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The Logic of Individual Choice: The Foundation of Supply and Demand

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Title: The Logic of Individual Choice: The Foundation of Supply and Demand


1
The Logic of Individual Choice The Foundation of
Supply and Demand
  • Chapter 8

2
Utility Theory and Individual Choice
  • Many different sciences try to explain why people
    do what they do.
  • Psychology, for example, explains behavior in
    terms of internal mechanisms, habitual behaviors,
    and differentiates between instinctual and
    acquired behavior.
  • Economists have a simple explanation for why we
    do what we do
  • Rational self interest.

3
Utility Theory and Individual Choice
  • Economists assume that the human condition is
    like a long decision tree from the cradle to the
    grave we move from one decision to another.
  • Decisions are made based on rational
    self-interest.
  • The assumption of rational self-interest itself
    presumes that men and women have free will to
    make decisions.

4
Utility Theory and Individual Choice
  • Using this simple theory of human behavior we can
    say that two factors determine what people decide
    to do
  • The pleasure they receive from doing or consuming
    something.
  • The price of doing or consuming that thing.

5
Utility Measuring Pleasure
  • Economists use the word Utility to denote the
    pleasure or satisfaction people get from doing or
    consuming something.
  • While we cannot measure utility we can evaluate
    the pleasure obtained from some good or action
    relatively.
  • For example, we might say that we like apples and
    oranges equally but we like bananas more that
    either. We might add that we like Pina Coladas
    more than bananas.
  • In this way, utility is measured using an ordinal
    scale.

6
Measuring Pleasure
  • Utility serves as the basis of economists'
    analysis of individual choice.

7
Total Utility
  • Total utility refers to the satisfaction one gets
    from ones consumption of a product.

8
Marginal Utility
  • Marginal utility refers to the satisfaction you
    get from the consumption of one additional unit
    of a product above and beyond what you have
    consumed up to that point.

9
Total Utility and Marginal Utility
  • As additional units are consumed, marginal
    utility decreases while total utility increases.
  • When total utility stops increasing, marginal
    utility is zero.
  • Beyond this point, total utility decreases and
    marginal utility is negative.

10
Diminishing Marginal Utility
  • The principle of diminishing marginal utility
    states that, after some point, the marginal
    utility received from each additional unit of a
    good decreases with each additional unit
    consumed.

11
Diminishing Marginal Utility
  • The principle does not say you do not enjoy
    consuming more of a good.
  • Only that as you consume more of the good, you
    enjoy additional units less than you enjoyed the
    initial units.

12
Marginal and Total Utility (Measures of utility
are hypothetical and for illustration only)
13
Marginal and Total Utility
Total utility
Marginal utility
14
Rational Choice and Marginal Utility
  • Rational choice begins with the premise that
    rational individuals want as much satisfaction as
    they can get from their available income.
  • This is sometimes referred to as the more is
    better premise.

15
Buying Units of Utility
  • In making choices, essentially what you are doing
    is buying units of utility.
  • Any choice that does not give you as many units
    of utility as possible is an irrational choice.
  • Since you want to get the most for your money,
    you make those choices that have the highest
    units of utility per unit of cost.

16
Choice 1 Pizza and Hero Sandwiches
  • You can spend another dollar on a slice of pizza
    that gives you an additional 41 units of utility
    or spend that dollar on a hero sandwich that
    gives you another 30 units of utility.

17
Choice 2 Studying Economics or Psychology
  • You can read another chapter of economics and get
    200 units of utility but it will cost you one
    hour of your time. Alternatively, you can read
    another chapter in psychology, get another 100
    units of utility, and only spend 40 minutes doing
    so.
  • Here the choices are expressed in units of time
    rather than in units of money.
  • The analysis, however, is the same.

18
Choice 3 Date with J or G ?
  • You can go out on Friday night with J and get
    2000 units of utility but it will cost you 70.
    Otherwise, you can go out with G and get 200
    units of utility for a mere 10.
  • Since you want to get the most for your money,
    you chose the one with the highest units of
    utility per dollar.

19
The Principle of Marginal Choice
  • According to the principle of rational choice you
    should spend your money on those things that give
    you the most marginal utility (MU) per dollar.
  • This principle says nothing more than it is
    rational to try to get the most bang for your
    buck.

20
The Principle of Marginal Choice implies that
  • If
  • Consume an additional unit of good x.

21
The Principle of Marginal Choice also implies that
  • If
  • Then consume an additional unit of good y.

22
The Principle of Marginal Choice
  • By 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.

23
Maximizing Utility and Equilibrium
  • The goal of the consumer is to maximize their
    utility subject to their budget constraint.
  • How can we tell if a consumer is maximizing
    utility?
  • The consumer maximizes utility when they consume
    goods such that the ratios of the marginal
    utility to price of all goods are equal,.

24
The Principle of Marginal Choice
  • If
  • Then you are in consumer equilibrium and have
    maximized utility.
  • You cannot increase your utility by adjusting
    your choices.
  • Any adjustment decreases utility unless you
    substitute things of equal utility.

25
An Example of Maximizing Utility
26
Rational Choice and Marginal Utility
  • If MUx/Px gt MUz/Pz, consume more of good x.
  • If MUy/Py gt MUz/Pz, consume more of good y.

27
Rational Choice and Marginal Utility
  • The general utility-maximizing rule is that you
    are maximizing utility when the marginal
    utilities per dollar of the goods consumed are
    equal.

28
Rational Choice and Marginal Utility
  • So the general principle of rational choice is to
    choose goods and services so that the marginal
    utilities per dollar of goods consumed are equal.
  • If
  • Then you are maximizing utility

29
Rational Choice and Marginal Utility
  • When 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
    can be.

30
Rational Choice and Marginal Utility
  • The rule does not say that the rational consumer
    should consume a good until its marginal utility
    reaches zero.
  • The consumer does not have enough money to buy
    all he wants.

31
Rational Choice and the Laws of Demand and Supply
  • The principle of rational choice leads to the law
    of demand.
  • When the price of a good goes up, the marginal
    utility per dollar we get from that good goes
    down and we demand less of it.
  • If there is diminishing marginal utility and the
    price of a good goes up, we consume less of that
    good.

32
Rational Choice and the Laws of Demand and Supply
  • If MUx/Px MUy/Py and the price of good y goes
    up, then MUx/Px gt MUy/Py.
  • Our condition for maximizing utility is no longer
    satisfied.

33
Rational Choice and the Laws of Demand and Supply
  • To continue maximizing utility, we must somehow
    raise the marginal utility we get from the good
    whose relative price has risen and lower the
    marginal utility we get from a good whose
    relative price has fallen.

34
Rational Choice and the Laws of Demand and Supply
  • Following the principle of diminishing marginal
    utility, we can increase marginal utility only by
    decreasing consumption of the good whose price
    has risen.

35
Rational Choice and the Laws of Demand and Supply
  • Since our demand for a good is an expression of
    our willingness to pay for it, quantity demanded
    is related to marginal utility.

36
Rational Choice and the Laws of Demand and Supply
  • Quantity demanded rises as price falls, other
    things constant.
  • Quantity demanded falls as price rises, other
    things constant.

37
Rational Choice and the Laws of Demand and Supply
  • The above shows the relationship between marginal
    utility and the price we are willing to pay.

38
Rational Choice and the Laws of Demand and Supply
  • Since our demand for a good is an expression of
    our willingness to pay for it, quantity demanded
    is related to marginal utility.

39
The Law of Supply
  • The law of supply comes from the principle of
    rational choice.
  • The discussion of the principle of rational
    choice and the law of demand also holds for the
    law of supply.

40
The Law of Supply
  • In supply decisions you are giving up something
    your time, land, or some other factor of
    production and getting money in return.

41
Opportunity Cost
  • Opportunity cost is the benefit forgone of the
    next-best alternative.
  • To say MUx/Px gt 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.

42
Opportunity Cost
  • When the marginal utilities per dollar spent are
    equal, the opportunity cost of the alternatives
    are equal.

43
Applying the Theory of Choice to the Real World
  • There are limits on the assumptions underlying
    the theory of rational decision-making.

44
The Cost of Decision Making
  • The cost of deciding among hundreds of possible
    choices lead us to do something irrational.
  • That is, do things without applying the rational
    choice model.

45
The Cost of Decision Making
  • A number of economists believe that most people
    use bounded rationality rather than using the
    rational choice model.
  • Bounded rationality means rationality based on
    rules of thumb.

46
The Cost of Decision Making
  • One of these rules of thumb is you get what you
    pay for.
  • The implication is that high price equals high
    quality.
  • This reliance on price for information changes
    the inferences one can draw from the analysis and
    can lead to upward-sloping demand curves.

47
The Cost of Decision Making
  • A second rule of thumb is follow the leader.
  • This rule leads to focal point equilibria in
    which a set of goods is consumed, not because the
    goods are objectively preferred to other goods,
    but because they have become focal points to
    which people have gravitated.

48
The Cost of Decision Making
  • Advertisers pay huge sums to mine these two rules
    of thumb.

49
Given Tastes
  • A second assumption implicit in economists
    theory of rational choice is that utility
    functions (tastes) are given, and are not shaped
    by society.
  • This is not true tastes often are significantly
    influenced by society.

50
Tastes and Individual Choice
  • One way in which economists integrate the above
    insights into economics is by emphasizing that
    the analysis is conducted on the assumption of
    given tastes.
  • To do otherwise would require a theory of tastes.

51
Tastes and Individual Choice
  • Whenever a need is satisfied, it is replaced by
    another want, which soon becomes another need.
  • Economists take account of changes in tastes as
    shift factors of demand.

52
Conclusion
  • Economists use their simple self-interest theory
    of choice because it cuts through many
    obfuscations.
  • In doing so, it often captures a part of reality
    that others miss.

53
Conclusion
  • Approaching problems by asking "What's in it for
    the people making the decision?" is a useful
    approach that will give you more insight than
    many other approaches.

54
The Logic of Individual Choice The Foundation of
Supply and Demand
  • End of Chapter 8

55
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