Consumer Theory: Summarized

1
Consumer Theory Summarized

• People buy what they want with what they have.
• People make decisions according to the dictates
  of cost-benefit analysis where the cost of buying
  a product is its price and the benefit is the
  utility a person derives from the products
  consumption.

2
Utility

• Utility - a measure of the satisfaction
  (happiness, benefit) that results from the
  consumption of a good.
• Total Utility- The total satisfaction a person
  receives from consuming a product.
• Marginal Utility- The utility a person receives
  from consuming an additional unit of a good.

3
The Laws of Gossen

• Hermann Gossen (1810-1858)
• Development of the Laws of Human Relationships,
  1854
• Gossens First Law The principle of diminishing
  marginal utility.
• The Law of Diminishing Marginal Utility - The
  marginal utility gained by consuming equal
  successive units of a good will decline as the
  amount consumed increases.
• Gossens Second Law Consumers will maximize
  their total utility by purchasing so that the
  last unit of money spend for any one good gives
  the same marginal utility as the last unit spent
  for any other. MU1/P1 MU2/P2 .........
  MUn/Pn

4
Marginal Utility and the Law of Demand

• What happens as price of a good rises?
• The amount of utility received per dollar spent
  declines, therefore people reduce their
  consumption of the good and consumes more of
  other commodities.

5
The Diamond-Water Paradox

• Adam Smith noted that diamonds, who have little
  value in use, had a greater value than water, an
  element that is essential to life. Why should
  values not correspond to usefulness?
• Although water provides more total utility than
  diamonds, it is marginal utility that dictates
  value.
• Why do diamonds have greater marginal utility
  than water? Because diamonds are relatively
  scarce.

6
The Distribution of Income and Interpersonal
Utility Comparisons

• Jeremy Bentham (1748-1832) and the utilitarians
• Bentham offered the following argument for an
  equal distribution of income
• The diminishing marginal utility of income
  suggests that an equal distribution of income
  would maximize social welfare.
• Problems (from Bentham)
• Equality diminishes incentives, thus diminishing
  long-run social welfare.
• Hence the distribution of income should be more
  equal, but not perfectly equal.
• 2. Interpersonal utility comparison - comparing
  the utility one person receives from a good with
  the utility another person receives from the same
  good.
• We cannot empirically measure utility. As a
  person accumulates more income we can expect
  marginal utility of each dollar to decline.
  However, we do not know the starting point. So
  it may not be the case that the marginal utility
  of an additional dollar for a rich person is
  necessarily lower than the marginal utility of an
  additional dollar for a poor person.

7
Why do individuals and nations trade?

• Each time a trade takes place, an apparent
  contradiction is expressed.
• The buyer says the good is worth more than the
  money spent. The sellers says the money paid is
  worth more than the good.
• How can this be explained? Diminishing Marginal
  Utility
• Be able to explain this argument.

8
Consumer Theory Summarized

• Consumer theory gives us the theoretical
  foundation for the demand curve, which is
  critical to our understanding of the firm.
• Consumer theory allows us to see why individuals
  and nations trade.
• Consumer theory solves the diamond-water paradox.