Consumer Choice Theory

Overview

• Over the last several weeks, we have taken demand and supply curves as given. We now start examining where demand and supply curves come from. In this section we focus on demand and analyze how consumers make decisions about how much a product to purchase.

• Consumer choice theory predicts that consumers will choose to buy the combination of goods and services that makes them as well off as possible from among all the combinations that their budgets allow them to buy.

Utility and Consumer Decision Making

• Utility: The enjoyment or satisfaction people receive from consuming goods and services.

• Marginal Utility: The change in total utility a person receives from consuming one more unit of a good or service.

• Law of Diminishing Marginal Utility: The principle that people experience diminishing additional satisfaction as they consumer more of a good or service in a given time period.

Total and Marginal Utility

NUMBER OFSLICES OF

PIZZA

TOTAL UTILITYFROM EATING

PIZZA

MARGINAL UTILITY

FROM THELAST SLICE

NUMBER OF CUPS OF

COKE

TOTAL UTILITYFROM

DRINKING COKE

MARGINAL UTILITYFROM THELAST CUP

0 0 -- 0 0 --1 20 20 1 20 202 36 16 2 35 153 46 10 3 45 104 52 6 4 50 55 54 2 5 53 3

6 51 3 6 52 1

Total and Marginal Utility

Maximizing Utility

• Consumer choice theory suggests consumers attempt to maximize their utility subject to their budget.

• A consumers budget places a constraint on how many and how much goods and services they can consume.

• The goal is to maximize utility using the amount of money that is available (i.e. a consumers budget).

Maximizing Utility

• Consumers maximize utility by equating the marginal utility per dollar spent on goods and services.

• To illustrate this, suppose the price of pizza is $2 per slice and the price of coke is $1 per can.

Maximizing Utility

(1)SLICES

OF PIZZA

(2)MARGINAL UTILITY

(MUPIZZA)

(3)MARGINAL

UTILITYPER DOLLAR (4)

CUPSOF COKE

(5)MARGINAL UTILITY

(MUCOKE)

(6)MARGINAL

UTILITYPER DOLLAR

1 20 10 1 20 20

2 16 8 2 15 15

3 10 5 3 10 10

4 6 3 4 5 5

5 2 1 5 3 3

6 3 1.5 6 1

-1

Pizza

Pizza

P

MU

Coke

Coke

P

MU

Maximizing Utility

• We can summarize the rules for maximizing utility as follows:

1. For two goods 1 and 2:

2. Spending on 1 + Spending on 2 = Budget

2

2

1

1

P

MU

P

MU

Where Demand Curves Come From

NUMBEROF

SLICESOF PIZZA

MARGINAL UTILITY

FROM LAST SLICE

(MUPIZZA)

MARGINAL UTILITY PER

DOLLAR

NUMBER OF CUPS

OF COKE

MARGINAL UTILITY

FROM LAST CUP

(MUCOKE)

MARGINAL UTILITY PER

DOLLAR

1 20 13.33 1 20 20

2 16 10.67 2 15 15

3 10 6.67 3 10 10

4 6 4 4 5 5

5 2 1.33 5 3 3

6 3 – 6 1 –

Pizza

Pizza

P

MU

Coke

Coke

P

MU

What happens if the price of pizza falls to $1:50?

Where Demand Curves Come From

A consumer responds optimally to a fall in the price of a product by consuming more of that product. In panel (a), the price of pizza falls from $2 per slice to $1.50, and the optimal quantity of slices consumed rises from 3 to 4. When we graph this result in panel (b),we have the consumer’s demand curve.