Assignment number 3: Consumer Behavior

1. Define Utility.

Utility is the satisfaction one gets from consuming a good or service

Not the same as usefulness
Subjective
Difficult to quantify
Utility is an abstract concept rather than a concrete, observable quantity. The units to which we
assign an "amount" of utility, therefore, are arbitrary, representing a relative value. Total utility
is the aggregate sum of satisfaction or benefit that an individual gains from consuming a given
amount of goods or services in an economy. The amount of a person's total utility corresponds
to the person's level of consumption. Usually, the more the person consumes, the larger his or
her total utility will be. Marginal utility is the additional satisfaction, or amount of utility, gained
from each extra unit of consumption.
Although total utility usually increases as more of a good is consumed, marginal utility usually
decreases with each additional increase in the consumption of a good. This decrease
demonstrates the law of diminishing marginal utility. Because there is a certain threshold of
satisfaction, the consumer will no longer receive the same pleasure from consumption once
that threshold is crossed. In other words, total utility will increase at a slower pace as an
individual increases the quantity consumed.
Take, for example, a chocolate bar. Let's say that after eating one chocolate bar your sweet
tooth has been satisfied. Your marginal utility (and total utility) after eating one chocolate bar
will be quite high. But if you eat more chocolate bars, the pleasure of each additional chocolate
bar will be less than the pleasure you received from eating the one before - probably because
you are starting to feel full or you have had too many sweets for one day.
Utility is the satisfaction that a person derives from the consumption of a good or service. Total
utility is the total satisfaction received from consuming a given total quantity of a good or
service, while marginal utility is the satisfaction gained from consuming another quantity of a
good or service. Sometimes, economists like to subdivide utility into individual units that they
call utils. However, because utility is subjective, meaning that it differs from person to person,
and because it varies continuously, depending on the quantity consumed, an util cannot
actually be measured, but is simply a heuristic device that allows economists to talk about the
degree of satisfaction of a product or service.
Although one definition of utility is usefulness, usefulness is not a quality in economic utility.
For instance, water is very useful, but doesn't have much utility for most people. On the other
hand, judging by recent gold prices in the market, gold has great utility for some people, but it
is not very useful.

2. Graphically illustrate and define total utility and marginal utility.

Util is one unit of satisfaction or pleasure

Total utility is the total amount of satisfaction
Marginal utility is the extra satisfaction from an additional unit of the good MU =
TU/Q

3. State the law of diminishing marginal utility.

One quality of marginal utility is that it always declines for each successive quantity consumed of a
particular good. If you like ice cream, and you eat one scoop, the first scoop will provide the greatest
satisfaction. If you eat another scoop, you'll probably enjoy that also, but the satisfaction will be less
than for the first. At some point, you will not want any more ice cream. The marginal utility will drop to
zero and will even become negative. This is an everyday illustration of the law of diminishing marginal
utility. Marginal utility declines for everything, including money. Although many people want to amass
great wealth, each dollar that is accumulated becomes worth less and less, because the marginal utility
of what it can buy declines.

As consumption of a good or service increases, the marginal utility obtained from each
additional unit of the good or service decreases
Explains downward sloping demand

4. Explain the water-diamond paradox.

One of the most disconcerting problems to Adam Smith, the father of modern economics, was
that he could not resolve the issue of valuation in human preferences. He described this
problem in "The Wealth of Nations" by comparing the high value of a diamond, which is
unessential to human life, to the low value of water, without which humans would die. He
determined "value in use" was irrationally separated from "value in exchange." Smith's

"diamond/water paradox" went unsolved until later economists combined two theories:
subjective valuation and marginal utility.
Labor Theory of Value
Like nearly all economists of his age, Smith followed the labor theory of value. Labor theory
stated that the price of a good reflected the amount of labor and resources required to bring it
to market. Smith believed diamonds were more expensive than water because they were more
difficult to bring to market.
On the surface, this seems logical. Consider building a wooden chair. A lumberjack uses a saw
to cut down a tree. The chair pieces are crafted by a carpenter. There is a cost for labor and
tools. For this endeavor to be profitable, the chair must sell for more than these production
costs. In other words, costs drive price.
The labor theory suffers from many problems. The most pressing is that it cannot explain prices
of items with little or no labor. Suppose a perfectly clear diamond naturally developed in a
perfect shape. It is then discovered by a man on a hike. Does it fetch a lower market price than
an identical diamond arduously mined, cut and cleaned by human hands? Clearly not. A buyer
does not care.
Subjective Value
What economists discovered was that costs do not drive price; it is exactly the opposite. Prices
drive cost. This can be seen with a bottle of expensive French wine. The reason the wine is
valuable is not because it comes from a valuable piece of land, is picked by high-paid workers or
is chilled by an expensive machine. It is valuable because people really enjoy drinking good
wine. People subjectively value the wine highly, which in turn makes the land it comes from
valuable and makes it worthwhile to construct machines to chill the wine. Subjective prices
drive costs.
Marginal Utility Vs. Total Utility
Subjective value can show diamonds are more expensive than water because people
subjectively value them more highly. However, it still cannot explain why diamonds should be
valued more highly than an essential good such as water.
Three economists, William Stanley Jevons, Carl Menger and Leon Walras, discovered the
answer almost simultaneously. They explained that economic decisions are made based on
marginal benefit rather than total benefit.
In other words, consumers are not choosing between all of the diamonds in the world versus all
of the water in the world. Clearly, water is more valuable. They are choosing between one
additional diamond versus one additional unit of water. This principle is known as marginal
utility.
A modern example of this dilemma is the pay gap between professional athletes and teachers.
As a whole, all teachers are probably valued more highly than all athletes. Yet the marginal
value of one extra NFL quarterback is much higher than the marginal value of one additional
teacher.

The diamond-water paradox poses the perplexing observations: Even though water is obviously
important to human activity (life cannot exist without water), the price of water is relatively
low. Alternatively, diamonds are clearly much less important to human existence, but the price
of diamonds is substantially higher. In other words, the utility obtained from water is obviously
very great, while the utility obtained from diamonds is substantially less. The key question that
arises is: Why are diamonds so much more expensive than water?
Tell the child to hold a cup of water in one hand, and a plastic diamond in the other ( Make sure
that they think that it is real ). Ask them to tell you which is more valuable - they should
respond
with
the
diamond.
So now we've both established that the diamond is more valuable than water. Now explain to
them why water is so important to human life. Water is necessary for life to exist at all, and you
and I are only alive on Earth because water is easily accessible for us.
There are two types of satisfaction for humans: the needs, and the wants. The needs are water,
food, shelter, etc. The wants are unnecessary items such as gold, or diamonds here. Many
people will not have the satisfaction of owning diamonds anytime in their lives. However,
diamonds are not necessary for human life. Most houses do not have hot and cold running
diamonds. Most people do not drink eight glasses of diamonds a day, take showers in
diamonds, or fill their Olympic-sized swimming pools with hundreds of gallons of diamonds.
Water is very plentiful. You can find water almost anywhere, and because there is so much, the
price is very low. Diamonds are extremely hard to find, and because of their rarity, they are
much
more
expensive.
If water supply were as limited as diamond supply, then the price of water would be many
times more than diamonds, because water in the same quantity as diamonds is much more
valuable to human life.
5. What is an indifference curve? Graphically illustrate.

Combinations of two products that yield the same amount of total utility
The consumer is indifferent as to which combination to purchase
What is preferred
Characteristics
Downsloping
Convex to the origin
Reflects the MRS

Indifference map:
Series of indifference curves where each curve reflects different amounts of utility
Each successive curve outward reflects a higher level of utility

6. What is a budget line? Graphically illustrate.

Combinations of two products a consumer can purchase with their money income

Slope is the ratio of the price of B to the price of A

Location varies with income changes

Location varies with price of products

What is attainable

7. How does an individual maximize utility?

Consumer allocates his or her income so that the last dollar spent on each product
yields the same amount of extra (marginal) utility
Algebraically
MU of product A
MU of product B
Price of A
Price of B

8. How does an individual derive his demand based on utility?