n Individual’s demand curve: Why does it slopes downward? Why does it slopes downward? n Why do...

Individual’s demand curve: Individual’s demand curve:

Why does Why does it slopes downward?it slopes downward?

Why do people demand goods and Why do people demand goods and services?services?• Receive satisfaction or pleasure from Receive satisfaction or pleasure from

consuming the good.consuming the good.• Economists terms this satisfaction Economists terms this satisfaction utilityutility..

Theory of DemandTheory of Demand

THE LAW OF DEMANDTHE LAW OF DEMAND

Two explanations...Two explanations... Income Effect

A lower price A lower price increase the increase the consumer’s real incomeconsumer’s real income, they are , they are “better off.”“better off.” Substitution Effect

A lower price relative to other goods A lower price relative to other goods the consumer substitutes more of this the consumer substitutes more of this product for other alternatives.product for other alternatives.

Theory of Consumer BehaviorTheory of Consumer Behavior

A Typical Consumer...A Typical Consumer...

• Exhibits Rational BehaviorExhibits Rational Behavior

• Knows Clear-Cut PreferencesKnows Clear-Cut Preferences

• Subject to a Budget ConstraintSubject to a Budget Constraint

• Responds to Price ChangesResponds to Price Changes

Consumer BehaviorConsumer Behavior In economics, we are not try to explain why In economics, we are not try to explain why

people get utility from certain goods.people get utility from certain goods. We take that as a given.We take that as a given.

Example:Example:• Some people like country music, others hate it.Some people like country music, others hate it.• Economists say, “Economists say, “givengiven an individual’s preferences an individual’s preferences

about country music, how many country music about country music, how many country music CD’s might they purchase. At alternative CD’s might they purchase. At alternative relativerelative prices.”prices.”

PreferencesUtilityUtility is the benefit or satisfaction is the benefit or satisfaction that a person gets from the that a person gets from the consumption of a good or serviceconsumption of a good or serviceThe units of measurement of utility are The units of measurement of utility are arbitrary--like the units of arbitrary--like the units of measurement of temperaturemeasurement of temperature

UtilsUtils Utility is measured in units called “utilsUtility is measured in units called “utils”” Economists once believed there would Economists once believed there would

be machines that we could attach to be machines that we could attach to people and measure how many utils they people and measure how many utils they received from consumption -- but that received from consumption -- but that never really panned outnever really panned out

So we use utils as an “ordinal” measureSo we use utils as an “ordinal” measure

The actual number of utils doesn’t matter, The actual number of utils doesn’t matter, just the relationship between them.just the relationship between them.

For this reason, we can’t compare utils For this reason, we can’t compare utils between people. We can only compare utils between people. We can only compare utils between goods and services for one person.between goods and services for one person.

Consumer BehaviorConsumer Behavior

Total and Marginal UtilityTotal and Marginal Utility Total UtilityTotal Utility (TU) - relates (TU) - relates

consumption of a good to the utility consumption of a good to the utility derived from consuming a good. derived from consuming a good. (This could be many units of a good)(This could be many units of a good)

Marginal UtilityMarginal Utility (MU) - the change in (MU) - the change in total utility when consumption of a total utility when consumption of a good changes by one unit.good changes by one unit.• MU = MU = TU / TU / Q consumed of a good Q consumed of a good

Law of Diminishing Law of Diminishing Marginal UtilityMarginal Utility

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

Law of Diminishing Law of Diminishing Marginal UtilityMarginal Utility

ExampleExample• If I’m really hungry, I get a lot of If I’m really hungry, I get a lot of

satisfaction from first slice of pizza.satisfaction from first slice of pizza.• If I keep eating pizza, the satisfaction If I keep eating pizza, the satisfaction

from the 8th slice would be much less from the 8th slice would be much less than that of the first slice.than that of the first slice.

Law of Diminishing MULaw of Diminishing MU

Notes about the Law of Diminishing MUNotes about the Law of Diminishing MU Law tells us that Law tells us that eventuallyeventually the marginal the marginal

utility curve will be downward sloping.utility curve will be downward sloping. Slope of the total utility curve is equal to Slope of the total utility curve is equal to

marginal utilitymarginal utility

Total UtilityTotal Utility

QMU = MU = TU / TU / QQ

Shape of TUShape of TU

Positive slope (in the decision range)Positive slope (in the decision range)• Consumer only purchases a good if gets Consumer only purchases a good if gets

some positive amount of utility (rational some positive amount of utility (rational behavior)behavior)

Slope gets flatter as Q increaseSlope gets flatter as Q increase

– Law of diminishing marginal utilityLaw of diminishing marginal utility

Total UtilityTotal Utility

Slope DecreasesSlope DecreasesMU DecreasesMU Decreases

Shape of MUShape of MU

Eventually downward slopingEventually downward sloping • Law of diminishing marginal utilityLaw of diminishing marginal utility

Positive (in the decision range)Positive (in the decision range)• Rational behaviorRational behavior

• Consumer only purchases a good if Consumer only purchases a good if they get some positive utility from it.they get some positive utility from it.

Marginal UtilityMarginal Utility

Total and Marginal UtilityTotal and Marginal UtilityHamburgersHamburgersconsumedconsumedper mealper meal

TotalTotalUtilityUtility

MarginalMarginalutilityutility(2)(2)

0011223344556677

001010

0 1 2 3 4 5 6 70 1 2 3 4 5 6 7

Units consumed per mealUnits consumed per meal

1010 88 66 44 22 00 -2-2

1 2 3 4 5 6 71 2 3 4 5 6 7

0011223344556677

0010101818

1010 88

0 1 2 3 4 5 6 70 1 2 3 4 5 6 7

1010 88 66 44 22 00 -2-2

MUMU 1 2 3 4 5 6 71 2 3 4 5 6 7

0011223344556677

001010181824242828303030302828

1010 88 66 44 22 00 -2-2

0 1 2 3 4 5 6 70 1 2 3 4 5 6 7

1010 88 66 44 22 00 -2-2

MUMU 1 2 3 4 5 6 71 2 3 4 5 6 7

Utility Maximizing RuleUtility Maximizing Rule

The consumer’s money incomeThe consumer’s money incomeshould be allocated so that theshould be allocated so that thelast dollar spentlast dollar spent on each product on each productpurchased purchased yields the same amountyields the same amountof extra (marginal) utilityof extra (marginal) utility..

Utility is Utility is maximizedmaximized when: when:all the consumer’s income is spent, all the consumer’s income is spent, and the and the marginal utility per dollar marginal utility per dollar spentspent is equal for all goodsis equal for all goods

The The marginal utility per dollar spentmarginal utility per dollar spent is is the marginal utility derived from the last the marginal utility derived from the last unit of a good consumed unit of a good consumed divided by the divided by the price of the good.price of the good.

Maximizing UtilityMaximizing Utility

Utility Maximization RuleUtility Maximization Rule

MU of product AMU of product A MU of product BMU of product B

Price of APrice of A Price of BPrice of B==

Price of APrice of A Price of BPrice of B>>

If this is true:If this is true:

Buy more A and MUBuy more A and MUAA

Price of APrice of A Price of BPrice of B<<If this is true:If this is true:

Buy more B and MUBuy more B and MUBB

Consumer ChoiceConsumer Choice For instance, I would much rather have a For instance, I would much rather have a Range Rover instead of my Ford ExplorerRange Rover instead of my Ford Explorer If I want to maximize my utility, If I want to maximize my utility, why don’t I buy a Range why don’t I buy a Range

Rover?Rover?

– Because it costs a lot more than the Ford ExplorerBecause it costs a lot more than the Ford Explorer– Because I have only so much moneyBecause I have only so much money

So if I want to maximize my utility, I don’t just pick the thing So if I want to maximize my utility, I don’t just pick the thing that gives me the most pleasure. that gives me the most pleasure.

I have to weigh the relative price of products and my I have to weigh the relative price of products and my income in my decisionincome in my decision..

Consumer Choice

The consumer must make The consumer must make judgements based on:judgements based on:

• The prices of productsThe prices of products• His or her preferencesHis or her preferences• His or her IncomeHis or her Income

Consumer ChoiceConsumer ChoiceIn order to make a decision I will need to In order to make a decision I will need to

convert utility to convert utility to utility per dollarutility per dollar.. This way, I can see that even though the This way, I can see that even though the

Range Rover gives me more utility, Range Rover gives me more utility, I get more utility per dollar from the Ford I get more utility per dollar from the Ford

Explorer.Explorer. So if I want to spend my So if I want to spend my money wisely, money wisely,

I buy the thing that gives me more utility I buy the thing that gives me more utility per dollar.per dollar.

Consumer Maximization

MUMUFF/P/PFF > MU > MURR/P/PRR

100,000/20,000 > 200,000/70,000100,000/20,000 > 200,000/70,000

5/1 > 2.9/15/1 > 2.9/1

Consumer MaximizationConsumer Maximization

Let’s say I walk over to the Putnum Let’s say I walk over to the Putnum Student Center for lunch and they Student Center for lunch and they have Chicken Tacos and Rocky Road have Chicken Tacos and Rocky Road Ice Cream. Ice Cream.

The The Tacos are $1 each and the Ice Tacos are $1 each and the Ice Cream is $2 a scoopCream is $2 a scoop.. I have $7 in my I have $7 in my pocket What do I buy?pocket What do I buy?

I have $7 to spend.Ice Cream costs $2Tacos cost $1 I can afford

7 Tacos3.5 Ice Creams

My Budget ConstraintMy Budget Constraint

Ice Cream

1 2 3 41 2 3 4

Remember, I want to choose the Remember, I want to choose the combination of Tacos and Ice Cream combination of Tacos and Ice Cream that gives me the greatest possible that gives me the greatest possible utility for my $7utility for my $7

Consider the following table, which Consider the following table, which states the total utility I get from all states the total utility I get from all possible quantities of Tacos and Ice possible quantities of Tacos and Ice CreamCream

Utility TableUtility Table

0 0 -- 0 --

1 24 29

2 44 46

3 60 56

4 70 58

5 72 59

6 72 59

QuantityQuantity Total Util.Total Util. Marginal Util.Marginal Util. Total Util.Total Util. Marginal Util.Marginal Util.Rocky RoadRocky Road TacosTacos

Utility TableUtility Table

0 0 -- 0 --

1 24 24 29 29

2 44 20 46 17

3 60 16 56 10

4 70 10 58 2

5 72 2 59 1

6 72 0 59 0

QuantityQuantity Total Util.Total Util. Marginal Util.Marginal Util. Total Util.Total Util. Marginal Util.Marginal Util.

Rocky RoadRocky Road TacosTacos

Consumer ChoiceConsumer Choice We need to find the marginal utility per dollar for both We need to find the marginal utility per dollar for both

goods.goods. Consider the first scoop of ice cream - it gives us 12 Consider the first scoop of ice cream - it gives us 12

utils per dollar. The first taco gives us 29 utils per utils per dollar. The first taco gives us 29 utils per dollar. dollar.

MU/$ Ice Cream < MU/$ TacoMU/$ Ice Cream < MU/$ Taco

24/2 = 12/1 < 29/124/2 = 12/1 < 29/1 So I want to buy the taco. So I want to buy the taco. Now I have $6 left.Now I have $6 left.

Utility Table

0 0 -- 0 --

1 24 24 29 29

2 44 20 46 17

3 60 16 56 10

4 70 10 58 2

5 72 2 59 1

6 72 0 59 0

Now I have to compare my second taco Now I have to compare my second taco (17 utils/$) with the first scoop of ice (17 utils/$) with the first scoop of ice cream (12 utils/$). cream (12 utils/$).

MU/$ Ice Cream < MU/$ TacoMU/$ Ice Cream < MU/$ Taco24/2 = 12/1 < 17/124/2 = 12/1 < 17/1

I will want to buy the second taco. I will want to buy the second taco. I have $5 left.I have $5 left.

Consumer ChoiceConsumer Choice

0 0 -- 0 --

1 24 24 29 29

2 44 20 46 17

3 60 16 56 10

4 70 10 58 2

5 72 2 59 1

6 72 0 59 0

Utility Table

Now I have to compare the third taco Now I have to compare the third taco

(10 utils/$) with the first scoop of ice cream (10 utils/$) with the first scoop of ice cream (12 utils/$). (12 utils/$).

MU/$MU/$ Ice Cream > MU/$ TacoIce Cream > MU/$ Taco 24/2 = 12/1 > 10/124/2 = 12/1 > 10/1

I will want to buy the ice cream. I will want to buy the ice cream. I have $3 left.I have $3 left.

0 0 -- 0 --

1 24 24 29 29

2 44 20 46 17

3 60 16 56 10

4 70 10 58 2

5 72 2 59 1

6 72 0 59 0

Utility Table

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

20/2 = 10/1 = 10/1I’ll take the taco. Now I have $2 Left.I’ll take the taco. Now I have $2 Left.

0 0 -- 0 --

1 24 24 29 29

2 44 20 46 17

3 60 16 56 10

4 70 10 58 2

5 72 2 59 1

6 72 0 59 0

Utility Table

Now I have to compare the fourth taco Now I have to compare the fourth taco (2 utils/$) to the second scoop of ice cream (10 (2 utils/$) to the second scoop of ice cream (10

utils/$). I will want to buy the ice cream. I have utils/$). I will want to buy the ice cream. I have no more money.no more money.

I bought 3 tacos which give a total utility of 56 I bought 3 tacos which give a total utility of 56 and 2 scoops of ice cream which give a total and 2 scoops of ice cream which give a total utility of 44. My total utility from lunch isutility of 44. My total utility from lunch is 56 + 56 + 44 =10044 =100..

There is no other combination of tacos and ice There is no other combination of tacos and ice cream that give a greater utility for $7.cream that give a greater utility for $7.

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

Ice Cream

1 2 3 41 2 3 4

MaximumMaximumUtilityUtility

0 0 -- 0 --

1 24 24 29 29

2 44 20 46 17

3 60 16 56 10

4 70 10 58 2

5 72 2 59 1

6 72 0 59 0

Utility Table

What if the price of the ice cream What if the price of the ice cream dropped to $1 a scoop.dropped to $1 a scoop.

Note that when the price went down, Note that when the price went down, I bought more - THIS IS WHERE THE I bought more - THIS IS WHERE THE LAW OF DEMAND COMES FROM.LAW OF DEMAND COMES FROM.

MUMUAA/P/PAA = MU = MUBB/P/PBB = MU = MUCC/P/PCC

What if the Price of good B falls?What if the Price of good B falls?

MUMUAA/P/PAA < MU < MUBB/P/PBB > MU > MUCC/P/PCC

The consumer should purchase The consumer should purchase more of product B, as the more of product B, as the demand curve predicts.demand curve predicts.

Thus, the Marginal Utility theory of consumer maximization

explains the Law of Demand

Consumer SurplusConsumer Surplus Consumer SurplusConsumer Surplus - the difference between the - the difference between the

price buyers pay for a good and the maximum price buyers pay for a good and the maximum amount they would be willing to pay for the good.amount they would be willing to pay for the good.

Example: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 SurplusConsumer Surplus

Consumer SurplusConsumer Surplus for the first for the first case of Beercase of Beer

Consumer Surplus Consumer Surplus for the second case for the second case of Beerof Beer

Another consumer Another consumer would pay $25would pay $25

Total Consumer Total Consumer SurplusSurplus

Consumer Surplus Consumer Surplus is the area below the is the area below the demand curve and demand curve and above market price.above market price.

income effectsubstitution effectutilitytotal utilitymarginal utilitylaw of diminishing marginal utilityutility-maximizing ruleconsumer maximization behaviorconsumer surplus

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