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Consumer Choice

Utility Consumer surplus Budget Constraints Indifference Curves

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I. Utility Analysis

what is utility? benefit you get from consuming a good determined by your tastes/preferences

(assume these are stable)

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total utility (TU)

total benefit from consuming good example

total benefit from 3 cookies

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TU increases as consumption increases, to a point

<TU 2 cookies TU 3 cookies

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marginal utility (MU)

change in TU from

consuming one more of a good example

how much MORE utility from

an additional pack of gum?

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change in TU from0 to 1 cookie

change in TU from1 cookie to 2 cookies

MU of 1st cookie

MU of 2nd cookie

=

=

0

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diminishing marginal utility

MU falls as consumption rises get sick of cookies

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MU of 1st cookie

> MU of 2nd cookie

0

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TU

cookie

TU rises at slower and slower rate

as MU declines

MU

cookie

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How to maximize TU?

use available budget equalize MU/$ across goods Huh?

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chose combination of cookies and milk where

price of cookies price of milk

MU cookies=

MU milk

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why?

chose combo of 6 cookies, 1 milk suppose MU/$1 of cookies = 4,

MU/$1 of milk = 15 by consuming fewer cookies, more milk…

I would add more to my TU

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TU vs. MU

Diamond-Water paradox $10,000

one carat diamond 5 million gallons of tap water

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why?

TU of water is greater than TU of diamonds water is essential for life

BUT water is abundant, diamonds are rarer MU of last diamond is higher

MU determines value

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MU and demand

MU declines as consumption rises willing to pay less for each additional unit

downward sloping demand

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example : pizzaP

Q

D

$10

4 pizzas

for 4th pizzawilling to pay $10

for 2nd pizza$15

2 pizza

willing to pay $15

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II. Consumer Surplus

difference between what you pay for a good,

any what you are WILLING to pay for a good

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example

market price pizza = $10 my marginal value of 3rd pizza this

week = $12 my consumer surplus = $2

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P

Q

D

$10

my demand curve

$12

3

my consumer surplus

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P

Q

D

$10

10,000

total consumer surplus

area between Dand price of pizza

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III. The Budget Line

given: consumer’s budget prices

draw a line representing choices consumption possibilities

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example

2 goods: milk & cookies bottle of milk = $1 cookie = $.50 daily budget = $4

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possible combinations

cookies milk

02468

43210

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budget line

milk

cookies

8

4

2

6

0421 3

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budget line

milk

cookies

8

4

2

6

0421 3

Affordable

Unaffordable

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what if prices change?

changes slope of budget line suppose cookies = $1

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budget line

milk

cookies

8

4

2

6

0421 3

cookie = $.50

cookie = $1

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what if budget changes

budget line shifts suppose budget = $5

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milk

cookies

budget = $4

budget = $58

4

2

6

0

10

421 3 5

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IV. Indifference Curves

(appendix) alternative way to show utility curve shows combo of goods

that deliver same total utility

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example: milk and cookies

milk

8

4

2

6

0421 3

cookies

Indifference curve

Every point on curve has same total utility

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TU is higher as curve shifts right

milk

cookies

higher TU

lower TU

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consumer equilibrium

maximize TU stay on budget

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consumer equilibriumcookies

8

milk4

4

2

best affordable point

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consumer equilibriumcookies

8

milk4

4

2

best affordable point

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sum it up

consumer decisions based on preferences budget constraint

consumer decisions made at the margin marginal benefit of one more compared to price of one more