OUTLINE -- CHAPTER 7

Consumer Decisions: Utility Maximization

 

  • Read the following from an online skiing discussion forum and answer the question WHY?
    • From epicski.com Barking Bears Forum:

      Skiing in/past March: why not popular?

      So, here in Oregon, we continue to get hammered by cold storms. Last week it was snow down in Portland, and dry, deep snow up in the Cascades (16-20" new overnight): the stuff that happens once every couple of years in Oregon. Today, there is another 7" of new snow on the mountain, and snow predicted on/off for the next two weeks. Base is at 175" and is very consolidated (we have had plenty of rain with that snow): that is all-natural, non-manmade snow.

      But, for some reason, people just stop skiing. WHY? I just don't understand. The skiing is great, the snow is superb! What else can they do this time of year? Sit inside and watch it rain? We get BIG dumps, and nobody is on the hill. Likewise in late April/early May, which has primo spring conditions (and the occasional good storm, followed by a bluebird day, which doesn't get any better) and again, nobody is on the hill!

 

I. Benefit-Cost Analysis and Consumer Decisions

A. Definition -- Economics
B. Definition -- Benefit-Cost Analysis
C. Definition -- Utility

II. REVIEW: Two Explanations of the Law of Demand

A. Income and Substitution Effects
income effect: A change in the price of a product changes a consumer’s real income (purchasing power) and thus the quantity of the product purchased.

substitution effect: A change in the price of a consumer good changes the relative expensiveness of that good and hence changes the consumer’s willingness to buy it rather than other goods.

The income and substitution effects combine to increase a consumer's ABILITY and WILLINGNESS to buy more of a specific good when its price falls.

B. Law of Diminishing Marginal Utility

Another explanation of the Law of Demand

As a consumer increases the consumption of a good or service the marginal utility obtained from each additional unit of the good or service decreases.

III. Theory of Consumer Behavior

A. Total Utility and Marginal Utility
1. utility
The want-satisfying power of a good or service; the satisfaction or pleasure a consumer obtains from the consumption of a good or service (or from the consumption of a collection of goods and services).

2. total utility / graph

The total amount of satisfaction derived from the consumption of a single product or a combination of products.

3. marginal utility

a. definition
The extra utility a consumer obtains from the consumption of one additional unit of a good or service;

b. calculation

equal to the change in total utility divided by the change in the quantity consumed.

MU = TU / Qconsumed

c. graph

1. yellow page

2. textbook

d. law of diminishing marginal utility

As a consumer increases the consumption of a good or service the marginal utility obtained from each additional unit of the good or service decreases.

3. MU, demand, and elasticity

a. Diminishing MU explains the law of demand

b. MU and elasticity

(1) if MU declines quickly as more is consumed, then demand is less elastic

Explanation:

if the price declines, only A LITTLE more will be purchased since LITTLE extra utility is recieved

Demand is less elastic

(2) if MU declines slowly as more is consumed, then demand is more elastic

Explanation:

if the price declines, A LOT more will be consumed since the MU of these additional units remains HIGH

Demand is more price elastic

4. Quick Review Quiz

B. Utility Maximizing Rule (benefit-cost analysis)

1. assumptions
a. rational behavior
b. preferences are known and measurable
c. budget constraint
d. prices

2. utility maximizing rule

To obtain the greatest utility the consumer should allocate money income so that the last dollar spent on each good or service yields the same marginal utility.

3. But this is really just Benefit-Cost Analysis (see Ch 2):

a. Benefit-Cost-Analysis:
select all where: MB > MC
up to where: MB = MC
but never where: MB < MC

b. utility maximizing rule:

MBx = MUx/Px

The MB of product X can be measured by finding the MU per dollar spent on product X

MCx = MUy/Py

The MC of product X can be measured by finding the MU that you are not receiving from a dollar's worth of your next best alternative (product Y)

Therefore:

MB = MC

or

MUx / Px = MUy / Py

To obtain the greatest utility the consumer should allocate money income so that the last dollar spent on each good or service yields the same marginal utility.

 

4. example 1: beer and steaks (yellow page)

5. example 2:

A consumer is consuming the following quantities of two goods both with a price of $1 and recieving the MU indicated:
Quantity
Benefits Received (MU)

Good A (price $1)
10
60

Good B (price $1)
8
80

Is this consumer maximizing his/her utility?

If not, should they consume :

(1) more A and less B or
(2) more B and less A?

If one more of B is consumed and one less of A is consumed:

What happens to the MU of B and the MU of A?
What happens to the TU received?
What happens to the total dollars spent?

IV. Utility Maximization and the Demand Curve

V. Applications of the Theory of Consumer Demand

A. Consider This … Vending Machines and Marginal Utility
  • Newspaper vending machines normally allow one to take multiple papers
  • Soft drink vending machines distribute one can or bottle at a time

 

  • WHY?

     

    1.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."

    2.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.

 

B. The Diamond-Water paradox:

Some essential goods like water have lower prices than luxuries like diamonds. WHY?
  • The paradox is resolved when we look at the abundance of water relative to diamonds.
  • 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.
  • 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.
  • The total utility of all water consumed is much larger than the total utility of all diamonds purchased.
  • However, society prefers an additional diamond to an additional drop of water, because of the abundant stock of water available.

 

C. Cash and Noncash Gifts

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.
  • Individuals know their own preferences better than the gift giver