Consumer Behavior and Utility MaximizationHOW CONSUMERS MAKE CHOICES UNDER INCOME CONSTRAINTS UTILITY MAXIMIZATION

IntroductionThe CONSUMER is essential to the arket. Understanding how the consumer makes his/her purchasing decisions is key.

Utility The value a consumer places on a unit of a good or service depends on the pleasure or satisfaction he or she expects to derive form having or consuming it at the point of making a consumption (consumer) choice.

In economics the satisfaction or pleasure consumers derive from the consumption of consumer goods is called utility.

Within the limits of Consumers incomes, consumers make their consumption choices by evaluating and comparing consumer goods with regard to their utilities.

1. Understanding UtilityUtility = 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 situationsie. A blanket to a person living in Arizona vs. a person living in Minnesota.Measured in utils (a personal measure)

1. Understanding UtilityTotal 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

Total utility = Sum of marginal utilities

Total and Marginal Utility for Ice Cream

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Q($) TU($) MU

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14040

28545

312035

414020

515010

61577

71603

81600

9155-5

10145-10

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40

85

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Total Utility

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14040

28545

312035

414020

515010

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71603

81600

9155-5

10145-10

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Total Utility

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($) MU

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20

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7

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-10

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14040

28545

312035

414020

515010

61577

71603

81600

9155-5

10145-10

145

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Total Utility

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($) MU

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Q($) TU($) MU

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14040

28545

312035

414020

515010

61577

71603

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9155-5

10145-10

145

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Total Utility

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($) MU

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Diminishing of Marginal UtilityExplains 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

law of diminishing marginal utility - marginal utility declines as more of a particular good is consumed in a given time period, ceteris paribuseven though marginal utility declines, total utility still increases as long as marginal utility is positive. Total utility will decline only if marginal utility is negativeLaw of Diminishing Marginal Utility

Law of Diminishing Marginal Utility(1)TacosConsumedPer Meal(2)TotalUtility,Utils(3)MarginalUtility,Utils012345670101824283030281086420-2TUMUTotal UtilityMarginal UtilityUnits Consumed Per MealUnits Consumed Per Meal

Marginal utility

Utility Maximizing Rules

How much ice cream does Jill buy in a month? Buying ice cream leaves Jill less money to buy other things: each dollar spent on ice cream could be spent on hamburger for ex. In fact, consumers compare the (expected) utility derived from one additional dollar spent on one good to the utility derived from one additional dollar spent on another good. Jill, like any other rational consumer, wishes to maximize her utility. The opportunity cost of one dollar spent on ice cream is the forgone utility of one dollar that could be on hamburger..

Utility Maximizing Rules A rational consumer would buy an additional unit of a good as long as the perceived dollar value of the utility of one additional unit of that good (say, its marginal dollar utility) is greater than its market price. The Two-Good Rule MUI MUH --------- = ---------- $PI $PH

Optimal Purchase Mix: Ice Cream and Hamburger

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Q($) TU($) MU

00

14040

28545

312035

414020

515010

61577

71603

81600

9155-5

10145-10

145

QMUIPIMUI/PIMUHPHMUH/PH

1401044567.5

245104.53065

335103.52063.3

4201021562.5

5101011061.7

67100.7661

73100.3360.5

80100060

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Total Utility

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($) MU

Sheet3

Utility Maximization under An Income constraint Consumers spending on consumer goods is constrained by their incomes:Income = Px Qx + Py Qy + Pw Ow + .+Pz Qz While the consumer tries to equalize MUx/Px , MUy/ Py, MUw/Pw,. and MUz/Pz , to maximize her utility her total spending cannot exceed her income. For example, with an and income of $86 Jill is trying to decide how much ice cream and how much hamburger she should buy. Jills income = 5x10 + 6 x 6 = 86

The Budget Line Income = QI.PI + QH.PH = (5 x 10)+(6 x 6) = 86 Ice CreamHamburger o8.614.335686/1086/6Slope = PH/PI = 6/10 = 8.6/14.33 = 0.6

Consumer equilibrium 1.2. All income is spent.The first condition listed above is sometimes referred to as the "equimarginal principle."

Theory of Consumer BehaviorNumerical Example:Find the Utility-Maximizing Combination of A and B, if you have an Income of $10(1)Unit ofProduct

Theory of Consumer BehaviorNumerical Example:Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10(1)Unit ofProductCompare Marginal UtilitiesThen Compare Per Dollar - MU/PriceChoose the HighestCheck Budget - Proceed to Next Item

Theory of Consumer BehaviorNumerical Example:Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10(1)Unit ofProductAgain, Compare Per Dollar - MU/PriceChoose the HighestBuy One of Each Budget Has $5 LeftProceed to Next Item

Theory of Consumer BehaviorNumerical Example:Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10(1)Unit ofProductAgain, Compare Per Dollar - MU/PriceBuy One More B Budget Has $3 LeftProceed to Next Item

Theory of Consumer BehaviorNumerical Example:Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10(1)Unit ofProductAgain, Compare Per Dollar - MU/PriceBuy One of Each Budget Exhausted

Theory of Consumer BehaviorNumerical Example:Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10(1)Unit ofProductFinal Result At These Prices, Purchase 2 of Item A and 4 of B

Theory of Consumer BehaviorAlgebraic Restatement:==Optimum Achieved - Money Income is Allocated so that the Last Dollar Spent on Each Good Yields the Same Extra or Marginal Utility

From Utils to BenefitBecause 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 consumers WILLINGNESS TO PAY.

Total Benefit ($), Marginal Benefit ($)

Golden Rule of Consumption

ASSIGMENT Two-Good Practice ProblemGiven MU, and an income/budget constraint of $20 find the Utility-Maximizing Combination of A and B

UnitMUMu/pUnitMUMu/p120101306210522043633153431.5451510.55-51-

Given TU, and an income/budget constraint of $9 find the Utility-Maximizing Combination of A and BTwo-Good Practice Problem

UnitTUMUMU/PUnitTUMUMU/P122-110-232105216633408432042446634222154884520-2-1

The Problem with UtilsAnswer 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 barHow many candy bars should Henry consume if each candy bar Is absolutely free (MC = 0)Costs $2Costs $4

Review Questions UtilityWhat is the marginal utility of the third cup of peanuts Brian consumes?A.3 units of utilityB.9 units of utilityC.12 units of utilityD.2 units of utilityE.14 units of utility

Review Questions UtilityIf 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 utilityB.1 cup of peanuts because the price of peanuts is lowerC.1 cup of peanuts, because the marginal utility per dollar for peanuts is lower than the marginal utility per dollar of jelly beansD.1 cup of jelly beans, because the marginal utility per dollar for jelly beans is higher than the marginal utility per dollar of peanutsE.1 cup of jelly beans, because jelly beans produce a higher total utility

Review Questions UtilityIf 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 whereA.the MU of hamburgers equals the MU of hot dogsB.the MU equals the TU of hamburgers, and the MU equals the TU of hot dogsC.the TU of hamburgers equals the TU of hot dogsD.the MU / P of hamburgers equals the MU / P of hot dogsE.the TU / P of hamburgers equals the TU / P of hot dogs

Review Questions UtilityEvery day Molly spends her lunch money consuming apples, at $1 each, and oranges, at $2 each. At her current level of consumption, mollys 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.

Review Questions UtilityIf generic peanut butter is an inferior good, a decline in consumer income causesA.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.