Chapter 9 CONSUMER THEORY A more in-depth look at the forces that shape our demand ** Key Tables and graphs adopted from Hubbard and Obrien Textbook – Pearson Publication**

Consumption so far, we have looked at demand/supply, but have not looked at the true influences of either; we will focus on demand in this section We know that household consumption choices are limited by: 1) Income available 2) Price of the product

BUDGET CONSTRAINTS BUDGET CONSTRAINT: represents the possible combinations of 2 commodities that a consumer can purchase, given: 1) market price of the products 2) consumer's income This is a consumer’s “consumption possibilities” frontier

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"

Utility Measure of pleasure or satisfaction one gets from consuming a product - measured in "utils" So, the consumers objective is to maximize utility given their budget constraints

Utility TOTAL UTILITY (TU) Number of units of utility a person gets by consuming a given quantity of the product during a particular time MARGINAL UTILITY (MU) amount by which an additional unit of the product increases a consumer's total utility Why can marginal utility be viewed as more important in the decision making process than total utility? LAW OF DIMINISHING MARGINAL UTILITY Beyond some level of consumption, the marginal utility of a product will decline as the quantity consumed increases

MAXIMIZING UTILITY Goal of consumer is to maximize utility subject to its budget constraint PROBLEM: How to allocate income among the possible consumption choices. Each time I buy a good, what happens? 1) utility increases, but at a declining rate 2) give up opportunity to buy other goods

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 product Gains in utility possible when marginal utility per dollar of 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 that of good Y Decision rule: MUX/ PX  MUY/ PY

Consumption Decision As 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.

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

Utility and Consumer Decision Making The Principle of Diminishing Marginal Utility The 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.

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 9-1 NUMBER OF SLICES OF PIZZA TOTAL UTILITY FROM EATING PIZZA MARGINAL UTILITY FROM THE LAST SLICE NUMBER OF CUPS OF COKE TOTAL UTILITY FROM DRINKING COKE MARGINAL UTILITY FROM THE LAST CUP -- 1 20 2 36 16 35 15 3 46 10 45 4 52 6 50 5 54 53 51 3 1

(3) MARGINAL UTILITY PER DOLLAR (6) MARGINAL UTILITY PER DOLLAR The Rule of Equal Marginal Utility per Dollar Spent Table 9-2 (1) SLICES OF PIZZA (2) MARGINAL UTILITY (MUPIZZA) (3) MARGINAL UTILITY PER DOLLAR (4) CUPS OF COKE (5) (MUCOKE) (6) MARGINAL UTILITY PER DOLLAR 1 20 10 2 16 8 15 3 5 4 6 3 1.5 1 -1

MARGINAL UTILITY PER DOLLAR (MARGINAL UTILITY/PRICE) The Rule of Equal Marginal Utility per Dollar Spent Table 9-3 COMBINATIONS OF PIZZA AND COKE WITH EQUAL MARGINAL UTILITIES PER DOLLAR MARGINAL UTILITY PER DOLLAR (MARGINAL UTILITY/PRICE) TOTAL SPENDING TOTAL UTILITY 1 slice of pizza and 3 cups of Coke 10 $2 + $3 = $5 20 + 45 = 65 3 slices of pizza and 4 cups of Coke 5 $6 + $4 = $10 46 + 50 = 96 4 slices of pizza and 5 cups of Coke 3 $8 + $5 = $13 52 + 53 = 105 We can summarize the two conditions for maximizing utility: 1. 2. Spending on pizza + Spending on Coke = Amount available to be spent

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 it Use of the law of diminishing marginal returns and consumer equilibrium to show this.

CRITICISMS OF MARGINAL UTILITY THEORY Utility cannot be observed People aren't "smart enough" - aren't "rational thinkers" Forces people to put a $value on goods

Key Terms KEY TERMS Behavioral economics Budget constraint Endowment effect Income effect Law of diminishing marginal utility Marginal utility (MU) Network externality Opportunity cost Substitution effect Sunk cost Utility