Consumer Choice and Utility Maximization 1 The

Consumer Choice and Utility Maximization 1

The Law of Diminishing “ADDITIONAL” “SATISFACTION” 2

DEFINITIONS • Law of Diminishing Marginal utility: Added satisfaction declines as a consumer acquires additional units of a given product. • Utility = a measure of want satisfying power. Utility is personal and subjective. 3

DEFINITIONS • Total Utility: The total amount of satisfaction or pleasure a person derives from consuming some specific quantity of a good or service. • Marginal Utility: The extra satisfaction a consumer realizes from an additional unit of that product 4

Thinking at the Margin # Times Watching Movie 1 st 2 nd 3 rd Total Marginal Utility $30 $15 $5 $50 Price $10 $10 $30 Would you see the movie three times? Notice that the total benefit is more than the total cost but you would NOT watch the movie the 3 rd time.

Calculate Marginal Utility # of Slices of Pizza 0 1 Total Utility (in utils) 0 8 2 3 4 5 6 7 8 Marginal Utility/Benefit 14 19 23 25 26 26 24 How many pizzas would you buy if the price per slice was $2? 6

Calculate Marginal Utility # of Slices of Pizza 0 1 Total Utility (in dollars) 0 8 2 3 4 5 6 7 8 14 19 23 25 26 26 24 Marginal Cost Utility/Benefit 0 8 $2 $2 6 5 4 2 1 0 -2 $2 $2 How many pizzas would you buy if the price per slice was $2? 7

Calculate Marginal Utility # of Slices of Pizza 0 1 2 3 4 5 6 7 8 Total Utility (in dollars) 0 8 Marginal Cost Utility/Benefit 0 8 2 2 0 -2 2 2 2 You will continue to 14 6 consume until 19 5 23 4 Marginal Benefit = 25 2 Marginal Cost 26 1 26 24 How many pizzas would you buy if the price per slice was $2? 8

CONSUMER BEHAVIOR You plan to take a vacation and want to maximize your utility. Based on the info below, which should you choose? Destination Marginal Utility (In Utils) Price Marginal Utility Per Dollar Tahiti 3000 $3, 000 1 Util Chicago 1000 $500 2 Utils 9

CONSUMER BEHAVIOR You plan to take a vacation and want to maximize your utility. Based on the info below, which should you choose? Destination Marginal Utility (In Utils) Price Marginal Utility Per Dollar Tahiti 3000 $3, 000 1 Util Chicago 1000 $500 2 Utils Calculating Marginal Utility Per Dollar allows you to compare products with different prices. 10

$10 Utility Maximization # Times Going Marginal Utility (Movies) 1 st 2 nd 3 rd 4 th 30 20 10 5 MU/P (Price =$10) Marginal Utility (Go Carts) $5 MU/P (Price =$5) 10 5 2 1 If you only have $25, what combination of movies and go carts maximizes your utility?

$10 Utility Maximization # Times Going Marginal Utility (Movies) 1 st 2 nd 3 rd 4 th 30 20 10 5 $5 (Price =$10) Marginal Utility (Go Carts) (Price =$5) 3 $2 $1 $. 50 10 5 2 1 $2 $1 $. 40 $. 20 MU/P If you only have $25, what combination of movies and go carts maximizes your utility?

$10 Utility Maximization # Times Going Marginal Utility (Movies) 1 st 2 nd 3 rd 4 th 30 20 10 5 $5 (Price =$10) Marginal Utility (Go Carts) (Price =$5) 3 $2 $1 $. 50 10 5 2 1 2 $1 $. 40 $. 20 MU/P If you only have $25, what combination of movies and go carts maximizes your utility?

$10 Utility Maximization # Times Going Marginal Utility (Movies) 1 st 2 nd 3 rd 4 th 30 20 10 5 $5 (Price =$10) Marginal Utility (Go Carts) (Price =$5) 3 2 1. 50 10 5 2 1. 40. 20 MU/P If you only have $25, what combination of movies and go carts maximizes your utility?

Utility Maximizing Rule The consumer’s money should be spent so that the marginal utility per dollar of each goods equal each other. MUx = MUy Px Py Assume apples cost $1 each and oranges cost $2 each. If the consumer has $7, identify the combination that maximizes utility. 15

Utility Maximizing Rule The utility maximizing rule assumes that you always consume where MU/P for each product is equal 16

Utility Maximizing Rule The utility maximizing rule assumes that you always consume where MU/P for each product is equal b) Assume that the cross-price elasticity of demand between peanuts and bananas is positive. A widespread disease has destroyed the banana crop. What will happen to the equilibrium price and quantity of peanuts in the short run? Explain. (a)Equilibrium price and quantity will both increase. Peanuts and bananas are substitutes (they have a positive cross-elasticity), so an increase in the price of bananas will cause demand for peanuts to increase. 17

Utility Maximizing Rule The utility maximizing rule assumes that you always consume where MU/P for each product is equal c) Assume that the price of bananas increases. (i) Will the substitution effect increase, decrease, or have no effect on the quantity of bananas demanded? (ii) What happens to Sasha's real income? i) Decrease ii) Decrease 18