Chapter 19 Demand for GoodsConsumer Choice, Behavior, 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 sit through entire football game in the pouring rain to watch your favorite team.

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.-example is…….

As long as MU is increasing TU must be increasing.

When MU is not increasing (diminishing) each unit added yields less utility

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

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 0

1 10

2 18 8

3 24 6

4 28 4

5 30 2

6 30 0

7 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 relationship

Price 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.

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

X

Price

MU larger? is Which

Price

MU

• 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

Price

MU larger? is Which

Price

MU

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

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/$pizza

Quantity TU MU Mu/$Wall climbing

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/$Pizza

Quantity TU MU Mu/$Wall Climbing

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 hourMU/pizza = MU/Wall Climbing P P

2 Pizza’s = $20 ($10 each)1.5 Hours Wall Climbing = $20 + $10 = $30Total= $50 budget

$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.

Last check on knowledge!Units Consumed

TU MU

0 01 10 102 8

3 25

4 305 3

6 34

Last check on knowledge!

Units Consumed

TU MU

0 0

1 10 10

2 18 8

3 25 7

4 30 5

5 33 3

6 34 1

Units Consumed

TU MU

0 0

1 10 10

2 8

3 25

4 30

5 3

6 34