Consumer Behavior and Utility Maximization

1. Consumer Behavior and Utility Maximization AP ECONOMICS – CHAPTER 5

2. 4 Key Concepts • Understanding Utility: Total and Marginal • Utility Maximization: Equalizing Marginal Utility per Dollar (MU/PA = MU/PB) • Individual and Market Demand Curves • Income and Substitution Effects (review from unit two)

3. Introduction • The CONSUMER is essential to the market. Understanding how the consumer makes his/her purchasing decisions is key.

4. 1. Understanding Utility • Utility = Satisfaction/Happiness/Pleasure one gets from consuming a good. • Utility and usefulness are NOT synonymous in economics. • Utility is difficult to quantify, as it differs between people and situations • ie. A blanket to a person living in Arizona vs. a person living in Minnesota. • Measured in “utils” (a personal measure)

5. 1. Understanding Utility • Total Utility (TU) • Total amount of satisfaction or pleasure a person derives from consuming a given quantity of that product • Marginal Utility (MU) • The extra satisfaction a consumer derives from one additional unit of that product. • In other words, the change in Total Utility that results from the consumption of one more unit

6. Law of Diminishing Marginal Utility • Explains that the more of a good a person gets, the less utility he gets from each additional unit. • Consumer wants in general are insatiable, but wants for particular items can be satisfied for a time. • Example: Durable goods such as an automobile

7. First is the Best • It is important to note that your marginal utility begins to fall after the very first unit you consume. • In other words, your very first taco holds great utility. While you may enjoy your second taco, it doesn’t bring as much utility as the first • At some point, your MU becomes negative. (takes away from your total satisfaction).

8. 30 20 Total Utility (Utils) ] ] ] ] ] ] ] 10 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7 10 8 6 Marginal Utility (Utils) 4 2 0 -2 Law of Diminishing Marginal Utility Total Utility (1) Tacos Consumed Per Meal (2) Total Utility, Utils (3) Marginal Utility, Utils TU 0 10 18 24 28 30 30 28 0 1 2 3 4 5 6 7 10 8 6 4 2 0 -2 Units Consumed Per Meal Marginal Utility MU Units Consumed Per Meal

9. 2. Utility Maximization • Explains how consumers allocate their money incomes among the many goods and services available for purchase • You will be faced with problems that provide you with a consumer’s MU or TU derived from purchasing 2 goods. You will be expected to show how many of each a rational consumer would purchase.

10. (3) Product B: Price = $2 (2) Product A: Price = $1 (b) Marginal Utility Per Dollar (MU/Price) (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, Utils (a) Marginal Utility, Utils First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 10 8 7 6 5 4 3 24 20 18 16 12 6 4 12 10 9 8 6 3 2 Theory of Consumer Behavior Numerical Example: Find the Utility-Maximizing Combination of A and B, if you have an Income of $10 (1) Unit of Product

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

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

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

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

15. (3) Product B: Price = $2 (2) Product A: Price = $1 (b) Marginal Utility Per Dollar (MU/Price) (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, Utils (a) Marginal Utility, Utils First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 10 8 7 6 5 4 3 24 20 18 16 12 6 4 12 10 9 8 6 3 2 Theory of Consumer Behavior Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (1) Unit of Product Final Result – At These Prices, Purchase 2 of Item A and4 of B

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

17. (3) Product B: Price = $5 (2) Product A: Price = $2 Two-Good Practice Problem Given MU, and an income/budget constraint of $20… find the Utility-Maximizing Combination of A and B

18. (3) Product B: Price = $1 (2) Product A: Price = $2 Two-Good Practice Problem Given TU, and an income/budget constraint of $9… find the Utility-Maximizing Combination of A and B

19. The Problem with Utils • Answer the following problem: • If Henry derives 5 utils from the 1st candy bar, 3 utils from the 2nd candy bar, 0 utils from the 3rd candy bar, and -5 utils from the 4th candy bar… • How many candy bars should Henry consume if each candy bar … • Is absolutely free (MC = 0) • Costs $2 • Costs $4

20. From ‘Utils’ to ‘Benefit’ • Because Utils cannot be compared between people, and cannot be compared to dollars… economists must measure satisfaction in Benefit. • Benefit is the same concept as utility, but it is measured in dollars (according to the consumer’s WILLINGNESS TO PAY. • Total Benefit ($), Marginal Benefit ($)

21. Golden Rule of Consumption • A rational consumer will continue to purchase until… MB = MC To consume one more would mean your marginal cost is greater than your marginal benefit

22. 3. Individual and Market Demand Curves • Start with an individual consumer • maybe you, maybe me, but could be anyone • Derive demand curve for that individual • focus on marginal utility or marginal benefit • Add up demand curves for many such individuals to get market demand curve

23. General economic principle People make purposeful choices with limited resources When applied to the behavior of consumers People maximize utility subject to a budget constraint Assumption about consumer behavior

24. 3. Individual and Market Demand Curves • Consider all consumers in the market • Add up quantity demanded by all individuals at each price to get market demand • Add horizontally to create market demand curve

26. 4. Substitution and Income Effects • This topic on the AP Course Outline was already covered in unit 2. • To review, just remember that both of these effects help to explain why the demand curve slopes downward.

27. Review Questions – Utility Which of the following factors contributes to a downward-sloping demand curve? I. The income effect II. The substitution effect III. Diminishing marginal utility • A. I only • B. III only • C. I and II only • D. II and III only • E. I, II, and III

28. Review Questions – Utility • What is the marginal utility of the third cup of peanuts Brian consumes? • A. 3 units of utility • B. 9 units of utility • C. 12 units of utility • D. 2 units of utility • E. 14 units of utility

29. Review Questions – Utility If the price of peanuts is $1 per cup and the price of jelly beans is $2 per cup, and Brian wants to maximize his utility, what should he purchase first? • A. 1 cup of peanuts because peanuts produce a lower total utility • B. 1 cup of peanuts because the price of peanuts is lower • C. 1 cup of peanuts, because the marginal utility per dollar for peanuts is lower than the marginal utility per dollar of jelly beans • D. 1 cup of jelly beans, because the marginal utility per dollar for jelly beans is higher than the marginal utility per dollar of peanuts • E. 1 cup of jelly beans, because jelly beans produce a higher total utility

30. Review Questions – Utility If TU = total utility, MU = marginal utility, and P = price, in order to maximize utility, a consumer should purchase the mix of hamburgers and hot dogs where • A. the MU of hamburgers equals the MU of hot dogs • B. the MU equals the TU of hamburgers, and the MU equals the TU of hot dogs • C. the TU of hamburgers equals the TU of hot dogs • D. the MU / P of hamburgers equals the MU / P of hot dogs • E. the TU / P of hamburgers equals the TU / P of hot dogs

31. Review Questions – Utility • If Matt’s total utility from consuming slices of cheese increased at a constant rate, no matter how many bratwurst Matt consumed, what would Matt’s demand curve for slices of cheese look like? • A. Vertical • B. Horizontal • C. Downward sloping • D. Upward sloping • E. First upward, but eventually downward sloping

32. Review Questions – Utility • Every day Molly spends her lunch money consuming apples, at $1 each, and oranges, at $2 each. At her current level of consumption, molly’s marginal utility of apples is 12 and her marginal utility of oranges is 18. If she has already spent all of her lunch money, how should Molly change her consumption decision to maximize utility? • A. She should make no changes; she is consuming the utility maximizing combination of apples and oranges. • B. She should increase her apple consumption and decrease her orange consumption until the marginal utility per dollar is equal for both. • C. She should decrease her apple consumption and increase her orange consumption until the marginal utility per dollar is equal for both. • D. She should increase her apple consumption and decrease her orange consumption until the marginal utility is equal for both. • E. She should decrease her apple consumption and increase her orange consumption until the marginal utility is equal for both.

33. Review Questions – Utility • If generic peanut butter is an inferior good, a decline in consumer income causes • A. the price of generic peanut butter to go down. • B. the demand for name-brand peanut butter to go up. • C. the supply of generic peanut butter to go up. • D. the demand for generic peanut butter to go up. • E. the price of bread to go down.

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

35. 2 Quantity Demanded Price Per Unit of B Price of Product B 1 0 4 6 Quantity Demanded of B Deriving the Demand Curve Same Numeric Example: 4 $2 6 1 Income Effects Substitution Effects DB