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.