Presentation on theme: "Chapter 9 CONSUMER THEORY"— Presentation transcript:
1 Chapter 9 CONSUMER THEORY A more in-depth look at the forcesthat shape our demand** Key Tables and graphs adopted from Hubbard and Obrien Textbook – Pearson Publication**
2 Consumptionso far, we have looked at demand/supply, but have not looked at the true influences of either; we will focus on demand in this sectionWe know that household consumption choices are limited by:1) Income available2) Price of the product
3 BUDGET CONSTRAINTSBUDGET CONSTRAINT: represents the possible combinations of 2 commodities that a consumer can purchase, given:1) market price of the products2) consumer's incomeThis is a consumer’s “consumption possibilities” frontier
4 PREFERENCES AND UTILITY Q: What determines your actions in every facet of life???A: The notion of "rational self-interest"- What helps fuel self-interest???“Benefit vs. price" - get the most benefit you can,but there is a constraint (income/price)How does one measure pleasure - "UTILITY"
5 UtilityMeasure of pleasure or satisfaction one gets from consuming a product- measured in "utils"So, the consumers objective is to maximize utilitygiven their budget constraints
6 UtilityTOTAL UTILITY (TU) Number of units of utility a person gets by consuming a given quantity of the product during a particular timeMARGINAL UTILITY (MU) amount by which an additionalunit of the product increases a consumer's total utilityWhy can marginal utility be viewed as more important in thedecision making process than total utility?LAW OF DIMINISHING MARGINAL UTILITYBeyond some level of consumption, the marginal utility of aproduct will decline as the quantity consumed increases
7 MAXIMIZING UTILITYGoal of consumer is to maximize utility subject to its budget constraintPROBLEM: How to allocate income among the possibleconsumption choices.Each time I buy a good, what happens?1) utility increases, but at a declining rate2) give up opportunity to buy other goods
8 Marginal Decisions Decisions are made “on the margin” How do we compare the MU of two different goods?Can we look at just the MU of each productGains in utility possible when marginal utility per dollarof one good exceeds that of another good.For two goods (X,Y), the consumption decision rule is:Consume good X as long as its MU/$ is greater or equal to thatof good YDecision rule: MUX/ PX MUY/ PY
9 Consumption DecisionAs long as MU/ $ is not the same for all goods, the consumer can reallocate income to buy more of the goods that have higher MU/$ than the others.
10 Consumer Equilibrium and Total Utility Maximization CONSUMER EQUILIBRIUM The consumer purchases goods until MU/$ is the same for all goods. When this occurs, and all available income is spent, total utility is maximized.Total Utility is maximized by marginal decisions
11 Utility and Consumer Decision Making The Principle of Diminishing Marginal UtilityThe figure shows that for the first 5 slices of pizza, the more you eat, the more your total satisfaction, or utility, increases.If you eat a sixth slice, you start to feel ill from eating too much pizza, and your total utility falls. Each additional slice increases your utility by less than the previous slice, so your marginal utility from each slice is less than the one before.Panel (a) shows your total utility rising as you eat the first 5 slices and falling with the sixth slice.Panel (b) shows your marginal utility falling with each additional slice you eat and becoming negative with the sixth slice. The height of the marginal utility line at any quantity of pizza in panel (b) represents the change in utility as a result of consuming that additional slice.For example, the change in utility as a result of consuming 4 slices instead of 3 is 6 utils, so the height of the marginal utility line in panel (b) for the fourth slice is 6 utils.
12 The Rule of Equal Marginal Utility per Dollar Spent Budget constraint The limited amount of income available to consumers to spend on goods and services.Table 9-1NUMBER OF SLICES OFPIZZATOTAL UTILITY FROM EATING PIZZAMARGINAL UTILITY FROM THE LAST SLICENUMBER OF CUPS OF COKETOTAL UTILITY FROM DRINKING COKEMARGINAL UTILITY FROM THE LAST CUP--1202361635153461045452650554535131
13 (3) MARGINAL UTILITY PER DOLLAR (6) MARGINAL UTILITY PER DOLLAR The Rule of Equal Marginal Utility per Dollar SpentTable 9-2(1)SLICESOF PIZZA(2)MARGINAL UTILITY(MUPIZZA)(3) MARGINAL UTILITY PER DOLLAR(4)CUPSOF COKE(5)(MUCOKE)(6) MARGINAL UTILITY PER DOLLAR12010216815354631.51-1
14 MARGINAL UTILITY PER DOLLAR (MARGINAL UTILITY/PRICE) The Rule of Equal Marginal Utility per Dollar SpentTable 9-3COMBINATIONS OF PIZZA AND COKE WITH EQUAL MARGINAL UTILITIES PER DOLLARMARGINAL UTILITY PER DOLLAR(MARGINAL UTILITY/PRICE)TOTAL SPENDINGTOTAL UTILITY1 slice of pizza and 3 cups of Coke10$2 + $3 = $5= 653 slices of pizza and 4 cups of Coke5$6 + $4 = $10= 964 slices of pizza and 5 cups of Coke3$8 + $5 = $13= 105We can summarize the two conditions for maximizing utility:1.Spending on pizza + Spending on Coke = Amount available to be spent
15 DEMAND CURVE REVISITED We've discussed that the law of demand dictates that the demand curve is downward sloping - here is another way to prove itUse of the law of diminishing marginal returns and consumer equilibrium to show this.
16 CRITICISMS OF MARGINAL UTILITY THEORY Utility cannot be observedPeople aren't "smart enough" - aren't "rational thinkers"Forces people to put a $value on goods