Chapter 19 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved Theory of Consumer Behavior

Chapter Objectives Marginal utility The law of diminishing returns Total utility Maximizing utility The water-diamond paradox Consumer surplus 19-2 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Utility What is utility? –Utility is NOT usefulness! –Utility means only that you think enough of something to buy it –Utility is measured by how much you are willing to pay for something 19-3 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Demand Schedule for Hamburgers PricePurchased $ Units 19-4 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Demand Schedule for Hamburgers PricePurchased $ Units 19-5 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Demand Schedule for Hamburgers PricePurchased $ Units 19-6 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Hypothetical Demand Schedule for Hamburgers PricePurchased $ Units 19-7 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

PricePurchased MU $ $ Marginal Utility is the additional utility derived from consuming one more unit of a good or service Units 19-8 Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

PricePurchased MU $ $ Marginal Utility is the additional utility derived from consuming one more unit of a good or service Note: Marginal Utility is the same as the price Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

PricePurchased MU $ $ Law of Diminishing Marginal Utility: As we consume more and more of a good or service,we like it less and less Units Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

PricePurchased MU TU $ $2.75 $ Total Utility is the utility derived from consuming a certain number of units of a good or service Units Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

PricePurchased MUTU $ $2.75 $ Total Utility is the utility derived from consuming a certain number of units of a good or service Units Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

PricePurchased MUTU $ $2.75 $ Total Utility is the utility derived from consuming a certain number of units of a good or service Units Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

PricePurchased MUTU $ $2.75 $ Total Utility is the utility derived from consuming a certain number of units of a good or service Units Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

PricePurchased MU TU $ $2.75 $ Total Utility is the utility derived from consuming a certain number of units of a good or service To get total utility, just add up the marginal utilities of the units purchased Units Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Maximizing Utility How much we buy of any good or service depends on –Its price –Our marginal utility schedule PricePurchased MUTU $ $2.75 $ Units In real life there is usually only ONE price! Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Maximizing Utility We try to spend our money on what will give us the most utility! –As we consume more of a good or service, its utility declines! –This means that we will keep buying more of a good or service until our marginal utility falls to the level of the price. At this point marginal utility is the same as the price Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Maximizing Utility We try to spend our money on what will give us the most utility! –As we consume more of a good or service, its utility declines! –This means that we will keep buying more of a good or service until our marginal utility falls to the level of the price. At this point marginal utility is the same as the price Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. Marginal Utility Price = 1

Maximizing Utility We try to spend our money on what will give us the most utility! –Remember, as we consume more of a good or service, its utility declines! –This means that we will keep buying more of a good or service until our MU falls to the level of the price PricePurchased MUTU $ $2.75 $ Units The price is $1.00. How many units would you buy? Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The answer is 3

Maximizing Utility We try to spend our money on what will give us the most utility! –Remember, as we consume more of a good or service, its utility declines! –This means that we will keep buying more of a good or service until our MU falls to the level of the price PricePurchased MUTU $ $2.75 $ Units The MU of the last unit purchased will always equal its price Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The answer is 3

Maximizing Utility We try to spend our money on what will give us the most utility! –Remember, as we consume more of a good or service, its utility declines! –This means that we will keep buying more of a good or service until our MU falls to the level of the price PricePurchased MUTU $ $2.75 $ Units The price is $2. How many units will you buy? Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The answer is 2

Maximizing Utility We try to spend our money on what will give us the most utility! –Remember, as we consume more of a good or service, its utility declines! –This means that we will keep buying more of a good or service until our MU falls to the level of the price PricePurchased MUTU $ $2.75 $ Units Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. The answer is 2 The MU of the last unit purchased will always equal its price

General Utility Formula The MU of the last unit purchased will always equal its price MU Price = == = = 1 If this is true for hamburgers it will be true for everything else MU 1 MU 2 MU 3 MU n P1P1 P2P2 P3P3 PnPn == = Remember, we will keep buying anything until its MU declines to the price level Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

PricePurchased MUTU $ $2.75 $ If a good or service were free, you would keep consuming until the MU fell to zero As we consume more units, MU declines, but TU keeps rising Therefore, we maximize our total utility when our MU falls to zero Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Price QD MU Price QD MU Price OD MU $ $3.00 $ $1.50 $ $ Hamburgers Fries Coke How many burgers, fries, and cokes would you consume if burgers were $3, fries were $.50 and cokes were $.50? Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Price QD MU Price QD MU Price OD MU $ $3.00 $ $1.50 $ $ Hamburgers Fries Coke How many burgers, fries, and cokes would you consume if burgers were $3, fries were $.50 and cokes were $.50? One hamburger; three fries; and two cokes Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Price QD MU Price QD MU Price OD MU $ $3.00 $ $1.50 $ $ Hamburgers Fries Coke Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved. How many burgers, fries, and cokes would you consume if burgers were $1, fries were $1.00 and cokes were $1.50?

Price QD MU Price QD MU Price OD MU $ $3.00 $ $1.50 $ $ Hamburgers Fries Coke How many burgers, fries, and cokes would you consume if burgers were $1, fries were $1.00 and cokes were $1.50? First answer: one hamburger; three fries; and two cokes Second answer: three hamburgers; two fries; one coke This is consistent with the law of supply and demand Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Water-Diamond Paradox Water, which is essential to life is cheap –Water is abundant –A great deal of water is consumed Therefore the MU of the last gallon consumed is as low as its price, which is relatively low Diamonds are not essential to life, yet they are very expensive –Diamonds are scarce –People buy relatively few diamonds Therefore the MU of the last diamond purchased is as high as its price, which is relatively very high Mu water MU diamonds P water P diamonds = = Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Surplus Consumer surplus is... the difference between what you pay for some good or service and what you would have been willing to pay PricePurchased MUTU $ $2.75 $ The price of hamburgers is $0.25 Hamburger Schedule Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Surplus Consumer surplus is... the difference between what you pay for some good or service and what you would have been willing to pay PricePurchased MUTU $ $2.75 $ The price of hamburgers is $0.25 Hamburger Schedule You would buy = $ Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Surplus Consumer surplus is... the difference between what you pay for some good or service and what you would have been willing to pay PricePurchased MUTU $ $2.75 $ The price of hamburgers is $0.25 Hamburger Schedule You would buy = $1.00 You would have been willing to pay $ Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Surplus Consumer surplus is... the difference between what you pay for some good or service and what you would have been willing to pay PricePurchased MUTU $ $2.75 $ The price of hamburgers is $0.25 Hamburger Schedule You would buy = $1.00 You would have been willing to pay $6.00 Your consumer surplus would be ($ $1.00) = $ Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Surplus Consumer surplus is... the difference between what you pay for some good or service and what you would have been willing to pay PricePurchased MUTU $ $2.75 $ Price of Hamburgers is $2.00 Hamburger Schedule Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Surplus Consumer surplus is... the difference between what you pay for some good or service and what you would have been willing to pay PricePurchased MUTU $ $2.75 $ Price of Hamburgers is $2.00 Hamburger Schedule You would buy 2.00 = $ Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Surplus Consumer surplus is... the difference between what you pay for some good or service and what you would have been willing to pay PricePurchased MUTU $ $2.75 $ Price of Hamburgers is $2.00 Hamburger Schedule You would buy 2.00 = $4.00 You would have been willing to pay $ Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Surplus Consumer surplus is... the difference between what you pay for some good or service and what you would have been willing to pay PricePurchased MUTU $ $2.75 $ Price of Hamburgers is $2.00 Hamburger Schedule You would buy 2.00 = $4.00 You would have been willing to pay $4.75 Your consumer surplus would be ($ $4.00) = $ Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

If the price of hamburger is $0.25, you would have purchased 4. The consumer surplus would be the triangle area above the price line D Consumer Surplus The consumer surplus in this graph would be represented by the area to the left of the demand curve (what you would have been willing to pay) and above the price line Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.

If the price of hamburger is $2.00, you would have purchased 2. The consumer surplus would be the triangle area above the price line D Consumer Surplus The consumer surplus in this graph would be represented by the area to the left of the demand curve (what you would have been willing to pay) and above the price line Copyright  2002 by The McGraw-Hill Companies, Inc. All rights reserved.