Chapter 19 Demand for Goods Consumer Choice, Behavior, Utility Maximization,

Income and Substitution Effect We have covered this. Price of good goes down… our real income purchases more Substitution Effect…. Willing to substitute dear product for cheaper product if dear product price goes up….

What is Utility? Pleasure or satisfaction obtained from good or service. More pleasure… more we are willing to pay. Favorite rock group… concert tickets are very costly… Willing to pay? Willing to substitute?... How many utils of satisfaction derived?

What is total utility? Total utility= amount of satisfaction obtained from entire consumption of a product. Willing to sit through entire football game in the pouring rain to watch your favorite team. 16oz steak good to last bite.

Marginal Utility? Marginal Utility= change in total utility obtained by consuming one more additional (marginal) unit of a good or service. TU Q Popcorn… each handful in a movie adds marginal utility. Sometimes… each beer consumed adds marginal utility. Some think total utility with each marginal addition! 

Diminishing Marginal Utility Law of Diminishing Marginal Utility = the marginal utility of a good declines as more of it is consumed in a given period of time.-example is……. As long as MU is increasing TU must be increasing. When MU is not increasing (diminishing) each unit added yields less utility

Utility Theory (cont'd) Observations Marginal utility falls as more is consumed. Marginal utility equals zero when total utility is at its maximum. 7

Diminishing Marginal Utility Point out that each added unit adds to total utility but at decreasing increments (diminishing MU). As long as marginal utility > 0, total utility increases. When marginal utility becomes negative, total utility maxes out and then decreases.

Example: Newspaper Vending Machines versus Candy Vending Machines Newspaper machines do not prevent people from taking more than one paper. Why not dispense candy the same way? The answer is found in the concept of diminishing marginal utility. Can you think of a circumstance under which a substantial number of newspaper purchasers might be inclined to take more than one newspaper from a vending machine? 9

TU and MU Tacos consumed in 1 meal TU MU 1 10 2 18 8 3 24 6 4 28 5 30 7 -2 As more of a product is consumed, Total utility increases at a Diminishing rate.

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

Marginal Utility, Demand and Elasticity How can law diminishing MU explain demand curve sloping downward? Ans: more units of good yield smaller MU.. Have to lower price to sell more. If MU drops quickly.. Demand is inelastic i.e. given decline in price elicits small increase in QD. If MU drops more slowly, the demand is elastic A small decline in price will elicit larger amounts of QD.

Relationships There is a relationship between price elasticity and total revenue. Total Revenue = price of a product multiplied by the quantity sold in a given time period: PxQ. TR= Price x Quantity sold

Price Elasticity and TR relationship Price hike increases TR if demand is inelastic (this is usually something we can’t live without) E< 1 Price hike reduces TR if demand is elastic (we can live without it) E > 1 Price hike does not change TR if demand is unitary elastic E = 1

Maximizing Utility How would you maximize your utility? Select that good which delivers the most marginal utility/dollar even for last dollar spent.

Optimizing Consumption Consider the following: Consumers have limited incomes (budgets) We must make choices of how to allocate our income We can use utils to measure the marginal utility additional consumption gives us Consumers will be able to optimize consumption by spending dollars on goods that give the highest marginal utility per dollar (most “bang for your buck”) Consumer optimum Combination of goods and services that maximizes utility for a given income Lecture notes: Now we show the example of a consumer choosing consumption with two goods that have two different prices. The consumer has a limited income. This is a constrained optimization problem. Goal: optimize (maximize) utility Constraint: limited budget due to income and prices

Deciding What to Buy In a simplified setting, we can narrow our consumption choice to two goods, X and Y We can spend each dollar optimally by asking Lecture notes: We can guarantee maximum total utility if we spend each marginal dollar where it gives us the highest marginal utility. When choosing to purchase one of two goods at the margin, we ask ourselves “which good will make me happiest with regards to what I’m paying for it?” In other words, which good gives me the most bang for my buck? I’ll maximize utility if I always spend so I get the most bang for my buck. In other words: Which good will give us the highest marginal utility per dollar spent? This is the “bang for your buck” question

Deciding What to Buy Why do we divide by the price? Must account for price differences in goods Some goods may give high MU, but are more expensive! If the X side is larger, what do we do? Spend next dollar on good X X will give us more happiness per dollar Important: after this consumption, MUX will fall! Lecture notes: Dividing by the price allows us to put different goods in a meaningful comparison. Imagine a monthly restaurant budget. We can eat at a fancy restaurant (very high MU) or eat fast food (lower MU). However, the fancy restaurant will also have much higher prices. Dividing by the price gives us a measure of happiness per dollar. In other words, if the fancy restaurant gives twice as much MU but has a price three times higher than the fast food, you may be getting more bang for your buck with fast food! Note: Rather than saying “spend next dollar on good X”, we may just have to buy one unit of good X. We might not always be able to purchase and consume goods in fractions. Instead, we’ll have to buy whole units of the good, which of course are not always priced at $1.

Example: Pizza and Pepsi Two goods, pizza and Pepsi Pizza is $2 per slice Pepsi is $1 per can You have $10 to spend Consumption of pizza and Pepsi both exhibit diminishing marginal utility If I consume pizza, MUpizza falls If I consume Pepsi, MUPepsi falls Lecture notes: MU is affected by your consumption. If you consume more of a good, the MU of that good falls. However, prices are not affected by your consumption. You are just one consumer—just because you buy food or drink, the price of that food or drink won’t change.

Pizza and Pepsi Optimum Pizza is $2. 00/slice; Pepsi is $1 Pizza and Pepsi Optimum Pizza is $2.00/slice; Pepsi is $1.00/can Budget = $10.00 Lecture notes: Marginal analysis: Spend money marginal where MU/$ is highest. In order, we buy: Pizza – gives us 10MU/$ ($8 remains after purchase) Pepsi – gives us 9MU/$ ($7 remains after purchase) Now, see that both goods give 8MU/$. We can afford both, so we buy both (the order doesn’t matter). After that, we have $4 remaining. Now, you buy Pepsi—gives us 7MU/$. ($3 remains after purchase) With exactly $3 left, you purchase one more of each good since they both give 6MU/$. You have ended with (MUpizza)/(PRICEpizza) = (MUpepsi)/(PRICEpepsi) AND You have spend all of your income.

Pizza and Pepsi Optimum Lecture notes: This table shows all affordable bundles. It shows that our marginal analysis of spending each dollar where it gives the most “bang for our buck” helped us arrive at the bundle in which total utility is maximized. By thinking at the margin about which good provides the highest marginal utility, you also maximize your total utility. Of course, we rarely think this way! But consumers make choices like this all the time. Instead of adding up utils, we think, “That isn’t worth it” or “That’s a steal.”

Activity Problem Total and Marginal Utility per Dollar from Pizza and Wall Climbing Budget: $50 Pizza costs $10 a piece; Wall Climbing is $20/hour or $10/half hour Quantity TU MU Mu/$ pizza Wall climbing   00 1 70 0.5 90 2 130 1.0 170 3 180 50 1.5 230 4 220 2.0 260 5 250 2.5 270

Answer to Activity Problem Total and Marginal Utility per Dollar from Pizza and Wall Climbing Budget: $50 Pizza costs $10 a piece; Wall Climbing is $20/hour or $10/half hour MU/pizza = MU/Wall Climbing P P Quantity TU MU Mu/$ Pizza Wall Climbing   00 1 70  7 0.5 90  90  9 2 130 60  6 1.0 170  80  8 3 180 50  5 1.5 230  60 4 220 40  4 2.0 260  30  3 5 250 30 2.5 270  10  1 2 Pizza’s = $20 ($10 each) 1.5 Hours Wall Climbing = $20 + $10 = $30 Total= $50 budget

$10.00 to spend for pizza and beer Maximize total utility between two goods Take my $10.00 spend it on good that yields most utility. Pt Beer TU MU MU/P $2.00 1 20 10 2 38 18 9 3 54 16 8 4 68 14 7 Slice Pizza TU MU MU/$ $2.00 1 20 10 2 36 16 8 3 50 14 7 4 58 $10.00 = 2 slices pizza and 3 pints beer. Total Utility = 56 pizza, 112 for beer.

Because MU declines, lower price is needed to lure the customer QD $2.75 1 $2.00 2 $1.00 3 $.25 4 $2.75 $.25 Because MU declines, lower price is needed to lure the customer to buy more. Mathematical Version… (assumes no savings.. Spend last $) MU of product A = MU of product B Price of A Price of B IF utility maximization occurs these ratios should be equal algebraically.

Last check on knowledge! Units Consumed TU MU 1 10 2 8 3 25 4 30 5 6 34

Last check on knowledge! Units Consumed TU MU 1 10 2 8 3 25 4 30 5 6 34 Units Consumed TU MU 1 10 2 18 8 3 25 7 4 30 5 33 6 34