Copyright 2008 The McGraw-Hill Companies 19 Consumer Behavior and Utility Maximization Click to Link to Appendix 19: Indifference Curve Analysis

Copyright 2008 The McGraw-Hill Companies

19Consumer Behavior and Utility Maximization

Click to Link to Appendix 19: Indifference Curve Analysis


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


What is Utility?

• The satisfaction or enjoyment a person obtains from consuming a good

O 19.1


What is a Util?

• A hypothetical unit used to measure how much utility a person obtains from consuming a good


What isMarginal Utility?

• The change in total utility a person derives from consuming an additional unit of a good


What is Total Utility?

• The total number of utils a person derives from consuming a specific quantity of a good


• Note that:

• MU = ΔTU/ ΔQ, that is marginal utility equals the change in total utility divided by the change in quantity of the good.


TU and MU

• Q TU MU• 0 0• 1 10 10• 2 18 8• 3 24 6• 4 28 4• 5 30 2• 6 30 0• 7 28 -2


What is the Law of Diminishing Marginal Utility?

• As more of a good is consumed, at some point, the marginal utility a person derives from each additional unit diminishes


Does the Law of Diminishing Marginal Utility apply to all goods consumed?

• YES, WITHIN A FIXED TIME PERIOD


Law of Diminishing Marginal Utility

0

10

20

30

1086420

-2

1 2 3 4 5 6 7

1 2 3 4 5 6 7

To

tal U

tilit

y (U

tils

)M

arg

inal

Uti

lity

(Uti

ls)

(1)Tacos

ConsumedPer Meal

(2)Total

Utility,Utils

(3)MarginalUtility,Utils

0

1

2

3

4

5

6

7

0

10

18

24

28

30

30

28

]]]]]]]

10

8

6

4

2

0

-2

TR

MU

Total Utility

Marginal Utility

Units Consumed Per Meal

Units Consumed Per Meal

G 19.1


P1

Q1

P2

Q2

12

D

Recall a Demand CurvePrice

QUANTITY


• What does marginal utility have to do with the demand curve? We can use the law of diminishing MU as another explanation for the law of demand.


• In consuming a product, how many units In consuming a product, how many units of the product will you buy?of the product will you buy?

Consume to the point where MU = P: why? Logically, as long as the MU exceeds the price you have to pay, you will continue to consume, but if the MU is less than the price, you will not consume.


P1

P2

Q1 Q215

MU

At P1, consume to Q1, since MU > P up to that point, at P2, consume to Q2, etc.


Consumer equilibrium

• Now go from 1 good to 2 or more goods: have to take prices of good into account


Consumer equilibrium condition

• Purchase X and Y in amounts such that

• MU x = MU y

• P x P y

Why?


Assume you are not in equilibrium… say that

MU x > MU y

P x P y

What would you do??


Purchase more of X (due to its greater satisfaction per dollar), and less of Y

But more of X reduces MUX and less of Y increases MUY so we are heading back to equilibrium!!


For more than 2 goods, the equilibrium condition becomes…..

• MUx/Px = Muy/Py =

• Muz/Pz = …….for all goods


Theory of Consumer Behavior• Utility Maximizing Rule

–Allocate Money Income so that Last Dollar Spent on Each Product Yields the Same Marginal Utility


Theory of Consumer BehaviorNumerical Example:Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10

(1)Unit of

Product

(a)MarginalUtility,Utils


(b)Marginal

UtilityPer Dollar(MU/Price)

(b)Marginal


(2)Product A:Price = $1

(3)Product B:Price = $2

First

Second

Third

Fourth

Fifth

Sixth

Seventh

10

8

7

6

5

4

3

24

20

18

16

12

6

4

10

8

7

6

5

4

3

12

10

9

8

6

3

2

Compare Marginal UtilitiesThen Compare Per Dollar - MU/PriceChoose the HighestCheck Budget - Proceed to Next Item



(1)Unit of

Product



(b)Marginal


(b)Marginal




First

Second

Third

Fourth

Fifth

Sixth

Seventh

10

8

7

6

5

4

3

24

20

18

16

12

6

4

10

8

7

6

5

4

3

12

10

9

8

6

3

2

Again, Compare Per Dollar - MU/PriceChoose the HighestBuy One of Each – Budget Has $5 LeftProceed to Next Item



(1)Unit of

Product



(b)Marginal


(b)Marginal




First

Second

Third

Fourth

Fifth

Sixth

Seventh

10

8

7

6

5

4

3

24

20

18

16

12

6

4

10

8

7

6

5

4

3

12

10

9

8

6

3

2

Again, Compare Per Dollar - MU/PriceBuy One More B – Budget Has $3 LeftProceed to Next Item



(1)Unit of

Product



(b)Marginal


(b)Marginal




First

Second

Third

Fourth

Fifth

Sixth

Seventh

10

8

7

6

5

4

3

24

20

18

16

12

6

4

10

8

7

6

5

4

3

12

10

9

8

6

3

2

Again, Compare Per Dollar - MU/PriceBuy One of Each – Budget Exhausted



(1)Unit of

Product



(b)Marginal


(b)Marginal




First

Second

Third

Fourth

Fifth

Sixth

Seventh

10

8

7

6

5

4

3

24

20

18

16

12

6

4

10

8

7

6

5

4

3

12

10

9

8

6

3

2

Final Result – At These Prices, Purchase 2 of Item A and 4 of B W 19.1


Theory of Consumer BehaviorAlgebraic 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


Pri

ce

of

Pro

du

ct

B

0

1

2

4 6

Quantity Demanded of B

Deriving the Demand CurveSame Numeric Example:

$2

1

4

6

Price Per Unit of B

QuantityDemanded

DBIncome Effects

Substitution EffectsO 19.2


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


Applications of Utility

• The water-diamond paradox--why is water so cheap and diamonds so expensive?


Water-high TU but low MU due to abundance, diamonds the

opposite-Price reflects marginal valuation, not totals


The marginal utility of money?

•Does it diminish as with goods?


Diminishing MU of money often used as an argument for

progressive taxation.


What is Interpersonal comparison of utility?

• A comparison of the marginal utility that different people derive from a good or a dollar


Economists argue that we should avoid such interpersonal utility

comparisons


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


Key Terms• law of diminishing marginal utility• utility• total utility• marginal utility• rational behavior• budget constraint• utility-maximizing rule• income effect• substitution effect

Documents

Copyright 2008 The McGraw-Hill Companies 19 Consumer Behavior and Utility Maximization Click to Link to Appendix 19: Indifference Curve Analysis