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Chapter 18. Consumer Choice, Behavior, and Utility Maximization. Income and Substitution Effect. We have covered this. Price of good goes down… our real income purchases more Substitution Effect…. Willing to substitute dear product for cheaper product if dear product price goes up…. - PowerPoint PPT Presentation
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Chapter 18Consumer Choice, Behavior, and
Utility Maximization
Income and Substitution Effect
We have covered this.Price of good goes down… our real
income purchases moreSubstitution Effect…. Willing to substitute
dear product for cheaper product if dear product price goes up….
What is Utility?
Pleasure or satisfaction obtained from good or service.
More pleasure… more we are willing to pay.Favorite rock group… concert tickets are
very costly… Willing to pay? Willing to substitute?... How many utils of satisfaction derived?
What is total utility?
Total utility= amount of satisfaction obtained from entire consumption of a product.
Willing to stay through all three acts of Le’ Miserable– great till the very last curtain call.
16oz steak good to last bite.
Marginal Utility?
Marginal Utility= change in total utility obtained by consuming one more additional (marginal) unit of a good or service. TU
Q Popcorn… each handful in a movie adds
marginal utility.Sometimes… each beer consumed adds
marginal utility. Some think total utility with each marginal addition!
Diminishing Marginal Utility
Law of Diminishing Marginal Utility = the marginal utility of a good declines as more of it is consumed in a given period of time.
As long as MU is increasing TU must be increasing.
When MU is not increasing (diminishing) each unit added yields less utility
Examples…………
Utility Theory (cont'd)
• Observations
– Marginal utility falls as more is consumed.
– Marginal utility equals zero when total utility is at its maximum.
Diminishing Marginal Utility
As long as marginal utility > 0, total utility increases. When marginal utility becomes negative, total utility maxes out and then decreases.
19-8
Diminishing Marginal Utility
Law of Diminishing Marginal Utility = the marginal utility of a good declines as more of it is consumed in a given period of time.
As long as MU is increasing TU must be increasing.
When MU is not increasing (diminishing) each unit added yields less utility
Example: Newspaper Vending Machines versus Candy Vending
Machines• Newspaper machines do not prevent people
from taking more than one paper. Why not dispense candy the same way?
• The answer is found in the concept of diminishing marginal utility.
• Can you think of a circumstance under which a substantial number of newspaper purchasers might be inclined to take more than one newspaper from a vending machine?
TU and MUTacos consumed in 1 meal
TU MU
0 01 102 18 83 24 64 28 45 30 26 30 07 28 -2
As more of a product is consumed, Total utility increases at aDiminishing rate.
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01234567
010182428303028
10 8 6 4 2 0 -2
Units consumed per meal
Units consumed per meal
30
20
10Tota
l Util
ity (u
tils)
Mar
gina
l Util
ity (u
tils) 10
8 6 4 2 0 -2
TU
MU
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
TOTAL AND MARGINAL UTILITYTacos
consumedper meal
TotalUtility,Utils
MarginalUtility,Utils
01234567
010182428303028
10 8 6 4 2 0 -2
Units consumed per meal
Units consumed per meal
30
20
10Tota
l Util
ity (u
tils)
Mar
gina
l Util
ity (u
tils) 10
8 6 4 2 0 -2
TU
MU
0 1 2 3 4 5 6 7
1 2 3 4 5 6 7
ObserveDiminishingMarginalUtility
Marginal Utility, Demand and Elasticity
How can law diminishing MU explain demand curve sloping downward?
Ans: more units of good yield smaller MU.. Have to lower price to sell more.
If MU drops quickly.. Demand is inelastic
i.e. given decline in price elicits small increase in QD.
If MU drops more slowly, the demand is elastic
A small decline in price will elicit larger amounts of QD.
Relationships
There is a relationship between price elasticity and total revenue.
Total Revenue = price of a product multiplied by the quantity sold in a given time period: PxQ.TR= Price x Quantity sold
Price Elasticity and TR relationshipPrice hike increases TR if demand is inelastic(this is usually something we can’t live without)
E< 1Price hike reduces TR if demand is elastic(we can live without it)
E > 1Price hike does not change TR if demand is
unitary elasticE = 1
Maximizing Utility
How would you maximize your utility?
Select that good which delivers the most marginal utility/dollar even for last dollar spent.
Let’s think of MU as MBRemember… If MC > MB should not
produce. Same thing can apply to purchase.Why purchase something if you have
decreased utility?Why purchase something if you have
diminishing benefit?
Optimizing Consumption• Consider the following:
– Consumers have limited incomes (budgets)– We must make choices of how to allocate our income– We can use utils to measure the marginal utility
additional consumption gives us– Consumers will be able to optimize consumption by
spending dollars on goods that give the highest marginal utility per dollar (most “bang for your buck”)
• Consumer optimum– Combination of goods and services
that maximizes utility for a given income
Deciding What to Buy• In a simplified setting, we can narrow our
consumption choice to two goods, X and Y• We can spend each dollar optimally by asking
Y
Y
X
XPriceMU larger? is Which
PriceMU
• In other words:– Which good will give us the highest marginal utility per
dollar spent?– This is the “bang for your buck” question
Deciding What to Buy
• Why do we divide by the price?– Must account for price differences in goods– Some goods may give high MU, but are more
expensive!• If the X side is larger, what do we do?
– Spend next dollar on good X– X will give us more happiness per dollar– Important: after this consumption, MUX will fall!
Y
Y
X
X
PriceMU larger? is Which
PriceMU
Example: Pizza and Pepsi• Two goods, pizza and Pepsi
– Pizza is $2 per slice– Pepsi is $1 per can– You have $10 to spend
• Consumption of pizza and Pepsi both exhibit diminishing marginal utility– If I consume pizza, MUpizza falls
– If I consume Pepsi, MUPepsi falls
• Do prices ever change?– Prices can change (see later), however, they are not
endogenously affected by your consumption
Pizza and Pepsi OptimumPizza is $2.00/slice; Pepsi is $1.00/can
Budget = $10.00
Pizza and Pepsi Optimum
Activity Problem
Quantity TU MU Mu/$ Quantity TU MU Mu/$
0 0 0 00 0 0 1 70 0.5 90 2 130 1.0 170 3 180 50 1.5 230 4 220 2.0 260 5 250 2.5 270
Total and Marginal Utility per Dollar from Pizza and Wall ClimbingBudget: $50 Pizza costs $10 a piece; Wall Climbing is $20/hour or $10/half hour
Answer to Activity Problem
Quantity TU MU Mu/$ Quantity TU MU Mu/$
0 0 0 00 0 0 1 70 70 7 0.5 90 90 92 130 60 6 1.0 170 80 83 180 50 5 1.5 230 60 64 220 40 4 2.0 260 30 35 250 30 3 2.5 270 10 1
Total and Marginal Utility per Dollar from Pizza and Wall ClimbingBudget: $50 Pizza costs $10 a piece; Wall Climbing is $20/hour or $10/half hour
2 Pizza’s = $20 ($10 each)1.5 Hours Wall Climbing = $20 + $10 = $30Total= $50 budget
Theory of Consumer Behavior
Theory of Rational BehaviorPreferencesBudget ConstraintsPricesTime (Time/value/money)
Bottom Line for Price Reductions and Increases
Income EffectSubstitution EffectLaw of Diminishing Marginal Utility( do we
buy more or less?)
Assumption (consumer is rational)Do we research Consumer Reports before
purchasing?Do we ponder and question?When might we be more meticulous?When would the theory of rational behavior
be less applicable?
Moving Forward With Logic
Utility is maximized if last dollar spent on product yields same amount of satisfaction
Assumes consumer will spend all his income.
Marginal Utility Theory consistent with law of demand
Should government provide the necessities of life for free?
As book points out:1) If food, water are necessities of life. No one
should be w/o them, then government should provide them free to all.
2) As you are hearing now… medical care is a necessity and should be provided free.
3) Course, we know there are no free lunches, but the cost to consumer would be $0.
4) Resources must be used to produce every unit of a good consumed.
5) If govt uses resources to produce goods with low marginal utility, (which food, water, and health care would have a zero price) other goods could not be produced that would have a higher marginal utility.
6) Remember if the price is $0, then consumer will consume the good as long as the marginal utility she derives from it is greater than 0
$10.00 to spend for pizza and beerMaximize total utility between two goods
Take my $10.00 spend it on good that yields most utility.
Pt Beer
TU MU MU/P$2.00
1 20 20 10
2 38 18 9
3 54 16 8
4 68 14 7
SlicePizza
TU MU MU/$$2.00
1 20 20 10
2 36 16 8
3 50 14 7
4 58 8 4
$10.00 to spend for pizza and beerMaximize total utility between two goods
Take my $10.00 spend it on good that yields most utility.
Pt Beer
TU MU MU/P$2.00
1 20 20 10
2 38 18 9
3 54 16 8
4 68 14 7
SlicePizza
TU MU MU/$$2.00
1 20 20 10
2 36 16 8
3 50 14 7
4 58 8 4
$10.00 = 2 slices pizza and 3 pints beer. Total Utility = 56 pizza, 112 for beer.
Price QD
$2.75 1
$2.00 2
$1.00 3
$.25 4
$2.75
$.25
Because MU declines, lower price is needed to lure the customerto buy more.
Mathematical Version… (assumes no savings.. Spend last $)MU of product A = MU of product B Price of A Price of B
IF utility maximization occurs these ratios should be equal algebraically.
Time/Value/Money
Assuming you want to derive total satisfaction for last dollar spent.
Golf Outing = $30.00Concert = $40.00Both are equal in utility to you.Which would actually be more costly to indulge in?Golf takes 4 hoursConcert approximately 2 hours
Other Important Info for Rational Utility Maximization Decision to be made
How much do you make an hour?If you earn $10.00 an hour, golf game
costs your $70.00… concert $60.00 How did you get this sum?
(Golf = $40.00 Market place + $30.00 )(Concert = $30.00 Market place + 30.00)Now you know in economic terms why driving all
over Dallas to pick up “loss leaders” is costly.TIME IS MONEY!
Remember.. SubstitutionWe have learned:
That maximizing our utility is our goal. That our marginal utility decreases with
each additional unit.That because of this the demand curve will
be downward slopingWe can also shift our demand curve to a
substitute (assuming we can get equal utils of satisfaction.)
Last check on knowledge!Units Consumed
TU MU
0 01 10 102 83 254 305 36 34
Last check on knowledge!
Units Consumed
TU MU
0 01 10 102 18 83 25 74 30 55 33 36 34 1
Units Consumed
TU MU
0 01 10 102 83 254 305 36 34
Kiley- Total Utility
If you feel you have maximized your satisfaction for Utility Maximization…we will proceed.
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