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

THE LAW OF DEMAND Two explanations... 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 Exhibits Rational Behavior Knows Clear-Cut Preferences Knows Clear-Cut Preferences Subject to a Budget Constraint Subject to a Budget Constraint Responds to Price Changes Responds to Price Changes

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

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 n Utility is measured in units called “utils” n 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 n So we use utils as an “ordinal” measure

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

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

Law of Diminishing Marginal Utility n 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.

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

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

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

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

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

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

Marginal Utility MU Q

Total and Marginal Utility Hamburgersconsumed per meal TotalUtilityMarginalutility  (2) Units consumed per meal Total Utility (utils) Marginal Utility (utils) TU

Total and Marginal Utility Hamburgersconsumed per meal TotalUtilityMarginalutility  (2) Units consumed per meal Total Utility (utils) Marginal Utility (utils) TU MU

Total and Marginal Utility Hamburgersconsumed per meal TotalUtilityMarginalutility  (2) Units consumed per meal Total Utility (utils) Marginal Utility (utils) TU MU

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.

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. Maximizing Utility

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

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

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

Consumer Choice n For instance, I would much rather have a Range Rover instead of my Ford Explorer Range Rover instead of my Ford Explorer n 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 n So if I want to maximize my utility, I don’t just pick the thing that gives me the most pleasure. n 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 The prices of products His or her preferences His or her preferences His or her Income 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 MU F /P F > MU R /P R MU F /P F > MU R /P R 100,000/20,000 > 200,000/70,000 5/1 > 2.9/1

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

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

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

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

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

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

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

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. Consumer Choice

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

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

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

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. Consumer Choice

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

n 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. (2 utils/$) to the second scoop of ice cream (10 utils/$). I will want to buy the ice cream. I have no more money. n 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 =100. n There is no other combination of tacos and ice cream that give a greater utility for $7. Consumer Choice

My Maximum satisfaction is at: Ice Cream = 2 Tacos = 3 Ice Cream Tacos Consumer Maximization MaximumUtility

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

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

Consumer Maximization MU A /P A = MU B /P B = MU C /P C MU A /P A = MU B /P B = MU C /P C What if the Price of good B falls? What if the Price of good B falls?

MU A /P A MU C /P C MU A /P A MU C /P C 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 Maximization

Consumer Surplus n 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. n Example: I’m willing to pay $30 for a case of BeerI’m willing to pay $30 for a case of Beer Beer is on sale for $20 a caseBeer is on sale for $20 a case Consumer surplus = $10Consumer surplus = $10

Consumer Surplus D Q P 0

S D Q P 0 $20 3

Consumer Surplus S D Q P 0 $ $30 Consumer Surplus for the first for the first case of Beer case of Beer

Consumer Surplus S D Q P 0 $ $30 $25 Consumer Surplus for the second case of Beer Another consumer would pay $25

Consumer Surplus S D Q P 0 Q* P* Total Consumer Surplus Consumer Surplus is the area below the demand curve and above market price.

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