Chapter 5/Consumer Choice: Individual and Market Demand
CHAPTER 5
CONSUMER CHOICE: INDIVIDUAL AND
MARKET DEMAND
Chapter 5 goes behind the market demand curve of Chapter 4 to show how it is based on the
preferences of individual consumers. The text develops the theory of marginal utility for a single
good; the appendix considers indifference curves in the case of two goods.
CHAPTER OUTLINE
SCARCITY AND DEMAND
Because income is limited, the decisions by a consumer to purchase different commodities
must be interdependent.
UTILITY: A TOOL TO ANALYZE PURCHASE DECISIONS
The theory of consumer choice states that each consumer spends his or her income in a way that
yields the greatest satisfaction (utility). Ultimately, the purpose of utility analysis is analyzing
how people behave, not what they think.
Total versus Marginal Utility
Total utility is the benefit to a consumer from all the units of a good purchased.
The “Law” of Diminishing Marginal Utility
The more of a good a consumer has, the less marginal utility an additional unit contributes to
overall satisfaction.
Using Marginal Utility: The Optimal Purchase Rule
When possible, a consumer should buy the quantity of each good at which price and marginal
utility are exactly equal.
From Diminishing Marginal Utility to Downward-Sloping Demand Curves
Because people’s marginal utility declines with the number of goods bought, demand curves
are negatively sloped.
Chapter 5/Consumer Choice: Individual and Market Demand
BEHAVIORAL ECONOMICS: ARE ECONOMIC DECISIONS REALLY
MADE “RATIONALLY”?
Economists and psychologists have questioned the assumption that economic decisions are
made rationally. Such research has led to a school of thought called behavioral economics.
CONSUMER CHOICE AS A TRADE-OFF: OPPORTUNITY COST
The decision to purchase something is simultaneously a decision to forgo something else.
Consumer’s Surplus: The Net Gain from a Purchase
Because purchases are voluntary, it follows that the purchaser must come out ahead.
RESOLVING THE DIAMOND-WATER PUZZLE
A commodity that is scarce, like diamonds, will have a high marginal utility and a high price,
when compared to a commodity that is plentiful, like water.
The plentiful commodity, however, often provides greater total utility.
Income and Quantity Demanded
FROM INDIVIDUAL DEMAND CURVES TO MARKET DEMAND
CURVES
The market demand curve is the horizontal sum of the individual demand curves.
The “Law” of Demand
Demand curves normally have a negative slope.
Chapter 5/Consumer Choice: Individual and Market Demand
Exceptions to the Law of Demand
Exceptions can occur:
1. some inferior goods
APPENDIX: ANALYZING CONSUMER CHOICE GRAPHICALLY:
INDIFFERENCE CURVE ANALYSIS
Geometry of the Available Choices: The Budget Line
The budget line is a graphical representation of all possible combinations of a household’s
purchases of two goods, given their prices and a fixed amount of money to spend.
Properties of the Budget Line
The budget line represents the maximum amounts of the commodities the consumer can
afford.
Changes in the Budget Line
What the Consumer Prefers: Properties of the Indifference Curve
An indifference curve is a line connecting all combinations of the commodities that are
equally desirable.
Properties of the indifference curve:
1. a higher indifference curve is preferred
2. indifference curves never intersect
The Slopes of Indifference Curves and Budget Lines
The slope of the indifference curve is the marginal rate of substitution of the two
commodities.
Chapter 5/Consumer Choice: Individual and Market Demand
Tangency Conditions
A consumer-maximizing utility will choose the point on the budget line tangent to an
Consequences of Income Changes: Inferior Goods
In the case of inferior goods, indifference curves are located such that an increase in income
leads to an increase in purchases of the normal good, but a reduction in purchases of the
inferior good.
Consequences of Price Changes: Deriving the Demand Curve
A fall in price changes the slope of the budget line and leads (usually) to an increase in
MARGIN DEFINITIONS
Total Monetary Utility: the maximum amount of money that a consumer is willing to pay for a
quantity of a good.
Marginal Utility: the maximum amount of money that a consumer is willing to pay for one
more unit of a good.
“Law” of Diminishing Marginal Utility: additional units of a commodity are worth less and
less to a consumer in money terms.
Marginal Analysis: a method for calculating optimal choices – the choices that best promote the
decision maker’s objective. It works by testing whether, and by how much, a small change in a
Chapter 5/Consumer Choice: Individual and Market Demand
Slope of an Indifference Curve: the maximum amount of one commodity a consumer is willing
to give up in exchange for one more unit of another commodity; also referred to as the marginal
rate of substitution.
MAJOR IDEAS
1. As consumers buy a good, the extra benefit they derive from each additional unit
declines.
2. For rational consumers, the marginal utility curve describes the demand curve.
3. When possible, a consumer should buy the quantity of each good at which price and
ON TEACHING THE CHAPTER
This material is fundamental, but instructors often have difficulty making it come alive for the
students. One strategy is to ask the students to predict their own responses in different market
situations (for example, a changing price of hamburgers), and then show how an economist
models that behavior.
One typical response from students is that this modeling is all silly, because they never knew a
consumer who consciously equated marginal utility and price. This can be a good place to take a
step back, and ask what economic models are and are not useful for. Of course people in a
supermarket aisle do not calculate marginal utility curves and equate them to price. Neither does
a driver on a two-lane road solve a differential equation before deciding whether she can pass the
car ahead and not crash into the approaching truck. But a traffic engineer might well find a
differential equation helpful in predicting how frequently passing attempts will be made at
Chapter 5/Consumer Choice: Individual and Market Demand
thing. One approach to take is this: Every consumer has a marginal utility curve for different
goods, a curve that is given by his or her tastes. Every consumer has a demand curve for different
goods, a curve that reflects his or her behavior as prices change. What makes the marginal utility
and the demand curves identical is the assumption that the consumer’s behavior is optimal, or
rational. Economists have different attitudes toward this point. One can take the position that
consumer behavior is by definition optimal, because consumers control it. Therefore the demand
PROBLEMS
1. The table shows the maximum amount of money you would be willing to pay for
increasing numbers of chicken pieces at Fastfood.
Chicken Pieces Maximum Payment
1 $2.00
2 3.80
3 5.40
4 6.80
5 8.00
6 9.00
7 9.80
8 10.40
9 10.80
10 11.00
11 11.00
a) Find the marginal utility for each chicken piece. What is the meaning of the marginal
utility of the 11th piece?
b) If the price of chicken pieces is $1.25 each, how many will you buy?
c) If the price falls to $0.50, how many will you buy? Explain carefully why you will
not buy one more.
Chapter 5/Consumer Choice: Individual and Market Demand
d) Suppose now that Fastfood stops selling chicken pieces individually, and only sells
them in 5-Packs. The price of a 5-Pack is $2.50. How many chicken pieces will you
consume? Reconcile your answers to c) and d).
e) What is the consumer surplus, or net benefit, that you get from purchasing chicken
pieces at $0.50 as in c)?
Solution:
a)
2. The price of whole chickens varied between $2 and $6; Dan and Chris will purchase the
following numbers this year:
Dan’s Chris’
Price Quantity Quantity
$6 4 6
557
478
3 11 9
2 20 10
a) If Dan and Chris are the only two buyers, calculate the market demand curve.
b) On graph paper, draw the demand curves for Dan, for Chris, and for the market.
Chicken
Pieces
Maximum
Payment
Marginal
Utility
1 $2.00 $2.00
2 3.80 1.80
3 5.40 1.60
Chapter 5/Consumer Choice: Individual and Market Demand
Solution:
a)
Price(in $)
Dan’s
Quantity
Chris’
Quantity
Market
Demand
6 4 6 10
b)
DISCUSSION QUESTIONS
1. “Economists are wrong to pay so much attention to the margin, to the last unit of a good
that is bought. The last unit is the least important. They should focus their attention on the
more important earlier units.” Discuss.
Suggested Answer: This statement might look correct to someone who is not familiar
with economics. Students should discuss the importance of margin. They should provide
2. “Perhaps economists consciously equate marginal utility with price as they are shopping
for groceries, but I am sure no one else does, and I suspect even they slip up. It is
ridiculous to describe consumer behavior in terms of a theory that consumers have never
even heard of.” Discuss.
Suggested Answer: Even though buyers may seem to make decisions much more
instinctively without any calculation of marginal utilities or equating it with the price,
Chapter 5/Consumer Choice: Individual and Market Demand
3. “The text explains that consumers who follow the optimal purchase rule will behave such
that their demand curve for a good is the same as their marginal utility curve. This is an
interesting but not very relevant piece of information. Consumers do not follow an
optimal purchase rule. They buy on impulse, and they often buy things that do them no
good. It is a serious mistake to develop models based on the assumption that human
behavior is rational.” Discuss.
Suggested Answer: Students should attempt to identify models based on the assumption
that human behavior is rational. Note that price is an objective, observable figure
determined by the market, whereas marginal utility is subjective and reflects consumer
4. “Price has nothing to do with utility or value. Tickets to the worst Broadway play cost
$50, while tickets to Oscar-winning movies cost no more than $10. I rest my case.”
Discuss.
Suggested Answer: This question is aimed at revealing the importance of marginal
analysis in economics. The price of a commodity depends on what that good is worth to