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Transcript of Copyright 2008 The McGraw-Hill Companies 19 Consumer Behavior and Utility Maximization Click to Link...
Copyright 2008 The McGraw-Hill Companies
19Consumer Behavior and Utility Maximization
Click to Link to Appendix 19: Indifference Curve Analysis
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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
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What is Utility?
• The satisfaction or enjoyment a person obtains from consuming a good
O 19.1
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What is a Util?
• A hypothetical unit used to measure how much utility a person obtains from consuming a good
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What isMarginal Utility?
• The change in total utility a person derives from consuming an additional unit of a good
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What is Total Utility?
• The total number of utils a person derives from consuming a specific quantity of a good
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• Note that:
• MU = ΔTU/ ΔQ, that is marginal utility equals the change in total utility divided by the change in quantity of the good.
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TU and MU
• Q TU MU• 0 0• 1 10 10• 2 18 8• 3 24 6• 4 28 4• 5 30 2• 6 30 0• 7 28 -2
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What is the Law of Diminishing Marginal Utility?
• As more of a good is consumed, at some point, the marginal utility a person derives from each additional unit diminishes
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Does the Law of Diminishing Marginal Utility apply to all goods consumed?
• YES, WITHIN A FIXED TIME PERIOD
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Law of Diminishing Marginal Utility
0
10
20
30
1086420
-2
1 2 3 4 5 6 7
1 2 3 4 5 6 7
To
tal U
tilit
y (U
tils
)M
arg
inal
Uti
lity
(Uti
ls)
(1)Tacos
ConsumedPer Meal
(2)Total
Utility,Utils
(3)MarginalUtility,Utils
0
1
2
3
4
5
6
7
0
10
18
24
28
30
30
28
]]]]]]]
10
8
6
4
2
0
-2
TR
MU
Total Utility
Marginal Utility
Units Consumed Per Meal
Units Consumed Per Meal
G 19.1
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P1
Q1
P2
Q2
12
D
Recall a Demand CurvePrice
QUANTITY
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• What does marginal utility have to do with the demand curve? We can use the law of diminishing MU as another explanation for the law of demand.
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• In consuming a product, how many units In consuming a product, how many units of the product will you buy?of the product will you buy?
Consume to the point where MU = P: why? Logically, as long as the MU exceeds the price you have to pay, you will continue to consume, but if the MU is less than the price, you will not consume.
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P1
P2
Q1 Q215
MU
At P1, consume to Q1, since MU > P up to that point, at P2, consume to Q2, etc.
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Consumer equilibrium
• Now go from 1 good to 2 or more goods: have to take prices of good into account
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Consumer equilibrium condition
• Purchase X and Y in amounts such that
• MU x = MU y
• P x P y
Why?
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Assume you are not in equilibrium… say that
MU x > MU y
P x P y
What would you do??
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Purchase more of X (due to its greater satisfaction per dollar), and less of Y
But more of X reduces MUX and less of Y increases MUY so we are heading back to equilibrium!!
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For more than 2 goods, the equilibrium condition becomes…..
• MUx/Px = Muy/Py =
• Muz/Pz = …….for all goods
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Theory of Consumer Behavior• Utility Maximizing Rule
–Allocate Money Income so that Last Dollar Spent on Each Product Yields the Same Marginal Utility
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Theory of Consumer BehaviorNumerical Example:Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10
(1)Unit of
Product
(a)MarginalUtility,Utils
(a)MarginalUtility,Utils
(b)Marginal
UtilityPer Dollar(MU/Price)
(b)Marginal
UtilityPer Dollar(MU/Price)
(2)Product A:Price = $1
(3)Product B:Price = $2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Compare Marginal UtilitiesThen Compare Per Dollar - MU/PriceChoose the HighestCheck Budget - Proceed to Next Item
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Theory of Consumer BehaviorNumerical Example:Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10
(1)Unit of
Product
(a)MarginalUtility,Utils
(a)MarginalUtility,Utils
(b)Marginal
UtilityPer Dollar(MU/Price)
(b)Marginal
UtilityPer Dollar(MU/Price)
(2)Product A:Price = $1
(3)Product B:Price = $2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Again, Compare Per Dollar - MU/PriceChoose the HighestBuy One of Each – Budget Has $5 LeftProceed to Next Item
Copyright 2008 The McGraw-Hill Companies
Theory of Consumer BehaviorNumerical Example:Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10
(1)Unit of
Product
(a)MarginalUtility,Utils
(a)MarginalUtility,Utils
(b)Marginal
UtilityPer Dollar(MU/Price)
(b)Marginal
UtilityPer Dollar(MU/Price)
(2)Product A:Price = $1
(3)Product B:Price = $2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Again, Compare Per Dollar - MU/PriceBuy One More B – Budget Has $3 LeftProceed to Next Item
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Theory of Consumer BehaviorNumerical Example:Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10
(1)Unit of
Product
(a)MarginalUtility,Utils
(a)MarginalUtility,Utils
(b)Marginal
UtilityPer Dollar(MU/Price)
(b)Marginal
UtilityPer Dollar(MU/Price)
(2)Product A:Price = $1
(3)Product B:Price = $2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Again, Compare Per Dollar - MU/PriceBuy One of Each – Budget Exhausted
Copyright 2008 The McGraw-Hill Companies
Theory of Consumer BehaviorNumerical Example:Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10
(1)Unit of
Product
(a)MarginalUtility,Utils
(a)MarginalUtility,Utils
(b)Marginal
UtilityPer Dollar(MU/Price)
(b)Marginal
UtilityPer Dollar(MU/Price)
(2)Product A:Price = $1
(3)Product B:Price = $2
First
Second
Third
Fourth
Fifth
Sixth
Seventh
10
8
7
6
5
4
3
24
20
18
16
12
6
4
10
8
7
6
5
4
3
12
10
9
8
6
3
2
Final Result – At These Prices, Purchase 2 of Item A and 4 of B W 19.1
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Theory of Consumer BehaviorAlgebraic 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
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Pri
ce
of
Pro
du
ct
B
0
1
2
4 6
Quantity Demanded of B
Deriving the Demand CurveSame Numeric Example:
$2
1
4
6
Price Per Unit of B
QuantityDemanded
DBIncome Effects
Substitution EffectsO 19.2
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Applications and Extensions
• DVDs and DVD Players
• The Diamond-Water
Paradox
• The Value of Time
• Medical Care Purchases
• Cash and Noncash Gifts
O 19.3
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Applications of Utility
• The water-diamond paradox--why is water so cheap and diamonds so expensive?
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Water-high TU but low MU due to abundance, diamonds the
opposite-Price reflects marginal valuation, not totals
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The marginal utility of money?
•Does it diminish as with goods?
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Diminishing MU of money often used as an argument for
progressive taxation.
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What is Interpersonal comparison of utility?
• A comparison of the marginal utility that different people derive from a good or a dollar
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Economists argue that we should avoid such interpersonal utility
comparisons
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Criminal Behavior
• 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”
Last
Word
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Key Terms• law of diminishing marginal utility• utility• total utility• marginal utility• rational behavior• budget constraint• utility-maximizing rule• income effect• substitution effect