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Chapter 7 Utility Maximization Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Law of Diminishing Marginal Utility • Law of diminishing marginal utility • As consumption of a good or service increases, the marginal utility obtained from each additional unit of a good or service decreases • Explains downward sloping demand curve LO1 7-2 Terminology • Utility is the satisfaction one gets from consuming a good or service • Not the same as usefulness • Subjective • Difficult to quantify LO1 7-3 Total Utility and Marginal Utility • Util is one unit of satisfaction or pleasure • Total utility is the total amount of satisfaction • Marginal utility is the extra satisfaction from an additional unit of the good • MU = ΔTU/ΔQ LO1 7-4 Total Utility and Marginal Utility Total Utility 4 5 6 7 LO1 0 ] 10 ] 18 ] 24 ] 28 ] 30 ] 30 ] 28 (3) Marginal Utility, Utils 10 8 30 Total utility (utils) 0 1 2 3 (2) Total Utility, Utils 4 2 0 -2 TU 20 10 0 6 Marginal utility (utils) (1) Tacos Consumed Per Meal 1 2 3 4 5 6 7 1 2 3 4 5 6 7 MU 10 8 6 4 2 0 -2 7-5 Theory of Consumer Behavior • • • • LO2 Rational behavior Preferences Budget constraint Prices 7-6 Utility Maximizing Rule • Consumer equilibrium • Consumer allocates his or her income so that the last dollar spent on each product yields the same amount of extra (marginal) utility • Algebraically, MU of product A Price of A LO2 = MU of product B Price of B 7-7 Numerical Example The Utility Maximizing Combination of Apples and Oranges Obtainable with an Income of $10 (1) Unit of Product (2) Apple (Product A): Price = $1 (3) Oranges (Product B): Price = $2 (b) (a) Marginal Utility Marginal Utility, per dollar Utils (MU/Price) (b) (a) Marginal Utility Marginal Utility, per dollar Utils (MU/Price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 6 16 8 Fifth 5 5 12 6 Sixth 4 4 6 3 Seventh 3 3 4 2 7-8 LO2 Decision-Making Process Sequence of Purchases to Achieve Consumer Equilibrium Choice Number Potential Choices Marginal Utility per Dollar Purchase Decision Income Remaining 1 First Apple First Orange 10 12 First orange for $2 $8 = $10 - $2 2 First Apple Second Orange 10 10 First apple for $1 and Second orange for $2 $5 = $8 - $3 3 Second Apple Third Orange 8 9 Third orange for $2 $3 = $5 - $2 4 Second Apple Fourth Orange 8 8 Second apple for $1 and Fourth orange for $2 $0 = $3 - $3 7-9 LO2 Deriving the Demand Curve Price Per Orange Quantity Demanded $2 4 1 6 Price per orange $2 $1 DO 0 LO3 4 6 Quantity demanded of oranges 7-10 Income and Substitution Effects • Income effect • The impact a price change has on a consumer’s real income • Substitution effect • The impact a price change on a product’s relative expensiveness LO4 7-11 Applications and Extensions • • • • • • LO5 New products iPad Diamond-water paradox Opportunity cost and time Medical care purchases Cash and noncash gifts 7-12 Criminal Behavior • The criminal attempts to maximize his or her total utility • Compares the marginal benefit with the marginal cost of the unlawful activity • Most people find the costs too high • For others, society imposes additional costs such as fines and imprisonment • Potential to reduce crime by increasing the cost of crime 7-13