Nature and Function of Product Markets

1. Nature and Function of Product Markets Section B: Theory of Consumer Choice

2. Utility • Utility means satisfaction or happiness • It is the satisfaction gained from consuming a good or service • Total utility is all the satisfaction you receive from consuming all units of a good or service • Marginal utility is the additional satisfaction you receive from consuming 1 more unit of a good or service

3. Example • John likes to eat pizza • He orders a large pepperoni pizza • The first slice he eats gives him a utility of 10 • This is the best since he is very hungry and it tastes great • The second slice is really good as well but it only gives him a satisfaction of 9 (marginal utility is 9) • Why did it give him less satisfaction than the first slice? • He had satisfied part of his hunger with the first slice • His total utility is now 19 (10+9)

4. Example 2 Alice drinks coffee. Below is a table showing how much utility she gets from each cup of coffee she drinks

5. How much should you consume? • Consumers will consume until the marginal utility they receive begins to decline • Example: Alice had a positive marginal utility until her 5th cup of coffee. • Marginal utility was -5 at the 5th cup • Alice should drink 4 cups and stop • This is where total utility is maximized

6. Why does utility begin to decline? • As people consume more, they get less utility from each unit • Total will continue to increase but in smaller amounts • Look at Alice again…

7. Her total utility is increasing through the 4th cup but • The 2nd cup did not give as much marginal utility as the first • The 3rd cup did not give as much marginal utility as the 2nd • The 4th cup did not give as much marginal utility as the 3rd

8. Alice is adding to her total as she consumes more but gets less satisfaction each time • This is the Law of Diminishing Marginal Utility • In a given time period, the marginal utility from consumption will increase at an increasing rate, then increase at a decreasing rate and then will begin to decline • This last stage is when total begins to decline

9. Constrained Utility Maximization • When consumers must pay for their goods and services, utility is constrained by their income • The marginal utility of the good must be greater than or equal to the price of the good

10. Constrained Utility – Two Goods • What if the consumer is choosing between 2 goods? • Each good will be purchased up to the point where the last dollar they spent on it is equal to the price • With 2 goods the MU per last dollar must be equal • Formula: MUx/Px = MUy/Py

11. Example • Alice has income of $15 per day to spend on coffee and pumpkin bread • Coffee is $4 per cup and pumpkin bread is $2 per slice If she buys 2 cups of coffee she will get a MU/$ of 3 and If she buys 3 slices of bread she will get MU/$ of 3 This way she spends all her income and her MU/$ is equal

12. Demand Curves • Utility creates individual demand curves • Shows how much people will purchase at each price based on utility maximization • Market demand curves are the sum of all consumer demand curves As utility from each unit declines, consumers are not willing to pay as much for the good – Law of Demand

13. Practice 1 • The most probable reason Sam drinks two cups of coffee at breakfast instead of four is that • The marginal utility of the coffee eventually diminishes • Most people can’t afford four cups of coffee • The total utility of coffee increases as one consumes more • The price of coffee increases as one buys more • The marginal satisfaction derived from cups of coffee remains constant

14. Practice 2 • Suppose Jones could increase his total utility from consuming cookies and ice cream bars by consuming one more ice cream bar and one fewer cookie. Which of the following is true? • The marginal utility of cookies exceeds the marginal utility of ice cream bars • The marginal utility of ice cream bars exceeds the marginal utility of cookies • The marginal utility of cookies is negative • The marginal utility per dollar spent on ice cream bars exceeds that of cookies • Jones’s total utility is at a maximum

15. Practice 3 • Ms. Johnson spends her entire daily budget on cookies at $1 each and milk cups at $2 each. At her current consumption, the marginal utility of cookies is 12 and the marginal utility of milk is 30. Ms. Johnson should • Do nothing; she is consuming her utility maximizing combination of cookies and chips • Increase her consumption of cookies until the marginal utility of cookies is equal to 30 • Decrease her consumption of cookies until the marginal utility of cookies equals 30 • Decrease her consumption of cookies and increase her consumption of milk until the marginal utility per dollar is equal for both goods • Increase her consumption of cookies and increase her consumption of milk until the marginal utility per dollar is equal for both goods

16. Practice 4 • The price of steak is $7 per pound, and the price of chicken is $2 per pound. • Your mother currently receives a marginal utility of 14 from consuming steak this week and 6 from consuming chicken this week. • The marginal utility of chicken is therefore less than that of steak. • Does this imply that your mother should buy less chicken this week? Explain.

17. Practice 5 • If, when you consume another piece of candy, your marginal utility is zero, then A) you should consume less candy. B) you want more candy. C) you have maximized your total utility from consuming candy. D) you have not yet reached the point of diminishing marginal utility.