CONSUMER BEHAVIOR. Total and Marginal Utility

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1 CONSUMER BEHAVIOR Total and Marginal Utility

2 Theory of Consumer Choice Both Budget Constraints and Consumer Preferences can be graphed: The slope of the budget constraint = the rate at which one consumer can trade off one good for another AND The relative prices of the two goods (PSSSTTT The secret? Same shape as a Production Possibilities Curve) Consumer preferences = The Indifference Curve

3 Theory of Consumer Choice Consumer Income is limited but choices are numerous Consumers must combine budget constraints and preferences

4 Budget Curve and Indifference Curve Budget Constraint Curve Good X Indifference Curve Good Y

5 Budget Curve and Indifference Curve

6 So How Do We Know Where our budget constraints and indifference curve meet?

7 Utility - DEFINITION The measurement of happiness or satisfaction derived from consuming a good or a service Added satisfaction declines as a consumer acquires additional units of a given product LAW OF DIMINISHING MARGINAL UTILITY

8 Things to keep in mind Utility and usefulness are not synonymous Utility is subjective Utility is difficult to quantify (but still units of utility are named utils. Those economists are clever if not creative!)

9 Total vs. Marginal Utility Total Utility = Total amount of satisfaction or pleasure a person derives from consuming some specific quantity of a good or service (measured in UTILS!) Marginal Utility = Extra amount of satisfaction a consumer realizes from an additional unit of that product Or the change in total utility that results from the consumption of 1 more unit of product

10 Things to keep in mind (Part II) Different goods and services result in different RATES of diminishing marginal utility EX: Bottled water might decrease in terms of marginal utility at a rate SLOWER than the change in the marginal utility of chewing gum

11 Consumer Behavior Diminishing marginal utility also explains how customers allocate their money incomes among many goods and services Utility is restrained by consumer choice and behavior:

12 Consumer Choice and Budget Rational behavior Rational consumers attempt to derive the greatest amount of satisfaction based on choice and budget Preferences Consumers have clear cut preferences which influence their choices Budget constraint Consumers have fixed/limited amount of money income which influences their choices (scarcity!) Prices Every good or service has a price tag which influences consumer choice

13 Maximizing Total Utility As a result of these constraints Consumers seek to maximize their total utility by combining purchases of goods and services To maximize utility: Allocate the available budget in a way that maximizes total utility Choose affordable combinations of goods which the sum of the utilities obtained from all goods and services consumed is as large as possible

14 Utility Maximizing Rule To maximize utility: A consumer must allocate the ENTIRE available budget Last dollar spend on each product yields the same amount of extra (marginal) utility Consumer equilibrium Formula MU of product A = MU of product B Price of A Price of B Or MUx = Muy Px Py

15 Example Unit of Product Apple Price (Product X) = $1 Orange Price (Product Y) = $2 Marginal Utility in Utils Marginal Utility per $ (MU/Price) Marginal Utility in Utils Marginal Utility per $ (MU/Price) 1 st nd rd th th th Budget Constraint = $10

16 Example Choice Number Potential Choices Marginal Utility per $ Purchase Decision Income Remaining 1 1 st apple 1 st orange st orange for $2 $8 ($10 - $2) 2 1 st apple 2 nd orange st apple for $1 2 nd orange for $2 $5 ($8 - $3) 3 2 nd apple 3 rd orange rd orange for $2 $3 ($5 - $2) 4 2 nd apple 4 th orange nd apple for $1 4 th orange for $2 $0 ($3 - $3)

17 Utility Maximizing Rule Last dollar utility: For apples = 8 utils For oranges = 8 utils (16/$2) MUx = Muy Px Py 8 Utils = 16 utils $1 $2

18 Budget Curve and Indifference Curve Budget Constraint Curve Apples Utility Maximization Point 2 Indifference Curve 4 Oranges