Consumer Choice 16

Modeling Consumer Satisfaction Utility –A measure of relative levels of satisfaction consumers enjoy from consumption of goods and services –Sometimes numerically quantified by a unit of happiness called a “util” Disadvantage of using “utils” –Cannot be compared across individuals –Not directly measureable or viewable Advantages of using “utils” –Can maximize utility, just like firms maximize profits –Internally consistent

Total and Marginal Utility Total utility –Overall amount of happiness from all consumption –Most of the time, total utility is directly related to consumption. Marginal utility –Additional utility gained from consuming one more unit of a good or service –Recall “marginal” = “additional” –For most consumption that we rationally choose to do, marginal utility is positive

Diminishing Marginal Utility If more consumption leads to higher utility, marginal utility is positive. –However, total utility will not increase at the same rate, and marginal utility starts to diminish Example: you’re very hungry and begin to eat –Pie slice #1 gives +20 to utility –Pie slice #2 gives +14 to utility –Pie slice #3 gives +6 to utility At this point: –Total utility = 40 –The marginal utility of the third slice was six utils

Diminishing Marginal Utility Why does marginal utility diminish? –We still enjoy additional consumption, but we don’t enjoy it as much as the previous units. Notes: –Diminishing MU is not that same as negative MU –Diminishing MU does not necessarily imply negative MU Can marginal utility be negative? –If MU < 0, it means that additional consumption makes you worse off (decreasing total utility) Eat too much and feel sick Exercise to the point of injury

Total and Marginal Utility

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

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 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, MU X will fall!

More Than Two Goods In the consumer optimum, the marginal utility per dollar was equal for both goods. At the last dollar spent, we had This can easily be extended to multiple goods:

Optimization in Real Life In real life, does it always work with perfect exact equality? –Maybe not, since the MU and prices may not work out exactly. –Depends on whether we’re able to buy and consume fractions of goods –However, we can still spend each dollar optimally at the margin where it gives us the most marginal utility –We’ll get as close to exact equality as possible

Price Changes Your individual consumption won’t affect prices, but they can sometimes change exogenously Suppose that you are consuming optimally What happens if Price X increases? We then have

Price Changes In this case, the solution is: –Consume more of Y and less X –Your preferences didn’t change, but X now gives less bang for the buck due to a higher price –Note that overall utility will decrease, since you are unable to purchase as many goods as before Why not just more Y? –If we had already consumed optimally and spent all our budget, we can’t afford more Y –We have to do a trade-off of Y for X

Price Changes Further Analysis When the price of a good changes, our consumption will change due to two factors, the substitution effect and the real-income effect Substitution effect –Occurs when a consumer buys more of a good as a result of a relative price change –We sub in more of the relatively cheaper good, and sub out some of the relatively more expensive goods –Illustrates that the two goods are at least somewhat substitutable in consumption

Price Changes Further Analysis Real-income effect –Occurs when there is a change in purchasing power as the result of a price change of a good –When a good gets cheaper, your dollars can buy more. This is similar to an increase in income. –Assuming normal goods, an increase in income means you’ll buy more goods. This affects both goods, not just the good whose price decreased. –Real-income effect is usually smaller than substitution effect (in terms of how greatly if affects consumption)

Diamond-Water Paradox Paradox? –Water is essential to life, yet cheap –Diamonds are (almost) pragmatically useless, yet expensive What’s wrong? –Unfair comparison between MU of diamonds and MU of water. We consume a large amount of water, so MU water is smaller. –Recall that MU is captured in the law of demand, and therefore by the price –However, TOTAL utility from water consumption is much greater than TU of diamond consumption!

Diamond-Water Paradox Uses of water –Cooking, drinking, bathing  high value –Watering lawns, washing cars  low value Prices –In most places, water is relatively abundant, and therefore cheap –Diamonds are relatively scarce and more expensive –With the high price of diamonds, you will only consume if you expect to get a high amount of marginal utility from the diamond

Water and Diamonds, Graphically

Economics in Super Size Me Total utility of McDonald’s is high because they are everywhere, cheap, and serve millions of people Can there be too much consumption?

Discrete Choice Models There are some goods in which we only purchase one of that good. Thus, diminishing MU may not apply. However, we still try to maximize our utility. Discrete choice model—we buy the one “best” choice out of many alternatives –Airline ticket –House –College education –Spouse!

Conclusion Money doesn’t make people happier, but it can allow them to buy more goods and services –Due to diminishing marginal utility, the amount of happiness gained from additional consumption will get smaller and smaller When maximizing utility, consumers face a budget constraint and must consider income, prices, and marginal utility Exogenous price changes will affect the optimal consumption bundle chosen by individuals

Practice What You Know What is true? A. Marginal utility generally diminishes with additional consumption of a good B. Marginal utility generally becomes negative with additional consumption of a good C. Marginal utility equals total utility D. Individuals avoid consuming goods in which they experience diminishing marginal utility

Practice What You Know Which of the following would most likely illustrate an example of negative marginal utility? A. Studying for another hour B. Sleeping in late on a weekend C. Eating too much food at an all-you-can-eat buffet D. Drinking a second glass of juice with a meal

Practice What You Know If I consume more of good Z, what happens? A. The price of good Z will fall B. The price of good Z will rise C. My marginal utility of good Z will fall D. My marginal utility of good Z will rise

Practice What You Know Suppose that To optimize utility, the consumer should: A. Buy more X B. Buy less X C. Buy more X and less Y D. Buy more Y and less X

Practice What You Know If the price of a good rises, consumers tend to purchase less of that good and instead purchase more of another good. This illustrates: A. The real-income effect B. The substitution effect C. Diminishing marginal utility D. The disadvantage of using “utils” to measure consumption