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I. Learning objectives
A. Understand
total utility, marginal utility, and the law of diminishing marginal
utility
B. How rational
consumers compare marginal utility-to-price ratios for products in
purchasing combinations of products that maximize their utility
C. How a demand
curve can be derived by observing the outcomes of price changes in
the utility-maximization mode
D. How the
utility-maximization model helps highlight the income and
substitution effects of a price change
II. Law of Diminishing Marginal Utility
A. Although consumer
wants in general are insatiable, wants for specific commodities can
be fulfilled. The more of a specific product that consumers obtain,
the less they will desire more units of that product. This can be
illustrated with almost any item. The text uses the automobile
example, but houses, clothing, and even food items work just as
well.
B. Utility is a
subjective notion in economics, referring to the amount of
satisfaction a person gets from consumption of a certain item.
C. Marginal utility
refers to the extra utility a consumer gets from one additional unit
of a specific product. In a short period of time, the marginal
utility derived from successive units of a given product will
decline. This is known as diminishing marginal utility.
D. Figure 19.1 and
the accompanying table illustrate the relationship between total and
marginal utility.
1. Total utility increases as each additional
burger is purchased
through the first fourteen, but utility rises at a diminishing rate since
each burger adds less and less to the consumer’s satisfaction.
2. Marginal utility becomes zero
at some point, and then even
negative--at the fifteenth unit and beyond. If more than fourteen tacos were
purchased, total utility would begin to fall. This illustrates the law
of diminishing marginal utility.
Consider This …
Vending Machines and Marginal Utility
- Newspaper vending machines
normally allow one to take multiple papers; publishers
allow this because they believe that people rarely take
more than one paper because the marginal utility of the
second paper is often zero, and it has little “shelf
life.”
- Soft drink vending machines
distribute one can or bottle at a time. Even if the
marginal utility of the second unit of soda is low in
the short run, the long shelf life would allow people to
keep sodas for later consumption.
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III. Theory of consumer behavior uses the
law of diminishing marginal utility to explain how consumers allocate
their income.
A. Consumer choice
and the budget constraint:
1. Consumers
are assumed to be rational, i.e. they are trying to get the most
value for their money.
2. Consumers
have clear‑cut preferences for various goods and services and
can judge the utility they receive from successive units of
various purchases.
3. Consumers’
incomes are limited because their individual resources are
limited. Thus, consumers face a budget constraint. (As we saw
with the individual budget line in Chapter 1)
4. Goods and
services have prices and are scarce relative to the demand for
them. Consumers must choose among alternative goods with their
limited money incomes.
B. Utility
maximizing rule explains how consumers decide to allocate their
money incomes so that the last dollar spent on each product
purchased yields the same amount of extra (marginal) utility.
1. A consumer
is in equilibrium when utility is “balanced (per dollar) at the
margin.” When this is true, there is no incentive to alter the
expenditure pattern unless tastes, income, or prices change.
2. Table 19.1
provides a numerical example of this for an individual named
Holly with $10 to spend. Follow the reasoning process to see
why 2 units of A and 4 of B will maximize Holly’s utility, given
the $10 spending limit.
3. It is
marginal utility per dollar spent that is equalized; that is,
consumers compare the extra utility from each product with its
cost.
4. As long as
one good provides more utility per dollar than another, the
consumer will buy more of the first good; as more of the first
product is bought, its marginal utility diminishes until the
amount of utility per dollar just equals that of the other
product.
5. Table 19.2
summarizes the step-by-step decision‑making process the rational
consumer will pursue to reach the utility‑maximizing combination
of goods and services attainable.
6. The
algebraic statement of this utility-maximizing state is that the
consumer will allocate income in such a way that:
MU of product
A/price of A = MU of product B/price of B = etc.
IV. Utility Maximization and the Demand
Curve
A. Determinants of
an individual’s demand curve are tastes, income, and prices of other
goods.
B. Deriving the
demand curve can be illustrated using item B in Table 19.1 and
considering alternative prices at which B might be sold. At lower
prices, using the utility‑maximizing rule, we see that more will be
purchased as the price falls.
C. The
utility‑maximizing rule helps to explain the substitution effect and
the income effect.
1. When the
price of an item declines, the consumer will no longer be in
equilibrium until more of the item is purchased and the marginal
utility of the item declines to match the decline in price.
More of this item is purchased rather than another relatively
more expensive substitute.
2. The income
effect is shown by the fact that a decline in price expands the
consumer’s real income and the consumer must purchase more of
this and other products until equilibrium is once again attained
for the new level of real income.
V. Applications and Extensions
A. The digital versatile disk (DVD) takeover:
1. DVDs and DVD
players entered the video media market in 1997. Around 320,000
players were sold in the U.S. that year. In 2002, 17 million
were sold, and the total number of DVD players in the U.S.
reached 48 million.
a.
Preferences changed due to improved quality and the amount
of video and sound available on one DVD.
b. DVD
player prices fell from over $1,000 or more to under $100.
This led to increased purchases of DVDs (a complementary
good).
c. DVDs and
videocassettes (VCs) are substitutes.
2. DVD players
and DVDs have a higher ratio of marginal utility to price than
do VCRs players and VCs. To maximize their utility, consumers
will switch from VCs to DVDs.
B. The
diamond-water paradox:
1. Before
marginal analysis, economists were puzzled by the fact that some
essential goods like water had lower prices than luxuries like
diamonds.
2. The paradox
is resolved when we look at the abundance of water relative to
diamonds.
3. Theory tells
us that consumers should purchase any good until the ratio of
its marginal utility to price is the same as that ratio for all
other goods.
a. The
marginal utility of an extra unit of water may be low as is
its price, but the total utility derived from water is very
large.
b. The
total utility of all water consumed is much larger than the
total utility of all diamonds purchased.
c. However,
society prefers an additional diamond to an additional drop
of water, because of the abundant stock of water available.
C. Time also has a
value, so this must be considered in decision‑making and utility
maximization. The total price of an item must include the value of
the time spent in consuming the product, i.e., the wage value of an
hour of time. When time is considered, consumer behavior appears to
be much more rational.
1. Highly paid
doctors may not spend hours hunting for bargains because their
time is more valuable than the money to be saved from finding
the best buy.
2. Foreigners
observe that Americans waste material goods but conserve time.
This could be because our high productivity makes our time more
valuable than many of the goods we waste.
D. Buying medical
care or eating at a buffet:
1. Most
Americans have health insurance for which they pay a fixed
monthly premium, which covers, say, 80 percent of their health
care costs. Therefore, the cost of obtaining care is only 20
percent of its stated price for the insured patient.
2. Following
the law of demand, people purchase a larger quantity of medical
care than if they had to pay the full price for each visit.
3. If you buy a
meal at an “all-you-can-eat” buffet, you eat more than if you
paid separately for each item.
E. Cash and noncash
gifts:
1. Noncash
gifts may yield less utility to the receiver than a cash gift of
equal monetary value because the noncash gift may not match the
receiver’s preferences.
2. Individuals
know their own preferences better than the gift giver.
3. Look back at
Table 19.1. If Holly had no income and was given $2 worth, she
would rather have the cash transfer to spend on B than to be
given 2 units of A. (She gets more utility or satisfaction by
spending her $2 on B.)
VI. LAST WORD: Criminal Behavior
A. The theory of
consumer behavior can provide some useful insights into criminal
behavior.
B. A person who
steals from a store imposes uncompensated costs on others – the
store owner, customers.
C. Whereas a person
who is thinking about buying an item weighs the cost (the price) and
the benefit (utility) of a particular purchase, a person who steals
also weighs the cost and benefit of stealing the item.
D. The cost to the
potential criminal is the possible guilt felt, the tools of the
trade, the income forgone while engaging in an illegitimate
activity, and possible fines and imprisonment. The potential
criminal will engage in criminal behavior if the benefits exceed the
costs.
E. Society can
reduce criminal behavior by increasing the cost of guilt through
family, educational, and religious efforts and by increasing the
direct costs by using more sophisticated security systems. Society
can also increase the penalties on those who are caught.
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