Utility Analysis

Utility Theory
Utility Want-satisfying power of a commodity or service Utility Analysis
Analysis of consumer decision making based on utility maximization

Util A representative unit by which utility is measured 1
Utility Theory
Marginal Utility: The change in total utility due to a one-unit change in the quantity of a good or service consumed
Marginal Utility = Change in total utility Change in number of units consumed
Equilibrium of the Consumer - Utility Maximization : The consumer is equilibrium (i.e. gets maximum total utility) if he consumes up to the point where the marginal utility of the last unit consumed equals the market price of that good
2
TOTAL AND MARGINAL UTILITY

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

30
0 1
0 10
20
10
10
Marginal Utility (utils)
10 8 6 4 2 0 -2

30
0 1 2
0 10 18
20
10 8
10
10 8 6 4 2 0 -2

30
0 1 2 3
0 10 18 24
20
10 8 6
10
10 8 6 4 2 0 -2
1

30
0 1 2 3 4
0 10 18 24 28
20
10 8 6 4
10
10 8 6 4 2 0 -2
1

30
0 1 2 3 4 5
0 10 18 24 28 30
20
10 8 6 4 2
10
10 8 6 4 2 0 -2
1

30
0 1 2 3 4 5 6
0 10 18 24 28 30 30
20
10 8 6 4 2 0
10
10 8 6 4 2 0 -2

TU
30
0 1 2 3 4 5 6 7
0 10 18 24 28 30 30 28
20
10 8 6 4 2 0 -2
10
10 8 6 4 2 0 -2
1
MU
2 3 4 5 6 7
10

TU
30
0 1 2 3 4 5 6 7
0 10 18 24 28 30 30 28
20
10 8 6 4 2 0 -2
10
Observe Diminishing Marginal Utility

2 3 4 5 6 7
10 8 6 4 2 0 -2
1 2 3 4 5 6 7
MU
11
Graphical Analysis: Total and Marginal Utility
12
Total and Marginal Utility of Downloading and Listening to Digital Music Albums
13
14
Total utility is maximized..
where
marginal utility is equal to zero.
15
Analysis
Marginal utility falls as more is consumed
Marginal utility equals zero when total utility is at its maximum
16
Diminishing Marginal Utility

The Law of Diminishing Marginal Utility
As more of any good or service is consumed, its extra (additional) benefits decline
Increase in total utility from consumption of a good or service become smaller and smaller as more is consumed during a given time period, the consumption of all other goods held constant That is the total utility will increase but at a decreasing rate
17
The Law of Diminishing Marginal Utility

Assumptions:
Units consumed are homogeneous No time gap between consumption of different units Consumer is rational (i.e. has complete knowledge and maximizes utility) Tastes, preferences etc. remain unchanged
18
THEORY OF CONSUMER BEHAVIOR
Rational Behavior Clear-Cut Preferences Subject to a Budget Constraint Responds to Price Changes
19
Optimizing Consumption Choices (The Law of Equi-Marginal Utility)

The case of more than two goods:
The rule is of equal marginal utilities per unit spent A consumer maximizes personal satisfaction (total
utility ) when he allocates his total money income in such a way that the last unit of money spent on each good viz. good A, good B, and good C, and so on, yields equal amount of marginal utility
20
Optimizing Consumption Choices

The Law of Equi-Marginal Utility
A little math: the rule of equal marginal utilities per dollar spent
MU of good A MU of good B MU of good Z = = .... = Price of good A Price of good B Price of good Z
21
UTILITY MAXIMIZING COMBINATION

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

22

$ 10 income
Unit of product
Marginal utility, utils Marginal utility per dollar (MU/price)
First
10
10
24
12
Examine the two marginal utilities

23

$ 10 income
Unit of product
First
10
10
24
12
Examine the two marginal utilities per dollar

24

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

25
UTILITY MAXIMIZING COMBINATION : The Law of Equi-Marginal Utility Product A: Price = $1 Marginal Marginal utility per utility, dollar utils (MU/price) Product B: Price = $2 Marginal Marginal utility per utility, dollar utils (MU/price)
$ 10 income
Unit of product
First 10 Second 8 Third 7 Fourth 6 What next? Fifth 5 Sixth 4 Seventh 3
10 8 7 6 5 4 3
24 20 18 16 12 6 4
12 10 9 8 6 3 2
26
UTILITY MAXIMIZING COMBINATION: The Law of Equi-Marginal Utility
$ 10 income Unit of product
Product A: Price = $1 Marginal Marginal utility per utility, dollar utils (MU/price)
Product B: Price = $2 Marginal Marginal utility per utility, dollar utils (MU/price)
First 10 Second 8 Third 7 What next? Fourth 6 Buy one of each Fifth 5 Sixth 4 Seventh 3
10 8 7 6 5 4 3
24 20 18 16 12 6 4
12 10 9 8 6 3 2
27
UTILITY MAXIMIZING COMBINATION: The Law of Equi-Marginal Utility Product A: Price = $1 Marginal Marginal utility per utility, dollar utils (MU/price) Product B: Price = $2 Marginal Marginal utility per utility, dollar utils (MU/price)
$ 10 income
Unit of product
First 10 10 Second 8 8 Third 7 7 Fourth 6 6 Fifth and then... 5 5 left) 4 Sixth ($5 4 Seventh 3 3
24 20 18 16 12 6 4
12 10 9 8 6 3 2
28
$ 10 income
Unit of product
First 10 Second 8 Third 7 Fourth 6 Fifth unit of5 third Sixth B 4 product Seventh 3
10 8 7 6 5 4 3
24 20 18 16 12 6 4
12 10 9 8 6 3 2
29
$ 10 income
Unit of product
First 10 Second 8 Third 7 Fourth 6 Fifth 5 $3 left... 4 Sixth Seventh 3
10 8 7 6 5 4 3
24 20 18 16 12 6 4
12 10 9 8 6 3 2
30
$ 10 income
Unit of product
First 10 Second 8 Third 7 Fourth 6 $3 left... Fifth 5 Buy both! Sixth 4 Seventh 3
10 8 7 6 5 4 3
24 20 18 16 12 6 4
12 10 9 8 6 3 2
31

$ 10 income
Unit of product
First 10 10 Second 8 8 Third 7 7 Fourth 6 6 Income is gone... the last dollar spent on 5 Fifth 5 each good gave the4 same 4 Sixth utility (8) per dollar Seventh 3 3
24 20 18 16 12 6 4
12 10 9 8 6 3 2
32
UTILITY MAXIMIZING COMBINATION (The Law of Equi-Marginal Utility)
Algebraic Restatement of the Utility Maximization Rule
MU of product A
Price of A 8 Utils $1
MU of product B
Price of B 16 Utils
$2
33
UTILITY MAXIMIZATION AND THE DEMAND CURVE
Deriving the Demand Schedule and Curve

Given from the previous example schedule:
Preferences or Tastes
Money Income Prices of Other Goods
34
Deriving the Demand Schedule and Curve Create a demand schedule from the purchase decisions as the price of the product is varied ...
Price per unit of B $2 1 Quantity Demanded 4 6
Graphically
35
Deriving the Demand Schedule and Curve

Price per unit of Good B $2
DB
0 4 6 Quantity Demanded of Good B
36
Equilibrium of the Consumer (Utility Maximization) The consumer is equilibrium (i.e. gets maximum total utility) if he consumes up to the point where the marginal utility of the last unit consumed equals the market price of that good
37
Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on an Income of $26
38
39
40
How a Price Change Affects Consumer Optimum

Recall from Table 20-1 Income = $26
Qd = 4 Qs = 2
MUd 36.5 = 7.3 = Pd 5 MUs 22 = Ps 3 = 7.3
41

Assume Price of Music Falls to $4
Qd = 4
Qs = 2
MUd 36.5 = 9.125 = Pd 4 MUs 22 = Ps 3 = 7.3
42

Assume Price of Music Falls to $4
Now Result
MUd MUs > Pd Ps Buy more downloads and MUd falls
43

Consumption decisions are summarized in the law of demand
The amount purchased is inversely related to price.
A consumers response to a price change

At higher consumption rate, marginal utility falls.
44
Digital Music Download Prices and Marginal Utility
45

The Substitution Effect
The tendency of people to substitute cheaper commodities for more expensive commodities
46

The Principle of Substitution
Consumers and producers shift away from goods and resources that become priced relatively higher in favor of goods and resources that are now priced relatively lower.
47

Purchasing Power
The value of money for buying goods and services
48

Real-Income Effect
The change in peoples purchasing power that occurs when, other things being constant, the price of one good that they purchase changes When that price goes up (down), real income, or purchasing power, falls (increases).
49
The Demand Curve Revisited

Question
How is the demand curve derived?
Answer
By presuming income, tastes, expectations, and the price of related goods are not changing as the price of the good changes
50
The Demand Curve Revisited

Marginal utility, total utility, and the diamond-water paradox
Water is essential to life but cheap. Diamonds are not essential to life but expensive.
51
The Diamond-Water Paradox
52
The Upside of Taking Off from a Less Convenient Airport

According to the principle of substitution, people shift away from consuming items that become priced relatively higher in favor of items that are now priced relatively lower. In recent years, the principle of substitution has applied to the services offered by several major airports. Many consumers of air travel are choosing to drive some distance before they depart to their ultimate destinations by plane.
53
The Upside of Taking Off from a Less Convenient Airport

Weighing relative marginal utilities and prices
Opting to avoid hassles that reduce marginal utility Responding to price changes
54
Selected Substitute Airport Pairs in the United States
55
Summary Discussion of Learning Objectives

Total utility versus marginal utility
Total utility is total satisfaction from consumption.
Marginal utility is the additional satisfaction from consuming an additional unit.
Law of diminishing marginal utility

Marginal utility ultimately declines as a person consumes more and more of a good or service.
56

The consumer optimum
Occurs when the marginal utility per dollar spent on the last unit consumed is equalized
The substitution effect of a price change

A person will substitute among goods by buying less of a good when its price increases.
57

The real-income effect of a price change
A price change affects the purchasing power of an individuals available income.
Why the price of diamonds exceeds the price of water even though people cannot long survive without water
Marginal utility, not total utility, determines how much people are willing to pay.
58

Utility Analysis

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Utility Analysis

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Utility Theory

Utility Want-satisfying power of a commodity or service Utility Analysis

Analysis of consumer decision making based on utility maximization

TOTAL AND MARGINAL UTILITY

Units consumed per meal Marginal Utility (utils)

Units consumed per meal

TOTAL AND MARGINAL UTILITY

Marginal Utility (utils)

Units consumed per meal

Units consumed per meal

TOTAL AND MARGINAL UTILITY

Marginal Utility (utils)

Units consumed per meal

Units consumed per meal

TOTAL AND MARGINAL UTILITY

Marginal Utility (utils)

Units consumed per meal

Units consumed per meal

TOTAL AND MARGINAL UTILITY

Marginal Utility (utils)

Units consumed per meal

Units consumed per meal

TOTAL AND MARGINAL UTILITY

Marginal Utility (utils)

Units consumed per meal

Units consumed per meal

TOTAL AND MARGINAL UTILITY

Marginal Utility (utils)

Units consumed per meal

Units consumed per meal

TOTAL AND MARGINAL UTILITY

Marginal Utility (utils)

Units consumed per meal

TOTAL AND MARGINAL UTILITY

Marginal Utility (utils)

Observe Diminishing Marginal Utility

Units consumed per meal

Graphical Analysis: Total and Marginal Utility

Total utility is maximized..

marginal utility is equal to zero.

Diminishing Marginal Utility

The Law of Diminishing Marginal Utility

THEORY OF CONSUMER BEHAVIOR

Optimizing Consumption Choices (The Law of Equi-Marginal Utility)

Optimizing Consumption Choices

UTILITY MAXIMIZING COMBINATION

The Law of Equi-Marginal Utility

How should the $10 income be allocated?

UTILITY MAXIMIZING COMBINATION

The Law of Equi-Marginal Utility

Examine the two marginal utilities

UTILITY MAXIMIZING COMBINATION

The Law of Equi-Marginal Utility

Examine the two marginal utilities per dollar

UTILITY MAXIMIZING COMBINATION

The Law of Equi-Marginal Utility

Decision: Buy 1 Product B for $2

First 10 Second 8 Third 7 Fourth 6 What next? Fifth 5 Sixth 4 Seventh 3

UTILITY MAXIMIZING COMBINATION: The Law of Equi-Marginal Utility

$ 10 income Unit of product

First 10 Second 8 Third 7 Fourth 6 Fifth 5 $3 left... 4 Sixth Seventh 3

UTILITY MAXIMIZING COMBINATION

UTILITY MAXIMIZING COMBINATION (The Law of Equi-Marginal Utility)

Algebraic Restatement of the Utility Maximization Rule