Chapter 19 THEORY OF CONSUMER BEHAVIOR Chapter 19

Chapter 19 THEORY OF CONSUMER BEHAVIOR Chapter 19 Copyright © 2014 Mc. Graw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of Mc. Graw-Hill Education.

Learning Objectives After this chapter, you should be able to: 1. Define and explain marginal utility 2. Apply the law of diminishing marginal utility 3. Measure total utility 4. Discuss and analyze maximizing utility 5. Define and solve the water-diamond paradox 6. Measure consumer surplus 19 -2

Utility What is utility? Utility is NOT usefulness! Utility means only that you think enough of something to buy it. Utility is measured by how much you are willing to pay for something. 19 -3

Hypothetical Demand Schedule for Hamburgers 19 -4

Marginal Utility The additional utility derived from consuming one more unit of a good or service. Note: MU is the same as the price. 19 -5

Law of Diminishing Marginal Utility As we consume more and more of a good or service, we like it less and less. Price Units Purchased MU $2. 75 1 $2. 75 2. 00 2 2. 00 1. 00 3 1. 00 . 25 4 . 25 19 -6

Total Utility The utility you derive from consuming a certain number of units of a good or service. To get total utility, just add up the marginal utilities of the units purchased. 19 -7

Maximizing Utility How much we buy of any good or service depends on: Its price. Our marginal utility schedule. Usually a business charges only ONE price! 19 -8

Maximizing Utility We try to spend our money on what will give us the most utility! As we consume more of a good or service, its utility declines! This means that we will keep buying more of a good or service until our marginal utility falls to the level of the price. At this point marginal utility is the same as the price. Marginal Utility Price = 1 19 -9

Maximizing Utility We try to spend our money on what will give us the most utility. Remember, as we consume more of a good or service, its utility declines. This means that we will keep buying more of a good or service until our MU falls to the level of the price. The price the business charges is $1. 00. How many units would you buy? The answer is 3. 19 -10

Maximizing Utility (continued) The MU of the last unit purchased will always equal its price. The answer is 3. 19 -11

Maximizing Utility The company charges $2. How many units will you buy? The answer is 2. 19 -12

Maximizing Utility We try to spend our money on what will give us the most utility! Remember, as we consume more of a good or service, its utility declines! This means that we will keep buying more of a good or service until our MU falls to the level of the price. The MU of the last unit purchased will always equal its price. The answer is 2. 19 -13

General Utility Formula The MU of the last unit purchased will always equal its price: MU 2. 75 = = Price 2. 75 2. 00 = 2. 00 1. 00. 25 = 1. 00 =. 25 1 This is not only true for hamburgers, it is true for everything. MU 1 MU 2 MU 3 MUn = = = Pn P 3 P 2 P 1 Remember, we will keep buying anything until its MU declines to the price level. 19 -14

General Utility Formula (continued) Price # Purchased MU $2. 75 TU $2. 75 1 $2. 75 2. 00 2 2. 00 4. 75 1. 00 3 1. 00 5. 75 . 25 4 . 25 6. 00 0 6. 00 • If a good or service were free, you would keep consuming until the MU fell to zero. • As we consume more units, MU declines, but TU keeps rising. Therefore, we maximize our total utility when our MU falls to zero. 19 -15

Questions for Discussion Hamburgers Fries Price QD Coke Price QD MU $ 3. 00 1 $3. 00 $1. 50 1 $1. 50 2. 00 2 2. 00 1. 00 2 1. 00 . 50 1. 00 3 1. 00 . 50 3 MU Price QD MU 1 $1. 50 2 . 50 • How many burgers, fries, and cokes would you consume if burgers were $3, fries were $. 50, and cokes were $. 50? 1 hamburger; 3 fries; 2 cokes 19 -16

Questions for Discussion Hamburgers Price QD MU Fries Price QD $ 3. 00 1 $3. 00 $1. 50 1 $1. 50 2. 00 2 2. 00 1. 00 2 1. 00 . 50 1. 00 3 1. 00 . 50 3 MU Coke Price QD MU 1 $1. 50 2 . 50 How many burgers, fries, and cokes would you consume if burgers were $1, fries were $1, and cokes were $1. 50? 1 st answer: 1 hamburger; 3 fries; 2 cokes 2 nd answer: 3 hamburgers; 2 fries; 1 coke This is consistent with the law of supply and demand. 19 -17

The Water-Diamond Paradox Water, which is essential to life, is cheap. Water is abundant. A great deal of water is consumed. • Therefore, the MU of the last gallon consumed is as low as its price, which is relatively low. Diamonds are not essential to life, yet they are very expensive. Diamonds are scarce. People buy relatively few diamonds. • Therefore, the MU of the last diamond purchased is as high as its price, which is relatively very high. MU water = MU diamonds = 1 Price water Price diamonds 19 -18

Some Limitations of Utility Applications Utility is not inherent in a particular good or service. Utility is simply a measure of what a particular buyer is willing to pay. Amanda may be willing to pay $100 for a pair of running shoes while Tom is only willing to pay $60 for the same style. We can’t assume a poor person would get more pleasure out of spending $10 than a rich person. • Even though it might sound reasonable …we cannot make interpersonal utility comparisons. We can observe a person’s spending behavior and determine their personal utility schedule. • People’s individual schedules can change over time. 19 -19

Consumer Surplus Consumer surplus is the difference between what you pay for some good or service and what you would have been willing to pay. Price # Purchased $2. 75 1 $2. 75 Hamburger 2. 00 2 2. 00 4. 75 Schedule 1. 00 3 1. 00 5. 75 . 25 4 . 25 6. 00 5 0 0 MU TU The price of hamburgers is $0. 25. You would buy 4 @. 25 = $1. 00. You would have been willing to pay $6. 00. Your consumer surplus would be ($6. 00 - $1. 00) = $5. 00. 19 -20

Consumer Surplus Consumer surplus is the difference between what you pay for some good or service and what you would have been willing to pay. Price # Purchased MU TU $2. 75 2. 00 2 2. 00 4. 75 1. 00 3 1. 00 5. 75 4 . 25 6. 00 0 Schedule 1 . 25 Hamburger $2. 75 5 0 Price of Hamburgers is $2. 00. You would buy 2 @ 2. 00 = $4. 00. You would have been willing to pay $4. 75. Your consumer surplus would be ($4. 75 - $4. 00) = $0. 75. 19 -21

Consumer Surplus The consumer surplus in this graph would be represented by the area to the left of the demand curve (what you would have been willing to pay) and above the price line. If the price of hamburger is $0. 25, you would have purchased 4. The consumer surplus would be the triangle area above the price line. 19 -22

Consumer Surplus The consumer surplus in this graph would be represented by the area to the left of the demand curve (what you would have been willing to pay) and above the price line. If the price of hamburger is $2. 00, you would have purchased 2. The consumer surplus would be the triangle area above the price line. 3. 00 2. 00 1. 00 0. 25 D 0 1 2 3 4 5 6 19 -23

Hypothetical Demand Schedule for Sessions with a Personal Trainer Try calculating MU and TU. 19 -24

Hypothetical Utility Schedule for Sessions with a Personal Trainer What is the consumer surplus for 4 sessions? Answer: $145 – (4 x $25) = $45. 19 -25

Do Price Gougers Rip Us off? The one thing you should remember from this chapter is that “nobody over pays!” The economic rule of thumb is: Even if you pay a very high price for a good or service you are not getting ripped off. This is true even if you are buying from a price gouger. In economics we can’t make moral judgments. 19 -26

Chapter Issue: All-You-Can-Eat Buffets You’re at an All-You-Can-Eat pizza buffet. You have 4 slices. You can’t quite finish the 4 th slice. How much marginal utility would you have gotten from a 5 th slice? • Answer: Less than zero. How much marginal utility did you get from the 4 th slice? • • Not a lot since you can’t finish it. The 4 th slice did, however, provide you with some marginal utility. 19 -27