Ch 20

1
Ch 20

• Consumer Choice
• Why we buy what we buy?

2
Things to understand

• Utility, Marginal Utility (MU), Total Utility
  (TU)
• Law of Diminishing Marginal Utility
• Utility Maximization rule
• How utility-maximizing consumers decide what m
  mix of goods to buy given their budget constraint
• Income Substitution effects of a price change
• Consistency between Law of Demand and consumer
  choices

3
Key words

• Utility
• Happiness, satisfaction, main goal in life of
  individuals
• In general, people want to get as much utility as
  possible within their constraints of limited
  resources (i.e. utility maximization)

4
Marginal Utility (MU)

• The change in total utility from consuming or
  having one more unit of product or service

5
Law of Diminishing MU

• You receive utility from consuming one unit of a
  good.
• If you consume a second unit your total utility
  rises, but it rises by a smaller amount than it
  did for the first unit consumed.
• Imagine that you are eating cookies.
• Utility rises by smaller and smaller increments
  as you consume additional units of a product.

6
Measuring Utility

• Util A standard unit or measure of utility
• In reality we cannot measure utility across
  individuals
• We can ask one individual to compare his/her
  utility from consuming goods

7
Hansons Total Marginal Utility from eating
cookies
8
Graph of Hansons TU MU
9
Meet an imaginary friend, Jo

• Jo lives in a small town with only 3 restaurants
  McDonalds, Sams Steakhouse, and Spaghetti
  Heaven.
• The closest restaurant outside her town is 2
  hours away.
• Someone give Jo 90 to spend going out to eat
  over the next 2 weeks.
• What mix of meals will Jo purchase?

10
Jos MU from consuming steak,Big Mac, and
spaghetti
11
Jos MU and MU/P from consuming steak, Big Mac,
and spaghetti
12
Now Jo must decide what mix of meals to purchase
with 90

• Goal is maximum utility
• Goal is NOT
• Maximum quantity consumed
• Buying only most preferred products
• Spending guideline for gaining maximum utility
• Spend each additional on good with highest
  available MU/P

13
How will Jo spend 90? What meal will she buy
1st, 2nd, 3rd, etc?
14
Jos utility maximizing purchases-Total utility
gained 146 utils
15
Jos utility maximizing bundle

• 6 Big Mac meals
• 3 steak meals
• 1 spaghetti meal
• No other combination that could be purchased for
  90 or less would give Jo more than 146 extra
  units of utility
• A different consumer would have a different MU
  schedule and might make different utility
  maximizing decisions.

16
What would happen to Jos choices if the price of
the steak dinner increased to 30?Jo would buy
less steak and more spaghetti.
17
Law of Diminishing Marginal Utility

• For each additional unit consumed, MU decreases
• As you consumer additional units, total utility
  rises by smaller and smaller increments
• For some products, MU may become negative at high
  consumption levels (think food)
• Marginal Utility is zero when total utility is
  maximum

18
Utility Maximization Rule

• Spend each additional dollar where that dollar
  will yield the highest additional marginal
  utility.
• Result is that the last dollar spent on each good
  yields equal marginal utility (or tends toward
  equality when goods are lumpy)

19
Revisiting Law of Demand

• A rational person will not pay more for a product
  than the value of the utility expected from
  consuming the product.
• Recall Law of diminishing marginal utility
• Each additional unit consumed brings increases
  satisfaction by a smaller increment than prior
  unit consumed
• If less satisfaction is received from an
  additional unit, a rational person would not be
  willing to pay as much for a second unit as a
  first unit
• Thus the price would need to be lower before
  consumers would be willing to purchase additional
  units of a good The law of demand.

20
Revisiting Law of Demand

• Income Effect
• Price goes up purchasing power goes down
  quantity demand falls
• Substitution Effect
• When the price of chicken increases, its
  substitute (beef) becomes relatively less
  expensive. It lessens the impact which the price
  increase has on our overall purchasing power.