jaz’s bundles contain more of the good on the horizontal axis.The Indifference CurveThe reason for decreasing MRS is that as Jaz gets more and more of one good, she is willing to give up lots of it to get more of the relatively scarce good. |Slope| = MUpop/Muchocolate = MRSA Map of Indifference CurvesThe bundles of goods forming indifference curve U3 give Jaz higher utility than bundles along U2,While the bundles of goods forming indifference curve U1 give Jaz less utility than bundles along U2.A Map of Indifference Curves, Fig. 8-3b, p 188048121620 2 4 6 8 10 12 14 16 18 20 22 Chocolate barsCans of popU2ABCDEU1U3Combining Indifference Curves and Budget LineThe goal for a consumer is to get as high on an indifference curve as possible, given her income constraint.More is preferred to less.Combining Indifference Curves and Budget Line, Fig. 8-4, p 189048121620 2 4 6 8 10 12 14 16 18 20 22 Chocolate barsCans of popU2U1U3Slope= -MUpop/Muchocolate barsSlope= -Ppop/Pchocolate barsDCGKCombining Indifference Curves and Budget LineAt the point D, Jaz maximizes her utility when: MUpop/Muchocolate bars = Ppop/Pchocolate barsCombining Indifference Curves and Budget LineIn other words, utility is maximized when the slopes of the budget constraint and the indifference curve are equal.The Logic of Individual Choice:The Foundation of Supply and DemandEnd of Chapter 8