Chapter 11: Income Inequality and Poverty Pages Consumer Behavior and Utility Maximization

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Law of Diminishing Marginal Utility Terminology Utility Total Utility Marginal Utility Marginal Utility and Demand Graphically… O 19.1 G 19.1

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Theory of Consumer Behavior Consumer Choice and Budget Constraint Rational Behavior Preferences Budget Constraint Prices Utility Maximizing Rule Allocate Money Income so that Last Dollar Spent on Each Product Yields the Same Marginal Utility

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Key Terms law of diminishing marginal utility utility total utility marginal utility rational behavior budget constraint utility-maximizing rule income effect substitution effect

McGraw-Hill/Irwin Copyright  2007 by The McGraw-Hill Companies, Inc. All rights reserved. Next Chapter Preview… Public Goods and Market Failure