Ch. 19: Consumer Choice: Maximizing Utility and Behavioral Economics

Del Mar College

John Daly©2003 South-Western Publishing, A Division of Thomson Learning

Utility Theory, Total and Marginal

• A good that gives you Utility is one that has the power to satisfy wants, or that gives you satisfaction.

• Diamond Water Paradox: The observation that those things that have the greatest value in use sometimes have little value in exchange and those things that have little value in utility sometimes have the greatest value in exchange.

• Utils are an artificial construct used to “measure” utility.• Total Utility is the total satisfaction a person receives

from consuming a particular quantity of good.• Marginal Utility is the additional utility gained from

consuming an additional unit of some good.

Law of Diminishing Marginal Utility

The law of Diminishing Marginal Utility states that for a given time period, the marginal utility gained by consuming equal successive units of a good will decline as the amount consumed increases.

Total Utility, Marginal Utility, and the Law of Diminishing Utility

The law of diminishing marginal utility is based on the idea that if a good has a variety of uses but only one unit of the good is available, then the consumer will use the first unit to satisfy his or her most urgent want.

Utility and the One-Hundredth Game of Chess

• Marginal utility begins to decline with the second unit of a good consumed.

• The marginal utility associated with consume equal successive units of a good will eventually decline as the amount consumed increases.

Interpersonal Utility Comparison

• The utility obtained by one person cannot be scientifically or objectively compared with the utility obtained from the same thing by another person because utility is subjective.

The Solution to the Diamond-Water Paradox

• Goods have both Total Utility and Marginal Utility

• The Total Utility of water is high while the Total Utility of Diamonds is low.

• The Marginal Utility of water is low while the Marginal Utility of Diamonds is high

Is Gambling Worth The Effort?

• Losing a dollar bet in a fair game causes you to lose more utility than winning a dollar causes you to gain utility.

• This is due to diminishing marginal utility.

Q & A

• State and solve the diamond-water paradox.

• If total utility is falling, what does this imply for marginal utility? Give an a mathematical example to illustrate your answer.

• When would the total utility of a good and the marginal utility of a good be the same?

Consumer Equilibrium

Occurs when the consumer has spent all income and the marginal utilities per dollar spent on each good purchased are equal.

Consumer Equilibrium and Demand

A consumer is in equilibrium when he or she derives the same marginal utility per dollar for all goods.

Income and Substitution Effects

• A person’s real income, or purchasing power, rises if with a given absolute income, he or she can purchase more goods and services.

• A fall in the relative price of a good will, and a rise in real income can, lead to greater purchases of the good.

• The portion of the change in the quantity demanded that is attributable to a change in its relative price is referred to as the substitution effect.

• The portion of the change in the quantity demanded that is attributable to a change in real income, brought about by a change in absolute price, is referred to as the income effect.

Income and Substitution Effects

Should The Government Provide Necessities of Life for Free?

• Resources must be used to produce every unit of a good consumed.

• If the government uses scarce resources to provide goods that have low marginal utility, then fewer resources are available for other goods.

• If some resources were withdrawn from producing these low utility goods, total utility would fall very little.

Q & A

• Alesandro purchases two goods, X and Y, and the utility gained for the last unit purchased of each is 16 utils and 23 utils, respectively. The prices of X and Y are $1 and $1.75, respectively. Is Alesandro in consumer equilibrium? Explain your answer.

• The text cites a situation in which the “buying” behavior of two rats followed the law of demand. Does it follow that these two rats were attempting to “equate marginal utilities per push of the lever”? Explain your answer.

Behavioral Economics• Are People Willing to Reduce Others’ Incomes? In a

study, 62% of the participants made themselves worse off in order to make someone else worse off.

• Is $1 always $1? Sometimes people “compartmentalize” their money.

• Coffee Mugs and the Endowment Effect: We value X more highly if we have it than if we do not have it because such behavior at one point in our evolution made possible a system of property rights in a world where the alternative was the Hobbesian jungle.

Q & A

• Brandon’s grandmother is very cautious about spending money. Yesterday, she gave Brandon $100 for his birthday. Brandon also received a gift of $100 from his father who isn’t nearly as cautious about spending money as Brandon’s grandmother is. Brandon believes that it would somehow be wrong to spend his grandmother’s gift on frivolous things, but that it wouldn’t be wrong to spend his father’s gift on such things. Why does Brandon feel this way? What economic effect is this?

• Explain the Endowment Effect.