Text of Chapter 18 Consumer Choice, Behavior, and Utility Maximization
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.
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 MU Tacos consumed in 1 meal TUMU 00 110 2188 3246 4284 5302 6 0 728-2 As more of a product is consumed, Total utility increases at a Diminishing rate.
TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0123456701234567 0 10 18 24 28 30 28 10 8 6 4 2 0 -2 Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 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 UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0123456701234567 0 10 18 24 28 30 28 10 8 6 4 2 0 -2 Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 TU MU 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7 Observe Diminishing Marginal Utility
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 relationship Price hike increases TR if demand is inelastic (this is usually something we cant live without) E< 1 Price hike reduces TR if demand is elastic (we can live without it) E > 1 Price hike does not change TR if demand is unitary elastic E = 1
Maximizing Utility How would you maximize your utility? Select that good which delivers the most marginal utility/dollar even for last dollar spent.
Lets think of MU as MB Remember 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 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, MU X will fall!
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, MU pizza falls If I consume Pepsi, MU Pepsi falls Do prices ever change? Prices can change (see later), however, they are not endogenously affected by your consumption
Pizza and Pepsi Optimum Pizza is $2.00/slice; Pepsi is $1.00/can Budget = $10.00
Pizza and Pepsi Optimum
Activity Problem QuantityTUMUMu/$QuantityTUMUMu/$ 000 0000 170 0.590 2130 1.0170 318050 1.5230 4220 2.0260 5250 2.5270 Total and Marginal Utility per Dollar from Pizza and Wall Climbing Budget: $50 Pizza costs $10 a piece; Wall Climbing is $20/hour or $10/half hour
Answer to Activity Problem QuantityTUMUMu/$QuantityTUMUMu/$ 000 0000 170 70.590 9 2130 60 61.0170 80 8 318050 51.5230 60 6 422040 42.0260 30 3 525030 32.5270 10 1 Total and Marginal Utility per Dollar from Pizza and Wall Climbing Budget: $50 Pizza costs $10 a piece; Wall Climbing is $20/hour or $10/half hour 2 Pizzas = $20 ($10 each) 1.5 Hours Wall Climbing = $20 + $10 = $30 Total= $50 budget
Theory of Consumer Behavior Theory of Rational Behavior Preferences Budget Constraints Prices Time (Time/value/money)
Bottom Line for Price Reductions and Increases Income Effect Substitution Effect Law 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 beer Maximize total utility between two goods Take my $10.00 spend it on good that yields most utility. Pt Beer TUMUMU/P $2.00 120 10 238189 354168 468147 Slice Pizza TUMUMU/$ $2.00 120 10 23616 8 35014 7 4588 4
$10.00 to spend for pizza and beer Maximize total utility between two goods Take my $10.00 spend it on good that yields most utility. Pt Beer TUMUMU/P $2.00 120 10 238189 354168 468147 Slice Pizza T