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Consumer Behavior and Utility Maximization

AP ECONOMICS CHAPTER 5

4 Key Concepts
Understanding Utility: Total and Marginal 2. Utility Maximization: Equalizing Marginal Utility per Dollar (MU/PA = MU/PB) 3. Individual and Market Demand Curves 4. Income and Substitution Effects (review from unit two)
1.

Introduction
The CONSUMER is essential to the market.

Understanding how the consumer makes his/her purchasing decisions is key.

1. Understanding Utility
Utility = Satisfaction/Happiness/Pleasure one

gets from consuming a good. Utility and usefulness are NOT synonymous in economics. Utility is difficult to quantify, as it differs between people and situations

ie. A blanket to a person living in Arizona vs. a person living in Minnesota.

Measured in utils (a personal measure)

1. Understanding Utility
Total Utility (TU) Total amount of satisfaction or pleasure a person derives from consuming a given quantity of that product Marginal Utility (MU) The extra satisfaction a consumer derives from one additional unit of that product. In other words, the change in Total Utility that results from the consumption of one more unit

Law of Diminishing Marginal Utility


Explains that the more of a good a person gets, the

less utility he gets from each additional unit. Consumer wants in general are insatiable, but wants for particular items can be satisfied for a time.

Example: Durable goods such as an automobile

First is the Best


It is important to note that your marginal utility

begins to fall after the very first unit you consume. In other words, your very first taco holds great utility. While you may enjoy your second taco, it doesnt bring as much utility as the first At some point, your MU becomes negative. (takes away from your total satisfaction).

Law of Diminishing Marginal Utility


Total Utility 30 TU 20 10 0 Marginal Utility (Utils)
(1) (2) (3) Tacos Total Marginal Consumed Utility, Utility, Per Meal Utils Utils

0 1 2 3 4 5 6 7

0 10 18

] ] ] 24 ] 28 ] 30 ] 30 ] 28

10 8 6 4 2 0 -2

Total Utility (Utils)

Units Consumed Per Meal

Marginal Utility 10 8 6 4 2 0 -2 1 2 3 4 5 6 7
Units Consumed Per Meal

MU

2. Utility Maximization
Explains how consumers allocate their money

incomes among the many goods and services available for purchase You will be faced with problems that provide you with a consumers MU or TU derived from purchasing 2 goods. You will be expected to show how many of each a rational consumer would purchase.

Theory of Consumer Behavior


Numerical Example:
Find the Utility-Maximizing Combination of A and B, if you have an Income of $10
(2) Product A: Price = $1 (b) Marginal (a) Marginal Utility Utility, Per Dollar (MU/Price) Utils (3) Product B: Price = $2 (b) Marginal (a) Marginal Utility Utility, Per Dollar (MU/Price) Utils

(1) Unit of Product

First Second Third Fourth Fifth Sixth Seventh

10 8 7 6 5 4 3

10 8 7 6 5 4 3

24 20 18 16 12 6 4

12 10 9 8 6 3 2

Theory of Consumer Behavior Numerical Example:


Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10
(2) Product A: Price = $1 (b) Marginal (a) Marginal Utility Utility, Per Dollar (MU/Price) Utils (3) Product B: Price = $2 (b) Marginal (a) Marginal Utility Utility, Per Dollar (MU/Price) Utils

(1) Unit of Product

First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Compare Marginal Utilities 16 Fourth 6 6 8 Then Compare Per 5 Dollar - MU/Price 6 Fifth 5 12 Choose the4Highest Sixth 4 6 3 Check Budget - Proceed to Next Item2 Seventh 3 3 4

Theory of Consumer Behavior


Numerical Example:
Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10
(2) Product A: Price = $1 (b) Marginal (a) Marginal Utility Utility, Per Dollar (MU/Price) Utils (3) Product B: Price = $2 (b) Marginal (a) Marginal Utility Utility, Per Dollar (MU/Price) Utils

(1) Unit of Product

First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Again, Compare Per Dollar -16 MU/Price Fourth 6 6 8 Choose the5Highest Fifth 5 12 6 Buy One of 4 Each Budget Has $5 Left Sixth 4 6 3 Proceed to 3 Next Item Seventh 3 4 2

Theory of Consumer Behavior


Numerical Example:
Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10
(2) Product A: Price = $1 (b) Marginal (a) Marginal Utility Utility, Per Dollar (MU/Price) Utils (3) Product B: Price = $2 (b) Marginal (a) Marginal Utility Utility, Per Dollar (MU/Price) Utils

(1) Unit of Product

First 10 10 Second 8 8 Third 7 7 Fourth 6 6 Again, Compare Per Dollar Fifth 5 5 Buy One More B 4 Budget Sixth 4 Proceed to 3 Next Item Seventh 3

24 12 20 10 18 9 16 8 -12 MU/Price 6 Has $3 Left 6 3 4 2

Theory of Consumer Behavior


Numerical Example:
Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10
(2) Product A: Price = $1 (b) Marginal (a) Marginal Utility Utility, Per Dollar (MU/Price) Utils (3) Product B: Price = $2 (b) Marginal (a) Marginal Utility Utility, Per Dollar (MU/Price) Utils

(1) Unit of Product

First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 6 16 8 Fifth 5 5 12 6 Again, Compare Per Dollar - MU/Price Sixth 4 4 6 3 Buy One of 3 Each 3Budget Exhausted Seventh 4 2

Theory of Consumer Behavior


Numerical Example:
Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10
(2) Product A: Price = $1 (b) Marginal (a) Marginal Utility Utility, Per Dollar (MU/Price) Utils (3) Product B: Price = $2 (b) Marginal (a) Marginal Utility Utility, Per Dollar (MU/Price) Utils

(1) Unit of Product

First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 6 16 8 Fifth 5 12 Final Result At 5 These Prices, 6 Sixth 4 4 6 3 Purchase 3 of Item A and 44 of B 2 2 Seventh 3

Theory of Consumer Behavior


Algebraic Restatement:
MU of Product A Price of A 8 Utils $1

=
=

MU of Product B Price of B 16 Utils $2

Optimum Achieved - Money Income


is Allocated so that the Last Dollar Spent on Each Good Yields the Same Extra or Marginal Utility

Two-Good Practice Problem


Given MU, and an income/budget constraint of $20 find the UtilityMaximizing Combination of A and B
(2) Product A: Price = $2 Unit 1 2 3 MU 20 10 6 Unit 1 2 3 (3) Product B: Price = $5 MU 30 20 15

4
5

3
1

4
5

5
-5

Two-Good Practice Problem


Given TU, and an income/budget constraint of $9 find the UtilityMaximizing Combination of A and B
(2) Product A: Price = $2 Unit 1 2 3 TU 22 32 40 Unit 1 2 3 (3) Product B: Price = $1 TU 10 16 20

4
5

46
48

4
5

22
20

The Problem with Utils


Answer the following problem:

If Henry derives 5 utils from the 1st candy bar, 3

utils from the 2nd candy bar, 0 utils from the 3rd candy bar, and -5 utils from the 4th candy bar

How many candy bars should Henry consume if each candy bar
Is absolutely free (MC = 0) Costs $2 Costs $4

From Utils to Benefit


Because Utils cannot be compared between people,

and cannot be compared to dollars economists must measure satisfaction in Benefit.

Benefit is the same concept as utility, but it is measured in dollars (according to the consumers WILLINGNESS TO PAY. Total Benefit ($), Marginal Benefit ($)

Golden Rule of Consumption


A rational consumer will continue to purchase

until

MB = MC
To consume one more would mean your marginal cost is greater than your marginal benefit

3. Individual and Market Demand Curves


Start with an individual consumer maybe you, maybe me, but could be anyone Derive demand curve for that individual focus on marginal utility or marginal benefit Add up demand curves for many such individuals to

get market demand curve

Assumption about consumer behavior


General economic When applied to the

principle People make purposeful choices


with

limited resources

behavior of consumers People maximize utility subject to a budget constraint

3. Individual and Market Demand Curves


Consider all consumers in the market Add up quantity demanded by all individuals at each

price to get market demand Add horizontally to create market demand curve

05_06

PRICE (DOLLARS) 5 4 3 2 1 0 1 2 3 4 5 Pete's demand curve

PRICE (DOLLARS) 5 4 3 2 1 0 1 2 3 4 5 Ann's demand curve

QUANTITY DEMANDED BY PETE (POUNDS) PRICE (DOLLARS) 5 4 3 2 1 0 1 2 3 4 5 6

QUANTITY DEMANDED BY ANN (POUNDS)

Market demand curve

10

QUANTITY DEMANDED IN MARKET (POUNDS)

4. Substitution and Income Effects


This topic on the AP Course Outline was already

covered in unit 2. To review, just remember that both of these effects help to explain why the demand curve slopes downward.

Review Questions Utility


Which of the following factors contributes to a downwardsloping demand curve?
I. The income effect II. The substitution effect III. Diminishing marginal utility

A. B. C. D. E.

I only III only I and II only II and III only I, II, and III

Review Questions Utility

What is the marginal utility of the third cup of peanuts

Brian consumes? A. 3 units of utility B. 9 units of utility C. 12 units of utility D. 2 units of utility E. 14 units of utility

Review Questions Utility

If the price of peanuts is $1 per cup and the price of jelly beans is $2 per cup, and Brian wants to maximize his utility, what should he purchase first? A. 1 cup of peanuts because peanuts produce a lower total utility B. 1 cup of peanuts because the price of peanuts is lower C. 1 cup of peanuts, because the marginal utility per dollar for peanuts is lower than the marginal utility per dollar of jelly beans D. 1 cup of jelly beans, because the marginal utility per dollar for jelly beans is higher than the marginal utility per dollar of peanuts E. 1 cup of jelly beans, because jelly beans produce a higher total utility

Review Questions Utility


If TU = total utility, MU = marginal utility, and P = price, in order to maximize utility, a consumer should purchase the mix of hamburgers and hot dogs where A. the MU of hamburgers equals the MU of hot dogs B. the MU equals the TU of hamburgers, and the MU equals the TU of hot dogs C. the TU of hamburgers equals the TU of hot dogs D. the MU / P of hamburgers equals the MU / P of hot dogs E. the TU / P of hamburgers equals the TU / P of hot dogs

Review Questions Utility


If Matts total utility from consuming slices of cheese

increased at a constant rate, no matter how many bratwurst Matt consumed, what would Matts demand curve for slices of cheese look like? A. Vertical B. Horizontal C. Downward sloping D. Upward sloping E. First upward, but eventually downward sloping

Review Questions Utility


Every day Molly spends her lunch money consuming apples, at $1

each, and oranges, at $2 each. At her current level of consumption, mollys marginal utility of apples is 12 and her marginal utility of oranges is 18. If she has already spent all of her lunch money, how should Molly change her consumption decision to maximize utility? A. She should make no changes; she is consuming the utility maximizing combination of apples and oranges. B. She should increase her apple consumption and decrease her orange consumption until the marginal utility per dollar is equal for both. C. She should decrease her apple consumption and increase her orange consumption until the marginal utility per dollar is equal for both. D. She should increase her apple consumption and decrease her orange consumption until the marginal utility is equal for both. E. She should decrease her apple consumption and increase her orange consumption until the marginal utility is equal for both.

Review Questions Utility


If generic peanut butter is an inferior good, a decline in

consumer income causes A. the price of generic peanut butter to go down. B. the demand for name-brand peanut butter to go up. C. the supply of generic peanut butter to go up. D. the demand for generic peanut butter to go up. E. the price of bread to go down.

Key Terms
law of diminishing marginal utility utility total utility marginal utility rational behavior budget constraint utility-maximizing rule

income effect
substitution effect

Deriving the Demand Curve


Same Numeric Example:

Price Per Quantity Unit of B Demanded

$2 1

4 6

Price of Product B

Income Effects
0

DB
4 6

Substitution Effects

Quantity Demanded of B