1. Chapter 6
Consumer Choice Theory
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2000 South-Western College Publishing
1

2. In this chapter, you will
learn to solve these
economic puzzles:
When ordering Big Macs,
Under what conditions might
Do white ratspizza, pay
milkshakes, obey and
you be willing to the
otherlaw of demand? you
$10,000 forhow can of
goods, a gallon
water and 1the highest one-
obtain cent for a
possible diamond?
carat satisfaction?
2

3. What is Util?
A hypothetical unit used
to measure how much
utility a person obtains
from consuming a good
3

4. What is Utility?
The satisfaction, or
pleasure, that people
receive from consuming
a good or service
4

5. What is Total Utility?
The amount of satisfaction
received from all the units
of a good or service
consumed
5

6. Why does a consumer
buy one bundle of goods,
rather than another?
Consumers make one
choice over another
depending on their
marginal utility
6

7. What is Marginal Utility?
The change in total utility
from one additional unit
of a good or service
7

8. What is the Law of
Diminishing
Marginal Utility?
The principle that the
extra satisfaction of a
good or service declines
as people consume more
in a given period
8

9. Diminishing Marginal Utility
8 Marginal Utility
6
4
2 MU
Q
1 2 3 4
9

10. Total Utility
16 Utils TU
12
8
4
Q
1 2 3 4
10

11. When is Total Utility
maximized?
When the marginal utility
per dollar of each good is
equal and the entire
budget is spent
11

12. What is
Consumer Equilibrium?
A condition in which total
utility cannot increase by
spending more of a
given budget on one
good and spending less
on another good
12

13. Even though water
provides a greater utility
than diamonds, why are
diamonds more expensive?
Water is plentiful in most
of the world, so its
marginal utility is low
13

14. Marginal Utility of Diamonds
8 Marginal Utility S
6
4
MUd
2 MU
Q
1 2 3 4
14

15. Marginal Utility of Water
8 Marginal Utility S
6
4
2 MUw MU
Q
1 2 3 4
15

16. Marginal Utility for Big Macs and
Milkshakes (utils per day) ($2 each)
BIG MACS MILKSHAKES
Quantity MU MU/P MU MU/P
1 8 4 6 3
2 4 2 4 2
3 2 1 1 1/2
4 1 1/2 0 0
16

17. Consumer Equilibrium
MU A MU B MU Z
price A = price B = price Z
17

18. Consumer Equilibrium
Price of Big Mac = $2
MU of Big Mac MU of milkshake
price of Big Mac = price of milkshake
4 utils 4 utils
$2 = $2
18

19. What happens if the
price of a Big Mac falls
to $1 and upsets the
previous equilibrium?
19

20. Consumer Equilibrium
Price of Big Mac = $1
MU of Big Mac MU of milkshake
price of Big Mac
>price of milkshake
4 utils > 4 utils
$1 $2
20

21. What happens to
the number of Big
Macs bought when
the price drops?
To restore maximum total
utility, the consumer
spends more on Big Macs
21

22. What does this discussion
of Utility reveal?
The law of demand, that is,
as the price of a good
declines, consumers will
buy more units of the
good, and vice versa
22

23. What are two alternative
explanations of demand?
Income effect
Substitution effect
23

24. What is the
Income effect?
The change in quantity
demanded of a good or
service caused by a
change in real income
(purchasing power)
24

25. What does the Income
effect show?
As prices decline, your real
income increases,
increasing your buying
power, so you buy more
units, ceteris paribus
25

26. What is the
Substitution effect?
The change in quantity
demanded of a good or
service caused by the
change in its price
relative to substitutes
26

27. What does the
Substitution effect show?
Suppose the price of a Pepsi
falls and the price of a
Coke remains unchanged;
you will buy more Pepsi,
because relatively, it is less
expensive than Coke
27

28. What does the
Substitution and Income
effect prove?
The law of demand, that is,
as the price of a good
declines, consumers will
buy more units of the
good, and vice versa
28

29. What is a Normal Good?
A good that consumers
will buy more of as their
incomes increase
29

30. What is an
Inferior Good?
A good that consumers
will buy less of as their
incomes increase
30

31. Key Concepts
31

32. Key Concepts
• What is Util?
• What is Utility?
• What is Total Utility?
• What is Marginal Utility?
• What is the Law of Diminishing Marginal U
• When is Total Utility maximized?
• What is Consumer Equilibrium?
32

33. Key Concepts cont.
• What are two alternative explanations of dem
• What is the Income effect?
• What is the Substitution effect?
• What does the Substitution and Income effec
• What is a Normal Good?
• What is an Inferior Good?
33

34. Summary
34

35. Utility is the satisfaction or
pleasure derived from consumption
of a good or service. Actual
measurement of utility is
impossible, but economists assume
it can be measured by a fictitious
unit called the util.
35

36. Total utility is the total level of
satisfaction derived from all units of
a good or service consumed.
Marginal utility is the change in
total utility from a one unit change
in the quantity of a good or service
consumed.
36

37. Diminishing Marginal Utility
8 Marginal Utility
6
4
2 MU
Q
1 2 3 4
37

38. Total Utility
16 Utils TU
12
8
4
Q
1 2 3 4
38

39. The law of diminishing
marginal utility states that
marginal utility of a good or
service eventually declines as
consumption increases.
39

40. Consumer equilibrium is the
condition of reaching the
maximum level of satisfaction,
given a budget, when the marginal
utility per dollar spent on each
good purchased is equal.
40

41. Consumer equilibrium and the
law of diminishing marginal utility
can be used to derive a downward-
sloping demand curve. When the
price of a good falls, consumer
equilibrium no longer holds because
the marginal utility the marginal
utility per dollar for the good rises.
41

42. To restore equilibrium, the
consumer must increase
consumption. As the quantity
demanded increases, the marginal
utility falls until equilibrium is
again achieved. Thus, the price falls
and the quantity demanded rises, as
predicted by the law of demand
42

43. Consumer Equilibrium
MU A MU B MU Z
price A = price B = price Z
43

44. The income effect and the
substitution effect are
complementary explanations for the
law of demand. When the price
changes, these effects work in
combination to change in the
quantity demanded in the opposite
directions.
44

45. As the price falls, real
purchasing power increases,
causing an increase in the
consumer’s willingness and ability
to purchase a good or service. This
is the income effect. Also, as the
price falls, the consumer substitutes
the cheaper the cheaper good for
other goods that are now relatively
more expensive. This is the
substitution effect.
45

46. If the marginal utility per last
dollar spend on each good is equal
and the entire budget is spent, total
utility is maximized.
46

47. When the price of a normal good
falls, the income effect and the
substitution effect combine to cause
the quantity demanded to increase.
47

48. Chapter 6 Quiz
©2000 South-Western College Publishing
48

49. 1. As an individual consumes more of a given
good, the marginal utility of that good to the
consumer
a. rises at an increasing rate.
b. rises at a decreasing rate.
c. falls.
d. rises.
C. As a consumer consumes more and more of
anything, the satisfaction received on the last
unit becomes less and less with each unit.
49

50. 2. The amount of added utility that a
consumer gains from the consumption of one
more unit of a good is called
a. incremental utility.
b. total utility.
c. diminishing utility.
d. marginal utility.
D. The word “margin” means that last
unit or the last increment.
50

51. 3. A certain consumer buys only food and
compact discs. If the quantity of food
bought increases, while that of compact discs
remains the same, the marginal utility of
food will
a. fall relative to the marginal utility of
compact discs.
b. rise relative to the marginal utility of
compact discs.
c. rise, but not as fast as the marginal utility
of compact discs falls.
d. fall, but not as fast as the marginal utility
of compact discs falls.
A. As more units of food are purchased, the
marginal utility diminishes, while that of
compact discs remains the same.
51

52. 4. Rational consumers will continue to
consume two goods until
a. the marginal utility per dollar’s worth of
the two goods is the same.
b. the marginal utility is the same for each
good.
c. the prices of the two goods are equal.
d. the prices of the two goods are unequal.
A. If a consumer can raise his/her marginal
utility by purchasing more of a good, more
units of that good will be purchased. At the
point that marginal utility cannot be
increased by purchasing more units of either
good, the consumer will stop purchasing.
52

53. 5. Assume a person’s consumption of just the
right amounts of pork and chicken is in
equilibrium. We can conclude that the
a. marginal utility of pork must equal the
marginal utility of chicken.
b. price of pork must equal the price of
chicken.
c. ratio of marginal cost to price must be the
same in both the pork and the chicken
markets.
d. ratio of marginal utility to price must be
the same for pork and chicken.
D. In terms of satisfaction, the two goods
become identical at the point of equilibrium.
53

54. 6. Assume an individual consumes only milk and
doughnuts, and he/she has arranged
consumption so that the last glass of milk
yields 12 utils and the last doughnut 6 utils. If
the price of milk is $1 per glass and the price
of a doughnut is $.50, we can conclude that the
a. consumer should consume less milk and
more doughnuts.
b. price of milk is too high relative to
doughnuts.
c. consumer should consume more milk and
fewer doughnuts.
d. consumer is in equilibrium.
D. At this point, the ratio of utils to price
is the same.
54

55. 7. Suppose an individual consumes pizza and
cola. To reach consumer equilibrium, the
individual must consume pizza and cola so
that the
a. price paid for the two goods is the same.
b. marginal utility of the two goods is equal.
c. ratio of marginal utility to price is the
same for both goods.
d. ratio of marginal utility of cola to
marginal utility of pizza is 1.
C. When the ratio of utils to price is the same
for two goods, the consumer cannot increase
his/her satisfaction by buying more of either.
55

56. 8. A state of consumer equilibrium for goods
consumed prevails when the
a. marginal utility of all goods is the same.
b. marginal utility per dollar’s worth of two
goods is the same.
c. price of two goods is the same.
d. marginal cost per dollar spent on two
goods is the same.
B. When the marginal utility of two goods is
the same, the consumer cannot increase
his/her level of satisfaction by purchasing
more of either good.
56

57. 9. The change in quantity demanded resulting
from a change in purchasing power is
known as the
a. income effect.
b. substitution effect.
c. law of demand.
d. consumer equilibrium effect.
A. When prices decline the purchasing power
of the consumer increases, and vice versa.
Therefore, a change in prices has the same
effect on the buying power of the consumer
as if his/her income had changed.
57

58. Total Utility for Multiplex Tickets,
Video Rentals, and Popcorn
Total Utility Total Utility Total Utility
from Multiplex from Video from Popcorn
Tickets Rentals
1 movie (30 utils) 1 video (14 utils) 1 bag (8 utils)
2 movies (54 utils) 2 videos (24 utils) 2 bags (13 utils)
3 movies (72 utils) 3 videos (30 utils) 3 bags (15 utils)
4 movies (84 utils) 4 videos (32 utils) 4 bags (16 utils)
Exhibit 4
58

59. 10. In exhibit 4, assume Multiplex tickets cost
$6 each, video rentals cost $2 each, and bags
of popcorn cost $1 each. What is the
marginal utility of renting a third video?
a. 6 utils.
b. 8 utils.
c. 10 utils.
d. 30 utils.
A. If the total utility for 2 videos is 24 utils
and the total utility for 3 videos is 30 utils,
the additional utils added by the third
video is 6.
59

60. 11. In exhibit 4, assume Multiplex tickets cost $6
each, video rentals cost $2 each, and bags of
popcorn cost $1 each. Suppose the consumer has
$12 per week to spend on Multiplex tickets,
video rentals, and popcorn. What combination
of goods will give the consumer the most utility?
a. 1 movie, 3 videos, and no popcorn.
b. 1 movie, 2 videos, and 2 bags of popcorn.
c. 1 movie, 1 video, and 4 bags of popcorn.
d. 2 movies, no video, and no bags of popcorn.
B. 67 total utils are achieved with this
combination, a yields 60 utils, c yields 60
utils and d yields 54 utils.
60

61. Internet Exercises
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62. END
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