Consumer Choice: Maximizing Utility and Behavioural Economics Ch. 18, R.A. Arnold, Economics 9th Ed

Diamond – Water Paradox This is the name of another interesting observation by Adam Smith. He observed that sometimes the things which are most useful to us (e.g. water) have a relatively (comparatively) low price and things which have little use (e.g. diamond) have a relatively high price. What could be an explanation for this? We can explain the paradox after learning this chapter.

Utility Theory In this chapter we study the household (consumer). Remember: Their main objective is to maximize utility Utility: Means satisfaction, happiness or benefit that results from the consumption of a good Utils: Are numbers that measure happiness or satisfaction. If the first cup of tea gives you 10 utils and the second cup gives you 9 utils. It means you get more satisfaction (utility) from the first cup of tea as compared to the second cup. Why? Can a theory explain this?

Law of Diminishing Marginal Utility The marginal utility gained by consuming equal successive units of a good will decline as the amount consumed increases during a given period of time. This law explains why the first cup of tea makes us more happy than the second one. In the definition above, marginal utility (MU) is the additional satisfaction we obtain from consuming one more unit of a good (e.g. one more cup of tea). The MU1st cup = 10 and MU2nd cup = 8. What could be MU3rd cup ? Ans: MU3rd cup < MU2nd cup

Continued Let Q represent the number of cups of tea. Then if Q increases then total utility increases. Direct relationship. In example in slide 3, the total utility of consuming 2 cups of tea = 10 + 8 = 18 utils > total utility of consuming 1 cup of tea = 10 utils. We get an upward sloping curve (next slide). But the gradient/slope decreases as Q increases. Why? As Q increases we can see that MU decreases. Inverse relationship. We get a downward sloping curve (next slide).

Consumer Equilibrium: Maximizing Utility Here, we see how a household (consumer) maximizes utility Constraint of household: limited (fixed) income (budget) We are assuming that the household is consuming all of their income on 10 apples and 10 oranges per week. The price (P) of each apple = $1 and the price (P) of each orange = $1. What is the households total income per week? Also given, MU oranges = 30 utils and MU apples = 20 utils Economic theory tells us that consumers make purchasing decisions by comparing MU and the price of one more unit of a good

Here we can see, (MU orange ÷ P orange ) > (MU apple ÷ P apple) This means the household can get more marginal utility per dollar from oranges as compared to apples. So the household should buy more oranges to increase their utility. But since they are consuming all of their limited income, they have to reduce the consumption of apples, to buy more oranges,. If the household buys more oranges then we know the MU from oranges will fall. Here when the household buys 1 more orange, MU from orange falls to 25 utils. And as they buy 1 less apple, MU from apples increases to 25 utils. Now, (MU orange ÷ P orange ) = (MU apple ÷ P apple). The household is maximizing its utility and they have no further incentive to change their consumption. The household is in equilibrium. At equilibrium they are consuming 11 oranges and 9 apples.

Maximizing Utility and the Law of Demand At the end of last slide, the household had reached equilibrium and it was maximizing utility i.e. (MU from oranges / P of oranges) = (MU from apples / P of apples) Now, if the price of apple falls then, (MU from oranges / P of oranges) < (MU from apples / P of apples) So the household increases their consumption of apples (since they get more marginal utility per dollar from apples) and reduces their consumption of oranges. This is consistent with the theory of demand which tells us if P of a good (apple) falls then the quantity demanded of (apple) rises.

Behavioural Economics Traditional Economic Theories and Models assume that individuals are rational, self- interested, and consistent. Behavioural Economics - a fairly modern branch of economics – challenges the above assumptions and argues that some human behaviour does NOT fit into the traditional economic framework. Here we study some findings by behavioural economists. In one study, it was found that people are actually willing to pay to reduce the income of others. This is not rational. Why would someone spend money to hurt someone else (note: they are losing money as well)? (p. 411) In another study, people who were given coffee mugs valued the coffee mug more than the ones who were not given a coffee mug (p. 415). This not consistent. Everyone should place the same value on a coffee mug. This is explained by the endowment effect. The idea is we can become emotionally attached to goods or we want to hold onto what we have, hence we value them more. Can you think of a situation where people behave in an irrational way? E.g. retail therapy