Mce10e Ch06 Im 11e

CHAPTER 6
CONSUMER CHOICE AND DEMAND
INTRODUCTION
This chapter examines the underpinnings of demand, using utility analysis to explore the relationship
between price and quantity demanded. Total and marginal utility are employed to show how a
consumer maximizes utility. The utility-maximizing conditions are laid out, and the effects of a
change in price on the consumption bundle are examined. The Appendix explains indifference
curves, budget lines, and utility maximization. The chapter emphasizes throughout that consumers
need not understand utility analysis in order to maximize utility; the topic of utility analysis is
developed to gain perspective on consumer behavior.
CHAPTER OUTLINE
I. Utility Analysis: Consumer choice in a world of scarcity is motivated by the desire to
maximize satisfaction.
A. Tastes and Preferences: Utility is subjective. Different people have different

tastes.
 Economists argue tastes are given and relatively stable – they aren’t in a
constant state of flux.
B. Law of Diminishing Marginal Utility

 The more of a good an individual consumes per time period, other things
constant, the smaller the increase in total utility from additional consumption.
 Total Utility: The total satisfaction derived from consumption
 Marginal utility: Change in total utility resulting from a one-unit change in
consumption
II. Measuring Utility: Developing numerical values for utility allows analysis about the
utility from consumption.
A. Units of Utility: Each person has a uniquely subjective utility scale. (See an
example in Exhibit 1)
B. Utility Maximization in a World without Scarcity: If a good is free, individuals

increase consumption as long as marginal utility is positive.
C. Utility Maximization in a World of Scarcity: Is achieved when the budget is

exhausted and the last dollar spent on each good yields the same marginal utility.
D. Utility-Maximizing Conditions: Consumer equilibrium is achieved when the

budget is exhausted and MUp / Pp = MUm / Pm
 Higher priced goods must yield more marginal utility than lower priced goods
to compensate for their higher prices.
© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
66 Chapter 6 Consumer Choice and Demand
E. Marginal Utility and the Law of Demand: By changing the price of one good and
observing the utility-maximizing levels of consumption, points along the demand
curve can be generated.
III. Applications of Utility Analysis
A. Your Consumer Surplus

 Marginal Valuation: the dollar value to an individual of the marginal utility
derived from consuming each additional unit of a good. Along the demand
curve, the price reflects your marginal valuation of the good.
 Consumer Surplus: the difference between the maximum amount you are
willing to pay and what you actually pay; the value of the total utility you
receive from consuming the goods minus your total spending on them.
B. Market Demand and Consumer Surplus

 Market demand curve: The horizontal sum of the individual demand curves
for all consumers in the market; shows the total quantity demanded per period
by all consumers at various prices.
 Consumer surplus: At a given price, the difference between the most
consumers would pay for that quantity of the good and the amount they do pay.
Reflected by the area under the demand curve but above the price.
Case Study: Public Policy: The Marginal Value of Free Medical Care
C. The Role of Time in Demand: People with a higher opportunity cost of time are
more willing to pay a higher money price for goods that save time.
 Cost of Consumption: The money price plus the time price of a good
IV. Conclusion
This chapter uses utility analysis to explore the relationship between price and quantity
demanded. The utility-maximizing conditions are laid out, and the effects of a change in
price on the consumption bundle are examined. The appendix explains indifference curves,
budget lines, and utility maximization.
Appendix: Indifference Curves and Utility Maximization

Consumers rank preferences.
 Indifference curve: Shows all combinations of goods that provide the consumer with the
same level of utility.
o Indicates what the consumer is willing to buy.
o Combinations of goods along an indifference curve reflect some constant, though
unspecified, level of utility.
o Slopes downward to the right.
o Is convex to the origin (bowed inward toward the origin).
Consumer Preferences
 Marginal rate of substitution (MRS): Absolute value of the slope of the indifference curve.
 Law of diminishing MRS: The amount of good A that a consumer is willing to give up to get
one more unit of good B declines as the consumption of B increases.
 Indifference map: Higher indifference curves represent higher levels of utility.
o Indifference curves do not intersect.
The Budget Line: Depicts all combinations of two goods that can be purchased at given
prices with a given amount of income.
 Can be thought of as a consumption possibilities frontier.
o Indicates what the consumer is able to buy.
o Slope of the budget line: Depends on relative prices (- Pp/ Pv).
Consumer Equilibrium at the Tangency

 A utility-maximizing consumer will select a combination along the budget line that is
tangent to the highest-attainable indifference curve.
o At the point of tangency, the MRS (slope of the indifference curve) is equal to the slope
of the budget line; MRS = Pp / Pm.
o The MRS = MUp / MUm = Pp / Pm
A rearrangement of terms in the preceding equation produces the same equilibrium
condition as prevailed under marginal utility analysis. MU p / Pp = MUm / Pm. The last dollar
spent on each good yields the same marginal utility.
Effects of a Change in Price: using the consumer equilibrium at tangency, by changing the price we
can derive additional points on the demand curve for a good.
Income and Substitution Effects: Sum to provide the overall effect of a change in price.
CHAPTER SUMMARY
Utility is the sense of pleasure or satisfaction that comes from consumption; it is the want-satisfying
power of goods, services, and activities. The utility you get from consuming a particular good
depends on your tastes. The law of diminishing marginal utility says that the more of a particular
good you consume per period, other things constant, the smaller the gain in total utility received
from each additional unit consumed. The total utility derived from a good is the sum of the marginal
utilities derived from each additional unit of the good consumed. At some point, additional
consumption could reduce total utility, meaning negative marginal utility.
Utility is subjective. Each consumer makes a personal assessment of the want-satisfying power of
consumption. By translating an individual’s subjective measure of satisfaction into units of utility,
we can predict the quantity demanded at a given price as well as the effect of a change in price on
quantity demanded.
The consumer’s objective is to maximize utility within the limits imposed by income and prices. In a
world without scarcity, utility is maximized by consuming a good until its marginal utility reaches
zero. In the real world—a world shaped by scarcity as reflected by prices—utility is maximized
when the budget is exhausted and the marginal utility of the final unit consumed divided by that
good’s price is identical for each different good.
Utility analysis can be used to construct an individual consumer’s demand curve. By observing the
effects of a change in price on consumption, we can generate points that trace a demand curve.
Consumers typically receive a surplus, or a bonus, from consumption. Consumer surplus is the
difference between the maximum amount consumers would pay for a given quantity of the good and
the amount they actually pay. Consumer surplus increases as the price declines.
Consumption involves a money price and a time price. People are willing to pay a higher money
price for products that save time.
The Appendix to this chapter provides many of the same insights into demand and utility
maximization using indifference curves. This method allows one to estimate the relative sizes of the
income and substitution effects, which are described in Chapter 3 as the reasons for the negative
slope of the demand curve.
TEACHING POINTS
1. This chapter and the next provide the foundation for microeconomics. This chapter will be the
first look most students will have at the concept of utility, and therefore many will be skeptical
in regard to its existence or relevance. In response to this skepticism you need to emphasize the
fact that we all subconsciously act as if we are utility maximizers in our daily decision making
even though utility itself is completely subjective. As such, utility maximization becomes the
underlying framework for the analysis of many forms of outcome assessment. Furthermore, the
fact that utility itself cannot be measured objectively does not mean that it can’t be
meaningfully quantified.
2. Diminishing marginal utility is easy to explain, but you should point out that some goods may
have ranges over which marginal utility increases. For example, the first gallon of gasoline you
put in your car may not yield as much marginal utility as the tenth. You can point out to
skeptics that it is not necessary to measure utility objectively (e.g., in utils) in order to have
diminishing marginal utility. This will probably be the first time students have had to think in
marginal terms. It will be useful to distinguish between marginal and average. Students often
find it confusing that total utility is at a maximum when marginal utility is zero. This point
should be emphasized and demonstrated through problems.
3. An important point to make is that movements in relative prices, rather than movements in the
overall price level, cause alterations in consumer allocations. You can illustrate this by setting
the ratio of marginal utilities equal to the ratio of prices. If a doubling or tripling of prices
occurs, there will be no change in consumer allocation. This also illustrates the utility-
maximization rule for allocating spending. It is the relative price rather than the absolute price
level that is critical in the allocation process. If one good costs twice as much as another, the
rational consumer must get at least twice the benefit from the higher-priced good if he or she is
going to consume it.
4. Consumer surplus is discussed at some length in this chapter. It is a subject that will be of
considerable importance in measuring efficiency gains and losses at later stages of the course.
It is essential that students recognize that the height of the demand curve represents the
marginal benefit (in dollar terms) for each unit of the good consumed. In developing consumer
surplus, this idea should be emphasized.
ANSWERS TO QUESTIONS FOR REVIEW

1. (Law of Diminishing Marginal Utility) Some restaurants offer “all you can eat” meals. How is
this practice related to diminishing marginal utility? What restrictions must the restaurant
impose on the customer in order to make a profit?
The marginal utility derived from each additional plate of food will diminish as you become
full. The marginal utility will continue to decrease until it reaches zero or becomes negative.
Food shows diminishing marginal utility after a certain amount has been consumed. The
restaurant must require that the consumer not take food home in a doggy bag and that the
consumer not share the meal with others at the table.
2. (Law of Diminishing Marginal Utility) Complete each of the following sentences:

a. Your tastes determine the _________ you derive from consuming a particular good.
b. _________ utility is the change in _________ utility resulting from a _________ change in
the consumption of a good.
c. As long as the marginal utility is positive, total utility is _________.
d. The law of diminishing marginal utility states that as an individual consumes more of a
good during a given time period, other things constant, total utility _________.
a. Utility
b. Marginal; total; one-unit
c. Rising
d. Increases by smaller amounts
3. (Marginal Utility) Is it possible for marginal utility to be negative while total utility is positive?
If yes, under what circumstances is it possible?
Yes, it is possible. Total utility rises as long as marginal utility is positive. When total utility
starts to drop, marginal utility becomes negative. Total utility is still positive as long as the
negative marginal utilities are not sizable enough to completely offset the positive marginal
utilities on earlier units of consumption.
4. (Utility-Maximizing Conditions) For a particular consumer, the marginal utility of cookies

equals the marginal utility of candy. If the price of a cookie is less than the price of candy, is
the consumer in equilibrium? Why or why not? If not, what should the consumer do to attain
equilibrium?
Using a numerical example, the marginal utility of a cookie is 10 and the marginal utility of
candy is 10. The price of a cookie is 5, but the price of candy is 10. To be in equilibrium, the
following equality (MUcookie / Pcookie) = (MUcandy / Pcandy) should hold. However, in this example,
the (MUcookie / Pcookie) > (MUcandy / Pcandy) because (10 / 5) > (10 / 10).
The consumer is not in equilibrium because the marginal utility per dollar spent on cookies (2)
is larger than the marginal utility per dollar spent on candy (1). According to the law of
diminishing marginal utility, the rational consumer would reduce consumption of candy and
increase consumption of cookies.
5. (Utility-Maximizing Conditions) Suppose that marginal utility of Good X = 100, the price of X
is $10 per unit, and the price of Y is $5 per unit. Assuming that the consumer is in equilibrium
and is consuming both X and Y, what must the marginal utility of Y be?
For the per dollar marginal utilities to be equal, the marginal utility of Y should be 50 (100/10
= X/5). Note that the key assumption is that the consumer is in equilibrium.
6. (Utility-Maximizing Conditions) Suppose that the price of X is twice the price of Y. You are a
utility maximizer who allocates your budget between the two goods. What must be true about
the equilibrium relationship between the marginal utility levels of the last unit consumed of
each good? What must be true about the equilibrium relationship between the marginal utility
levels of the last dollar spent on each good?
Assuming utility maximization, the marginal utility level for the last unit of the higher-priced
good (X) must be twice as high as the marginal utility level of good Y. The marginal utility
levels of the last dollar spent on each good will also be equal.
7. (Market Demand Curve) Given the many individual demand curves for a good, describe how
to derive the market demand curve for that good.
The market demand curve is simply the horizontal sum of all the individual demand curves in
the market. The market demand curve shows the total quantity demanded per period by all
consumers at various prices.
8. (Consumer Surplus) The height of the demand curve at a given quantity reflects the marginal
valuation of the last unit of that good consumed. For a normal good, an increase in income
shifts the demand curve to the right and therefore increases its height at any quantity. Does this
mean that consumers get greater marginal utility from each unit of this good than they did
before? Explain.
Marginal valuation is the dollar value of the marginal utility derived from consuming a unit of
the good—it is not the marginal utility itself. A shift in the demand curve does not necessarily
mean that there is a shift in the marginal utilities. In this case, the increased income has
changed the dollar value of the marginal utilities—it generates a greater willingness to pay for
each unit, so the demand curve shifts up to the right. Marginal utility, however, is determined
by consumer tastes, which have not changed.
9. (Consumer Surplus) Suppose the supply of a good is perfectly elastic at a price of $5. The
market demand curve for this good is linear, with zero quantity demanded at a price of $25.
Given that the slope of this linear demand curve is −0.25, draw a supply and demand graph to
illustrate the consumer surplus that occurs when the market is in equilibrium.
The slope of the demand curve is rise over run, or p/qd . (See the Appendix to Chapter 1 for
a review of slope.) Therefore, with a slope of −0.25, a $1 drop in price generates a 4-unit
increase in quantity demanded. The demand curve intersects the vertical axis at $25 and the
horizontal axis at 100 units. A $20 drop in price from $25 to $5 increases the quantity
demanded from zero to 80 units at $5. The consumer surplus equals the area below the demand
curve and above the perfectly elastic supply curve; the shaded area shown in the following
graph.
10. (Case Study: The Marginal Value of Free Medical Care) Medicare recipients pay a monthly
premium for coverage, must meet an annual deductible, and have a copayment for doctors'
office visits. What impact would an increase in the monthly premium have on their consumer
surplus? What would be the impact of a reduction in copayments? President George W. Bush
introduced some coverage of prescription medications. What is the impact on consumer
surplus of offering some coverage for prescription medication?
Increased monthly premiums would reduce consumer surplus. Reduced copayments would
increase consumer surplus. Coverage for prescription medication would lead to increased
consumer surplus.
11. (Role of Time in Demand) In many amusement parks, you pay an admission fee to the park but
you do not need to pay for individual rides. How do people choose which rides to go on?
The rides are allocated on the basis of the time costs incurred while standing in line waiting
for the ride. Those who really prefer a particular ride or those who have abundant time
available will be willing to wait longer. Those with little time available may elect to ride other
less crowded but also less thrilling rides.
ANSWERS TO PROBLEMS AND EXERCISES

12. (Utility Maximization) The following tables illustrate Eileen’s utilities from watching first-run
movies in a theater and from renting movies online. Suppose that she has a monthly movie
budget of $36, each movie ticket costs $6, and each video rental costs $3.
Movies in a Theater
Q TU MU MU/P
0 0 —— ———
1 200 —— ———
2 290 —— ———
3 370 —— ———
4 440 —— ———
5 500 —— ———
6 550 —— ———
7 590 —— ———
Online Movies
Q TU MU MU/P
0 0 —— ————
1 250 —— ————
2 295 —— ————
3 335 —— ————
4 370 —— ————
5 400 —— ————
6 425 —— ————
a. Complete the tables.

b. Do these tables show that Eileen’s preferences obey the law of diminishing marginal
utility? Explain your answer.
c. How much of each good does Eileen consume in equilibrium?
d. Suppose the prices of both types of movies drop to $1 while Eileen’s movie budget shrinks
to $10. How much of each good does she consume in equilibrium?
a. Movies in a Theater Online Movies

Q TU MU MU/P Q TU MU MU/P
0 0 0 0 0 0 0 0
1 200 200 33.33 1 250 250 83.33
2 290 90 15.0 2 295 45 15.0
3 370 80 13.33 3 335 40 13.33
4 440 70 11.67 4 370 35 11.67
5 500 60 10.0 5 400 30 10.0
6 550 50 8.33 6 425 25 8.33
7 590 40 6.67
b. Yes, for both goods. For both theater movies and video rentals, marginal utility drops
as consumption rises, starting with the second movie.
c. Four theater movies plus four video rentals. Each has a per dollar MU of 11.67 at that
consumption level, and total spending equals $36 ($24 on theater movies and $12 on
video rentals).
d. Seven theater movies and three video rentals. Each has a per dollar MU of 40 at that
consumption level, and total spending equals $10 ($7 on theater movies and $3 on video
rentals).
13. (Utility Maximization) Suppose that a consumer has a choice between two goods, X and Y. If
the price of X is $2 and the price of Y is $3, how much of X and Y does the consumer purchase,
given an income of $17? Use the following information about marginal utilities:
Units MUX MUY
1 10 5
2 8 4
3 2 3
4 2 2
5 1 2
The marginal utility per dollar will give the following data:
Good X Good Y
Units MUX MUX/PX MUY MUY/PY
1 10 5 5 1.66
2 8 4 4 1.33
3 2 1 3 1
4 2 1 2 .66
5 1 .5 2 .66
Therefore, the rational consumer will consume four units of Good X and three units of Good
Y. Note that the ratio of marginal utility per dollar spent on X and Y is the same for X = 4 and
Y = 3. Realize the importance of the equilibrium condition that all income is spent on the two
goods. If only three units of X are consumed, the consumer still has $2 of income left.
14. (The Law of Demand and Marginal Utility) Daniel allocates his budget of $24 per week among
three goods. Use the following table of the marginal utilities for Good A, Good B, and Good C
to answer the questions:
QA MUA QB MUB QC MUC

1 50 1 75 1 25
2 40 2 60 2 20
3 30 3 40 3 15
4 20 4 30 4 10
5 15 5 20 5 7.5
a. If the price of A is $2, the price of B is $3, and the price of C is $1, how much of each does
Daniel purchase in equilibrium?
b. If the price of A rises to $4 while the other prices and Daniel’s budget remain unchanged,
how much of each does he purchase in equilibrium?
c. Using the information from parts (a) and (b), draw the demand curve for good A. Be sure
to indicate the price and quantity for each point on the curve.
a. Four units each of goods A, B, and C. The per dollar marginal utility is 10 for each good,
and total spending equals $24 ($8 on A, $12 on B, and $4 on C).
b. Two units of A with four units each of goods B and C. The per dollar marginal utility is 10
for each good, and total spending equals $24 ($8 on A, $12 on B, and $4 on C).
c.
15. (Consumer Surplus) Suppose the linear demand curve for shirts slopes downward and that
consumers buy 500 shirts per year when the price of shirts is $30 and 1,000 shirts per year
when the price is $25.
a. Compared to the prices of $30 and $25, what can you say about the marginal valuation that
consumers place on the 300th shirt, the 700th shirt, and the 1,200th shirt they might buy
each year?
b. With diminishing marginal utility, are consumers deriving any consumer surplus if the
price is $25 per shirt? Explain.
c. Use a market demand curve to illustrate the change in consumer surplus if the price drops
from $30 to $25.
a. The 300th shirt is worth more than $30 to some consumers, the 700th shirt is worth less
than $30 for all consumers but more than $25 for some consumers, and the 1200th shirt is
worth less than $25 for all consumers.
b. Yes. The price consumers pay for shirts is the same for all shirts, even though their benefits
vary from shirt to shirt because of diminishing marginal utility. For example, some
consumers in this market value the 1st through the 499th shirt at more than $30. When the
price is $30, therefore, they derive surplus on the first 499 shirts equal to the summed
marginal valuations of the shirts less the total cost of $14,970 (499 × $30).
c. On the following graph, the shaded area represents the increase in consumer surplus.
ANSWERS TO APPENDIX QUESTIONS

1. (Consumer Preferences) The absolute value of the slope of the indifference curve equals the
marginal rate of substitution. If two goods were perfect substitutes, what would the indifference
curves look like? Explain.
They would be negatively sloped straight lines because each unit of one good that is given up
will be perfectly (and equally) offset by more units of the other good. No matter how much we
consume of one good (even with diminishing marginal utility), the trading rate between goods
that is necessary to keep total utility constant remains constant.
2. (Effects of a Change in Price) Chris has an income of $90 to allocate between Goods A and B.
Initially, the price of A is $3 and the price of B is $4.
a. Draw Chris’s budget line, indicating its slope if units of A are measured on the horizontal
axis and units of B are on the vertical axis.
b. Add an indifference curve to your graph and label the point of consumer equilibrium.
Indicate Chris’s consumption level of A and B. Explain why this is a consumer
equilibrium. What can you say about Chris's total utility at this equilibrium?
c. Now suppose that the price of A rises to $4. Draw the new budget line, a new point of
equilibrium, and the consumption level of Goods A and B. What is Chris’s marginal rate of
substitution at the new equilibrium point?
d. Draw the demand curve for Good A, labeling the different price-quantity combinations
determined in parts (b) and (c).
Refer to the diagram below.

a. The slope of the budget line through point e is –3/4.
b. Point e is where the highest attainable indifference curve (given prices and income) is
tangent to the budget line. At that point, the marginal rate of substitution equals the slope
of the budget line—any change in the allocation of the consumer’s budget would shift the
consumer to a lower indifference curve. Consumption of good A equals a1, and
consumption of good B equals b1. Chris's total utility is maximized at consumer
equilibrium.
c. In the upper panel, the new equilibrium occurs at point f. Consumption levels of goods A
and B change to a2 and b2 , respectively. The marginal rate of substitution at point f equals
–1.
d. The demand curve for Good A is derived in the lower panel from the consumer optimum
points e and f in the upper panel. Points E and F on the demand curve correspond to
consumer optimum points e and f.

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CHAPTER 6

CONSUMER CHOICE AND DEMAND

A. Tastes and Preferences: Utility is subjective. Different people have different

B. Law of Diminishing Marginal Utility

B. Utility Maximization in a World without Scarcity: If a good is free, individuals

C. Utility Maximization in a World of Scarcity: Is achieved when the budget is

D. Utility-Maximizing Conditions: Consumer equilibrium is achieved when the

III. Applications of Utility Analysis

A. Your Consumer Surplus

B. Market Demand and Consumer Surplus

Appendix: Indifference Curves and Utility Maximization

Consumer Equilibrium at the Tangency

ANSWERS TO QUESTIONS FOR REVIEW

2. (Law of Diminishing Marginal Utility) Complete each of the following sentences:

4. (Utility-Maximizing Conditions) For a particular consumer, the marginal utility of cookies

ANSWERS TO PROBLEMS AND EXERCISES

a. Complete the tables.

a. Movies in a Theater Online Movies

Units MUX MUY

Units MUX MUX/PX MUY MUY/PY

QA MUA QB MUB QC MUC

ANSWERS TO APPENDIX QUESTIONS

Refer to the diagram below.

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