Utility Lecture Notes

7/30/2019 Utility Lecture Notes

1/35

A P E C O N O M I C S C H A P T E R 5

Consumer Behavior andUtility Maximization


2/35

4 Key Concepts

1. Understanding Utility: Total and Marginal2. Utility Maximization: Equalizing Marginal Utility

per Dollar (MU/P A = MU/P B)

3. Individual and Market Demand Curves4. Income and Substitution Effects (review from unit

two)


3/35

Introduction

The CONSUMER is essential to the market.Understanding how the consumer makes his/herpurchasing decisions is key.


4/35

1. Understanding Utility

Utility = Satisfaction/Happiness/Pleasure onegets from consuming a good.Utility and usefulness are NOT synonymous in

economics.Utility is difficult to quantify, as it differs betweenpeople and situations

ie. A blanket to a person living in Arizona vs. a person livingin Minnesota.

Measured in utils (a personal measure)


5/35

1. Understanding Utility

Total Utility (TU)Total amount of satisfaction or pleasure a person derivesfrom consuming a given quantity of that product

Marginal Utility (MU)The extra satisfaction a consumer derives from oneadditional unit of that product.In other words, the change in Total Utility that results fromthe consumption of one more unit


6/35

Law of Diminishing Marginal Utility

Explains that the more of a good a person gets, theless 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


7/35

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, itdoesnt bring as much utility as the first At some point, your MU becomes negative. (takesaway from your total satisfaction).


8/35

Law of Diminishing Marginal Utility

0

10

20

30

10

86420

-2

1 2 3 4 5 6 7

1 2 3 4 5 6 7

T o t a

l U t i l i t y ( U t i l s )

M a r g

i n a

l U t i l i t y

( U t i l s )

(1)Tacos

ConsumedPer Meal

(2)Total

Utility,Utils

(3)Marginal

Utility,Utils

0

1234567

0

10182428303028

]]]]]]]

108642

0-2

TU

MU

Total Utility

Marginal Utility

Units Consumed Per Meal

Units Consumed Per Meal


9/35

2. Utility Maximization

Explains how consumers allocate their money incomes among the many goods and servicesavailable for purchase

You will be faced with problems that provide you with a consumers MU or TU derived frompurchasing 2 goods. You will be expected to show how many of each a rational consumer would

purchase.


10/35

Theory of Consumer BehaviorNumerical Example: Find the Utility-Maximizing Combination ofA and B, if you have an Income of $10

(1)Unit of

Product

(a)Marginal

Utility,Utils

(a)Marginal

Utility,Utils

(b)Marginal

UtilityPer Dollar(MU/Price)

(b)Marginal


(2)Product A:Price = $1

(3)Product B:Price = $2

FirstSecond

ThirdFourthFifthSixth

Seventh

108

7654

3

2420

181612

6

4

108

7654

3

1210

9863

2


11/35

Theory of Consumer BehaviorNumerical Example: Utility-Maximizing Combination of ProductsA and B Obtainable with an Income of $10

(1)Unit of

Product

(a)Marginal

Utility,Utils

(a)Marginal

Utility,Utils

(b)Marginal


(b)Marginal




FirstSecond


Seventh

108

7654

3

2420

181612

6

4

108

7654

3

1210

9863

2

Compare Marginal UtilitiesThen Compare Per Dollar - MU/PriceChoose the Highest

Check Budget - Proceed to Next Item


12/35

Theory of Consumer BehaviorNumerical Example: Utility-Maximizing Combination of Products

A and B Obtainable with an Income of $10

(1)Unit of

Product

(a)Marginal

Utility,Utils

(a)Marginal

Utility,Utils

(b)Marginal


(b)Marginal




FirstSecond


Seventh

108

7654

3

2420

181612

6

4

108

7654

3

1210

9863

2

Again, Compare Per Dollar - MU/PriceChoose the HighestBuy One of Each Budget Has $5 Left

Proceed to Next Item


13/35



(1)Unit of

Product

(a)Marginal

Utility,Utils

(a)Marginal

Utility,Utils

(b)Marginal


(b)Marginal




FirstSecond


Seventh

108

7654

3

2420

181612

6

4

108

7654

3

1210

9863

2

Again, Compare Per Dollar - MU/PriceBuy One More B Budget Has $3 Left

Proceed to Next Item


14/35



(1)Unit of

Product

(a)Marginal

Utility,Utils

(a)Marginal

Utility,Utils

(b)Marginal


(b)Marginal




FirstSecond


Seventh

108

7654

3

2420

181612

6

4

108

7654

3

1210

9863

2

Again, Compare Per Dollar - MU/Price

Buy One of Each Budget Exhausted


15/35



(1)Unit of

Product

(a)Marginal

Utility,Utils

(a)Marginal

Utility,Utils

(b)Marginal


(b)Marginal




FirstSecond


Seventh

108

7654

3

2420

181612

6

4

108

7654

3

1210

9863

2

Final Result At These Prices,

Purchase 2 of Item A and 4 of B


16/35

Theory of Consumer BehaviorAlgebraic Restatement:

MU of Product A

Price of A

MU of Product B

Price of B=

8 Utils

$1

16 Utils

$2=

Optimum Achieved - Money Income is Allocated so that the Last Dollar

Spent on Each Good Yields the Same

Extra or Marginal Utility


17/35

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



Unit MU Unit MU

1 20 1 30

2 10 2 20

3 6 3 15

4 3 4 5

5 1 5 -5


18/35



Unit TU Unit TU

1 22 1 10

2 32 2 16

3 40 3 20

4 46 4 22

5 48 5 20

Given TU, and an income/budget constraint of $9 find the Utility-Maximizing Combination of A and B

Two-Good Practice Problem


19/35

The Problem with Utils

Answer the following problem:If Henry derives 5 utils from the 1 st candy bar, 3utils from the 2 nd candy bar, 0 utils from the 3 rd

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 $2Costs $4


20/35

From Utils to Benefit

Because Utils cannot be compared between people,and cannot be compared to dollars economistsmust measure satisfaction in Benefit .

Benefit is the same concept as utility, but it is measured indollars (according to the consumers WILLINGNESS TOPAY .Total Benefit ($), Marginal Benefit ($)


21/35

Golden Rule of Consumption

A rational consumer will continue to purchaseuntil

MB = MCTo consume one more would mean your

marginal cost is greater than your marginal benefit


22/35

Start with an individual consumermaybe 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 toget market demand curve

3. Individual and Market Demand Curves


23/35

Assumption about consumer behavior

General economicprinciple

Peoplemake purposefulchoices with limited resources

When applied to the behavior of consumers

People maximize utility subject to a budgetconstraint


24/35

3. Individual and Market Demand Curves

Consider all consumers in the market Add up quantity demanded by all individuals at eachprice to get market demand

Add horizontally to create market demand curve

05_06 PRICE PRICE


25/35

5

4

3

2

1

0 1 2 3 4 5

5

4

3

2

1

0 1 2 3 4 5

5

4

3

2

1

0 1 2 3 4 5 6 7 8 9 10

QUANTITY DEMANDEDBY PETE (POUNDS)

QUANTITY DEMANDEDBY ANN (POUNDS)

QUANTITY DEMANDEDIN MARKET (POUNDS)

PRICE(DOLLARS)

PRICE(DOLLARS)

PRICE(DOLLARS)

Marketdemandcurve

Ann'sdemandcurve

Pete'sdemandcurve


26/35

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 slopesdownward.


27/35

Review Questions Utility

Which of the following factors contributes to a downward-sloping demand curve?

I. The income effectII. 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


28/35


What is the marginal utility of the third cup of peanutsBrian 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


29/35


If the price of peanuts is $1 per cup and the price of jelly beans is $2per cup, and Brian wants to maximize his utility, what should hepurchase first?

A. 1 cup of peanuts because peanuts produce a lower totalutility B. 1 cup of peanuts because the price of peanuts is lowerC. 1 cup of peanuts, because the marginal utility per dollar forpeanuts is lower than the marginal utility per dollar of jelly beans

D. 1 cup of jelly beans, because the marginal utility per dollarfor jelly beans is higher than the marginal utility per dollar of peanutsE. 1 cup of jelly beans, because jelly beans produce a highertotal utility


30/35


If TU = total utility, MU = marginal utility, and P = price, inorder to maximize utility, a consumer should purchasethe mix of hamburgers and hot dogs where A. the MU of hamburgers equals the MU of hot dogsB. the MU equals the TU of hamburgers, and the MUequals 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 hotdogsE. the TU / P of hamburgers equals the TU / P of hotdogs


31/35


If Matts total utility from consuming slices of cheeseincreased at a constant rate, no matter how many bratwurst Matt consumed, what would Matts demandcurve for slices of cheese look like? A. VerticalB. HorizontalC. Downward slopingD. Upward slopingE. First upward, but eventually downward sloping


32/35


Every day Molly spends her lunch money consuming apples, at $1each, and oranges, at $2 each. At her current level of consumption, mollys marginal utility of apples is 12 and hermarginal utility of oranges is 18. If she has already spent all of herlunch money, how should Molly change her consumption decisionto 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 herorange consumption until the marginal utility per dollar is equalfor both.C. She should decrease her apple consumption and increase herorange consumption until the marginal utility per dollar is equalfor both.D. She should increase her apple consumption and decrease herorange 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.


33/35


If generic peanut butter is an inferior good, a decline inconsumer 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.


34/35

Key Terms

law of diminishing marginal utility utility total utility

marginal utility rational behavior budget constraint

utility-maximizing rule income effect substitution effect


35/35

P

r i c e o

f P r o

d u c

t B

0

1

2

4 6

Q tit D d d f B

Deriving the Demand CurveSame Numeric Example:

$21

46

Price Per

Unit of B

Quantity

Demanded

D B Income Effects

Substitution Effects

Documents

Utility Lecture Notes