Consumer Choice and Demand CHAPTER 13
Chapter Checklist
When you have completed your study of this chapter, you will be able to
1. Calculate and graph a budget line that shows the limits to a person’s
consumption possibilities.
2. Explain the marginal utility theory and use it to derive a consumer’s demand
curve.
3. Use marginal utility theory to explain the paradox of value: why water is vital
but cheap while diamonds are relatively useless but expensive.
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13.1 Consumption Possibilities (1 of 16)
The Budget Line
A budget line describes the limits to consumption choices and depends on a
consumer’s budget and the prices of goods and services.
Let’s look at Tina’s budget line:
Tina has $4 a day to spend on two goods: bottled water and gum.
The price of water is $1 a bottle.
The price of gum is 50¢ a pack.
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13.1 Consumption Possibilities (2 of 16)
Figure 13.1 shows Tina’s consumption possibilities.
Points A through E on the graph represent the rows of the table.
The line passing through the points is Tina’s budget line.
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13.1 Consumption Possibilities (3 of 16)
The budget line separates combinations that are affordable from combinations
that are unaffordable.
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13.1 Consumption Possibilities (4 of 16)
A Change in the Budget
When a consumer’s budget increases, consumption possibilities expand.
When a consumer’s budget decreases, consumption possibilities shrink.
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13.1 Consumption Possibilities (5 of 16)
Figure 13.2 shows the effects of changes in a consumer’s budget.
An decrease in the budget shifts the budget line leftward.
The slope of the budget line doesn’t change because prices have not changed.
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13.1 Consumption Possibilities (6 of 16)
An increase in the budget shifts the budget line rightward.
Again, the slope of the budget line doesn’t change because prices have not
changed.
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13.1 Consumption Possibilities (7 of 16)
Changes in Prices
• If the price of one good rises when the prices of other goods and the budget
remain the same, consumption possibilities shrink.
• If the price of one good falls when the prices of other goods and the budget
remain the same, consumption possibilities expand.
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13.1 Consumption Possibilities (8 of 16)
Figure 13.3 shows the effect of a fall in the price of water.
On the initial budget line, the price of water is $1 a bottle (and gum is 50¢ a pack), as
before.
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13.1 Consumption Possibilities (9 of 16)
When the price of water falls from $1 a bottle to 50¢ a bottle, the budget
line rotates outward and becomes less steep.
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13.1 Consumption Possibilities (10 of 16)
Figure 13.4 shows the effect of a rise in the price of water.
Again, on the initial budget line, the price of water is $1 a bottle (and gum is
50¢ a pack), as before.
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13.1 Consumption Possibilities (11 of 16)
When the price of water rises from $1
to $2 a bottle, the budget line rotates
inward and becomes steeper.
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13.1 Consumption Possibilities (12 of 16)
Prices and the Slope of the Budget Line
You’ve just seen that when the price of one good changes and the price of the
other good remains the same, the slope of the budget line changes.
In Figure 13.3, when the price of water falls, the budget line becomes less
steep.
In Figure 13.4, when the price of water rises, the budget line becomes steeper.
Recall that slope equals rise over run.
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13.1 Consumption Possibilities (13 of 16)
Let’s calculate the slope of the initial
budget line.
When the price of water is $1 a bottle:
Slope equals 8 packs of gum divided by
4 bottles of water.
Slope equals 2 packs per bottle.
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13.1 Consumption Possibilities (14 of 16)
Next, calculate the slope of the budget
line when water costs 50¢ a bottle.
When the price of water is 50¢ a bottle:
Slope equals 8 packs of gum divided by
8 bottles of water.
Slope equals 1 pack per bottle.
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13.1 Consumption Possibilities (15 of 16)
Finally, calculate the slope of the
budget line when water costs $2 a
bottle.
When the price of water is $2 a bottle:
Slope equals 8 packs of gum divided by
2 bottles of water.
Slope equals 4 packs per bottle.
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13.1 Consumption Possibilities (16 of 16)
You can think of the slope of the budget line as an opportunity cost.
The slope tells us how many packs of gum a bottle of water costs.
Another name for opportunity cost is relative price, which is the price of one
good in terms of another good.
A relative price equals the price of one good divided by the price of another
good and equals the slope of the budget line.
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13.2 Marginal Utility Theory (1 of 23)
Utility is the benefit or satisfaction that a person gets from the consumption of
a good or service.
Temperature: An Analogy
The concept of utility helps us make predictions about consumption choices in
much the same way that the concept of temperature helps us make predictions
about physical phenomena.
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13.2 Marginal Utility Theory (2 of 23)
Total Utility
Total utility is the total benefit that a person gets from the consumption of a
good or service.
Total utility generally increases as the quantity consumed of a good increases.
Table 13.1 shows an example of total utility from bottled water and chewing
gum.
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13.2 Marginal Utility Theory (3 of 23)
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13.2 Marginal Utility Theory (4 of 23)
Marginal Utility
Marginal utility is the change in total utility that results from a one-unit
increase in the quantity of a good consumed.
To calculate marginal utility, we use the total utility numbers in Table 13.1.
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13.2 Marginal Utility Theory (5 of 23)
The marginal utility of the third bottle of water is
36 units minus 27 units, which equals 9 units.
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13.2 Marginal Utility Theory (6 of 23)
We call the general tendency for marginal utility to decrease as the quantity of
a good consumed increases the principle of diminishing marginal utility.
Think about your own marginal utility from the things that you consume.
The numbers in Table 13.1 display diminishing marginal utility.
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13.2 Marginal Utility Theory (7 of 23)
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13.2 Marginal Utility Theory (8 of 23)
Figure 13.5 shows total utility and marginal
utility.
Part (a) graphs Tina’s total utility from bottled
water.
Each bar shows the extra total utility she gains
from each additional bottle of water—her
marginal utility.
The blue line is Tina’s total utility curve.
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13.2 Marginal Utility Theory (9 of 23)
Part (b) shows how Tina’s marginal utility from
bottled water diminishes by placing the bars
shown in part (a) side by side as a series of
declining steps.
The downward sloping blue line is Tina’s
marginal utility curve.
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13.2 Marginal Utility Theory (10 of 23)
Maximizing Total Utility
The goal of a consumer is to allocate the available budget in a way that
maximizes total utility.
The consumer achieves this goal by choosing the point on the budget line at
which the sum of the utilities obtained from all goods is as large as possible.
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13.2 Marginal Utility Theory (11 of 23)
The best budget allocation occurs when a person follows the utility-maximizing
rule:
1. Allocate the entire available budget.
2. Make the marginal utility per dollar equal for all goods.
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13.2 Marginal Utility Theory (12 of 23)
Allocate the Available Budget
The available budget is the amount available after choosing how much to save
and how much to spend on other items.
Tina has already committed most of her income to other goods and saving. Tina
has an available budget of $4 a day for water and chewing gum.
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13.2 Marginal Utility Theory (13 of 23)
Step 1: Make a table that shows the quantities of the two goods that use the
entire budget.
Each row shows an affordable combination.
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13.2 Marginal Utility Theory (14 of 23)
Equalize the Marginal Utility Per Dollar
Step 2: Make the marginal utility per dollar equal for both goods.
Marginal utility per dollar is the marginal utility from a good relative to the
price paid for the good.
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13.2 Marginal Utility Theory (15 of 23)
To calculate marginal utility per dollar, we divide the marginal utility from a
good by its price.
For example, at $1 a bottle, Tina buys 1 bottle of water and her marginal utility
from bottled water is 15 units.
So Tina’s marginal utility per dollar from bottled water is 15 units divided by $1,
which equals 15 units per dollar.
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13.2 Marginal Utility Theory (16 of 23)
Suppose that Tina allocates her budget such that the marginal utility per dollar
from gum is greater than her marginal utility per dollar from water.
Is Tina maximizing her total utility?
No. She is not maximizing total utility.
If Tina buys more gum and less water, her marginal utility from gum will
decrease and her marginal utility from water will increase.
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13.2 Marginal Utility Theory (17 of 23)
If Tina increases the amount of gum she buys and decreases the amount of
water she buys until her marginal utility per dollar for gum equals her marginal
utility per dollar for water, she will maximize her total utility.
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13.2 Marginal Utility Theory (18 of 23)
Step 3: Make a table that shows the marginal utility per dollar for the two
goods for each affordable combination.
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13.2 Marginal Utility Theory (19 of 23)
Row C shows the utility-maximizing quantities of water and gum.
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13.2 Marginal Utility Theory (20 of 23)
Finding an Individual Demand Curve
We have found one point on Tina’s demand curve for water:
When her budget is $4 a day, water is $1 a bottle and gum is 50¢ a pack, Tina
buys 2 bottles of water.
To find another point on her demand curve for water, let’s change the price of
water to 50¢ a bottle.
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13.2 Marginal Utility Theory (21 of 23)
A fall in the price of water increases the marginal utility per dollar from water,
so Tina buys more water.
Table 13.3 shows Tina’s affordable combinations of water and gum when water
is 50¢ a bottle.
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13.2 Marginal Utility Theory (22 of 23)
Row E shows Tina’s utility-maximizing quantities of water and gum.
That is, when water is 50¢ a bottle (budget is $4 a day and gum is 50¢ a pack),
Tina buys 4 bottles of water.
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13.2 Marginal Utility Theory (23 of 23)
Figure 13.6 shows Tina’s demand curve
for bottled water when her budget is
$4 a day and gum is 50¢ a pack.
When water is $1 a bottle, Tina buys 2
bottles and is at point C.
When water falls to 50¢ a bottle, Tina
buys 4 bottles and moves to point E.
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13.3 Efficiency, Price, and Value (1 of 5)
Consumer Efficiency
When a consumer maximizes utility, the consumer is using her or his resources
efficiently.
Using what you’ve learned, you can now give the concept of marginal benefit a
deeper meaning.
Marginal benefit is the maximum price a consumer is willing to pay for an
extra unit of a good or service when total utility is maximized.
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13.3 Efficiency, Price, and Value (2 of 5)
The Paradox of Value
For centuries, philosophers have been puzzled by the fact that water is vital for
life but cheap while diamonds are used only for decoration yet are very
expensive.
You can solve this puzzle by distinguishing between total utility and marginal
utility.
Total utility tells us about relative value; marginal utility tells us about relative
price.
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13.3 Efficiency, Price, and Value (3 of 5)
When the high marginal utility of diamonds is divided by the high price of a
diamond, the result is a number that equals the low marginal utility of water
divided by the low price of water.
The marginal utility per dollar spent is the same for diamonds as for water.
Consumer Surplus
Consumer surplus measures value in excess of the amount paid.
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13.3 Efficiency, Price, and Value (4 of 5)
Figure 13.7 shows the paradox of value.
The demand curve D shows the
demand for water.
The demand curve and the supply
curve S determine the price of water at
PW and the quantity at QW.
The consumer surplus from water is the
area of the large green triangle.
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13.3 Efficiency, Price, and Value (5 of 5)
In this figure, the demand curve D is
the demand for diamonds.
The demand curve and the supply
curve S determine the price of a
diamond at PD and the quantity at QD.
The consumer surplus from diamonds
is the area of the small green triangle.
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Eye on Song Downloads and Streaming (1 of 6)
How Much Would You Pay for a Song?
You might say that you’re willing to pay only 99¢ for a song, but that’s not the
answer of the average consumer.
And it is probably not really your answer either. It is also not what the answer
would have been just a few years ago.
We can work out what people are willing to pay for a song by finding the
demand curve for songs and then finding the consumer surplus.
To find the demand curve, we need to look at the prices and quantities in the
market for songs.
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Eye on Song Downloads and Streaming (2 of 6)
How Much Would You Pay for a Song?
In 2015, Americans spent $6.3 billion on all forms of recorded music, down
from $14 billion in 2000.
But the combined quantity of discs and downloads bought increased from 1
billion in 2000 to 1.5 billion in 2015.
And the average price of a unit of recorded music fell from $14 to $4.28.
The average price fell because the mix of formats changed dramatically.
In 2000, we bought 900 million CDs; in 2015, we bought only 98 million CDs
and downloaded 1.3 billion music files and paid 16 million streaming
subscriptions.
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Eye on Song Downloads and Streaming (3 of 6)
How Much Would You Pay for a Song?
Figure 1 shows the longer history of the changing formats of recorded music.
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Eye on Song Downloads and Streaming (4 of 6)
How Much Would You Pay for a Song?
The music that we buy isn’t just one good—it is several different goods.
We’ll distinguish singles from albums and focus on the demand for singles.
In 2000, we bought 100 million singles and paid an average price of $5.00.
In 2015, we downloaded 1,500 million singles files and paid an average price of
$1.20 each.
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Eye on Song Downloads and Streaming (5 of 6)
How Much Would You Pay for a Song?
Figure 2 shows the demand curve for
singles.
In 2000, 100 million singles were
bought at an average price of $5.00.
In 2015, 1,200 million singles were
download at an average price of $1.20.
The green area shows the increase in
consumer surplus, which is $2 billion or
$1.40 per single.
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Eye on Song Downloads and Streaming (6 of 6)
How Much Would You Pay for a Song?
The increase in consumer surplus of $1.40 per song is an estimate of how much
more an average buyer would be willing to pay for an average song.
Paid subscriptions for streaming increase consumer surplus even more.
A streaming subscription is a fixed cost per month, so the average price of a
song is the monthly subscription divided by the number of different songs
played.
But the price of the marginal song is zero, so consumer surplus becomes the
entire area under the demand curve at a zero price minus the fixed subscription
cost.
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Appendix: Indifference Curves (1 of 18)
An Indifference Curve
An indifference curve is a line that shows combinations of goods among which
a consumer is indifferent.
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Appendix: Indifference Curves (2 of 18)
Figure A13.1 shows Tina’s indifference curve and Tina’s preference map.
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Appendix: Indifference Curves (3 of 18)
In part (a), Tina is equally happy consuming at any point along the green
indifference curve.
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Appendix: Indifference Curves (4 of 18)
Point C is neither better nor worse than any other point along the indifference
curve.
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Appendix: Indifference Curves (5 of 18)
Points below the indifference curve are worse than points on the indifference
curve—are not preferred.
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Appendix: Indifference Curves (6 of 18)
Points above the indifference curve are better than points on the indifference
curve—are preferred.
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Appendix: Indifference Curves (7 of 18)
Part (b) shows three indifference curves—I0, I1, and I2—that are part of Tina’s
preference map.
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Appendix: Indifference Curves (8 of 18)
The indifference curve in part (a) is curve I1 in part (b). Tina is indifferent
between points C and G.
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Appendix: Indifference Curves (9 of 18)
Tina prefers point J to point C or point G. And she prefers either point C or point
G to any point on curve I0.
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Appendix: Indifference Curves (10 of 18)
Marginal Rate of Substitution
The marginal rate of substitution is the rate at which a person will give up good
y (the good measured on the y-axis) to get more of good x (the good measured
on the x-axis) and at the same time remain on the same indifference curve.
Diminishing marginal rate of substitution is the general tendency for the
marginal rate of substitution to decrease as the consumer moves down along
the indifference curve, increasing consumption of good x and decreasing
consumption of good y.
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Appendix: Indifference Curves (11 of 18)
Figure A13.2 shows the calculation of
the marginal rate of substitution.
The marginal rate of substitution (MRS)
is the magnitude of the slope of an
indifference curve.
First, we’ll calculate the MRS at point C.
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Appendix: Indifference Curves (12 of 18)
Draw a straight line with the same
slope as the indifference curve at point
C.
The slope of this red line is 8 packs of
gum divided by 4 bottles of water,
which equals 2 packs of gum per bottle
of water.
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Appendix: Indifference Curves (13 of 18)
This number is Tina’s marginal rate of
substitution. Her MRS = 2.
At point C, when she consumes 2
bottles of water and 4 packs of gum,
Tina is willing to give up gum for water
at the rate of 2 packs of gum per bottle
of water.
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Appendix: Indifference Curves (14 of 18)
Now calculate Tina’s MRS at point G.
The red line at point G tells us that Tina
is willing to give up 4 packs of gum to
get 8 bottles of water.
Her marginal rate of substitution at
point G is 4 divided by 8, which equals
1/2.
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Appendix: Indifference Curves (15 of 18)
Consumer Equilibrium
The goal of the consumer is to buy the affordable quantities of goods that make
the consumer as well off as possible.
The consumer’s preference map describe the way a consumer values different
combinations of goods.
The consumer’s budget and the prices of the goods limit the consumer’s
choices.
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Appendix: Indifference Curves (16 of 18)
Figure A13.3 shows consumer
equilibrium.
Tina’s indifference curves describe her
preferences.
Tina’s budget line describes the limits
on her choice.
Tina’s best affordable point is C. At
point C, she is on her budget line and
also on the highest attainable
indifference curve.
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Appendix: Indifference Curves (17 of 18)
Tina can consume the same quantity of
water at point L but less gum.
She prefers C to L.
Point L is equally preferred to points F
and H, which Tina can also afford.
Points on the budget line between F
and H are preferred to F and H. And of
all those points, C is the best affordable
point for Tina.
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Appendix: Indifference Curves (18 of 18)
Deriving the Demand Curve
To derive Tina’s demand curve for bottled water:
• Change the price of water
• Shift the budget line
• Work out the new best affordable point
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Appendix: Indifference (1 of 2)
Figure A13.4 shows how to derive Tina’s demand curve.
When the price of water is $1 a bottle, Tina’s best
affordable point is C in part (a) and at point A on her
demand curve in part (b).
When the price of water is 50¢ a bottle, Tina’s best
affordable point is K in part (a) and at point B on her
demand curve in part (b).
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Tina’s demand curve in part (b) passes through
points A and B.
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