AP ECONOMICS – CHAPTER 5 Consumer Behavior and Utility Maximization

AP ECONOMICS – CHAPTER 5

Consumer Behavior and Utility Maximization

4 Key Concepts

1. Understanding Utility: Total and Marginal2. Utility Maximization: Equalizing Marginal

Utility per Dollar (MU/PA = MU/PB)

3. Individual and Market Demand Curves4. Income and Substitution Effects (review

from unit two)

Introduction

The CONSUMER is essential to the market. Understanding how the consumer makes his/her purchasing decisions is key.

1. Understanding Utility

Utility = Satisfaction/Happiness/Pleasure one gets from consuming a good.

Utility and usefulness are NOT synonymous in economics.

Utility is difficult to quantify, as it differs between people and situations ie. A blanket to a person living in Arizona vs. a

person living in Minnesota.

Measured in “utils” (a personal measure)

1. Understanding Utility

Total Utility (TU) Total amount of satisfaction or pleasure a person

derives from consuming a given quantity of that product

Marginal Utility (MU) The extra satisfaction a consumer derives from one

additional unit of that product. In other words, the change in Total Utility that

results from the consumption of one more unit

Law of Diminishing Marginal Utility

Explains that the more of a good a person gets, the less utility he gets from each additional unit.

Consumer wants in general are insatiable, but wants for particular items can be satisfied for a time. Example: Durable goods such as an automobile

First is the Best

It is important to note that your marginal utility begins to fall after the very first unit you consume.

In other words, your very first taco holds great utility. While you may enjoy your second taco, it doesn’t bring as much utility as the first

At some point, your MU becomes negative. (takes away from your total satisfaction).

Law of Diminishing Marginal Utility

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2. Utility Maximization

Explains how consumers allocate their money incomes among the many goods and services available for purchase

You will be faced with problems that provide you with a consumer’s MU or TU derived from purchasing 2 goods. You will be expected to show how many of each a rational consumer would purchase.

Theory of Consumer BehaviorNumerical Example:Find the Utility-Maximizing Combination of A and B, if you have an Income of $10

(1)Unit of

Product

(a)MarginalUtility,Utils


(b)Marginal

UtilityPer Dollar(MU/Price)

(b)Marginal


(2)Product A:Price = $1

(3)Product B:Price = $2

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Theory of Consumer Behavior

Numerical Example:Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10

(1)Unit of

Product



(b)Marginal


(b)Marginal




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Compare Marginal UtilitiesThen Compare Per Dollar - MU/PriceChoose the HighestCheck Budget - Proceed to Next Item

Theory of Consumer BehaviorNumerical Example:Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10

(1)Unit of

Product



(b)Marginal


(b)Marginal




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Again, Compare Per Dollar - MU/PriceChoose the HighestBuy One of Each – Budget Has $5 LeftProceed to Next Item


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Again, Compare Per Dollar - MU/PriceBuy One More B – Budget Has $3 LeftProceed to Next Item


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Again, Compare Per Dollar - MU/PriceBuy One of Each – Budget Exhausted


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Final Result – At These Prices, Purchase 2 of Item A and 4 of B

Theory of Consumer BehaviorAlgebraic Restatement:

MU of Product A

Price of A

MU of Product B

Price of B=

8 Utils

$1

16 Utils

$2=

Optimum Achieved - Money Income is Allocated so that the Last Dollar

Spent on Each Good Yields the Same Extra or Marginal Utility

Two-Good Practice ProblemGiven MU, and an income/budget constraint of $20… find the Utility-Maximizing Combination of A and B



Unit MU Unit MU

1 20 1 30

2 10 2 20

3 6 3 15

4 3 4 5

5 1 5 -5



Unit TU Unit TU

1 22 1 10

2 32 2 16

3 40 3 20

4 46 4 22

5 48 5 20

Given TU, and an income/budget constraint of $9… find the Utility-Maximizing Combination of A and B

Two-Good Practice Problem

The Problem with Utils

Answer the following problem:If Henry derives 5 utils from the 1st candy

bar, 3 utils from the 2nd candy bar, 0 utils from the 3rd candy bar, and -5 utils from the 4th candy bar… How many candy bars should Henry consume if

each candy bar … Is absolutely free (MC = 0) Costs $2 Costs $4

From ‘Utils’ to ‘Benefit’

Because Utils cannot be compared between people, and cannot be compared to dollars… economists must measure satisfaction in Benefit. Benefit is the same concept as utility, but it is

measured in dollars (according to the consumer’s WILLINGNESS TO PAY.

Total Benefit ($), Marginal Benefit ($)

Golden Rule of Consumption

Start with an individual consumer maybe you, maybe me, but could be anyone

Derive demand curve for that individual focus on marginal utility or marginal benefit

Add up demand curves for many such individuals to get market demand curve

3. Individual and Market Demand Curves

Assumption about consumer behavior

General economic principle People make purposeful

choices with limited

resources

When applied to the behavior of consumers People maximize utility subject to a budget

constraint

3. Individual and Market Demand Curves

Consider all consumers in the marketAdd up quantity demanded by all individuals

at each price to get market demandAdd horizontally to create market demand

curve

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QUANTITY DEMANDEDBY PETE (POUNDS)

QUANTITY DEMANDED

BY ANN (POUNDS)

QUANTITY DEMANDED

IN MARKET (POUNDS)

PRICE(DOLLARS)

PRICE(DOLLARS)

PRICE(DOLLARS)

Marketdemandcurve

Ann'sdemandcurve

Pete'sdemandcurve

4. Substitution and Income Effects

This topic on the AP Course Outline was already covered in unit 2.

To review, just remember that both of these effects help to explain why the demand curve slopes downward.

Review Questions – Utility

Which of the following factors contributes to a downward-sloping demand curve? I. The income effect II. The substitution effect III. Diminishing marginal utility

A. I onlyB. III onlyC. I and II onlyD. II and III onlyE. I, II, and III


What is the marginal utility of the third cup of peanuts Brian consumes?

A. 3 units of utilityB. 9 units of utilityC. 12 units of utilityD. 2 units of utilityE. 14 units of utility


If the price of peanuts is $1 per cup and the price of jelly beans is $2 per cup, and Brian wants to maximize his utility, what should he purchase first?

A. 1 cup of peanuts because peanuts produce a lower total utility

B. 1 cup of peanuts because the price of peanuts is lower

C. 1 cup of peanuts, because the marginal utility per dollar for peanuts is lower than the marginal utility per dollar of jelly beans

D. 1 cup of jelly beans, because the marginal utility per dollar for jelly beans is higher than the marginal utility per dollar of peanuts

E. 1 cup of jelly beans, because jelly beans produce a higher total utility


If TU = total utility, MU = marginal utility, and P = price, in order to maximize utility, a consumer should purchase the mix of hamburgers and hot dogs where

A. the MU of hamburgers equals the MU of hot dogs

B. the MU equals the TU of hamburgers, and the MU equals the TU of hot dogs

C. the TU of hamburgers equals the TU of hot dogsD. the MU / P of hamburgers equals the MU / P of

hot dogsE. the TU / P of hamburgers equals the TU / P of

hot dogs


If Matt’s total utility from consuming slices of cheese increased at a constant rate, no matter how many bratwurst Matt consumed, what would Matt’s demand curve for slices of cheese look like?

A. VerticalB. HorizontalC. Downward slopingD. Upward slopingE. First upward, but eventually downward

sloping


Every day Molly spends her lunch money consuming apples, at $1 each, and oranges, at $2 each. At her current level of consumption, molly’s marginal utility of apples is 12 and her marginal utility of oranges is 18. If she has already spent all of her lunch money, how should Molly change her consumption decision to maximize utility?

A. She should make no changes; she is consuming the utility maximizing combination of apples and oranges.

B. She should increase her apple consumption and decrease her orange consumption until the marginal utility per dollar is equal for both.

C. She should decrease her apple consumption and increase her orange consumption until the marginal utility per dollar is equal for both.

D. She should increase her apple consumption and decrease her orange consumption until the marginal utility is equal for both.

E. She should decrease her apple consumption and increase her orange consumption until the marginal utility is equal for both.


If generic peanut butter is an inferior good, a decline in consumer income causes

A. the price of generic peanut butter to go down.B. the demand for name-brand peanut butter to

go up.C. the supply of generic peanut butter to go up.D. the demand for generic peanut butter to go

up.E. the price of bread to go down.

Key Terms

law of diminishing marginal utility

utilitytotal utilitymarginal utilityrational behaviorbudget constraintutility-maximizing ruleincome effectsubstitution effect

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Quantity Demanded of B

Deriving the Demand CurveSame Numeric Example:

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Price Per Unit of B

QuantityDemanded

DBIncome Effects

Substitution Effects

Documents

AP ECONOMICS – CHAPTER 5 Consumer Behavior and Utility Maximization