Chapter 19 Theory of Consumer Behavior Copyright 2002

Chapter Objectives • • • Marginal utility The law of diminishing returns Total utility Maximizing utility The water-diamond paradox Consumer surplus Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 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 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -3

Hypothetical Demand Schedule for Hamburgers Price $2. 75 Units Purchased 1 Copyright 2002 by

Hypothetical Demand Schedule for Hamburgers Price Units Purchased $2. 75 1 2. 00 2

Marginal Utility is the additional utility derived from consuming one more unit of a good or service Price Units Purchased MU $2. 75 1 $2. 75 2. 00 2 2. 00 1. 00 3 1. 00 . 25 4 . 25 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -8

Marginal Utility is the additional utility derived from consuming one more unit of a good or service Price Purchased MU $2. 75 1 $2. 75 2. 00 2 2. 00 1. 00 3 1. 00 . 25 4 . 25 Note: Marginal Utility is the same as the price. Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -9

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 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -10

Total Utility is the utility derived from consuming a certain number of units of a good or service Price Units Purchased MU $2. 75 1 $2. 75 2. 00 2 2. 00 1. 00 3 1. 00 . 25 4 TU . 25 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. $2. 75 19 -11

Total Utility is the utility derived from consuming a certain number of units of a good or service Price Units Purchased MU TU $2. 75 1 $2. 75 2. 00 2 2. 00 4. 75 1. 00 3 1. 00 . 25 4 . 25 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -12

Total Utility is the utility derived from consuming a certain number of units of a good or service Price Units Purchased MU TU $2. 75 1 $2. 75 2. 00 2 2. 00 4. 75 1. 00 3 1. 00 5. 75 . 25 4 . 25 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -13

Total Utility is the utility derived from consuming a certain number of units of a good or service Price Units Purchased MU 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 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -14

Total Utility is the utility derived from consuming a certain number of units of a good or service Units Price Purchased MU 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 To get total utility, just add up the marginal utilities of the units purchased Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -15

Maximizing Utility • How much we buy of any good or service depends on – Its price – Our marginal utility schedule Price Units Purchased MU 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 In real life there is usually only ONE price! Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -16

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. Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -17

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 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -18

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 Price The price is $1. 00. How many units would you buy? Units Purchased MU TU $2. 75 1 $2. 75 2. 00 2 2. 00 4. 75 1. 00 3 1. 00 5. 75 . 25 4 . 25 The answer is 3 6. 00 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -19

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 Price The MU of the last unit purchased will always equal its price Units Purchased MU TU $2. 75 1 $2. 75 2. 00 2 2. 00 4. 75 1. 00 3 1. 00 5. 75 . 25 4 . 25 The answer is 3 6. 00 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -20

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 Price The price is $2. How many units will you buy? Units Purchased MU TU $2. 75 1 $2. 75 2. 00 2 2. 00 4. 75 1. 00 3 1. 00 5. 75 . 25 4 . 25 The answer is 2 6. 00 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -21

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 Price The MU of the last unit purchased will always equal its price Units Purchased MU TU $2. 75 1 $2. 75 2. 00 2 2. 00 4. 75 1. 00 3 1. 00 5. 75 . 25 4 . 25 The answer is 2 6. 00 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -22

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 If this is true for hamburgers it will be true for everything else 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 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -23

Price Purchased MU 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 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -24

Hamburgers Price QD MU Fries Price QD MU Coke Price OD 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 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? Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -25

Hamburgers Price QD MU Fries Price QD MU Coke Price OD 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 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? One hamburger; three fries; and two cokes Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -26

Hamburgers Price QD MU Fries Price QD MU Coke Price OD 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 1 $1. 50 2 . 50 How many burgers, fries, and cokes would you consume if burgers were $1, fries were $1. 00 and cokes were $1. 50? Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -27

Hamburgers Price QD MU Fries Price QD MU Coke Price OD 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 1 $1. 50 2 . 50 How many burgers, fries, and cokes would you consume if burgers were $1, fries were $1. 00 and cokes were $1. 50? First answer: one hamburger; three fries; and two cokes Second answer: three hamburgers; two fries; one coke This is consistent with the law of supply and demand Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -28

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 Muwater MUdiamonds = 1 = Pdiamonds Pwater Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -29

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 1 $2. 75 Hamburger 2. 00 2 2. 00 4. 75 Schedule 1. 00 3 1. 00 5. 75 . 25 4 . 25 6. 00 0 5 0 The price of hamburgers is $0. 25 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -30

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 1 $2. 75 Hamburger 2. 00 2 2. 00 4. 75 Schedule 1. 00 3 1. 00 5. 75 . 25 4 . 25 6. 00 0 5 0 The price of hamburgers is $0. 25 You would buy 4 @. 25 = $1. 00 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -31

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 1 $2. 75 Hamburger 2. 00 2 2. 00 4. 75 Schedule 1. 00 3 1. 00 5. 75 . 25 4 . 25 6. 00 0 5 0 The price of hamburgers is $0. 25 You would buy 4 @. 25 = $1. 00 You would have been willing to pay $6. 00 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -32

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 1 $2. 75 Hamburger 2. 00 2 2. 00 4. 75 Schedule 1. 00 3 1. 00 5. 75 . 25 4 . 25 6. 00 0 5 0 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 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -33

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 1 $2. 75 Hamburger 2. 00 2 2. 00 4. 75 Schedule 1. 00 3 1. 00 5. 75 . 25 4 . 25 6. 00 0 5 0 Price of Hamburgers is $2. 00 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -34

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 1 $2. 75 Hamburger 2. 00 2 2. 00 4. 75 Schedule 1. 00 3 1. 00 5. 75 . 25 4 . 25 6. 00 0 5 0 Price of Hamburgers is $2. 00 You would buy 2 @ 2. 00 = $4. 00 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -35

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 1 $2. 75 Hamburger 2. 00 2 2. 00 4. 75 Schedule 1. 00 3 1. 00 5. 75 . 25 4 . 25 6. 00 0 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 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -36

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 1 $2. 75 Hamburger 2. 00 2 2. 00 4. 75 Schedule 1. 00 3 1. 00 5. 75 . 25 4 . 25 6. 00 0 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 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 19 -37

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 3. 00 2. 00 1. 00 0. 25 0 D 1 2 3 4 5 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 6 19 -38

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 0 D 1 2 3 4 5 Copyright 2002 by The Mc. Graw-Hill Companies, Inc. All rights reserved. 6 19 -39