Consumer Behavior and Utility Maximization 19 C H A P T E R

Chapter 19. Consumer Choice Utility Consumer surplus Budget Constraints Indifference Curves Utility Consumer surplus Budget Constraints Indifference Curves

Biscuits

Choclate

I. Utility Analysis what is utility?  benefit you get from consuming a good  determined by your tastes/preferences (assume these are stable) what is utility?  benefit you get from consuming a good  determined by your tastes/preferences (assume these are stable)

total utility (TU) total benefit from consuming good example  total benefit from 3 cookies total benefit from consuming good example  total benefit from 3 cookies

TU increases as consumption increases, to a point < TU 2 cookies TU 3 cookies

marginal utility (MU) change in TU from consuming one more of a good example  how much MORE utility from an additional pack of gum? change in TU from consuming one more of a good example  how much MORE utility from an additional pack of gum?

change in TU from 0 to 1 cookie change in TU from 1 cookie to 2 cookies MU of 1 st cookie MU of 2 nd cookie = = 0

diminishing marginal utility MU falls as consumption rises get sick of cookies MU falls as consumption rises get sick of cookies

MU of 1 st cookie > MU of 2 nd cookie 0

TU cookie TU rises at slower and slower rate as MU declines MU cookie

How to maximize TU? use available budget equalize MU/$ across goods Huh? use available budget equalize MU/$ across goods Huh?

chose combination of cookies and milk where price of cookiesprice of milk MU cookies = MU milk

why?why? chose combo of 6 cookies, 1 milk suppose MU/$1 of cookies = 4, MU/$1 of milk = 15 by consuming fewer cookies, more milk… I would add more to my TU chose combo of 6 cookies, 1 milk suppose MU/$1 of cookies = 4, MU/$1 of milk = 15 by consuming fewer cookies, more milk… I would add more to my TU

TU vs. MU Diamond-Water paradox $10,000  one carat diamond  5 million gallons of tap water Diamond-Water paradox $10,000  one carat diamond  5 million gallons of tap water

why?why? TU of water is greater than TU of diamonds  water is essential for life BUT water is abundant, diamonds are rarer  MU of last diamond is higher MU determines value TU of water is greater than TU of diamonds  water is essential for life BUT water is abundant, diamonds are rarer  MU of last diamond is higher MU determines value

MU and demand MU declines as consumption rises willing to pay less for each additional unit  downward sloping demand MU declines as consumption rises willing to pay less for each additional unit  downward sloping demand

example : pizza P Q D $10 4 pizzas for 4th pizza willing to pay $10 for 2nd pizza $15 2 pizza willing to pay $15

II. Consumer Surplus difference between what you pay for a good, any what you are WILLING to pay for a good difference between what you pay for a good, any what you are WILLING to pay for a good

exampleexample market price pizza = $10 my marginal value of 3rd pizza this week = $12 my consumer surplus = $2 market price pizza = $10 my marginal value of 3rd pizza this week = $12 my consumer surplus = $2

P Q D $10 my demand curve $12 3 my consumer surplus

P Q D $10 10,000 total consumer surplus area between D and price of pizza

III. The Budget Line given:  consumer’s budget  prices draw a line representing choices consumption possibilities given:  consumer’s budget  prices draw a line representing choices consumption possibilities

exampleexample 2 goods: milk & cookies bottle of milk = $1 cookie = $.50 daily budget = $4 2 goods: milk & cookies bottle of milk = $1 cookie = $.50 daily budget = $4

possible combinations cookies milk

budget line milk cookies

budget line milk cookies Affordable Unaffordable

what if prices change? changes slope of budget line suppose cookies = $1 changes slope of budget line suppose cookies = $1

budget line milk cookies cookie = $.50 cookie = $1

what if budget changes budget line shifts suppose budget = $5 budget line shifts suppose budget = $5

milk cookies budget = $4 budget = $

IV. Indifference Curves (appendix) alternative way to show utility curve shows combo of goods that deliver same total utility (appendix) alternative way to show utility curve shows combo of goods that deliver same total utility

example: milk and cookies milk cookies Indifference curve Every point on curve has same total utility

TU is higher as curve shifts right milk cookies higher TU lower TU

consumer equilibrium maximize TU stay on budget maximize TU stay on budget

consumer equilibrium cookies 8 milk best affordable point

consumer equilibrium cookies 8 milk best affordable point

sum it up consumer decisions based on  preferences  budget constraint consumer decisions made at the margin  marginal benefit of one more  compared to price of one more consumer decisions based on  preferences  budget constraint consumer decisions made at the margin  marginal benefit of one more  compared to price of one more

I.Introduction A.We spend Millions of KDs on goods and services each. yet no two consumers spend their incomes in the same way. How can this be explained? B.Why does a consumer buy a particular bundle of goods and services rather than others? Examining these issues will help us understand consumer behavior and the law of demand. 40

II.Two Explanations of the Law of Demand A.Income and substitution effects explain the inverse relationship between price and quantity demanded. 1.The income effect is the impact of a change in price on consumers’ real incomes and on the quantity of that product demanded. An increase in price means that less real income is available to buy subsequent amounts of the product. 41 You have less income to buy same amount of the product as before

2.The substitution effect A higher price for a particular product means that the item has become relatively more expensive compared to its substitutes. (i.e. Tea and Coffee) Therefore, consumers will buy less of this product and more of the substitutes, whose prices are relatively lower than before. 42 other products are cheaper now

Utility Maximization Rule affordable Of all different affordable combinations of goods and services, which combination will yield the maximum satisfaction? 43 Affordable: Px(X) + Py(Y) = I Px/Mux = Py/MUy The consumer will allocate (I) so that the last $ spent on a product = the same amount of MU

First Second Third Fourth Fifth Sixth Seventh $ 10 income UTILITY MAXIMIZING COMBINATION Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) 44

First Second Third Fourth Fifth Sixth Seventh $ 10 income UTILITY MAXIMIZING COMBINATION Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) 45 1 unit of (A) and 2 units of (B) is affordable: 1(1) + 2(2) = 5$ Still $5 left!

First Second Third Fourth Fifth Sixth Seventh $ 10 income UTILITY MAXIMIZING COMBINATION Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) 46 4 of (A) and 5 of (B) 1(4) + 2(5)=$11 Not affordable

First Second Third Fourth Fifth Sixth Seventh $ 10 income UTILITY MAXIMIZING COMBINATION Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) 47 2 of (A) and 4 of (B) 1(2) + 2(4) =$10

3.It is marginal utility per dollar spent that is equalized; that is, consumers compare the extra utility from each product with its cost. 48

An Indifference Curve An indifference curve is a line that shows all the consumption bundles that yield the same amount of total utility for an individual.

An Indifference Curve Map

Properties of Indifference Curves  indifference curves never cross  the farther out an indifference curve is, the higher the total utility it indicates

The tangency condition between the indifference curve and the budget line holds when the indifference curve and the budget line just touch. It determines the optimal consumption bundle. Tangency Condition

Understanding the Relative Price Rule At the optimal consumption bundle: −MU R /MU M = − P R /P M

Differences in Preferences

Even rats can make rational choices! And if rats can make rational choices, so can people! Rats and Rational Choice SCENARIO

1.Refer to the figure below. As described in the textbook, even a rat would not choose: A)point C. B)point A. C)point B. D)either point A or point B. Rats and Rational Choice

1.Refer to the figure below. As described in the textbook, even a rat would not choose: A)point C. B)point A. C)point B. D)either point A or point B. Rats and Rational Choice

2.The difference between BL 1 and BL 2 is likely the result of: A)a change in the consumer’s income. B)a change in the prices of the goods. C)both a and b. D)cannot be determined. Rats and Rational Choice

2.The difference between BL 1 and BL 2 is likely the result of: A)a change in the consumer’s income. B)a change in the prices of the goods. C)both a and b. D)cannot be determined. Rats and Rational Choice

3.Which of the following is the expression for the optimal consumption bundle of two goods, X and Y? A) MU X = P X and MU Y = P Y B) MU X /P Y = MU Y /P X C) MU X /P X = MU Y /P Y D)none of the above Rats and Rational Choice

3.Which of the following is the expression for the optimal consumption bundle of two goods, X and Y? A) MU X = P X and MU Y = P Y B) MUX/PY = MUY/PX C) MUX/PX = MUY/PY D)none of the above