Solution Manual for Microeconomics for Today

8th Edition Tucker 1133435068 9781133435068

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Chapter 6
Consumer Choice Theory
CHAPTER SUMMARY

We buy goods and services because they give us satisfaction (utility). The rational consumer
attempts to maximize total satisfaction (total utility) given their limited income (or budget constraint).
When additional units of a good or service are consumed within any given period of time the extra
satisfaction (marginal utility) associated with each additional unit of the good or service consumed
diminishes. This fact of life is referred to as the law of diminishing marginal utility.
Consumer equilibrium is a combination of goods and services consumed which produces for the
consumer maximum total utility. This is accomplished when the marginal (extra) utility per last dollar
spent on all goods and services consumed is the same. In other words, assuming a two good case (goods
X and Y), consumer equilibrium is defined as: MUx/Px = MUy/Py.
If the marginal utility per last dollar spent on good X is greater than the marginal utility per last
dollar spent on good Y (MUx/Px > MUy/Py), the rational consumer will consume more of good X and
less of good Y. By doing so, the consumer's total utility will increase. Moreover, as more of X is
consumed, its marginal utility will diminish. As less of good Y is consumed, the marginal utility
associated with the remaining units will be greater. Therefore, the consumer will be moving toward
equality between the ratios of the marginal utility in relation to the price for each good. Eventually,
equality between the ratio of the marginal utility and the price for the two goods will be observed. This
defines consumer equilibrium. The opposite logic is also true. Therefore, consumer equilibrium exists
when the ratio of the marginal utility to the price for all goods and services is the same (for a two good
case: when, MUx/Px = MUy/Py). In other words, when the marginal utility per last dollar spent on all
goods is the same.
The theory of consumer behavior explains why the law of demand exists. If the price of good X falls
then the rational consumer will buy more of good X because the marginal utility per last dollar spent will
now exceed that for all other goods. Moreover, when we consider income and substitution effects, we can
more easily see why the law of demand exists.

NEW CONCEPTS INTRODUCED

utility marginal utility total utility

consumer equilibrium income effect substitution effect
law of diminishing marginal utility
INSTRUCTIONAL OBJECTIVES
After completing this chapter, students should be able to:

1. Distinguish between total utility and marginal utility.

2. Calculate marginal utility given total utility figures associated with units of consumption.
3. Explain the law of diminishing marginal utility.
4. Explain what is meant and what constitutes consumer equilibrium.
54 Economics for Today Chapter 6: Consumer Choice Theory 54

5. Explain under what conditions a rational consumer will consume more of one good and less of
another in order to maximize satisfaction given a limited budget.
6. Explain how the theory of consumer behavior gives rise to the law of demand.
7. Define and explain what an income and substitution effect is.
8. Explain how the income and substitution effects combined give rise to the law of demand being
observed for a normal good.

CHAPTER OUTLINE

I. Preview

II. From Utility to the Law of Demand

a. Total Utility and Marginal Utility

Exhibit 1 "Diminishing Marginal Utility and Total Utility Curves for Consuming Big Macs"

b. Consumer Equilibrium

You're The Economist: Analyze the Issue

"Why Is Water Less Expensive than Diamonds" Applicable Concept: total utility and marginal
utility

Exhibit 2 "The Diamond-Water Paradox"

Exhibit 3 "Marginal Utility for Big Macs and Milkshakes (Utils per Day)"

c. From Consumer Equilibrium to the Law of Demand

Checkpoint: "When Dining Out, Do You Eat Smart?"

III. Income and Substitution Effects and the Law of Demand

a. Income Effect
b. Substitution Effect

You're The Economist: Analyze the Issue

"Testing the Law of Demand with White Rats" Applicable Concept: substitution effect

Checkpoint: "Does the Substitution Effect Apply to Buying a Car?"

IV. List of Key Concepts

V. Summary

VI. Summary of Conclusion Statements

a. If the marginal utility per dollar of each good is equal and the entire budget is spent, total utility
is maximized.
b. When the price of a normal good falls, both the income and the substitution effects combine to
cause the quantity demanded to increase.

VII. Study Questions and Problems

55 Economics for Today Chapter 6: Consumer Choice Theory 55

VIII. Checkpoint Answers

IX. Sample Quiz

HINTS FOR EFFECTIVE TEACHING

1. I find it very helpful to begin this chapter with a short lecture on the theory of rational behavior (also
known as benefit-cost analysis and optimality analysis). I stress that it is really benefit-cost
analysis.
I indicate that there are only two types of benefit-cost analysis: unconstrained and constrained.
Unconstrained benefit-cost analysis refers to those situations when the decision maker simply "does
it" (it being some activity) or "doesn't do it." It's up to them. That is, nothing is stopping the person
from doing as much of the activity as they desire, or requiring a certain amount. In the
unconstrained situation, the appropriate (optimal---best) amount of the activity to undertake is when
the marginal benefits no longer exceed the marginal cost (when MB = MC). A good example of an
application of the unconstrained benefit-cost decision is the production decision by a firm. In that
case, the marginal benefits are marginal revenue (the selling price if the firm is a competitive firm).
Nevertheless, in all cases, if MB > MC then the decision maker should do more of the activity
because it is worth it (that is, the extra benefits exceed the extra costs), and vice versa.
Constrained benefit-cost analysis obviously refers to those situations when the decision maker is
constrained in some regard. The general rule for the optimal amount to pursue is when MBx/MCx =
MBy/MCy. If MBx/MCx > MBy/MCy then do more of X and less of Y, and vice versa. There are
many applications of this general rule beyond the consumption decision discussed in this chapter
(the consumption decision is constrained by a given budget or income, prices of goods, and tastes
or preferences). For example, the employment decision is a constrained one.
By introducing "rational decision making" (or, benefit-cost analysis) before getting into the details
of this chapter may help put this chapter into a greater context of understanding. In addition, and
maybe more importantly, it may enable you to more easily introduce other general economic
principles later which follow from this lecture, like those mentioned (i.e. the profit-maximizing
production rule and the profit-maximizing quantity of resources to employ...).

2. It is usually helpful to point out that a synonym for "utility" is "satisfaction," and a synonym for
"marginal" is "extra." Sometimes the jargon of economics gets in the way of student understanding.

3. Some students are usually confused about the difference between total and marginal utility. A good
way to start distinguishing between these two concepts might be to refer to the water-diamond
paradox, which is discussed in the "You're the Economist" boxed section of this chapter. It is also
helpful to ask students to think of some simple everyday examples where a distinction between the
two concepts can be made (e.g. eating an ice cream cone, drinking, sleeping, studying, and watering
a plant...)

4. The law of diminishing marginal returns simply means there is diminishing extra satisfaction
associated with the increased consumption of any good or service. Ask students to think of any
exceptions. If they can think of any, then they must be examples of irrational behavior.

5. Stress that economists are aware people don't go around consciously assessing the marginal utility in
relation to price when considering consumption decisions. However, we do subconsciously behave
as if we do.

6. It is usually helpful to take a numerical example of two goods then ask students to determine
consumer equilibrium. Give students only the total utility associated with each level of consumption
56 Economics for Today Chapter 6: Consumer Choice Theory 56

and the price of each good. They should be able to derive marginal utility and then apply the
algebraic expression for consumer equilibrium.

7. When looking at the algebraic expression for consumer behavior stress that the ratio of marginal
utility in relation to price is simply a ratio of satisfaction in relation to price. This should help them
to more easily and correctly conclude what the rational consumer should do when there is an
inequality.

8. Stress that given an inequality, for example, MUx/Px > MUy/Py, because of the law of diminishing
marginal utility, as more of good X is consumed and less of good Y is consumed then MUx gets
smaller while MUy gets larger (MUy gets larger because the fewer remaining units of good Y left
will be relatively more valuable---e.g. when your significant other takes just one bite of your hot dog,
that's O.K...but, two bites?...then three!). As this happens we are moving toward equality in the
overall algebraic expression---we are moving toward consumer equilibrium.
Also make it clear that consumer equilibrium implies some amount of goods X and Y consumed.

9. The income and substitution effects should be distinguished and should be easily understood if
intuitively explained.

CRITICAL THINKING/GROUP DISCUSSION QUESTIONS

1. If MUx/Px < MUy/Py, is the consumer in equilibrium, or should the consumer purchase more of X
and less of Y, or vice versa?
The consumer is not in equilibrium. To get there, the consumer should purchase more of X and
less of Y.

2. Assume a two-good case, goods X and Y, and the consumer is initially in equilibrium. If the price of
X declines then explain how a consumer will respond, and why, using the analysis introduced in this
chapter. How is this related to the law of demand?
The consumer will purchase more of good X because the marginal utility in relation to the price
of good X will now exceed that for good Y. As the consumer purchases more of good X and less
of good Y, the consumer will be moving toward an equality between the ratio of the marginal
utility of good X in relation to the price paid for good X and that for good Y. Eventually an
equality between the two will be observed which defines consumer equilibrium, When we
compare the old equilibrium with the new one, we observe more of good X being purchased.
That is, because the price of good X fell, the consumer has found that in acting out of her own
self-interest that more of X will be purchased. This is exactly what the law of demand predicts---
when the price of a good falls, consumers will purchase more of the good.

3. Assume the consumption of just two goods, X and Y. Also assume the consumer is in equilibrium.
What do you think would happen to consumer equilibrium given each of the following changes?
a. Income rises.
Because the consumer now has more to spend, the consumer will now purchase more of both
X and Y. We are unable to determine exactly how much more of each good will be
consumed. We would require more information to determine that (i.e. how much income
rose, the marginal utility schedule and the price of goods X and Y).

b. The price of both X and Y double.

The amount of X and Y would both be cut in half.
57 Economics for Today Chapter 6: Consumer Choice Theory 57

c. The consumer now prefers X more and Y less.

This affects the marginal utility of both goods. The consumer will consume more of X and
less of Y.

4. Suppose you are interested in purchasing just ice cream and cake for an upcoming birthday party.
Assume you have only $45 to spend, the price per cake is $10 and the price per package of ice cream
is $5. You have estimated the utility (or satisfaction) from the consumption of cake and ice cream
according to the following tables.

ICE CREAM CAKE

Quantity Total Utility Quantity Total Utility

0 0 0 80
1 100 1 130
2 175 2 250
3 225 3 350
4 250 4 425
5 260 5 465

a. How many cakes and packages of ice cream should you purchase for the party? Why?
You should purchase 3 cakes and 3 packages of ice cream because this satisfies the
algebraic formula for consumer equilibrium (i.e. this is the only quantity in which the
marginal utility in relation to the price of both goods is equal).

b. Now suppose the price of cake falls to $7.50. Now how many cakes and packages of ice cream
should you buy for the party? Why?
Now you should purchase 3 packages of ice cream and 4 cakes.

c. How is the observed change in the quantity demanded of cake and the decrease in the price of
cake related to the law of demand?
The law of demand states there is an inverse relationship between the price and the quantity
demanded. This was observed in this case. The law of demand exists because of the principle
of rational choice.

6. Why does the law of demand exist?

Ultimately because of the law of diminishing marginal utility.

7. How are the substitution and income effects related to the law of demand?
Because of a lower price people will buy more not only because the product is relatively less
expensive (substitution effect), but also because of the increased purchasing power due to the
price decrease (income effect).

CLASSROOM GAMES

Approximately 170 non-computerized economic games (experiments) for use in the classroom are
available for free at http://www.marietta.edu/~delemeeg/games/. The following games are recommended
to help teach some of the concepts in this chapter:

Game #2—Objective: To teach students an intuitive understanding of total utility, marginal utility, and
diminishing marginal utility
Game #119—Objective: To illustrate issues regarding equity and efficiency regarding income
distribution.
58 Economics for Today Chapter 6: Consumer Choice Theory 58

ANSWERS TO: "You're the Economist: Analyze the Issue"

WHY IS WATER LESS EXPENSIVE THAN DIAMONDS?

1. Can you imagine a situation in which water would be more expensive than diamonds?
If you were lost in a desert without water, the marginal utility of water is infinitely greater
than the marginal utility of scarce diamonds. In this case, you would pay everything in your
possession for water and diamonds would be worth nothing.

2. Suppose the price per gallon of water is 1 cent and the price per carat of a diamond is $10,000.
Is the total utility of diamonds 10,000 times as great as the total utility received from water?
The total utility (usefulness) of water is high and the total utility of diamonds is relatively
low. Price, then, is determined by marginal utility and not total utility. The total utility of
diamonds is therefore not 10,000 times as great as the total utility received from water.

TESTING THE LAW OF DEMAND WITH WHITE RATS

Based on the behavior of rats described above, what do conclude about the substitution effect and the
slope of the demand curve?
The substitution effect predicts that given those new prices the rats would consume more Collins
mix and less root beer. This is exactly how the rats responded to this price change. The
conclusion is that white rats are rational consumers and demand curves are downward sloping
for Collins mix and root beer.

ANSWERS TO EVEN-NUMBERED "Study Questions and Problems"

2. No. There are diminishing returns even to food that you enjoy. As you consume more tacos,
eventually the cost of additional tacos will exceed the benefits, and it is a rational choice to stop
eating tacos.

4. Assuming the law of diminishing marginal utility and a marginal utility equal to zero, the total utility
of consuming meals at the cafeteria per week is at a maximum. Consuming more meals at the
cafeteria would mean marginal utility is negative and total utility falls as you feel nauseous and sick.

6. Consumer equilibrium is not achieved, and maximum total utility has not been reached. You receive
15 utils per dollar spent on Coke and 10 utils per dollar spent on pizza. You can increase total utility
by purchasing more Coke and less pizza until the marginal utility per dollar is equal for both these
goods.

8. Consumer equilibrium is reached where the marginal utilities per dollar of both steak and
hamburger meals are equal. This occurs at 3 meals of each per month. Total utility realized will be
76 utils (20 + 15 + 12 for steak meals and 15 + 8 + 6 for hamburger meals). To arrive at this
answer requires calculating the MU/$1 for steak and hamburger meals by dividing column 2 by
column 3 and column 5 by column 6, respectively. The total utility for each meal is the sum of the
marginal utilities for each meal consumed to the number where the MU/$1 (1.2) of both meals are
equal at 3 meals of each choice. Try any other combination of steaks and hamburgers with a budget
of $45 and you will find that it will total less than 76 utils. Computed from the following table:
59 Economics for Today Chapter 6: Consumer Choice Theory 59

Steak meals Marginal utility Hamburger meals Marginal utility

per month per $1 Per month per $1

1 2.0
2 1.5
3 1.2
4 1.0
5 0.8
1 3.0
2 1.6
3 1.2
4 0.8
5 0.4

10. When the price of a BMW falls, the real income of consumers rises because they can afford to buy
more BMWs. This is the income effect. A second reason consumers buy more BMWs is that these
cars become less expensive in relation to substitute goods such as the Mercedes. As a result,
consumers substitute the now relatively cheaper BMW for competing cars whose prices remain
unchanged. When the price falls, these two reasons combine to explain why consumers buy more of a
good when its price falls.

CHAPTER 6 SUMMARY QUIZ

1. Which of the following statements is true?

a. Total utility is the extra satisfaction from the consumption of a good or service.
b. Marginal utility is the amount of satisfaction received from all the units of a good or service
consumed.
c. The law of diminishing marginal utility states that as more of a good or service is consumed
total utility decreases.
d. Consumer equilibrium is a combination of goods and services consumed which maximizes total
utility from a given budget.

2. If a consumer wishes to maximize satisfaction given limited income and MUx/Px < MUy/Py then
the consumer should:
a. do nothing because she/he is in equilibrium.
b. buy more of X and less of Y.
c. buy more of Y and less of X.
d. buy more of both X and Y.
e. buy less of both X and Y.

3. Consumer equilibrium exists when:

a. the marginal utility of each good and service consumed is equal.
b. the total utility of each good and service consumed is equal.
c. the marginal utility of each good and service consumed equals its price.
d. ratio of marginal utility to price for all goods and services is equal.

4. When the price of a normal good falls, then:

a. both the income and substitution effects combine to cause the quantity demanded to increase.
b. the substitution effect will cause people to buy more because the good is relatively less
expensive.
c. the income effect will cause people to buy more because of the increased purchasing power
associated with the lower price.
d. all of the above.
60 Economics for Today

ANSWERS TO CHAPTER 6 SUMMARY QUIZ

1. d
2. c
3. d
4. d