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19 C HAPTE R Consumer Behavior and Utility Maximization Chapter 19. Consumer Choice • Utility • Consumer surplus • Budget Constraints • Indifference Curves Biscuits 1 2 3 4 5 6 Choclate 1 2 3 4 5 6 I. Utility Analysis • what is utility? benefit you get from consuming a good determined by your tastes/preferences (assume these are stable) total utility (TU) • total benefit from consuming good • example total benefit from 3 cookies • TU increases as consumption increases, to a point TU 2 cookies < TU 3 cookies marginal utility (MU) • change in TU from • consuming one more of a good example how much MORE utility from an additional pack of gum? change in TU from 0 to 1 cookie MU of 1st cookie = 0 change in TU from 1 cookie to 2 cookies = MU of 2nd cookie diminishing marginal utility • MU falls as consumption rises • get sick of cookies MU of 1st cookie 0 > MU of 2nd cookie TU TU rises at slower and slower rate cookie MU as MU declines cookie How to maximize TU? • use available budget • equalize MU/$ across goods • Huh? • chose combination of cookies and milk where MU cookies = price of cookies MU milk price of milk why? • chose combo of 6 cookies, 1 milk • suppose MU/$1 of cookies = 4, • MU/$1 of milk = 15 by consuming fewer cookies, more milk… I would add more to my TU TU vs. MU • Diamond-Water paradox • $10,000 one carat diamond 5 million gallons of tap water why? • TU of water is greater than TU of • • diamonds water is essential for life BUT water is abundant, diamonds are rarer MU of last diamond is higher MU determines value MU and demand • MU declines as consumption rises • willing to pay less for each additional unit downward sloping demand example : pizza P willing to pay $15 for 2nd pizza $15 $10 willing to pay $10 for 4th pizza D Q 2 pizza 4 pizzas II. Consumer Surplus • difference between what you pay for a good, any what you are WILLING to pay for a good example • market price pizza = $10 • my marginal value of 3rd pizza this week = $12 • my consumer surplus = $2 my demand curve P $12 my consumer surplus $10 D Q 3 P total consumer surplus $10 area between D and price of pizza D Q 10,000 III. The Budget Line • given: • • consumer’s budget prices draw a line representing choices consumption possibilities example • 2 goods: milk & cookies • bottle of milk = $1 • cookie = $.50 • daily budget = $4 possible combinations cookies 0 2 4 6 8 milk 4 3 2 1 0 budget line cookies 8 6 4 2 0 milk 1 2 3 4 budget line cookies 8 6 Unaffordable 4 2 Affordable 0 milk 1 2 3 4 what if prices change? • changes slope of budget line • suppose cookies = $1 budget line cookies cookie = $.50 8 6 cookie = $1 4 2 0 milk 1 2 3 4 what if budget changes • budget line shifts • suppose budget = $5 cookies 10 8 budget = $5 6 4 2 budget = $4 milk 0 1 2 3 4 5 IV. Indifference Curves • (appendix) • alternative way to show utility • curve shows combo of goods that deliver same total utility example: milk and cookies cookies Every point on curve has same total utility 8 6 4 2 Indifference curve 0 milk 1 2 3 4 TU is higher as curve shifts right cookies higher TU lower TU milk consumer equilibrium • maximize TU • stay on budget consumer equilibrium cookies 8 best affordable point 4 milk 2 4 consumer equilibrium cookies 8 best affordable point 4 milk 2 4 sum it up • consumer decisions based on • preferences budget constraint consumer decisions made at the margin marginal benefit of one more compared to price of one more • • • • I. Introduction A. We spend Millions of KDs on goods and services each. yet no two consumers spend their incomes in the same way. How can this be explained? B. Why does a consumer buy a particular bundle of goods and services rather than others? Examining these issues will help us understand consumer behavior and the law of 40 demand. II. Two Explanations of the Law of Demand • • • A. Income and substitution effects explain the inverse relationship between price and quantity demanded. 1. The income effect is the impact of a change in price on consumers’ real incomes and on the quantity of that product demanded. You have less income to buy An increase in price means that less real same amount income is available to buy subsequent of the product amounts of the product. as before 41 • 2. The substitution effect • A higher price for a particular product means that the item has become relatively more expensive compared to its substitutes. (i.e. Tea and Coffee) • other productswill buy less of Therefore, consumers are more cheaper this product and of the now substitutes, whose prices are relatively lower than before. 42 • Utility Maximization Rule Affordable: Px(X) + Py(Y) = I • Of all different affordable combinations of goods and services, which combination will yield the maximum satisfaction? Px/Mux = Py/MUy The consumer will allocate (I) so that the last $ spent on a product = the same amount of MU 43 UTILITY MAXIMIZING COMBINATION $ 10 income Unit of product Product A: Price = $1 Marginal Marginal utility per utility, dollar utils (MU/price) First 10 Second 8 Third 7 Fourth 6 Fifth 5 Sixth 4 Seventh 3 10 8 7 6 5 4 3 Product B: Price = $2 Marginal Marginal utility per utility, dollar utils (MU/price) 24 20 18 16 12 6 4 12 10 9 8 6 3 2 44 UTILITY MAXIMIZING COMBINATION $ 10 income Unit of product Product A: Price = $1 Marginal Marginal utility per utility, dollar utils (MU/price) Product B: Price = $2 Marginal Marginal utility per utility, dollar utils (MU/price) First 10 10 Second 8 8 1 unit of (A) and 2 units of (B) is affordable: 7 Third 7 1(1) + 2(2) = 5$ Fourth 6Still $5 left! 6 Fifth 5 5 Sixth 4 4 Seventh 3 3 24 20 18 16 12 6 4 12 10 9 8 6 3 2 45 UTILITY MAXIMIZING COMBINATION $ 10 income Unit of product Product A: Price = $1 Marginal Marginal utility per utility, dollar utils (MU/price) First 10 4 of (A) and 5 of (B) 1(4) + 2(5)=$11 8 Second Not affordable Third 7 Fourth 6 Fifth 5 Sixth 4 Seventh 3 10 8 7 6 5 4 3 Product B: Price = $2 Marginal Marginal utility per utility, dollar utils (MU/price) 24 20 18 16 12 6 4 12 10 9 8 6 3 2 46 UTILITY MAXIMIZING COMBINATION $ 10 income Unit of product Product A: Price = $1 Marginal Marginal utility per utility, dollar utils (MU/price) First 10 Second 8 Third 7 Fourth 6 Fifth 5 2 of (A) and 4 of (B) Sixth 4 1(2) + 2(4) =$10 Seventh 3 10 8 7 6 5 4 3 Product B: Price = $2 Marginal Marginal utility per utility, dollar utils (MU/price) 24 20 18 16 12 6 4 12 10 9 8 6 3 2 47 3. It is marginal utility per dollar spent that is equalized; that is, consumers compare the extra utility from each product with its cost. 48 An Indifference Curve An indifference curve is a line that shows all the consumption bundles that yield the same amount of total utility for an individual. An Indifference Curve Map Properties of Indifference Curves indifference curves never cross the farther out an indifference curve is, the higher the total utility it indicates Tangency Condition The tangency condition between the indifference curve and the budget line holds when the indifference curve and the budget line just touch. It determines the optimal consumption bundle. Understanding the Relative Price Rule At the optimal consumption bundle: −MUR/MUM = − PR/PM Differences in Preferences SCENARIO • Rats and Rational Choice Even rats can make rational choices! And if rats can make rational choices, so can people! • Rats and Rational Choice 1. Refer to the figure below. As described in the textbook, even a rat would not choose: A) point C. B) point A. C) point B. D) either point A or point B. • Rats and Rational Choice 1. Refer to the figure below. As described in the textbook, even a rat would not choose: A) point C. B) point A. C) point B. D) either point A or point B. • Rats and Rational Choice 2. The difference between BL1 and BL2 is likely the result of: A) a change in the consumer’s income. B) a change in the prices of the goods. C) both a and b. D) cannot be determined. • Rats and Rational Choice 2. The difference between BL1 and BL2 is likely the result of: A) a change in the consumer’s income. B) a change in the prices of the goods. C) both a and b. D) cannot be determined. • Rats and Rational Choice 3. Which of the following is the expression for the optimal consumption bundle of two goods, X and Y? A) MUX = PX and MUY = PY B) MUX/PY = MUY/PX C) MUX/PX = MUY/PY D) none of the above • Rats and Rational Choice 3. Which of the following is the expression for the optimal consumption bundle of two goods, X and Y? A) MUX = PX and MUY = PY B) MUX/PY = MUY/PX C) MUX/PX = MUY/PY D) none of the above