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CHAPTER
10
C
ONSUMER
C
HOICE
T
HEORY
10.1
Consumer Behavior
APPENDIX:
A More Advanced Theory of Consumer
Choice
10.2 The Consumer’s Choice
I
n this chapter, we discuss how individuals allocate
their income between different bundles of goods.
This decision involves trade-offs—if you buy more
of one good, you cannot afford as much of other
goods. Why do consumers buy more of a product
when the price falls and less of a product when the
price rises? How do consumers respond to rising
income? Falling income? How do we as consumers
choose certain bundles of goods with our available
budget to fit our desires? We address these questions
in this chapter to strengthen our understanding of
the law of demand.
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Households, Firms, and Market Structure
MODULE 3
SECTION
10.1
Consumer Behavior
What is the substitution effect?
Can we make interpersonal utility
comparisons?
What is the income effect?
What is diminishing marginal utility?
As you may recall from Chapter 4, the law of demand
is intuitive. Put simply, at a higher price, consumers
will buy less (a decrease in the quantity demanded); at
a lower price, consumers will buy more (an increase
in quantity demanded),
ceteris paribus
. However, the
downward-sloping demand curve has three other
explanations: (1) the income and substitution effects
of a price change, (2) the law of diminishing marginal
utility, and (3) an interpretation using indifference
curves and budget lines (in the appendix).
Let’s start with out first explanation of a downward-
sloping demand curve—the substitution and income
effects of a price change. For example, if the price of
pizza increases, the quantity of pizza demanded will fall
because some consumers might switch out of pizza
into hamburgers, tacos, burritos, submarine sandwiches,
or some other foods that
substitute for pizza.
This behavior is called
the
substitution effect
of a price change. In
addition, a price increase
for pizza will reduce
the quantity of pizza
demanded because it reduces a buyer’s purchasing
power. The buyer cannot buy as many pieces of pizza
at higher prices as she could at lower prices, which is
called the
income effect
of a price change.
The second explanation for the negative relation-
ship between price and quantity demanded is what
economists call
diminishing marginal utility.
In a
given time period, a buyer will receive less satisfaction
from each successive unit consumed. For example, a
second ice cream cone will yield less satisfaction than
the first, a third less sat-
isfaction than the second,
and so on. It follows
from diminishing mar-
ginal utility that if people
are deriving less satisfac-
tion from successive
units, consumers would
buy added units only if
the price were reduced.
Let’s now take a closer
look at utility theory.
substitution effect
a consumer’s switch to another simi-
lar good when the price of the pre-
ferred good increases
income effect
reduction in quantity demanded of
a good when its price increases
because of a consumer’s decreased
purchasing power
diminishing
marginal utility
a good’s ability to provide less satis-
faction with each successive unit
consumed
UTILITY
To more clearly define the relationship between con-
sumer choice and resource allocation, economists
developed the concept of
utility
—a measure of the
relative levels of satis-
faction that consumers
get from the consump-
tion of goods and serv-
ices. Defining one
util
as equivalent to one
unit of satisfaction,
Economists conducted an experiment with rats to see how they
would respond to changing prices of different drinks (changing
the number of times a rat had to press a bar). Rats responded
by choosing more of the beverage with a lower price, showing
they were willing to substitute when the price changed. That is,
even rats seem to behave rationally—responding to incentives
and opportunities to make themselves better off.
utility
a measure of the relative levels of
satisfaction consumers get from
consumption of goods and services
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Consumer Choice Theory
CHAPTER 10
economists can indi-
cate relative levels
of consumer satisfac-
tion that result from
alternative choices.
For example, for a java junkie who wouldn’t dream
of starting the day without a strong dose of
caffeine, a cup of coffee might generate 150 utils
of satisfaction while a cup of herb tea might only
generate 10 utils.
Inherently, utility varies from individual to indi-
vidual depending on specific preferences. For exam-
ple, Jason might get 50 utils of satisfaction from
eating his first piece of apple pie, while Brittany may
only derive 4 utils of satisfaction from her first piece
of apple pie.
In fact, a whole school of thought called utilitar-
ianism, based on utility theory, was developed by
Jeremy Bentham. Bentham believed that society
should seek the greatest happiness for the greater
number (See Bentham’s biography below.).
util
one unit of satisfaction
UTILITY IS A PERSONAL MATTER
Economists recognize that it is not really possible to
make interpersonal utility comparisons. That is, they
know that it is impossible to compare the relative sat-
isfactions of different persons. The relative satisfactions
gained by two people drinking cups of coffee, for
example, simply cannot be measured in comparable
terms. Likewise, although we might be tempted to
believe that a poorer person would derive greater util-
ity from finding a $100 bill than would a richer person,
we should resist the temptation. We simply cannot
prove it. The poorer person may be “monetarily” poor
because money and material things are not important
to her, and the rich person may have become richer
because of his lust for the things money can buy.
great economic thinkers
Jeremy Bentham (1748–1832)
Jeremy Bentham was born in London in 1748. He was a gifted child, reading his-
tory and other “serious” books at age 3, playing the violin at age 5, and study-
ing Latin and French when he was only 6. At 12, he entered Queens College,
Oxford, where he studied law. In his late teens, Bentham decided to concen-
trate on his writings. With funding provided by his father, he wrote a series of
books on philosophy, economics, and politics. He would often write for 8 to
12 hours a day, a practice that continued through his life, leaving scholars
material to compile for years to come. Most of his writings were not pub-
lished until well over a century after his death.
According to Bentham, “pain and pleasure are the sovereign masters gov-
erning man’s conduct”: People will tend to pursue things that are pleasurable
and avoid things that are painful. To this day, the rule of rational choice—
weighing marginal benefits against marginal costs—has its roots in the earlier
works of Jeremy Bentham. That is, economists predict human behavior on the
basis of people’s responses to changing incentives; people make choices on the
basis of their expected marginal benefits and their expected marginal costs.
Although Bentham was most well known for utilitarianism, a philosophy
stemming from his rational-choice ideas, he also had much to say on the sub-
jects of prison reform, religion, relief to the poor, international law, and
animal welfare. He was an ardent advocate of equality. Good humored, med-
itative, and kind, he was thought to be a visionary and ahead of his time, and
he attracted the leading thinkers of the day to his company.
Bentham died in London in 1832. He left behind a strange legacy. At his
request, his body was dissected, his skeleton padded and fully clothed, and his
head preserved in the manner of South American headhunters. He asked that
this “auto-icon,” as it is now called, be seated in a glass case at the University
College in London, and that his remains should be present at all meetings for
the board. The auto-icon is still there today, although the mummified head,
which did not preserve well, has been replaced by a wax head. The real head
became an easy target for students and one story has the head being used at
soccer practice! No one is quite sure why Bentham desired such an odd after-
life for his body; explanations range from it being a testament to an inflated
sense of self-worth to a statement about religion or a practical joke.
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Households, Firms, and Market Structure
MODULE 3
SECTION
10.1
E
XHIBIT
1
Total and Marginal Utility
a. Total Utility
30
Total
Utility
20
10
Q
0
1
2345
67
Pizza Slices (consumed per hour)
b. Marginal Utility
10
8
6
How many utils is she deriving from this cup of coffee? Can we
accurately compare her satisfaction of a cup of coffee with
another person’s?
4
Marginal Utility
2
0
–2
1
2
34
5
67
Q
Pizza Slices (consumed per hour)
TOTAL UTILITY AND MARGINAL UTILITY
Economists recognize two different dimensions of
utility: total utility and marginal utility.
Total utility
is the total amount of satisfaction derived from the
consumption of a certain number of units of a good
or service. In comparison,
marginal utility
is the
extra satisfaction generated by an additional unit of a
good that is consumed
in a particular time
period. For example,
eating four slices of
pizza in an hour might
generate a total of 28
utils of satisfaction.
The first three slices of
pizza might generate a
total of 24 utils, while
the last slice generates
only 4 utils. In this case,
the total utility of eating four slices of pizza is 28 utils,
and the marginal utility of the fourth slice is 4 utils.
Notice in Exhibit 1(a) how total utility increases as
consumption increases (we see more total utility after
the fourth slice of pizza than after the third). But
As you can see in a, the total utility from pizza
increases as consumption increases. In b marginal util-
ity decreases as consumption increases. That is, as you
eat more pizza, your satisfaction from each additional
slice diminishes.
Slices of Pizza
Total Utility
Marginal Utility
(per day)
(utils)
(utils)
0
0
10
total utility
total amount of satisfaction derived
from the consumption of a certain
number of goods or services
marginal utility
extra satisfaction generated by con-
sumption of an additional good or
service during a specific time period
1
10
8
2
18
6
3
24
4
4
28
2
5
30
0
6
30
−
2
7
28
notice, too, that the increase in total utility from each
additional unit (slice) is less than the unit before,
which indicates the marginal utility. In Exhibit 1(b)
we see how the marginal utility falls as consumption
increases.
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Consumer Choice Theory
CHAPTER 10
using what you’ve learned
Diminishing Marginal Utility
Why do most individuals take only one newspaper from covered,
coin-operated newspaper racks when it would be so easy to take
more? Do you think potato chips, candy, or sodas could be sold profitably in
the same kind of dispenser? Why or why not?
Although ethical considerations keep some people from taking
additional papers, the law of diminishing marginal utility is also
at work here. The second newspaper adds practically zero utility to most
individuals on most days, so they typically feel no incentive to take more
than one. The exception to this case might be on Sundays, when supermar-
ket coupons are present. In that instance, while the marginal utility is still
lower for the second paper than for the first, the marginal utility of the
second paper may be large enough to tempt some individuals to take addi-
tional copies.
On the other hand, if putting money in a vending machine gave access
to many bags of potato chips, candy bars, or sodas, the temptation to take
more than one might be too great for some people. After all, the potato
chip bags would still be good tomorrow. Therefore, vending machines with
Q
A
Why are newspaper racks different from vending machines?
foods and drinks only dispense one item at a time, because it is likely that,
for most people, the marginal utility gained from another unit of food or
drink is higher than for a second newspaper.
DIMINISHING MARGINAL UTILITY
It follows from the
law of diminishing mar-
ginal utility that as a
person uses more and
more units of a good to
satisfy a given want, the
intensity of the want,
and the utility derived
from further satisfying
that want, diminishes. Think about it: If you are starv-
ing, your desire for that first piece of pizza will be great,
but as you eat, you gradually become more and more
full, reducing your desire for yet another piece.
diminishing
marginal utility
the concept that states that as an
individual consumes more and
more of a good, each successive
unit generate less and less utility
(or satisfaction)
Although economists believe that total utility
increases with additional consumption, they also
argue that the incremental satisfaction—the marginal
utility—that results from the consumption of addi-
tional units tends to decline as consumption increases.
In other words, each successive unit of a good that is
consumed generates less satisfaction than did the pre-
vious unit. This concept is traditionally referred to as
the
diminishing marginal utility.
Exhibit 1(b)
demonstrates this graphically, where the marginal
utility curve has a negative slope.
using what you’ve learned
The Diamond-Water Paradox:
Marginal and Total Utility
“Nothing is more useful than water: but it will not purchase scarce any-
thing. . . . Diamond, on the contrary, has scarce any value in use; but a very
great quantity of other goods may frequently be had in exchange for it.”
—Adam Smith, Wealth of Nations, 1776
Q
Use the concept of marginal utility to evaluate the social value of
water versus diamonds.
The classic diamond-water paradox is the observation that some-
times those things that are necessary for life, like water, are inex-
pensive, and those items that are not necessary for life, like diamonds, are
expensive. This paradox puzzled philosophers for centuries. The answer
A
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