2 Total and Marginal Utility Image: Animated Figure 16.1Lecture notes:The relationship between total utility and marginal utility can be seen by observing the dashed line that connects (a) and (b). Since the marginal utility becomes negative after five brownies are consumed, the total utility eventually falls. To the left of the dashed line, the marginal utility is positive in panel (b) and the total utility is rising in panel (a). Conversely, to the right of the dashed line the marginal utility is negative, and total utility is falling.Calculus-minded students will note that MU is the derivative of TU.
3 Here we show a generic example with a risk avoider Here we show a generic example with a risk avoider. Two monetary values of interest are, say, X1 and X2 and those values have utility U(X1) and U(X2), respectivelyUtilityU(X2)U(X1)$X X2
4 Say the outcome of a risky decision is to have X1 occur p% of the time and X2 occur (1 – p)% . Then the EMV isp(X1) + (1 – p)(X2). The expected utility of the risky decision is found in a similar way and without proof I tell you the expected utility isUtilityU(X2)U(X1)EU$EMVX X2along the straight line connecting the points on the curve directly above the EMV for the decision. We have the expected utility as EU = pU(X1) + (1 – p)U(X2)
5 In general we say people have one of three attitudes toward risk In general we say people have one of three attitudes toward risk. People can be risk avoiders, risk seekers (or risk lover) , or indifferent toward risk (risk neutral).Utility ValueRisk neutralRisk avoiderRisk loverMonetary ValueUtility values are assigned to monetary values and the general shape for each type of person is shown above. Note that for equal increments in dollar value the utility either rises at a decreasing rate (avoider), constant rate or increasing rate.
6 Diamond-Water Paradox Water is essential to life, yet cheapDiamonds are (almost) pragmatically useless, yet expensiveWhat’s wrong?Unfair comparison between MU of diamonds and MU of water. We consume a large amount of water, so MUwater is smaller.Recall that MU is captured in the law of demand, and therefore by the priceHowever, TOTAL utility from water consumption is much greater than TU of diamond consumption!Lecture notes:Total utility is determined by the amount of consumer surplus enjoyed from a transaction. We learned thatconsumer surplus is the area under the demand curve and above the price, or the gains from trade a consumer enjoys.
7 Diamond-Water Paradox Uses of waterCooking, drinking, bathing high valueWatering lawns, washing cars low valuePricesIn most places, water is relatively abundant, and therefore cheapDiamonds are relatively scarce and more expensiveWith the high price of diamonds, you will only consume if you expect to get a high amount of marginal utility from the diamondLecture notes:Therefore, if the price of a diamond rises, consumers enjoy less surplus from buying them.
8 Water and Diamonds, Graphically Image: Animated Figure 16.2Lecture notes:The diamond-water paradox exists because people fail to recognize that demand and supply are equally important in determining the value a good creates in society. The demand for water is large while the demand for diamonds is small.If we look at the amount of consumer surplus, we observe that the light green area (TUw) is much larger than the dark green area (TUd), because water is essential for life. As a result, water creates significantly more total utility than diamonds. However, since water is abundant in most places, the price, Pwater, is low. On the other hand, diamonds are rare and the price is high, Pdiamond.
9 Discrete Choice Models There are some goods in which we only purchase one of that good. Thus, diminishing MU may not apply. However, we still try to maximize our utility.Discrete choice model—we buy the one “best” choice out of many alternativesAirline ticketHouseCollege educationSpouse!“Beyond the Book” SlideAirline ticketLook for the best departure and arrival times, price, number of layoversHouseLook for price, location, distance from work, color, size, number of bedroomsCollege educationBest program, location, scholarships, friendsSpouseLooks, intelligence, personality, earning power, maybe race or religion. Note that you can choose your spouse you don’t really “buy” one.
10 ConclusionMoney doesn’t make people happier, but it can allow them to buy more goods and servicesDue to diminishing marginal utility, the amount of happiness gained from additional consumption will get smaller and smallerWhen maximizing utility, consumers face a budget constraint and must consider income, prices, and marginal utilityExogenous price changes will affect the optimal consumption bundle chosen by individuals
11 Practice What You KnowWhich of the following would most likely illustrate an example of negative marginal utility?Studying for another hourSleeping in late on a weekendEating too much food at an all-you-can-eat buffetDrinking a second glass of juice with a mealClicker QuestionCorrect answer: CNegative MU means we’ve consumed up to a point where further consumption makes us worse off. Maybe it makes us feel sick or even injures us. If MU < 0, then TU decreases. At the buffet, it is easy and tempting to overeat since the marginal cost of more food is $0.
12 Practice What You Know If I consume more of good Z, what happens? The price of good Z will fallThe price of good Z will riseMy marginal utility of good Z will fallMy marginal utility of good Z will riseClicker QuestionCorrect answer: CThere is an inverse relationship between consumption of a good and MU of that good. Prices won’t change with consumption—one individual consumer won’t affect the price of good Z.
13 Practice What You Know Suppose that To optimize utility, the consumer should:Buy more XBuy less XBuy more X and less YBuy more Y and less XClicker QuestionCorrect answer: DThe equation says you are getting more “bang for your buck” with good Y. Thus, you should buy more Y. However, if you are already spending all of your income, you must buy less X in order to be able to afford more Y.
14 Practice What You KnowIf the price of a good rises, consumers tend to purchase less of that good and instead purchase more of another good. This illustrates:The real-income effectThe substitution effectDiminishing marginal utilityThe disadvantage of using “utils” to measure consumptionClicker QuestionCorrect answer: BThe substitution effect illustrates that in a two-good model, the two goods are at least somewhat substitutable in consumption.