Consumer Choice: Maximizing Utility

Consumer Choice: Maximizing Utility

Definition. Utility: A measure of the satisfaction, happiness, or benefit that results from the consumption of a good. Util: An artificial construct used to measure utility. Total Utility: The total satisfaction received from consuming a particular quantity of a good. Marginal Utility: The additional utility a person receives from consuming an additional unit of a good.

Demand for Mogu-Mogu

Think Diamonds vs. Water Total Utility versus marginal utility Goods change as we become more familiar with them Interpersonal utility comparisons. We often do compare marginal utility of additional income across different income levels, but it is not always appropriate

Income is limited! Normally You have to make trade-offs in purchasing different goods Example: To buy 1 more Justin Bieber CD at Php375, need to give up something else, i.e., 3 Starbucks Lattes at Php125 each. The trade-off occurs rationally because you know how much you value each of these goods.

The Budget Constraint Virtually all individuals must face two facts of economic life Have to pay prices for the goods and services they buy Have limited funds to spend A consumer s budget constraint identifies which combinations of goods and services the consumer can afford with a limited budget Budget line is the graphical representation of a budget constraint The price of one good relative to the price of another The slope of the budget line indicates the spending trade-off between one good and another Amount of one good, that must be sacrificed in order to buy more of another good 6

The Budget Constraint Number of Movies per Month 15 12 9 6 3 A With Php1500 per month, Iego can afford 15 movies and no concerts,... B G 12 movies and 1Sarah geronimo concert or any other combination on the budget line. C 1 2 3 4 5 7 H D Points below the line are also affordable. E But not points above the line. F Number of Concerts per Month

Changes in the Budget Line Changes in income Increase in income will shift the budget line upward (and rightward) A decrease in income will shift the budget line downward (and leftward) Shifts are parallel Changes in price In each case, one of the budget line s intercepts will change, as well as its slope When the price of a good changes, the budget line rotates Both its slope and one of its intercepts will change 8

Shifting of the Budget Line Number of Movies per Month 30 (a) 1. An increase in income shifts the budget line rightward, with no change in slope. 15 5 9 15 Number of Concerts per Month

Changes in the Budget Line Number of Movies per Month 30 (b) 2. A decrease in the price of movies rotates the budget line upward. 15 5 15 Number of Concerts per Month

Changes in the Budget Line Number of Movies per Month 30 (c) 3. while a decrease in the price of concerts rotates it rightward. 15 5 11 15 Number of Concerts per Month

Rationality(Indifference Curve) One common denominator People have preferences We assume that you can look at two alternatives and state either that you prefer one to the other or That you are entirely indifferent between the two you value them equally Another common denominator Preferences are logically consistent, or transitive When a consumer can make choices, and is logically consistent, we say that she has rational preferences Rationality is a matter of how you make your choices, and not what choices you make What matters is that you make logically consistent choices 12

More Is Better We generally feel that more is better The model of consumer choice is designed for preferences that satisfy the more is better condition It would have to be modified to take account of exceptions The consumer will always choose a point on the budget line Rather than a point below it 13

Theories Theories of consumer decision making Marginal utility Indifference curve Both assume that preferences are rational Both assume that consumer would be better off with more of any good Both theories come to same general conclusions about consumer behavior Our goal is to describe and predict how consumers are likely to behave in markets Rather than describe what actually goes on in their minds 14

Marginal Utility Marginal utility of an additional unit Change in utility derived from consuming an additional unit of a good The law of diminishing marginal utility, as defined by Alfred Marshall (1842-1924) states that Marginal utility of a thing to anyone diminishes with every increase in the amount of it he/she already has 15

Total And Marginal Utility Utils 70 60 50 40 30 20 Utils 30 20 16 Total Utility 1 2 3 4 5 6 Mogu-Mogu per Week 2. is called the marginal utility of an additional bottle. 1. The change in total utility from one more bottle... 3. Marginal utility falls as more bottles are consumed. Marginal Utility 1 2 3 4 5 6 Mogu-Mogu per Week

Budget Constraint and Preferences (Marginal Utility) If we combine information about preferences (marginal utility values) with information about what is affordable (the budget constraint) Can develop a useful rule to guide us to an individual s utility-maximizing choice Highest possible utility will be point at which marginal utility per PESO is the same for both goods 17

Consumer Decision Making Number of Movies per Month MU P concerts concerts 40, MU P movies movies 15 15 12 9 6 3 A B MU P concerts concerts C D G 20, MU P concerts concerts MU P movies E F movies 15, 20 MU P movies movies 35 1 2 3 4 5 Number of Concerts per Month 18

Budget Constraint and Preferences (Marginal Utility) For any two goods x and y, with prices P x and P Y, whenever MU x / P x > MU Y / P Y, a consumer is made better off shifting away from y and toward x When MU Y / P Y > MU X / P X, a consumer is made better off by shifting spending away from x and toward y Leads to an important conclusion A utility-maximizing consumer will choose the point on the budget line where marginal utility per peso is the same for both goods (MU X / P X = MU Y / P Y ) At that point, there is no further gain from reallocating expenditures in either direction 19

Budget Constraint and Preferences (Marginal Utility) No matter how many goods there are to choose from, when the consumer is doing as well as possible It must be true that MU X / P X = MU Y / P Y for any pair of goods x and y If this condition is not satisfied, consumer will be better off consuming more of one and less of the other good in the pair 20

Consumer Equilibrium Occurs when the consumer has spent all income and the marginal utilities per peso spent on each good purchased are equal. other education entertain. recreation transport. housing food MU A /P A =MU B /P B =MU C /P C = MU Z /P Z A B

Changes In Income A rise in income with no change in price leads to a new quantity demanded for each good Whether a particular good is normal (quantity demanded increases) or inferior (quantity demanded decreases) depends on the individual s preferences As represented by the marginal utilities for each good, at each point along the budget line 22

Effects of an Increase in Income Number of Movies per Month 30 27 H'' 2. If his preferences are as given in the table, he'll choose point H 1. When Iego's income rises to Php3000, his budget line shifts outward. 15 12 9 6 3 A B C D E F H H' 3.But different marginal utility numbers could lead him to H' or H'' 1 2 3 4 5 6 7 8 9 Number of Concerts per Month 23

Changes In Price A drop in the price of concerts rotates the budget line rightward, pivoting around its vertical intercept The consumer will select the combination of movies and concerts on his budget line that makes him as well off as possible Will be combination at which marginal utility per dollar spent on both goods is the same 24

Deriving the Demand Curve Number of Movies per Month 15 8 6 1. When the price of concerts is Php300, point D is best for Iego. K D J 2. If the price falls to Php0, Iego's budget line rotates rightward, and he choose point J. Price per Concert 30 0 3 5 7 15 30 3. And if the price drops to Php50, he chooses D point K. 5 J K 4. The demand curve shows the quantity Iego chooses at each price. 3 7 Number of Concerts per Month 25

The Individual s Demand Curve Curve showing quantity of a good or service demanded by a particular individual at each different price In theory, an individual s demand curve could slope upward 26

Substitution Effect Substitution effects As the price of a good falls, the consumer substitutes that good in place of other goods whose prices have not changed Substitution effect of a price change arises from a change in the relative price of a good And it always moves quantity demanded in the opposite direction to the price change When price decreases (increases), substitution effect works to increase (decrease) quantity demanded 27

Income Effect Income effect As price of a good decreases, the consumer s purchasing power increases, causing a change in quantity demanded for the good Income effect of a price change arises from a change in purchasing power over both goods A drop (rise) in price increases (decreases) purchasing power Income effect can work to either increase or decrease the quantity of a good demanded, depending on whether the good is normal or inferior 28

Combining Substitution and Income Effect A change in the price of a good changes Relative price of the good (the substitution effect) and Overall purchasing power of the consumer (the income effect) 29

Normal Goods Substitution and income effects work together Causing quantity demanded to move in opposite direction of price Normal goods must always obey law of demand 30

Inferior Goods Substitution and income effects of a price change work against each other Substitution effect moves quantity demanded in the opposite direction of the price While income effect moves it in same direction of price But since substitution effect virtually always dominates Consumption of inferior goods will virtually always obey law of demand 31

AGAIN, Income and Substitution Effects P Price Decrease: Substitution Effect Q D Ultimate Effect (Almost Always) Purchasing Power Q D Q D if normal if inferior Q D P Price Increase: Substitution Effect Q D Purchasing Power Q D Q D if normal if inferior Q D 32

Total utility AGAIN, Utility Total satisfaction from a specific quantity Marginal utility Extra satisfaction from an additional unit Law of diminishing marginal utility Explains downward sloping demand 7-33

Marginal Utility (Utils) Total Utility (Utils) AGAIN,Utility Graphically Total Utility (1) Tacos Consumed Per Meal (2) Total Utility, Utils (3) Marginal Utility, Utils 30 20 TU 0 1 2 3 4 5 6 7 0 18 24 28 30 30 28 ] ] ] ] ] ] ] 8 6 4 2 0-2 0 8 6 4 2 0-2 1 2 3 4 5 6 7 Units Consumed Per Meal Marginal Utility MU 1 2 3 4 5 6 7 Units Consumed Per Meal 7-34

AGAIN, Consumer Behavior Key dimensions of the consumer problem Rational behavior Preferences Budget constraint Prices 7-35

AGAIN, Theory of Consumer Behavior Find utility maximizing combination of goods Utility maximizing rule Allocate income Last peso spent on each good yields same marginal utility Marginal utility per peso 7-36

AGAIN, Numerical Example Combinations of apples and oranges obtainable with an income of Php (1) Unit of Product First Second Third (2) Apple (product A) Price = 1 (a) Marginal Utility, Utils 8 7 (b) Marginal Utility Per Peso (MU/Price) 8 7 (3) Orange (product B) Price = 2 (a) Marginal Utility, Utils (b) Marginal Utility Per Peso (MU/Price) Sixth 4 4 6 3 Check Seventh budget 3 - proceed 3 to next 4 item 2 7-37 24 20 18 Compare marginal utilities Fourth 6 6 16 Then Fifth compare 5 per peso 5 - MU/Price 12 Choose the highest 12 9 8 6

Numerical Example Combinations of apples and oranges obtainable with an income of Php (1) Unit of Product First Second Third (2) Apple (product A) Price = 1 (a) Marginal Utility, Utils 8 7 (b) Marginal Utility Per Peso (MU/Price) 8 7 (3) Orange (product B) Price = 2 (a) Marginal Utility, Utils (b) Marginal Utility Per Peso (MU/Price) Again, compare per peso - MU/Price Fourth 6 6 16 Choose Fifth the highest 5 5 12 Buy one of each budget has Php5 left Sixth 4 4 6 3 Proceed Seventh to next 3 item 3 4 2 7-38 24 20 18 12 9 8 6

Numerical Example Combinations of apples and oranges obtainable with an income of Php (1) Unit of Product First Second Third Fourth Seventh (2) Apple (product A) Price = 1 (a) Marginal Utility, Utils 8 7 6 3 (b) Marginal Utility Per Peso (MU/Price) 8 7 6 3 (3) Orange (product B) Price = 2 (a) Marginal Utility, Utils 24 20 18 16 4 (b) Marginal Utility Per Peso (MU/Price) Again, compare per peso - MU/Price Fifth 5 5 12 6 Buy one more orange budget has Php3 left Sixth 4 4 6 3 Proceed to next item 12 9 8 2 7-39

Numerical Example Combinations of apples and oranges obtainable with an income of Php (1) Unit of Product First Second Third Fourth Fifth Seventh (2) Apple (product A) Price = 1 (a) Marginal Utility, Utils 8 7 6 5 3 (b) Marginal Utility Per Peso (MU/Price) (3) Orange (product B) Price = 2 (a) Marginal Utility, Utils Again, Sixth compare 4 per peso 4 - MU/Price 6 Buy one of each budget exhausted 8 7 6 5 3 24 20 18 16 12 4 (b) Marginal Utility Per Peso (MU/Price) 12 9 8 6 3 2 7-40

Numerical Example Combinations of apples and oranges obtainable with an income of Php (1) Unit of Product First Second Third Seventh (2) Apple (product A) Price = 1 (a) Marginal Utility, Utils 8 7 (b) Marginal Utility Per Peso (MU/Price) (3) Orange (product B) Price = 2 (a) Marginal Utility, Utils Fourth 6 6 16 Fifth 5 5 12 Final result at these prices, Sixth 4 4 6 purchase 2 apples and 4 oranges 3 8 7 3 24 20 18 4 (b) Marginal Utility Per Peso (MU/Price) 12 9 8 6 3 2 7-41

Algebraic Generalization MU of product A price of A 8 Utils Php1 = = MU of product B price of B 16 Utils Php2 Optimum Achieved Money income is allocated so that the last peso spent on each product yields the same extra or marginal utility

Consumers in Markets Since market demand curve tells us quantity of a good demanded by all consumers in a market Can derive it by summing individual demand curves of every consumer in that market 43

From Individual To Market Demand Price Dan Price Alvir Price Marj 4 4 4 3 2 c 3 3 + 2 C' + 2 C'' = 1 1 1 0 4 12 0 6 12 0 20 Number of Mogu-MoguBottles per Week 44

From Individual To Market Demand Price 4 3 A B Market Demand Curve 2 C 1 D 3 27 44 Number of Mogu-Mogu Bottles per Week 45 E

Consumer Theory in Perspective: Extensions of the Model Problems The simple model ignores uncertainty Imperfect information People can spend more than their incomes in any given year by borrowing funds or spending out of savings You might think consumer theory always regards people as relentlessly selfish In fact, when people trade in impersonal markets, this is mostly true People try to allocate their spending among different goods to achieve the greatest possible satisfaction 46

Who cares about this? (Beyond Econ Class in Pisay) Companies, like P&G, realize that people have limited budgets. They want to maximize consumer utility with THEIR products. Adjust product qualities to change utility to consumer. Adjust prices Methods Focus groups Test markets Advertising Packaging Reformulations P&G Product Family

Limits to Utility Theory Utility theory assumes people are: Rational, self-interested, & consistent. In recent years, many limitations to utility theory in economics have been noted by psychologists and economists. These affect different kinds of transactions differently. Probably have little effect on buying and selling everyday things.

Inconsistent behavior? Spite: In experiments, some people have been observed to spend money to reduce the money other people have won In a study, 62% of the participants made themselves worse off in order to make someone else worse off. Compartmentalizing: People often treat money differently depending on the circumstances: Endowment Effect: We value things we are endowed with more than things we don t have Coffee mugs: 15 to sell; to buy.