1. Consumer Behavior and Utility Maximization 21 C H A P T E R

2. THE LAW OF DEMAND A Closer Look… The Income Effect A lower price frees income for additional purchases - and vice versa The Substitution Effect A lower price relative to other goods attracts new buyers - and vice versa

3. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 0 10 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

4. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 0 10 10 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

5. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 0 10 18 10 8 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

6. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 3 0 10 18 24 10 8 6 0 1 2 3 4 5 6 7 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 1 2 3 4 5 6 7

7. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 3 4 0 10 18 24 28 10 8 6 4 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

8. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 3 4 5 0 10 18 24 28 30 10 8 6 4 2 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

9. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 3 4 5 6 0 10 18 24 28 30 30 10 8 6 4 2 0 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

10. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 3 4 5 6 7 0 10 18 24 28 30 30 28 10 8 6 4 2 0 -2 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 TU MU 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7

11. TOTAL AND MARGINAL UTILITY Tacos consumed per meal Total Utility, Utils Marginal Utility, Utils 0 1 2 3 4 5 6 7 0 10 18 24 28 30 30 28 10 8 6 4 2 0 -2 Units consumed per meal Units consumed per meal 30 20 10 Total Utility (utils) Marginal Utility (utils) 10 8 6 4 2 0 -2 TU MU 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7 Observe Diminishing Marginal Utility

13. THEORY OF CONSUMER BEHAVIOR Utility Maximizing Rule The consumer’s money income should be allocated so that the last dollar spent on each product yields the same amount of extra (marginal) utility. Illustrated...

14. First 10 10 24 12 UTILITY MAXIMIZING COMBINATION How should the $10 income be allocated? Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) $ 10 income

15. First 10 10 24 12 UTILITY MAXIMIZING COMBINATION Examine the two marginal utilities Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) $ 10 income

16. First 10 10 24 12 UTILITY MAXIMIZING COMBINATION Examine the two marginal utilities … per dollar Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) $ 10 income

17. First 10 10 24 12 UTILITY MAXIMIZING COMBINATION Decision: Buy 1 Product B for $2 Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) $ 10 income

18. 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 Sixth 4 4 6 3 Seventh 3 3 4 2 UTILITY MAXIMIZING COMBINATION Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) $ 10 income What next?

19. 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 Sixth 4 4 6 3 Seventh 3 3 4 2 UTILITY MAXIMIZING COMBINATION Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) $ 10 income What next? Buy one of each

20. 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 Sixth 4 4 6 3 Seventh 3 3 4 2 UTILITY MAXIMIZING COMBINATION Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) $ 10 income and then... ($5 left)

21. 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 Sixth 4 4 6 3 Seventh 3 3 4 2 UTILITY MAXIMIZING COMBINATION Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) $ 10 income third unit of product B

22. 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 Sixth 4 4 6 3 Seventh 3 3 4 2 UTILITY MAXIMIZING COMBINATION Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) $ 10 income $3 left...

23. 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 Sixth 4 4 6 3 Seventh 3 3 4 2 UTILITY MAXIMIZING COMBINATION Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) $ 10 income $3 left... Buy both!

24. 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 Sixth 4 4 6 3 Seventh 3 3 4 2 UTILITY MAXIMIZING COMBINATION Unit of product Product A: Price = $1 Product B: Price = $2 Marginal utility, utils Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility per dollar (MU/price) $ 10 income Income is gone... the last dollar spent on each good gave the same utility (8) per dollar

25. Algebraic Restatement of the Utility Maximization Rule = UTILITY MAXIMIZING COMBINATION MU of product A Price of A MU of product B Price of B 8 Utils $1 16 Utils $2 =

26. UTILITY MAXIMIZATION AND THE DEMAND CURVE Deriving the Demand Schedule and Curve

27. UTILITY MAXIMIZATION AND THE DEMAND CURVE Create a demand schedule from the purchase decisions as the price of the product is varied ... Price per unit of B Quantity Demanded $2 4 1 6 Graphically… Deriving the Demand Schedule and Curve

28. UTILITY MAXIMIZATION AND THE DEMAND CURVE Deriving the Demand Schedule and Curve Quantity Demanded of Good B Price per unit of Good B $2 1 0 4 6 D B

29. UTILITY MAXIMIZATION AND THE DEMAND CURVE Deriving the Demand Schedule and Curve Quantity Demanded of Good B Price per unit of Good B $2 1 0 4 6 D B Income and Substitution Effects Revisited

30. APPLICATIONS AND EXTENSIONS Vending Machines The Diamond-Water Paradox

32. Next… Chapter 22 The Costs Of Production Indifference Curve Analysis