Download Marginal Utility

Chapter 18
Consumer Choice, Behavior, and
Utility Maximization
Income and Substitution Effect
We have covered this.
Price of good goes down… our real
income purchases more
Substitution Effect…. Willing to substitute
dear product for cheaper product if dear
product price goes up….
What is Utility?
Pleasure or satisfaction obtained from good
or service.
More pleasure… more we are willing to pay.
Favorite rock group… concert tickets are
very costly…
Willing to pay?
Willing to substitute?...
How many utils of satisfaction derived?
What is total utility?
Total utility= amount of satisfaction obtained
from entire consumption of a product.
Willing to stay through all three acts of Le’
Miserable– great till the very last curtain
call.
16oz steak good to last bite.
Marginal Utility?
 Marginal Utility= change in total utility obtained
by consuming one more additional (marginal)
unit of a good or service.
TU
Q
 Popcorn… each handful in a movie adds
marginal utility.
 Sometimes… each beer consumed adds
marginal utility. Some think total utility with each
marginal addition! 
Diminishing Marginal Utility
Law of Diminishing Marginal Utility = the
marginal utility of a good declines as more
of it is consumed in a given period of time.
As long as MU is increasing TU must be
increasing.
When MU is not increasing (diminishing)
each unit added yields less utility
 Examples…………
Utility Theory (cont'd)
• Observations
– Marginal utility falls as more is consumed.
– Marginal utility equals zero when total utility is
at its maximum.
Diminishing Marginal Utility
As long as marginal utility > 0, total utility increases. When
marginal utility becomes negative, total utility maxes out and then
decreases.
19-8
Diminishing Marginal Utility
Law of Diminishing Marginal Utility = the
marginal utility of a good declines as more
of it is consumed in a given period of time.
As long as MU is increasing TU must be
increasing.
When MU is not increasing (diminishing)
each unit added yields less utility
Example: Newspaper Vending
Machines versus Candy Vending
Machines
• Newspaper machines do not prevent people
from taking more than one paper. Why not
dispense candy the same way?
• The answer is found in the concept of
diminishing marginal utility.
• Can you think of a circumstance under which a
substantial number of newspaper purchasers
might be inclined to take more than one
newspaper from a vending machine?
TU and MU
As more of a product is
consumed, Total utility
increases at a
Diminishing rate.
Tacos
consumed
in 1 meal
TU
0
1
0
10
2
18
8
3
24
6
4
28
4
5
30
2
6
30
0
7
28
-2
MU
TOTAL AND MARGINAL UTILITY
0
10
18
24
28
30
30
28
10
8
6
4
2
0
-2
30
Total Utility (utils)
0
1
2
3
4
5
6
7
TU
20
10
0
Marginal Utility (utils)
Tacos
Total Marginal
consumed Utility, Utility,
per meal Utils
Utils
1
2
3
4
5
6
7
Units consumed per meal
10
8
6
4
2
0
-2
MU
1
2
3
4
5
6
7
Units consumed per meal
TOTAL AND MARGINAL UTILITY
0
10
18
24
28
30
30
28
10
8
6
4
2
0
-2
30
Total Utility (utils)
0
1
2
3
4
5
6
7
TU
20
10
0
Marginal Utility (utils)
Tacos
Total Marginal
consumed Utility, Utility,
per meal Utils
Utils
Observe
Diminishing
Marginal
Utility
1
2
3
4
5
6
7
Units consumed per meal
10
8
6
4
2
0
-2
MU
1
2
3
4
5
6
7
Units consumed per meal
Marginal Utility, Demand and Elasticity
 How can law diminishing
MU explain demand
curve sloping downward?
 Ans: more units of good
yield smaller MU.. Have
to lower price to sell
more.
 If MU drops quickly..
Demand is inelastic
 i.e. given decline in price
elicits small increase in
QD.
 If MU drops more slowly,
the demand is elastic
 A small decline in price
will elicit larger amounts
of QD.
Relationships
There is a relationship between price
elasticity and total revenue.
Total Revenue = price of a product
multiplied by the quantity sold in a given
time period: PxQ.
TR= Price x Quantity sold
Price Elasticity and TR relationship
 Price hike increases TR if demand is inelastic
(this is usually something we can’t live without)
E< 1
 Price hike reduces TR if demand is elastic
(we can live without it)
E>1
 Price hike does not change TR if demand is
unitary elastic
E=1
Maximizing Utility
How would you maximize your utility?
Select that good which delivers the most
marginal utility/dollar even for last dollar
spent.
Let’s think of MU as MB
Remember… If MC > MB should not
produce.
Same thing can apply to purchase.
Why purchase something if you have
decreased utility?
Why purchase something if you have
diminishing benefit?
Optimizing Consumption
• Consider the following:
– Consumers have limited incomes (budgets)
– We must make choices of how to allocate our income
– We can use utils to measure the marginal utility
additional consumption gives us
– Consumers will be able to optimize consumption by
spending dollars on goods that give the highest
marginal utility per dollar (most “bang for your buck”)
• Consumer optimum
– Combination of goods and services
that maximizes utility for a given income
Deciding What to Buy
• In a simplified setting, we can narrow our
consumption choice to two goods, X and Y
• We can spend each dollar optimally by asking
MUX
Price X
Which is larger?
MUY
Price Y
• In other words:
– Which good will give us the highest marginal utility per
dollar spent?
– This is the “bang for your buck” question
Deciding What to Buy
MU X
Price X
Which is larger?
MU Y
Price Y
• Why do we divide by the price?
– Must account for price differences in goods
– Some goods may give high MU, but are more
expensive!
• If the X side is larger, what do we do?
– Spend next dollar on good X
– X will give us more happiness per dollar
– Important: after this consumption, MUX will fall!
Example: Pizza and Pepsi
• Two goods, pizza and Pepsi
– Pizza is $2 per slice
– Pepsi is $1 per can
– You have $10 to spend
• Consumption of pizza and Pepsi both exhibit
diminishing marginal utility
– If I consume pizza, MUpizza falls
– If I consume Pepsi, MUPepsi falls
• Do prices ever change?
– Prices can change (see later), however, they are not
endogenously affected by your consumption
Pizza and Pepsi Optimum
Pizza is $2.00/slice; Pepsi is $1.00/can
Budget = $10.00
Pizza and Pepsi Optimum
Activity Problem
Total and Marginal Utility per Dollar from Pizza and Wall
Climbing
Budget: $50 Pizza costs $10 a piece; Wall Climbing is
$20/hour or $10/half hour
Quantity
TU
MU
0
1
2
3
4
5
0
70
130
180
220
250
0
50
Mu/$
Quantity
TU
MU
00
0.5
1.0
1.5
2.0
2.5
0
90
170
230
260
270
0
Mu/$
Answer to Activity Problem
Total and Marginal Utility per Dollar from Pizza and Wall Climbing
Budget: $50 Pizza costs $10 a piece; Wall Climbing is $20/hour or $10/half
hour
Quantity
TU
MU
0
1
2
3
4
5
0
70
130
180
220
250
0
70
60
50
40
30
Mu/$
Quantity TU
MU
Mu/$
7
6
5
4
3
00
0.5
1.0
1.5
2.0
2.5
0
90
80
60
30
10
9
8
6
3
1
2 Pizza’s = $20 ($10 each)
1.5 Hours Wall Climbing = $20 + $10 = $30
Total= $50 budget
0
90
170
230
260
270
Theory of Consumer Behavior
Theory of Rational Behavior
Preferences
Budget Constraints
Prices
Time (Time/value/money)
Bottom Line for Price Reductions and
Increases
Income Effect
Substitution Effect
Law of Diminishing Marginal Utility( do we
buy more or less?)
Assumption (consumer is rational)
Do we research Consumer Reports before
purchasing?
Do we ponder and question?
When might we be more meticulous?
When would the theory of rational behavior
be less applicable?
Moving Forward With Logic
Utility is maximized if last dollar spent on
product yields same amount of satisfaction
Assumes consumer will spend all his
income.
Marginal Utility Theory consistent with law
of demand
Should government provide the necessities
of life for free?
As book points out:
1) If food, water are necessities of life. No one
should be w/o them, then government should
provide them free to all.
2) As you are hearing now… medical care is a
necessity and should be provided free.
3) Course, we know there are no free lunches,
but the cost to consumer would be $0.
4) Resources must be used to produce
every unit of a good consumed.
5) If govt uses resources to produce goods
with low marginal utility, (which food,
water, and health care would have a zero
price) other goods could not be produced
that would have a higher marginal utility.
6) Remember if the price is $0, then
consumer will consume the good as long
as the marginal utility she derives from it
is greater than 0
$10.00 to spend for pizza and beer
Maximize total utility between two goods
Take my $10.00 spend it on good that yields most utility.
Slice
Pizza
TU
MU
MU/$
$2.00
Pt
Beer
TU
MU
MU/P
$2.00
1
2
3
4
20
36
50
58
20
16
14
8
10
1
20
20
10
8
2
38
18
9
7
3
54
16
8
4
68
14
7
4
$10.00 to spend for pizza and beer
Maximize total utility between two goods
Take my $10.00 spend it on good that yields most utility.
Slice
Pizza
TU
MU
MU/$
$2.00
Pt
Beer
TU
MU
MU/P
$2.00
1
2
3
4
20
36
50
58
20
16
14
8
10
1
20
20
10
8
2
38
18
9
7
3
54
16
8
4
68
14
7
4
$10.00 = 2 slices pizza and 3 pints beer. Total Utility = 56 pizza,
112 for beer.
Price
QD
$2.75
$2.75
1
$2.00
2
$1.00
3
$.25
4
$.25
Because MU declines, lower price is needed to lure the customer
to buy more.
Mathematical Version… (assumes no savings.. Spend last $)
MU of product A
= MU of product B
Price of A
Price of B
IF utility maximization occurs these ratios should be equal
algebraically.
Time/Value/Money
Assuming you want to derive total satisfaction for
last dollar spent.
Golf Outing = $30.00
Concert = $40.00
Both are equal in utility to you.
Which would actually be more costly to indulge in?
Golf takes 4 hours
Concert approximately 2 hours
Other Important Info for Rational Utility
Maximization Decision to be made
How much do you make an hour?
If you earn $10.00 an hour, golf game
costs your $70.00… concert $60.00
How did you get this sum?
(Golf = $40.00 Market place + $30.00 )
(Concert = $30.00 Market place + 30.00)
Now you know in economic terms why driving all
over Dallas to pick up “loss leaders” is costly.
TIME IS MONEY!
Remember.. Substitution
We have learned:
 That maximizing our utility is our goal.
 That our marginal utility decreases with
each additional unit.
That because of this the demand curve will
be downward sloping
We can also shift our demand curve to a
substitute (assuming we can get equal
utils of satisfaction.)
Last check on knowledge!
Units
Consumed
TU
0
1
2
3
4
5
6
0
10
MU
10
8
25
30
3
34
Last check on knowledge!
Units
Consumed
TU
0
1
2
3
4
5
6
0
10
MU
10
8
25
30
3
34
Units
Consumed
TU
MU
0
1
2
3
4
5
6
0
10
18
25
30
33
34
10
8
7
5
3
1
Kiley- Total Utility
If you feel you have maximized your
satisfaction for Utility Maximization…we
will proceed.