Total and Marginal Utility Consumer Behavior Total and Marginal Utility

Theory of Consumer Choice Both Budget Constraints and Consumer Preferences can be graphed: The slope of the budget constraint = the rate at which one consumer can trade off one good for another AND The relative prices of the two goods (PSSSTTT – The secret? Same shape as a Production Possibilities Curve) Consumer preferences = “The Indifference Curve”

Theory of Consumer Choice Consumer Income is limited but choices are numerous Consumers must combine budget constraints and preferences

Budget Curve and Indifference Curve Budget Constraint Curve Good X Indifference Curve Good Y

Budget Curve and Indifference Curve

UTILITY MAXIMIZATION So How Do We Know… Where our budget constraints and indifference curve meet: UTILITY MAXIMIZATION

REVIEW! Utility - DEFINITION The measurement of happiness or satisfaction derived from consuming a good or a service Added satisfaction declines as a consumer acquires additional units of a given product LAW OF DIMINISHING MARGINAL UTILITY

Things to keep in mind… “Utility” and “usefulness” are not synonymous Utility is subjective Utility is difficult to quantify (but still…units of utility are named utils. Those economists are clever if not creative!)

Total vs. Marginal Utility Total Utility = Total amount of satisfaction or pleasure a person derives from consuming some specific quantity of a good or service (measured in UTILS!) Marginal Utility = Extra amount of satisfaction a consumer realizes from an additional unit of that product Or…the change in total utility that results from the consumption of 1 more unit of product

Things to keep in mind (Part II)… Different goods and services result in different RATES of diminishing marginal utility EX: Bottled water might decrease in terms of marginal utility at a rate SLOWER than the change in the marginal utility of chewing gum

Consumer Behavior Diminishing marginal utility also explains how customers allocate their money incomes among many goods and services Utility is restrained by consumer choice and behavior:

Consumer Choice and Budget Rational behavior Rational consumers attempt to derive the greatest amount of satisfaction based on choice and budget Preferences Consumers have clear cut preferences which influence their choices Budget constraint Consumers have fixed/limited amount of money income which influences their choices (scarcity!) Prices Every good or service has a price tag which influences consumer choice

Maximizing Total Utility As a result of these constraints… Consumers seek to maximize their total utility by combining purchases of goods and services To maximize utility: Allocate the available budget in a way that maximizes total utility Choose affordable combinations of goods which the sum of the utilities obtained from all goods and services consumed is as large as possible

Utility Maximizing Rule To maximize utility: A consumer must allocate the ENTIRE available budget Last dollar spend on each product yields the same amount of extra (marginal) utility Consumer equilibrium Formula MU of product A = MU of product B Price of A Price of B Or MUx = MUy Px Py

Example Budget Constraint = $10 Apple Price (Product X) = $1 Orange Price (Product Y) = $2 Unit of Product Marginal Utility in Utils Marginal Utility per $ (MU/Price) 1st 10 24 12 2nd 8 20 3rd 7 18 9 4th 6 16 5th 5 6th 4 3 Budget Constraint = $10

Example Choice Number Potential Choices Marginal Utility per $ Purchase Decision Income Remaining 1 1st apple 1st orange 10 12 1st orange for $2 $8 ($10 - $2) 2 2nd orange 1st apple for $1 2nd orange for $2 $5 ($8 - $3) 3 2nd apple 3rd orange 8 9 3rd orange for $2 $3 ($5 - $2) 4 4th orange 2nd apple for $1 4th orange for $2 $0 ($3 - $3)

Utility Maximizing Rule Last dollar utility: For apples = 8 utils For oranges = 8 utils (16/$2) MUx = Muy Px Py 8 Utils = 16 utils $1 $2

Budget Curve and Indifference Curve Budget Constraint Curve Utility Maximization Point Apples Indifference Curve 2 4 Oranges

Practice Problem #1 Quantity of Cookies Total Utility of Cookies Quantity of Cupcakes Total Utility of Cupcakes 1 10 26 2 18 46 3 24 62 4 66 Assume the price of a cookie is $1 Assume the price of a cupcake is $2 Budget is $8. All of this budget will be spent Using Socrative, answer the questions regarding consumer preference

Practice Problem #2 Assume the price of a pizza is $2.00 and the price of soda is $1.00. At your current levels of consumption, the Marginal Utility from pizza is 10 utils and the Marginal Utility from Soda is 6. Which should you consume more of: Pizza or Soda MUp/Pp = ? 10/2 = 5 MUs/Ps = ? 6/1 = 6 Consume more ? Soda Consume less ? Pizza Why??? Total Utility increases with soda consumption

Practice Problem #3 The price of steak is $7 per pound and the price of chicken is $2 per pound. Your mother currently receives a marginal utility of 14 utils from consuming steak this week and 6 utils from consuming chicken. Should your mother buy less chicken this week? No – MU per$ is 2 for steak and 3 from chicken Should buy more chicken and less steak to increase total utility

Practice Problem #4 Apples (price of apples = $.50) Grapefruit (price of grapefruit = $1.00) Qty of Apples TU of Apples MU of Apples MU/$ of Apples Qty of GF TU of GF MU of GF MU/$ of GF 1 10 20 25 2 18 8 16 40 15 3 7 14 53 13 4 30 5 63 34 68 6 37 71 39 73 74 You have $6.00 to spend. At what combination do you maximize utility? Remember MUx/Px = MUy/Py! Which combination maximizes our utility? Why?