Section 01: Consumer Behavior

Utility

In this section, we are going to take a closer look at what is behind the demand also curve and the habits of consumers. How does a consumer decide to spfinish his/her revenue on the many type of different things that he/she wants, i.e., food, apparel, real estate, entertainment? We assume that the goal of the customer is to maximize his/her level of satisfactivity or joy, constrained by his/her revenue.

Economists usage the term utility as a meacertain of satisfactivity, joy, or happiness. How a lot satisfactivity does a person get from eating a pizza or watching a movie? Measuring utility is based specifically on the choices of the individual and also has actually nothing to carry out with the price of the great. Let’s carry out an experiment in utility.

Tip 01: Get some of your favorite candy, pastries, or cookies.

Tip 02: Take a bite and also evaluate, on a range from 0 to 100 (with 100 being the best utility), the level of energy from that bite. Record the marginal energy of that bite (i.e., exactly how much you acquire from that one extra bite).

Step 03: Repeat step 02. It is crucial to be constant through each unit consumed, i.e., the same dimension and also no drinking milk or water part method though. When you run out of candy or your marginal energy goes to zero you can soptimal.

You are watching: A consumer is maximizing her utility with a particular money income when:

Law of Diminishing Marginal Utility

The regulation of diminishing marginal utility claims that as more of the good is consumed, the added satisfaction from another bite will certainly inevitably decrease. The marginal utility is the satisfaction acquired from each extra bite. As even more of the excellent is consumed, we acquire less added satisfaction from consuming another unit. Thus also if an excellent were free and also you could consume as much as you wanted, there would be a limit to the amount you would consume as a result of the regulation of diminishing marginal energy.

Summing the marginal utilities gives us the complete energy. For instance, let’s say the first cocoa was an 85 and also the second cacao had actually a marginal utility of 79, then the full energy from consuming two chocolates is 164. The complete utility from consuming 3 chocolates is 85+79+73 = 237. As long as our marginal utility is positive our total energy boosts although via diminishing marginal utility it increases at a decreasing rate.

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Can marginal energy be negative? Yes. At a holiday dinner, you may overeat and also experience from indigestion afterwards to a point where you regret having consumed as well much, however at the time of the dinner, you meant higher utility from eating the last of the meal. We would not willingly consume a things that provided us negative marginal utility. Then why would certainly an individual stuff themselves throughout a hot dog eating challenge where plainly the last warm dogs consumed are making them worse off? Although the marginal utility from the last hot dog itself makes the perchild worse off, the energy from winning the contest is higher making the marginal utility positive.

The marginal utility of a things can adjust. For example, in the time of a drought water gives a high positive marginal utility, and with more rain the marginal energy declines. At some allude, tright here is also much rain, it turns from being a good energy to a bad one and also the marginal energy of even more rain, when it is currently flooding, is negative.

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Maximizing Utility

Utility values have the right to be figured out by an individual ranking his/her choices from leastern preferred to most preferred. The resulting ranking or utility worths are subjective or individual. They are also ordinal quite than cardinal. Ordinal means that the energy values ssuggest specify a ranking of choices fairly than an actual cardinal measurement.

Imagine a class has 10 students in the course and also the teacher lined the students up according to height. He then numbered them off according to elevation, assigning the shortest student a 1 and also the tallest student a 10. Is it true that student number 4 is twice tall as student number 2? Of course not. All we know from the ranking is that student number 4 is taller than student number 2. Now, imagine that in one more class an additional teacher has actually additionally ranked 10 students according to height. Is it true that student number 10 from the second classroom is taller than student 1 from the first classroom? We cannot say given that the ranking is only valid within a details course. In order to say a student is twice as tall as another student or to be able to compare students in between classes, we would need a cardinal meacertain of height choose inches or centimeters.

Since utility is ordinal and not cardinal we cannot make interpersonal comparisons of utility. Does a wealthy perboy worth a dollar more or less than a bad person? While some would say that a negative person likely has more unmet needs and hence he would worth the dollar even more. The answer is that it all relies on the preferences of the people. A negative person may favor to live an extra simplistic life and place a lower value on having actually an extra dollar than a wealthy person that has a “love of money” (1 Timothy 6:10). We sindicate cannot make such an interindividual comparison of utility.

So how does the customer decide what to purchase? Unfortunately every little thing has a price and also consumers only have so a lot money to spfinish. Consequently consumers try to spfinish the restricted money they have actually on what will give them the best amount of satisfactivity. The decision preeminence for utility maximization is to purchase those items that provide the greatest marginal utility per dollar and are affordable or within the budobtain. Many grocery stores carry out a tag that indicates the price per pound for the great. This enables consumers to compare the price per pound for various brands or different sizes. The exact same idea is offered for maximizing energy but we divide the marginal energy by the price to get the marginal energy per dollar.

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Let’s say that we eat only 2 goods: milk shakes and pizza wright here the price of each slice of pizza is $2 and the price of each shake is $1 and also we just have actually $11 to spend. Due to the fact that the price of each great is different we need to divide the marginal energy by the price to allow for a common comparison. We then compare the marginal utility per dollar for pizzas verses shakes. For the initially unit the marginal utility per dollar of a shake is 50 compared to only 45 for the pizza, so we would purchase the initially shake. We then compare the marginal energy per dollar of the initially pizza (45) to the marginal utility per dollar of the second shake (40) and also purchase the first slice of pizza. If the marginal utility per dollar is the same for the 2 goods and we have actually inconcerned purchase both then we would certainly carry out so, as checked out in the second slice of pizza and also the second shake.

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We proceed to alsituate on budgain on those items that yield the highest marginal utility per dollar. In this instance, we would certainly purchase 4 slices or pizza and also 3 milkshakes and also spfinish our whole budobtain of $11. The full energy from this purchase would certainly be the sum of the marginal utilities: 50 + 90 + 80 + 40 + 70 + 60 + 30 = 420. At the last items purchased the marginal energy per dollar spent on the 2 products is the same, no various other combicountry of pizzas and milk shakes will certainly offer us better utility provided our budget.

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Practice

Here is your possibility to practice. Holly has actually $20 to spfinish on either movies or bowling and wants to maximize her utility. Complete the table and also recognize just how many kind of movies and rounds of bowling will maximize her utility.

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Our first step is to divide the marginal energy of each item by the price. With an revenue of $20 she is limited in what she can purchase. Because the marginal utility per dollar for bowling (15) is greater than the marginal utility of the first movie (12.5) she would initially go bowling, spfinishing $4. Comparing the initially movie (12.5) to the second round of bowling (10) she would go to the movie spfinishing an additional $8 and a complete of $12. The decision is a tiny harder. Holly has eight dollars still to spend and also the marginal energy per dollar is the same for each excellent. If she chooses the movie she will spend all eight dollars, but if she goes bowling she will spend 4 dollars and still have four to spfinish. We have assumed that she desires to spend all her money and gains no energy from holding the cash. Since she can’t afford to buy one more movie yet would instead by a third round of bowling, which only has a marginal energy per dollar of 7.5. Thus we view that to maximize her utility, she would purchase one round of bowling and also 2 movies providing her a full energy of (60 + 100 + 80) = 240. Recall our decision dominion is to have actually the marginal energy per dollar invested on the last items be the exact same for all items. In this situation, we are unable to have that precisely but we try to gain as close as feasible. Tbelow is no various other combination that would certainly offer us higher energy given our revenue.

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Deriving Demand

Knowing just how the consumer behaves allows us to derive a demand curve. Let’s say that Suzette eats either an apple or an oselection as a snack. She has $12 to spfinish. Given that each fruit costs two dollars, she will certainly maximize her utility by purchasing 3 apples and also 3 oranges. If we are looking at the demand for oarrays, this will certainly provide us one point on the demand also curve. At a price of $2.00, the amount demanded of oarrays is 3.

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Respeak to that as we relocate alengthy the demand also curve, the just point that alters is the price of the great (ceteris paribus or holding all else constant). If the price of oranges decreases to $1, the amount of ovarieties demanded rises to 6.

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We deserve to plot the 2 points and create a demand also curve for oarrays. At a price of $2 the amount demanded is 3 and at a price of $1 the quantity demanded is 6. Recall that the demand also curve shows the marginal benefit or the willingness to pay of the customer.

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The demand curve can be watched in the diamond-water paradox. Why does water that is crucial to sustain life cost so much much less than diamonds that are atheistically pleasing, however are fairly unnecessary? Recontact that price reflects the scarcity of a good. Overall, the supply of water is fairly plentiful while the supply of diamonds is fairly limited. Hence the price we pay for water is low compared to the price of diamonds.

Is it logical for someone that is maximizing his utility to purchase both water and diamonds? When deciding what to purchase we compare the marginal energy divided by the price. With numerous water intake, the complete utility of water is incredibly large yet the marginal utility of the last gallon consumed is fairly low. Few diamonds are purchased so while the marginal energy is incredibly huge, say the diamond ring you just purchased for your future spousage, the total energy is low since few diamonds are purchased.

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How Businesses React

Knowing that people suffer diminishing marginal energy, exactly how perform businesses react? Respeak to that consumer surplus is the area listed below the demand also curve yet above the price. Think of some examples of exactly how businesses react offered the legislation of diminishing marginal energy.

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One instance is the price per unit based upon package size. An ice cream store has actually three different serving sizes - a 6, 10, and also 12 ounce cup. The price of the smallest dimension, "Like It," is $4.29 or 71.5 cents per ounce. For just 32 cents more, one have the right to have actually four more ounces, "Love It," making the marginal expense per ounce 8 cents and the average expense per ounce 46 cents. Upgrading to the "Gotta Have It" size adds a secondary two ounces via just 15.5 cents per ounce even more and also an average cost per ounce of only 41 cents. Without a doubt the huge dimension is cheaper per ounce, but not everyone desires to eat that large of a serving. For those just wanting a tiny serving, the store takes benefit of their greater willingness to pay for that percent dimension. Whether its ice cream, eggs, milk, popcorn, or cereal, it is common practice to charge a higher price per unit for a smaller package size. However it pays for consumers to execute the math given that businesses will certainly at times charge a higher price on the bigger packperiods dimension. If customers believe that bigger is always cheaper and fail to carry out the math, they might get recorded paying a greater price per unit.

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Services frequently follow a comparable pricing system through reduced average prices for even more regular attendance. For instance, below are the prices for the “hopper pass” at Disneyland also. Tickets to sporting events follow a similar pricing technique through the per game price being reduced if multiple games are purchased, such as the seaboy pass.

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Consider this instance. You are on a lengthy plane ride, seated beside an eccentric looking womale and a businessman. Halfmethod into the flight, the womale says to you and also the businessguy, that she is very affluent and also bored of flying. To break up the monotony, she uses you and the businessman a possibility to break-up $5,000. The rules are as follows: the businessguy makes an market of how to split the money and you either accept or disapprove. If you accept, you get the agreed upon separation. If you don’t, you both acquire nopoint. This is a one time sell. The businessguy thinks and offers the complying with break-up $4,995 for him and $5 for you. Do you accept or reject the offer? Why?

The answer to these inquiries will certainly vary among individuals. Some will certainly accept stating they have 5 dollars more than they did prior to. Others will certainly disapprove the sell, saying that it is worth at leastern 5 dollars to them to deny they businessmale the $4,995. Remember that once we talk about energy, it has not only monetary items yet also the nonmonetary.

In The Theory of Mdental Sentiments, Adam Smith wrote: "How selfish soever male may be meant, tbelow are evidently some values in his nature which interest him in the fortune of others and also render their happiness necessary to him though he derives nopoint from it except the pleasure of seeing it.” Remember that energy is acquired from many kind of various areas consisting of organization and philanthropic acts.

Reference: http://www.econlib.org/Library/Enc/bios/Smith.html

Section 02: Indifference Curves and Spending Plan Constraints

Indistinction Curves

Indifference curves and budacquire constraints allow for a much more thorough evaluation of demand also. For modeling objectives we will look at the 2 items. An indifference curve shows the different combinations of the 2 goods that yield the very same level of utility, independent of the price of the goods. Due to the legislation of diminishing marginal energy, the indifference curve between the two products is convex to the origin. All combinations of the two goods (pizza and shakes) that are on the indifference curve (A, B, and also C) yield the very same level of utility, say Utility = 100. Having even more of good, yields a higher level of utility (combination D) and having less of the products returns a lower level of energy (combination E).

See more: M A Characteristic Of A Purely Competitive Labor Market Would Be:

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An indifference curve map shows the household of indifference curves. There can be an limitless variety of indifference curves that would reflect the level of energy at various combicountries of the two products. Just as a line on a topographical map shows the different points that are at the same elevation, the different points along an indifference curve, indicate that exact same level of energy.

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Source: U.S. Geological Survey

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Marginal Rate of Substitution

The marginal price of substitution is the slope of the curve and also actions the price at which the consumer would certainly be willing to offer up one excellent for the other while keeping the very same level of utility. Thus the marginal rate of substitution shows the ratio of marginal utilities in between the 2 products.

For instance, at suggest A, the consumer would certainly be willing to trade one shake for one extra slice of pizza. At allude B, the consumer currently has many pizza however few shakes so the marginal energy from an additional pizza is relatively reduced and also the marginal energy from the shake he would have to offer up would certainly be relatively huge, hence to preserve the very same level of energy he would certainly need to get 3 pizzregarding willingly offer up one half a shake.

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Since any kind of combination of the 2 items will certainly just yield one level of energy at a specific point in time, indifference curves will never cross each various other.

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Spending Plan Constraint

The budget constraint indicates the combinations of the two goods that can be purchased offered the consumer’s revenue and prices of the 2 products. The intercept points of the budacquire constraint are computer by splitting the earnings by the price of the great. For example, if the customer had actually $8 to spend and also the price of pizza was $2 and shakes were $1, then the consumer can buy 4 pizzas ($8/$2) or eight shakes ($8/$1). Any combicountry of the two items that are on or beneath the budacquire constraint are affordable, while those to the external (farther from the origin) are unaffordable.

A greater revenue will reason a parallel shift rightward of the budget constraint while a decrease in revenue will certainly cause a parallel transition leftward.

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Changing the prices of the items changes the slope of the budacquire constraint. If the consumer’s revenue is $8 and also the price of pizza is $2 and the price of shakes is $1, then the budacquire constraint would be BC1. If the price of pizza drops to $1, then the budacquire constraint would certainly turn out on the x-axis to BC2. Additionally, if the price of shakes enhanced to two dollars then the budobtain constraint would become BC3.

The slope of the budgain constraint is the negative ratio of the prices (-Px/Py). For instance, offered the price of pizza (on the x-axis) is $2 and the price of shakes (on the y-axis) is $1, then the slope of the budget constraint would certainly be -2.

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Utlity Maximization

Given the goal of consumers is to maximize utility given their budgain constraints, they look for that combination of goods that allows them to reach the highest indistinction curve offered their budget constraint. This occurs wbelow the indifference curve is tangent to the budgain constraint (combination A). Keep in mind that combinations B and C price the same amount as A; but, A is on a greater indifference curve. Combicountry D yields that same energy as C and also B however doesn’t use every one of the revenue, hence the consumer ca rise energy by consuming even more. Combicountry E is desired to combination A, yet is unattainable given the budgain constraint.

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We abovementioned that energy is maximized wbelow the marginal energy per dollar spent is the very same for each of the products. At the allude wbelow the indistinction curve is tangent to the budgain constraint, the slope of the indistinction curve which is the ratio of marginal utilities (-MUx/Muy) is equal to the slope of the budacquire constraint (- Price x / Price y). This equation have the right to be recomposed to display that the marginal energy per dollar invested will certainly be the exact same for both goods.

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The demand curve have the right to be derived from the indifference curves and also budget constraints by transforming the price of the good. For example, if the price of pizza is $4, the quantity demanded of pizza is two. If the price of pizza decreases, the budacquire constraint becomes flatter and also the customer deserve to purchase more pizza, say the price of pizza drops to $2 and customer purchases 4 systems. If the price drops to $1.33, the amount demanded rises to 5. Plotting each of the price and also amount demanded points creates the demand also curve for pizza.

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Income and also Substitution Effects

When pointing out why the demand curve is downward sloping, we outlined the substitution result and revenue impact. We have the right to observe the transforms in amount demanded alengthy the demand curve as a result of the change in price; yet, the indistinction curves and also budget constraints have the right to assist us analyze the size of the revenue and substitution impacts.

For instance, say the consumers revenue is $15 and the price of apples is $1 and the price of oranges is $3. At these prices the consumer purchases 6 apples and three oranges. When the price of oarrays drops to $1, the customer purchases eight apples and also seven oranges. Thus on the demand curve for oranges, the consumer purchases 3 oarrays once the price is 3 dollars and also seven oarrays when the price is one dollar.

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Bringing the new budacquire constraint ago to the original indifference curve allows us to break down the earnings and substitution impacts. Due to the fact that the slope of the budobtain constraint reflects the proportion of prices, the substitution result is the boost in the variety of oarrays that would certainly be purchased provided the brand-new prices, while staying on the original indistinction curve that is relocating from suggest A to point B. The activity from allude B to allude C is the revenue impact, the added usage of ovarieties as a result of the boosted purchasing power. With a decrease in the price of ovarieties, the loved one price of apples has actually raised and also fewer apples would certainly be consumed as a result of the substitution effect; but, because of boosted purchasing power, more apples are purchased and more ovarieties.

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Respeak to from our elasticity discussion that the revenue elasticity for an inferior good is negative. For example, as earnings rises the demand also for offered garments decreases. Looking at second-hand clothes on the x-axis, as the price declines the substitution will be positive (movement from point A to suggest B); yet, the income impact (motion from B to C) will be negative.

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Extreme Cases

When examining indifference curves and also budobtain constraints, we can look at a few extremes. One extreme case would be if the 2 goods are perfect complements. For instance, you do not get added satisfaction from having one more appropriate shoe, unless you have actually a left shoe to go via it. In the instance of perfect complements, you constantly consume at the minimum combination of the two products.

Another excessive is perfect substitutes. You purchase paper in either the 100 or 200 sheet packs and just value the variety of sheets. You are invarious between having 2 one-hundred sheet packeras or one two-hundred sheet package. In the instance of perfect substitutes, tright here are 3 different outcomes that will certainly maximize utility. If the price of one package, yields a reduced per sheet price, the consumer will buy just that excellent, so consumption will take location at among the 2 intercepts. The 3rd outcome is as soon as the budget constraint has actually the same slope as the indifference curve. In this situation, any combicountry along the budget constraint will yield the exact same level of utility.

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Government Food Stamps Example

Why does the federal government offer welfare recipients food stamps rather of cash? Why are food stamps offered on the babsence market for a discount? Let’s assume a perchild has $75 of revenue and also receives $75 of food stamps from the federal government. For simplicity, we will certainly assume that the price of each unit of food and also the price of apparel are each one dollar. The budacquire constraint permits the customer to purchase up to 150 units of food, yet because food stamps deserve to just be provided to purchase food, the customer is restricted to just being able to purchase 75 devices of various other items.

The amount of food and various other items, the individual will certainly purchase relies on the shape of his indifference curve. Provided that the person spends at least 75 dollars on food, he is not constrained by receiving food stamps instead of cash.

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Unfortunately, for those people with strong addictions, such as cigarettes or alcohol, their indistinction curves reflect the greater value got from the addict substance. Because food stamps just apply to purchasing food, the consumer is not able to gain as a lot utility and is minimal to allude A. If the food stamps had remained in the develop of cash, the customer would certainly have actually purchased 40 units of food and also 110 units of alcohol, point B, which would certainly yield a higher level of utility.

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If the consumer could transform a portion of the food stamps to cash, also at a discount, he would certainly have the ability to reach a higher indifference curve. Assume that he deserve to trade food stamps on the black market for 50 cents on the dollar which exhas a tendency his budobtain constraint increasing the amount of alcohol that deserve to be purchased. Selling food stamps at a discount enables the customer to relocate to point C, which yields a greater energy than suggest A.

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We can also design why individuals purchase items today and also carry the debt on their crmodify cards paying a high interest price. For instance, let’s say the price of each great is $1. Assume Will has $100 of earnings which he can spend now or invest the money and also receive $150 later on. By waiting, Will would have a greater purchasing power, yet his intake bundle will depend on his choices. If he has actually a solid preference for having usage this day, he would be willing to pay a greater price for those items now. The same is true for those who buy items on credit. They are willing to pay the purchase price plus all the interemainder, so that they have the right to have it now (so the indistinction curve touches the budgain constraint at a point closer to the x-axis as viewed in the figure).

Similarly, some people are willing to pay to go to the expensive theaters to see a movie when it is first released. Others will certainly wait till it comes to the cheap theaters or even till it comes out on DVD/Blu-ray. Although people are paying for the “movie experience” and not simply the film itself, we can watch the moment preferences of people and the price differentials over time (as represented by various placements of the indifference curves).