The Analysis of Consumer Choice

“The golden rule for every business is this: put yourself in your customer’s place.”

-Orison Swett Marden

Slide 1 of 17

A look back on utility

We introduced marginal utility in the previous module. There we learned that it is the increase in

satisfaction that one obtains from consuming something.

We explored a new term, “utils” to help quantify how much we enjoy something.

I realize that this is abstract (even silly?) but we need such a measurement to conduct analysis…so we

have the “util”.

We also reviewed an important law that will shape our exploration of consumer choices: the Law of

Diminishing Marginal Utility.

The Law of Diminishing Marginal Utility

Slide 2 of 17

A quick review of diminishing marginal utility

Just as a reminder, The law of diminishing marginal utility tells us that we get less

satisfaction from each successive unit we consume.

In more technical terms, this means that for all goods and services, the marginal utility curve is downward sloping.

Marginal utility can…and will…eventually turn negative for all goods and services.

This is easy to imagine if we consider pizza. The first slice is delicious…marginal utility is high.

The tenth slice…well…I bet you wish you did not eat it as you feel bloated and overstuffed. For that piece marginal

utility is very low, perhaps even negative.

Slide 3 of 17

A Real World Application of Diminishing Marginal Utility

The concept of marginal utility has impacts in the world around us.

For example, here we have a newspaper machine. You put in your money, open the door to see the entire stack

of papers and take one.

This however is a soda machine. Put in your money and only one unit is dispensed.

Why the difference?

Marginal utility for a news paper drops quickly. After you read one, it is unlikely

that you will read another one.

That means it is unlikely that you will take more than one if given access to

all of them. Diminishing marginal utility sets in quickly.

Diminishing marginal utility does not set in quickly for sodas. In fact, a

second soda is almost as good as the first.

If given access to the entire inventory, what might you be tempted to do? Be

honest!

Therefore, because of the law of diminishing marginal utility, the soda producers must install much more

sophisticated machinery to sell their products!Slide 4 of 17

Let’s turn our attention to consumer choice

We know that consumer’s want to maximize their utility.

We also know that they face constraints… for example, each of us

only has so much money.

How does a consumer decide what to buy?

Let’s explore this idea further…and as we do, we’ll derive the demand

curve.

Slide 5 of 17

Deriving the demand curve

Consumer’s face choices among literally thousand upon thousands of

goods and services.

First the assumptions:

To keep things simple, we’ll assume that the world has only two goods:

product A and product B.

RealityWhat we will assume

In reality, information is not perfect. But consumers do the best they can

through Marginal Cost Marginal Benefit analysis to make themselves

happy.

Consumers allocate their resources (i.e. spend their money) in a way that

maximizes their utility.

In reality, consumers can save money or borrow from tomorrow by charging.

Consumers have limited resources. Specifically, we will assume that each consumer has $10 per day to spend

and must spend all of it.

Slide 6 of 17

The first unit of B brings the

consumer 24 utils. That is 12 utils per

dollar.

Here’s a utility maximizing exercise showing how consumers might make choices

The Utility Maximizing Combination is 2 units of A and 4

Units of B.

The first unit of A brings the

consumer 10 utils. That is 10 utils per

dollar.

This consumer would buy a unit of B. It brings 12 units of utility per dollar. If the consumer is

maximizing utility per dollar, Product B

looks better.

In doing so, this consumer would be

left with $8.

What would they buy next?

For the next choice, each product is

valued at 10 utils per dollar. It is a tie.

This consumer would buy a unit of A and

B.

In doing so, this consumer would be

left with $5.

What would they buy next?

Next, this consumer would buy a unit of B.

It brings 9 units of utility per dollar

versus 8 utils per dollar for product A.

In doing so, this consumer would be

left with $3.

What would they buy next?

The next choice is also a tie.

This consumer would buy a unit of

A and B. They each bring 8 units of utility per dollar.

In doing so, this consumer would be left with $0.

The consumer has now spent

their $10.

And this combination of

goods (2 units of A and 4 units of B) yields 96 utils.

No other combination of A and B that can be purchased for $10 can exceeds that!

Please remember: at $2 per unit of B,

this consumer wanted 4 units of B

Here we see this consumer has ten

dollars.

We’ll assume that Product A costs $1 and

Product B cost $2.

Having bought one unit of B for $2, this

consumer has $8 left to spend.

Slide 7 of 17

Overly analytical?

I realize that it is tough to believe that we all sit around calculating our “marginal utility per

dollar”?

People do not sit there and say, “I’ll take a coke because it gives my 10 utils (what

ever that means!).

But trust me. Somewhere in your brain, these calculations are taking place as you spend all

your time trying to maximize your utility.

Now let’s see what happens if the Price of B fell to $1.B is on SALE !

Slide 8 of 17

Assume the price of B falls to $1

This table shows a the hypothetical consumer’s MU

and MU per dollar given the new

price.

Assume this consumer has $10

to spend. What would they buy?

What if the Price of B fell to $1?

This consumer would buy a unit of

B. It brings 24 units of utility per

dollar.

In doing so, this consumer would be left with $9.

What would they buy next?

This consumer would buy another unit of B. It brings 20 units of utility

per dollar.

In doing so, this consumer would be left with $8.

What would they buy next?

This consumer would buy another unit of B. It brings 18 units of utility

per dollar.

In doing so, this consumer would be left with $7.

What would they buy next?

This consumer would buy another unit of B. It brings 16 units of utility

per dollar.

In doing so, this consumer would be left with $6.

What would they buy next?

This consumer would buy another unit of B. It brings 12 units of utility

per dollar.

In doing so, this consumer would be left with $5.

What would they buy next?

This consumer would buy a unit of

A. It brings 10 units of utility per

dollar.

In doing so, this consumer would be left with $4.

What would they buy next?

This consumer would buy a unit of A. It brings 8 units of utility per dollar.

In doing so, this consumer would be left with $3.

What would they buy next?

This consumer would buy a unit of A. It brings 7 units of utility per dollar.

In doing so, this consumer would be

left with $2.

What would this consumer buy next?

It is a tie.

This consumer would buy a unit of A and B. They each bring 6 units of utility

per dollar.

In doing so, this consumer would be

left with $0.

This combination of goods (4 units

of A and 6 units of B) yields 127 utils.

No other combination of A and B that can be purchased for $10 can exceeds that!

Utility Maximizing Combination is 4 units of A and 6 units of B

Please remember: at $1, this consumer wanted 6 units of B

Slide 9 of 17

Once we understand

Utility Maximization, we

can easily see why

quantity demand and

price are inversely

related.

Let’s reflect back to the downward sloping demand curve

DIn other words…we can

“Derive the demand

curve”!

Slide 10 of 17

Deriving the Demand Curve

When Product B was $2, this consumer chose to purchase

4 units of B

When the price of Product B fell to $1, 6 units of B were

purchased!

Connecting those points may give us this consumer’s

demand curve for this product. Note it’s downward slope!

D

Demand for Product B

Slide 11 of 17

Individual ExerciseI suggest you do this- you will see one of these on the test

Step one: Determine the utility maximizing combination of A and B with these two scenarios Step two: Graph the demand curve for product B

3.0

Slide 12 of 17

Why is the demand curve downward sloped?

• There are 3 primary reasons

– Law of Diminishing Marginal Utility

– Income effect

– Substitution effect

Let’s quickly explore these three ideas...

Slide 13 of 17

Reason #1: Diminishing Marginal Utility

• As we consume more of an item, each successive unit brings us less satisfaction

• Eventually, the marginal cost of that item outweighs the marginal utility

Eventually, kids get tired of swinging. Diminishing marginal

utility sets in!(Trust me, it takes a long time.)

Slide 14 of 17

Reason #2: Income effect

• A fall in the price of a good we buy means we have more money to spend

• As prices of a good we buy decline, our purchasing power or “real income” increases (and vice versa). We demand more of all normal goods.

Slide 15 of 17

Reason #3: Substitution effect

A higher price for a good causes us to demand less of it as we seek to find “a

better buy”

For example, if butter prices

increased a lot, I think many of us would substitute

margarine.

Slide 16 of 17

In summary

But they face constraints such as a limited income.

Consumers seek to maximize their utility.

They therefore conduct cost benefit analysis to select goods that most satisfies them.

A review of this analysis - where we derive the demand curve - can prove to us that the demand curve is

downward sloped.

Slide 17 of 17