The Theory of Consumer Behavior

Chapter 07

McGraw-Hill/Irwin Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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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

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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.

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Hypothetical Demand Schedule for Hamburgers

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The additional utility derived from consuming one more unit of a good or service.

Marginal Utility

Note: MU is the same as the price.

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Price Units Purchased MU

$2.75 1 $2.75

2.00 2 2.00

1.00 3 1.00

.25 4 .25

Law of Diminishing Marginal Utility

As we consume more and more of a good or service, we like it less and less.

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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.

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Maximizing Utility

How much we buy of any good or service depends on:• Its price.• Our marginal utility schedule.

In real life there is usually only ONE price!

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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

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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 is $1.00. How many units would you buy?

The answer is 3.

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Maximizing Utility (continued)

The MU of the last unit purchased will always equal its price.

The answer is 3.

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Maximizing Utility

The price is $2. How many units will you buy?

The answer is 2.

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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 answer is 2.

The MU of the last unit purchased will always equal its price.

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General Utility Formula

The MU of the last unit purchased will always equal its price:

MU 2.75 2.00 1.00 .25Price 2.75 2.00 1.00 .25= = = = = 1

If this is true for hamburgers, it will be true for everything else.

MU1 MU2 MU3 MUn

P1 P2 P3 Pn= ==

Remember, we will keep buying anything until its MU declines to the price level.

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Price # Purchased MU TU

$2.75 1 $2.75 $2.75

2.00 2 2.00 4.75

1.00 3 1.00 5.75

.25 4 .25 6.00

0 0 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.

General Utility Formula (continued)

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Price QD MU Price QD MU Price QD MU

$ 3.00 1 $3.00 $1.50 1 $1.50 $1.50 1 $1.50

2.00 2 2.00 1.00 2 1.00 .50 2 .50

1.00 3 1.00 .50 3 .50

Hamburgers Fries Coke

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

Questions for Discussion

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Price QD MU Price QD MU Price QD MU

$ 3.00 1 $3.00 $1.50 1 $1.50 $1.50 1 $1.50

2.00 2 2.00 1.00 2 1.00 .50 2 .50

1.00 3 1.00 .50 3 .50

Hamburgers Fries Coke

How many burgers, fries, and cokes would you consume if burgers were $1, fries were $1, and cokes were $1.50?

Questions for Discussion

1st answer: 1 hamburger; 3 fries; 2 cokes

2nd answer: 3 hamburgers; 2 fries; 1 coke

This is consistent with the law of supply and demand.

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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

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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.

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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 $2.75

2.00 2 2.00 4.75

1.00 3 1.00 5.75

.25 4 .25 6.00

0 5 0

The price of hamburgers is $0.25.

Hamburger

Schedule

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.

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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 $2.75

2.00 2 2.00 4.75

1.00 3 1.00 5.75

.25 4 .25 6.00

0 5 0

Price of Hamburgers is $2.00.

Hamburger

Schedule

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.

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Consumer Surplus

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.

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.

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0 1 2 3 4 5 6

3.00

Consumer Surplus

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.

D

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.

1.00

2.00

0.25

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Hypothetical Demand Schedule for Sessions with a Personal Trainer

Try calculating MU and TU.

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Hypothetical Utility Schedule for Sessions with a Personal Trainer

What is the consumer surplus for 4 sessions?

Answer: $145 – (4 x $25) = $45.

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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.

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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 4th slice.• How much marginal utility would you have gotten from a 5th

slice? Answer: Less than zero.

• How much marginal utility did you get from the 4th slice? Not a lot since you can’t finish it. The 4th slice did, however, provide you with some marginal

utility.