Consumer Behavior and Utility Maximization 8 C H A P T E R Consumer Behavior and Utility Maximization

A Closer Look… THE LAW OF DEMAND The Income Effect A lower price frees income for additional purchases - and vice versa The Substitution Effect A lower price relative to other goods attracts new buyers - and vice versa

LAW OF DIMINISHING MARGINAL UTILITY Utility Defined Subjective Nature Difficult to Quantify Total Utility Marginal Utility graphically examined...

1 10 TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 10 Total Utility (utils) 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) 1 2 3 4 5 6 7 Units consumed per meal

1 10 10 TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utils Marginal Utility, Utils 30 20 10 1 10 Total Utility (utils) 10 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) 1 2 3 4 5 6 7 Units consumed per meal

1 2 10 18 10 8 TOTAL AND MARGINAL UTILITY Tacos consumed per meal Utils Marginal Utility, Utils 30 20 10 1 2 10 18 Total Utility (utils) 10 8 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) 1 2 3 4 5 6 7 Units consumed per meal

1 2 3 10 18 24 10 8 6 TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 2 3 10 18 24 Total Utility (utils) 10 8 6 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) 1 2 3 4 5 6 7 Units consumed per meal

1 2 3 4 10 18 24 28 10 8 6 4 TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 2 3 4 10 18 24 28 Total Utility (utils) 10 8 6 4 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) 1 2 3 4 5 6 7 Units consumed per meal

1 2 3 4 5 10 18 24 28 30 10 8 6 4 2 TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 2 3 4 5 10 18 24 28 30 Total Utility (utils) 10 8 6 4 2 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) 1 2 3 4 5 6 7 Units consumed per meal

1 2 3 4 5 6 10 18 24 28 30 10 8 6 4 2 TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 2 3 4 5 6 10 18 24 28 30 Total Utility (utils) 10 8 6 4 2 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) 1 2 3 4 5 6 7 Units consumed per meal

1 2 3 4 5 6 7 10 18 24 28 30 10 8 6 4 2 -2 TOTAL AND MARGINAL UTILITY TU Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 2 3 4 5 6 7 10 18 24 28 30 Total Utility (utils) 10 8 6 4 2 -2 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) MU 1 2 3 4 5 6 7 Units consumed per meal

Observe Diminishing Marginal Utility TOTAL AND MARGINAL UTILITY TU Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 Observe Diminishing Marginal Utility 1 2 3 4 5 6 7 10 18 24 28 30 Total Utility (utils) 10 8 6 4 2 -2 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) MU 1 2 3 4 5 6 7 Units consumed per meal

A Typical Consumer... Exhibits Rational Behavior THEORY OF CONSUMER BEHAVIOR A Typical Consumer... Exhibits Rational Behavior Has Clear-Cut Preferences Subject to a Budget Constraint Responds to Price Changes

illustrated... Utility Maximizing Rule THEORY OF CONSUMER BEHAVIOR Utility Maximizing Rule The consumer’s money income should be allocated so that the last dollar spent on each product yields the same amount of extra (marginal) utility illustrated...

How should the $10 Income be allocated? UTILITY MAXIMIZING COMBINATION $ 10 income Product A: Price = $1 Product B: Price = $2 Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First 10 10 24 12 How should the $10 Income be allocated?

Examine the two marginal utilities UTILITY MAXIMIZING COMBINATION $ 10 income Product A: Price = $1 Product B: Price = $2 Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First 10 10 24 12 Examine the two marginal utilities

Examine the two marginal utilities …per dollar UTILITY MAXIMIZING COMBINATION $ 10 income Product A: Price = $1 Product B: Price = $2 Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First 10 10 24 12 Examine the two marginal utilities …per dollar

Decision: Buy 1 Product B for $2 UTILITY MAXIMIZING COMBINATION $ 10 income Product A: Price = $1 Product B: Price = $2 Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First 10 10 24 12 Decision: Buy 1 Product B for $2

What next? First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 UTILITY MAXIMIZING COMBINATION $ 10 income Product A: Price = $1 Product B: Price = $2 Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product 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 What next?

What next? Buy one of each UTILITY MAXIMIZING COMBINATION $ 10 income Product A: Price = $1 Product B: Price = $2 Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product 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 What next? Buy one of each

and then... ($5 left) First 10 10 24 12 Second 8 8 20 10 UTILITY MAXIMIZING COMBINATION $ 10 income Product A: Price = $1 Product B: Price = $2 Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product 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 and then... ($5 left)

third unit of product B First 10 10 24 12 Second 8 8 20 10 UTILITY MAXIMIZING COMBINATION $ 10 income Product A: Price = $1 Product B: Price = $2 Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product 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 third unit of product B

$3 left... First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 UTILITY MAXIMIZING COMBINATION $ 10 income Product A: Price = $1 Product B: Price = $2 Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product 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 $3 left...

$3 left... Buy both! First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 UTILITY MAXIMIZING COMBINATION $ 10 income Product A: Price = $1 Product B: Price = $2 Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product 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 $3 left... Buy both!

the last dollar spent on UTILITY MAXIMIZING COMBINATION $ 10 income Product A: Price = $1 Product B: Price = $2 Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product 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 Income is gone... the last dollar spent on each good gave the same utility (8) per dollar

Algebraic Restatement of the Utility Maximization Rule UTILITY MAXIMIZING COMBINATION Algebraic Restatement of the Utility Maximization Rule MU of product A Price of A MU of product B Price of B =

UTILITY MAXIMIZATION AND THE DEMAND CURVE Deriving the Demand Schedule and Curve Given from the previous example schedule: Preferences or Tastes Money Income Prices of Other Goods

UTILITY MAXIMIZATION AND THE DEMAND CURVE Deriving the Demand Schedule and Curve Create a demand schedule from the purchase decisions as the price of the product is varied ... Price per unit of B Quantity Demanded $2 4 1 6 Graphically…

UTILITY MAXIMIZATION AND THE DEMAND CURVE Deriving the Demand Schedule and Curve $2 Price per unit of Good B 1 DB 4 6 Quantity Demanded of Good B

UTILITY MAXIMIZATION AND THE DEMAND CURVE Substitution Effects and Income Effects Revisited Deriving the Demand Schedule and Curve $2 Price per unit of Good B 1 DB 4 6 Quantity Demanded of Good B

Chapter Conclusions The Compact Disc Takeover APPLICATIONS AND EXTENSIONS The Compact Disc Takeover The Diamond-Water Paradox The Value of Time Medical Care Purchases Cash and Noncash Gifts Chapter Conclusions

law of diminishing marginal utility rational behavior KEY TERMS income effect substitution effect utility total utility marginal utility law of diminishing marginal utility rational behavior budget constraint utility-maximizing rule Copyright McGraw-Hill/Irwin 2002 BACK END

Next… Chapter 21 APPENDIX Indifference Curve Analysis