Consumer Behavior: Utility Maximization 1

Theory of Demand Individual’s demand curve: Why does it slopes downward? Why do people demand goods and services? Receive satisfaction or pleasure from consuming the good. Economists terms this satisfaction utility. 4

Two explanations... THE LAW OF DEMAND Income Effect A lower price increase the consumer’s real income, they are “better off.” Substitution Effect A lower price relative to other goods the consumer substitutes more of this product for other alternatives.

Theory of Consumer Behavior A Typical Consumer... Exhibits Rational Behavior Knows Clear-Cut Preferences Subject to a Budget Constraint Responds to Price Changes

Consumer Behavior In economics, we are not try to explain why people get utility from certain goods. We take that as a given. Example: Some people like country music, others hate it. Economists say, “given an individual’s preferences about country music, how many country music CD’s might they purchase. At alternative relative prices.” 5

Preferences Utility is the benefit or satisfaction that a person gets from the consumption of a good or service The units of measurement of utility are arbitrary--like the units of measurement of temperature

Utils Utility is measured in units called “utils” Economists once believed there would be machines that we could attach to people and measure how many utils they received from consumption -- but that never really panned out So we use utils as an “ordinal” measure

Consumer Behavior The actual number of utils doesn’t matter, just the relationship between them. For this reason, we can’t compare utils between people. We can only compare utils between goods and services for one person.

Total and Marginal Utility Total Utility (TU) - relates consumption of a good to the utility derived from consuming a good. (This could be many units of a good) Marginal Utility (MU) - the change in total utility when consumption of a good changes by one unit. MU = TU /  Q consumed of a good 9

Law of Diminishing Marginal Utility Law of Diminishing Marginal Utility - eventually, a point is reached where the marginal utility obtained by consuming additional units of a good starts to decline, ceteris paribus. 10

Law of Diminishing Marginal Utility Example If I’m really hungry, I get a lot of satisfaction from first slice of pizza. If I keep eating pizza, the satisfaction from the 8th slice would be much less than that of the first slice. 11

Law of Diminishing MU Notes about the Law of Diminishing MU Law tells us that eventually the marginal utility curve will be downward sloping. Slope of the total utility curve is equal to marginal utility 12

Total Utility TU TU TU MU = TU / Q Q Q 20

Shape of TU Positive slope (in the decision range) Consumer only purchases a good if gets some positive amount of utility (rational behavior) Slope gets flatter as Q increase Law of diminishing marginal utility 22

Total Utility TU TU TU Q Slope Decreases MU Decreases TU Q Q 21

Shape of MU Eventually downward sloping Law of diminishing marginal utility Positive (in the decision range) Rational behavior Consumer only purchases a good if they get some positive utility from it. 16

Marginal Utility MU MU Q 15

Total and Marginal Utility Hamburgers consumed per meal Total Utility Marginal utility (2) 30 20 10 1 2 3 4 5 6 7 10 Total Utility (utils) TU 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) 1 2 3 4 5 6 7 Units consumed per meal

Total and Marginal Utility Hamburgers consumed per meal Total Utility Marginal utility (2) 30 20 10 TU 1 2 3 4 5 6 7 10 18 Total Utility (utils) 10 8 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) MU 1 2 3 4 5 6 7 Units consumed per meal

Total and Marginal Utility Hamburgers consumed per meal Total Utility Marginal utility (2) 30 20 10 TU 1 2 3 4 5 6 7 10 18 24 28 30 Total Utility (utils) 10 8 6 4 2 -2 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) MU 1 2 3 4 5 6 7 Units consumed per meal

Utility Maximizing Rule The consumer’s money income should be allocated so that the last dollar spent on each product purchased yields the same amount of extra (marginal) utility.

Maximizing Utility Utility is maximized when: all the consumer’s income is spent, and the marginal utility per dollar spent is equal for all goods The marginal utility per dollar spent is the marginal utility derived from the last unit of a good consumed divided by the price of the good.

Utility Maximization Rule MU of product A MU of product B = Price of A Price of B

Utility Maximization Rule If this is true: MU of product A MU of product B > Price of A Price of B Buy more A and MUA

Utility Maximization Rule If this is true: MU of product A MU of product B < Price of A Price of B Buy more B and MUB

Consumer Choice Because it costs a lot more than the Ford Explorer For instance, I would much rather have a Range Rover instead of my Ford Explorer If I want to maximize my utility, why don’t I buy a Range Rover? Because it costs a lot more than the Ford Explorer Because I have only so much money So if I want to maximize my utility, I don’t just pick the thing that gives me the most pleasure. I have to weigh the relative price of products and my income in my decision.

Consumer Choice The consumer must make judgements based on: The prices of products His or her preferences His or her Income

Consumer Choice In order to make a decision I will need to convert utility to utility per dollar. This way, I can see that even though the Range Rover gives me more utility, I get more utility per dollar from the Ford Explorer. So if I want to spend my money wisely, I buy the thing that gives me more utility per dollar.

Consumer Maximization MUF/PF > MUR/PR 100,000/20,000 > 200,000/70,000 5/1 > 2.9/1

Consumer Maximization Let’s say I walk over to the Putnum Student Center for lunch and they have Chicken Tacos and Rocky Road Ice Cream. The Tacos are $1 each and the Ice Cream is $2 a scoop. I have $7 in my pocket What do I buy?

My Budget Constraint Tacos Ice Cream I have $7 to spend. Ice Cream costs $2 Tacos cost $1 I can afford 7 Tacos 3.5 Ice Creams 7 5 3 1 Tacos 1 2 3 4 Ice Cream

Consumer Maximization Remember, I want to choose the combination of Tacos and Ice Cream that gives me the greatest possible utility for my $7 Consider the following table, which states the total utility I get from all possible quantities of Tacos and Ice Cream

Utility Table Rocky Road Tacos Quantity Total Util. Marginal Util.

Utility Table Rocky Road Tacos Quantity Total Util. Marginal Util.

Consumer Choice We need to find the marginal utility per dollar for both goods. Consider the first scoop of ice cream - it gives us 12 utils per dollar. The first taco gives us 29 utils per dollar. MU/$ Ice Cream < MU/$ Taco 24/2 = 12/1 < 29/1 So I want to buy the taco. Now I have $6 left.

Utility Table Rocky Road Tacos Quantity Total Util. Marginal Util.

Consumer Choice MU/$ Ice Cream < MU/$ Taco 24/2 = 12/1 < 17/1 Now I have to compare my second taco (17 utils/$) with the first scoop of ice cream (12 utils/$). MU/$ Ice Cream < MU/$ Taco 24/2 = 12/1 < 17/1 I will want to buy the second taco. I have $5 left.

Utility Table Rocky Road Tacos Quantity Total Util. Marginal Util.

Consumer Choice 24/2 = 12/1 > 10/1 Now I have to compare the third taco (10 utils/$) with the first scoop of ice cream (12 utils/$). MU/$ Ice Cream > MU/$ Taco 24/2 = 12/1 > 10/1 I will want to buy the ice cream. I have $3 left.

Utility Table Rocky Road Tacos Quantity Total Util. Marginal Util.

Consumer Choice Now I have to compare the third taco (10 utils/$) with the second scoop of ice cream (10 utils/$). It doesn’t matter which I pick, since they make me equally happy. MU/$ Ice Cream = MU/$ Taco 20/2 = 10/1 = 10/1 I’ll take the taco. Now I have $2 Left.

Utility Table Rocky Road Tacos Quantity Total Util. Marginal Util.

Consumer Choice Now I have to compare the fourth taco (2 utils/$) to the second scoop of ice cream (10 utils/$). I will want to buy the ice cream. I have no more money. I bought 3 tacos which give a total utility of 56 and 2 scoops of ice cream which give a total utility of 44. My total utility from lunch is 56 + 44 =100. There is no other combination of tacos and ice cream that give a greater utility for $7.

Consumer Maximization My Maximum satisfaction is at: Ice Cream = 2 Tacos = 3 7 5 3 1 Tacos Maximum Utility 1 2 3 4 Ice Cream

Utility Table Rocky Road Tacos Quantity Total Util. Marginal Util.

Consumer Maximization What if the price of the ice cream dropped to $1 a scoop. Note that when the price went down, I bought more - THIS IS WHERE THE LAW OF DEMAND COMES FROM.

Consumer Maximization MUA/PA = MUB/PB = MUC/PC What if the Price of good B falls?

Consumer Maximization MUA/PA < MUB/PB > MUC/PC The consumer should purchase more of product B, as the demand curve predicts.

Consumer Maximization Thus, the Marginal Utility theory of consumer maximization explains the Law of Demand

Consumer Surplus Consumer Surplus - the difference between the price buyers pay for a good and the maximum amount they would be willing to pay for the good. Example: I’m willing to pay $30 for a case of Beer Beer is on sale for $20 a case Consumer surplus = $10 36

Consumer Surplus P D Q 39

Consumer Surplus P S $20 D Q 3 41

Consumer Surplus P S $30 $20 D Q 1 3 Consumer Surplus for the first case of Beer P S $30 $20 D Q 1 3 42

Consumer Surplus Another consumer would pay $25 P S $30 $25 $20 D Q for the second case of Beer P S $30 $25 Another consumer would pay $25 $20 D Q 1 2 3 43

Consumer Surplus P S P* D Q Q* Consumer Surplus is the area below the Total Consumer Surplus P S Consumer Surplus is the area below the demand curve and above market price. P* D Q Q* 49

law of diminishing marginal utility utility-maximizing rule income effect substitution effect utility total utility marginal utility law of diminishing marginal utility utility-maximizing rule consumer maximization behavior consumer surplus KEY TERMS