Copyright 2008 The McGraw-Hill Companies 19 Consumer Behavior and Utility Maximization Click to Link to Appendix 19: Indifference Curve Analysis

Copyright 2008 The McGraw-Hill Companies Chapter Objectives Total Utility, Marginal Utility, and the Law of Diminishing Marginal Utility How Rational Consumers Compare Marginal Utility-to-Price Ratios for Products in Purchasing Combinations to Maximize Total Utility How to Derive the Demand Curve by Observing Behavior How the Utility-Maximization Model Highlights Income and Substitution Effects of a Price Change Budget Lines, Indifference Curves, Utility Maximization, and Demand Derivation in the Indifference Curve Model of Consumer Behavior

Copyright 2008 The McGraw-Hill Companies What is Utility? The satisfaction or enjoyment a person obtains from consuming a good O 19.1

Copyright 2008 The McGraw-Hill Companies What is a Util? A hypothetical unit used to measure how much utility a person obtains from consuming a good

Copyright 2008 The McGraw-Hill Companies What is Marginal Utility? The change in total utility a person derives from consuming an additional unit of a good

Copyright 2008 The McGraw-Hill Companies What is Total Utility? The total number of utils a person derives from consuming a specific quantity of a good

Copyright 2008 The McGraw-Hill Companies Note that: MU = ΔTU/ ΔQ, that is marginal utility equals the change in total utility divided by the change in quantity of the good.

Copyright 2008 The McGraw-Hill Companies TU and MU Q TU MU

Copyright 2008 The McGraw-Hill Companies What is the Law of Diminishing Marginal Utility? As more of a good is consumed, at some point, the marginal utility a person derives from each additional unit diminishes

Copyright 2008 The McGraw-Hill Companies Does the Law of Diminishing Marginal Utility apply to all goods consumed? YES, WITHIN A FIXED TIME PERIOD

Copyright 2008 The McGraw-Hill Companies Law of Diminishing Marginal Utility Total Utility (Utils) Marginal Utility (Utils) (1) Tacos Consumed Per Meal (2) Total Utility, Utils (3) Marginal Utility, Utils ] ] ] ] ] ] ] TR MU Total Utility Marginal Utility Units Consumed Per Meal G 19.1

Copyright 2008 The McGraw-Hill Companies P1P1 Q1Q1 P2P2 Q2Q2 12 D Recall a Demand Curve Price QUANTITY

Copyright 2008 The McGraw-Hill Companies What does marginal utility have to do with the demand curve? We can use the law of diminishing MU as another explanation for the law of demand.

Copyright 2008 The McGraw-Hill Companies In consuming a product, how many units of the product will you buy?In consuming a product, how many units of the product will you buy? Consume to the point where MU = P: why? Logically, as long as the MU exceeds the price you have to pay, you will continue to consume, but if the MU is less than the price, you will not consume.

Copyright 2008 The McGraw-Hill Companies P1 P2 Q1 Q2 15 MU At P1, consume to Q1, since MU > P up to that point, at P2, consume to Q2, etc.

Copyright 2008 The McGraw-Hill Companies Consumer equilibrium Now go from 1 good to 2 or more goods: have to take prices of good into account

Copyright 2008 The McGraw-Hill Companies Consumer equilibrium condition Purchase X and Y in amounts such that MU x = MU y P x P y Why?

Copyright 2008 The McGraw-Hill Companies Assume you are not in equilibrium… say that MU x > MU y P x P y What would you do??

Copyright 2008 The McGraw-Hill Companies Purchase more of X (due to its greater satisfaction per dollar), and less of Y But more of X reduces MU X and less of Y increases MU Y so we are heading back to equilibrium!!

Copyright 2008 The McGraw-Hill Companies For more than 2 goods, the equilibrium condition becomes….. MUx/Px = Muy/Py = Muz/Pz = …….for all goods

Copyright 2008 The McGraw-Hill Companies Theory of Consumer Behavior Utility Maximizing Rule –Allocate Money Income so that Last Dollar Spent on Each Product Yields the Same Marginal Utility

Copyright 2008 The McGraw-Hill Companies Theory of Consumer Behavior Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (1) Unit of Product (a) Marginal Utility, Utils (a) Marginal Utility, Utils (b) Marginal Utility Per Dollar (MU/Price) (b) Marginal Utility Per Dollar (MU/Price) (2) Product A: Price = $1 (3) Product B: Price = $2 First Second Third Fourth Fifth Sixth Seventh Compare Marginal Utilities Then Compare Per Dollar - MU/Price Choose the Highest Check Budget - Proceed to Next Item

Copyright 2008 The McGraw-Hill Companies Theory of Consumer Behavior Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (1) Unit of Product (a) Marginal Utility, Utils (a) Marginal Utility, Utils (b) Marginal Utility Per Dollar (MU/Price) (b) Marginal Utility Per Dollar (MU/Price) (2) Product A: Price = $1 (3) Product B: Price = $2 First Second Third Fourth Fifth Sixth Seventh Again, Compare Per Dollar - MU/Price Choose the Highest Buy One of Each – Budget Has $5 Left Proceed to Next Item

Copyright 2008 The McGraw-Hill Companies Theory of Consumer Behavior Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (1) Unit of Product (a) Marginal Utility, Utils (a) Marginal Utility, Utils (b) Marginal Utility Per Dollar (MU/Price) (b) Marginal Utility Per Dollar (MU/Price) (2) Product A: Price = $1 (3) Product B: Price = $2 First Second Third Fourth Fifth Sixth Seventh Again, Compare Per Dollar - MU/Price Buy One More B – Budget Has $3 Left Proceed to Next Item

Copyright 2008 The McGraw-Hill Companies Theory of Consumer Behavior Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (1) Unit of Product (a) Marginal Utility, Utils (a) Marginal Utility, Utils (b) Marginal Utility Per Dollar (MU/Price) (b) Marginal Utility Per Dollar (MU/Price) (2) Product A: Price = $1 (3) Product B: Price = $2 First Second Third Fourth Fifth Sixth Seventh Again, Compare Per Dollar - MU/Price Buy One of Each – Budget Exhausted

Copyright 2008 The McGraw-Hill Companies Theory of Consumer Behavior Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (1) Unit of Product (a) Marginal Utility, Utils (a) Marginal Utility, Utils (b) Marginal Utility Per Dollar (MU/Price) (b) Marginal Utility Per Dollar (MU/Price) (2) Product A: Price = $1 (3) Product B: Price = $2 First Second Third Fourth Fifth Sixth Seventh Final Result – At These Prices, Purchase 2 of Item A and 4 of B W 19.1

Copyright 2008 The McGraw-Hill Companies Theory of Consumer Behavior Algebraic 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 Product Yields the Same Extra or Marginal Utility

Copyright 2008 The McGraw-Hill Companies Price of Product B Quantity Demanded of B Deriving the Demand Curve Same Numeric Example: $ Price Per Unit of B Quantity Demanded DBDB Income Effects Substitution Effects O 19.2

Copyright 2008 The McGraw-Hill Companies Applications and Extensions DVDs and DVD Players The Diamond-Water Paradox The Value of Time Medical Care Purchases Cash and Noncash Gifts O 19.3

Copyright 2008 The McGraw-Hill Companies Applications of Utility The water-diamond paradox--why is water so cheap and diamonds so expensive?

Copyright 2008 The McGraw-Hill Companies Water-high TU but low MU due to abundance, diamonds the opposite-Price reflects marginal valuation, not totals

Copyright 2008 The McGraw-Hill Companies The marginal utility of money? Does it diminish as with goods?

Copyright 2008 The McGraw-Hill Companies Diminishing MU of money often used as an argument for progressive taxation.

Copyright 2008 The McGraw-Hill Companies What is Interpersonal comparison of utility? A comparison of the marginal utility that different people derive from a good or a dollar

Copyright 2008 The McGraw-Hill Companies Economists argue that we should avoid such interpersonal utility comparisons

Copyright 2008 The McGraw-Hill Companies Criminal Behavior Economic Analysis Offers Insights Into Property Crimes Such as Robbery, Burglary, and Auto Theft Theory of a Rational Consumer Buy Versus Steal Decision Compare Marginal Utility of Item Versus Costs – Guilt, Fines, or Prison Time Crime May Be Reduced by “Increasing” the “Price of Crime” Last Word

Copyright 2008 The McGraw-Hill Companies Key Terms law of diminishing marginal utility utility total utility marginal utility rational behavior budget constraint utility-maximizing rule income effect substitution effect