7 Consumer Behavior and Utility Maximization Click to Link to Appendix 7: Indifference Curve Analysis

Chapter Objectives Total Utility, Marginal Utility, and the Law of Diminishing Marginal Utility How Rational Consumers Compare Marginal Utility-to-Price Ratios for Products in Purchasing Combinations to Maximize Total Utility How to Derive the Demand Curve by Observing Behavior How the Utility-Maximization Model Highlights Income and Substitution Effects of a Price Change Budget Lines, Indifference Curves, Utility Maximization, and Demand Derivation in the Indifference Curve Model of Consumer Behavior

Law of Diminishing Marginal Utility Terminology Utility Total Utility Marginal Utility Marginal Utility and Demand Graphically… O 7.1 G 7.1

Law of Diminishing Marginal Utility Total Utility 10 20 30 8 6 4 2 -2 1 3 5 7 Total Utility (Utils) Marginal Utility (Utils) (1) Tacos Consumed Per Meal (2) Total Utility, Utils (3) Marginal Utility, Utils TR 1 2 3 4 5 6 7 10 18 24 28 30 ] 10 8 6 4 2 -2 Units Consumed Per Meal Marginal Utility MU Units Consumed Per Meal

Theory of Consumer Behavior Consumer Choice and Budget Constraint Rational Behavior Preferences Budget Constraint Prices Utility Maximizing Rule Allocate Money Income so that Last Dollar Spent on Each Product Yields the Same Marginal Utility

Theory of Consumer Behavior Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (2) Product A: Price = $1 (3) Product B: Price = $2 (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, Utils (1) Unit of Product First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 24 20 18 16 12 10 8 7 6 5 4 3 12 9 2 Compare Marginal Utilities Then Compare Per Dollar - MU/Price Choose the Highest Check Budget - Proceed to Next Item

Theory of Consumer Behavior Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (2) Product A: Price = $1 (3) Product B: Price = $2 (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, Utils (1) Unit of Product First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 24 20 18 16 12 10 8 7 6 5 4 3 12 9 2 Again, Compare Per Dollar - MU/Price Choose the Highest Buy One of Each – Budget Has $5 Left Proceed to Next Item

Theory of Consumer Behavior Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (2) Product A: Price = $1 (3) Product B: Price = $2 (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, Utils (1) Unit of Product First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 24 20 18 16 12 10 8 7 6 5 4 3 12 9 2 Again, Compare Per Dollar - MU/Price Buy One More B – Budget Has $3 Left Proceed to Next Item

Theory of Consumer Behavior Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (2) Product A: Price = $1 (3) Product B: Price = $2 (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, Utils (1) Unit of Product First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 24 20 18 16 12 10 8 7 6 5 4 3 12 9 2 Again, Compare Per Dollar - MU/Price Buy One of Each – Budget Exhausted

Theory of Consumer Behavior Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (2) Product A: Price = $1 (3) Product B: Price = $2 (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, Utils (1) Unit of Product First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 24 20 18 16 12 10 8 7 6 5 4 3 12 9 2 Final Result – At These Prices, Purchase 2 of Item A and 4 of B W 7.1

Theory of Consumer Behavior Algebraic Restatement: MU of Product A Price of A MU of Product B Price of B = 8 Utils $1 16 Utils $2 = Optimum Achieved - Money Income is Allocated so that the Last Dollar Spent on Each Product Yields the Same Extra or Marginal Utility

Deriving the Demand Curve Same Numeric Example: Price of Product B 1 2 4 6 Quantity Demanded of B Price Per Unit of B Quantity Demanded $2 4 1 6 Income Effects Substitution Effects DB O 7.2

Applications and Extensions DVDs and DVD Players The Diamond-Water Paradox The Value of Time Medical Care Purchases Cash and Noncash Gifts O 7.3

Criminal Behavior Last Word Economic Analysis Offers Insights Into Property Crimes Such as Robbery, Burglary, and Auto Theft Theory of a Rational Consumer Buy Versus Steal Decision Compare Marginal Utility of Item Versus Costs – Guilt, Fines, or Prison Time Crime May Be Reduced by “Increasing” the “Price of Crime”

Key Terms law of diminishing marginal utility utility total utility rational behavior budget constraint utility-maximizing rule income effect substitution effect

The Costs of Production Next Chapter Preview… Chapter 8 Click to Link to Appendix 7: Indifference Curve Analysis

Indifference Curve Analysis Budget Line (Constraint) Income Changes Price Changes Appendix 2 4 6 8 10 12 Quantity of A Quantity of B Income = $12 PA = $1.50 Units of A (Price = $1.50) Units of B (Price = $1) Total Expenditure 8 6 4 2 3 6 9 12 $12 12 (Unattainable) Income = $12 PB = $1 Indifference Curve Analysis Demand Curve Appendix Terms (Attainable) Return to Chapter 7

Indifference Curve Analysis What is Preferred Downsloping Convex to Origin Marginal Rate of Substitution (MRS) Appendix 2 4 6 8 10 12 Quantity of A Quantity of B j Combination Units of A Units of B j k l m 12 6 4 3 2 4 6 8 k l m Indifference Curve Analysis Demand Curve Appendix Terms I O 7.4 Return to Chapter 7

Indifference Curve Analysis The Indifference Map Equilibrium Position at Tangency Appendix 2 4 6 8 10 12 Quantity of A Quantity of B MRS = PB PA Preferred – But Requires More Income W X Indifference Curve Analysis Demand Curve Appendix Terms I4 I3 I2 I1 Return to Chapter 7

Derivation of the Demand Curve Measurement of Utility Appendix X 2 4 6 8 10 12 Quantity of A Quantity of B I2 I3 Marginal Utility of A of B Price of A Price of B = At $1 Price for B, 6 Units are Purchased Record the Results As Price of B Increases to $1.50, Only 3 Units of B are Bought Connect the Points to Create the Demand Curve Price of B $1.50 1.00 .50 1 2 3 4 5 6 7 8 9 10 11 12 Quantity of B Indifference Curve Analysis Demand Curve Appendix Terms DB Return to Chapter 7

marginal rate of substitution (MRS) indifference map Appendix Key Terms budget line indifference curve marginal rate of substitution (MRS) indifference map equilibrium position Appendix Indifference Curve Analysis Demand Curve Appendix Terms Return to Chapter 7

The Costs of Production Next Chapter Preview… Chapter 8 Indifference Curve Analysis Demand Curve Appendix Terms Return to Chapter 7