Section 01: consumer Behavior

Utility

In this section, we space going to take it a closer look in ~ what is behind the need curve and also the actions of consumers. Just how does a consumer decide to invest his/her revenue on the numerous different points that he/she wants, i.e., food, clothing, housing, entertainment? us assume the the score of the consumer is come maximize his/her level of satisfaction or joy, constrained by his/her income.

Economists use the hatchet utility as a measure up of satisfaction, joy, or happiness. Exactly how much satisfaction does a person obtain from eat a pizza or the town hall a movie? Measuring utility is based solely on the choices of the individual and has nothing to carry out with the price of the good. Let’s carry out an experiment in utility.

Step 01: gain some of her favorite candy, pastries, or cookies.

Step 02: take it a bite and also evaluate, on a scale from 0 come 100 (with 100 being the greatest utility), the level of energy from that bite. Document the marginal utility of that bite (i.e., just how much you obtain from that one extr bite).

Step 03: Repeat action 02. It is crucial to be regular with each unit consumed, i.e., the exact same size and no drink milk or water part method though. Once you operation out of candy or her marginal utility goes come zero you can stop.

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Law that Diminishing Marginal Utility

The law of diminishing marginal utility says that as more of the good is consumed, the extr satisfaction from one more bite will eventually decline. The marginal utility is the satisfaction acquired from each added bite. As more of the good is consumed, we gain less added satisfaction from consuming an additional unit. Thus even if a an excellent were totally free and you can consume as lot as girlfriend wanted, there would be a border to the quantity you would consume as result of the regulation of diminishing marginal utility.

Summing the marginal utilities offers us the total utility. For example, stop say the an initial chocolate was an 85 and also the second chocolate had actually a marginal utility of 79, climate the complete utility from consuming two chocolates is 164. The total utility native consuming 3 chocolates is 85+79+73 = 237. As long as our marginal utility is hopeful our complete utility boosts although through diminishing marginal utility it boosts at a to decrease rate.

Can marginal utility be negative? Yes. At a holiday dinner, you may overeat and also suffer native indigestion later on to a point where you remorse having eaten too much, however at the moment of the dinner, girlfriend expected better utility from eating the last of the meal. We would not willingly consume an item that offered us negative marginal utility. Then why would an individual ingredient themselves throughout a warm dog eating dispute where plainly the last warm dogs consumed room making lock worse off? return the marginal energy from the last hot dog itself makes the person worse off, the energy from to win the dispute is better making the marginal utility positive.

The marginal utility of things can change. Because that example, throughout a dryness water provides a high hopeful marginal utility, and also with much more rain the marginal utility declines. At some point, over there is too lot rain, it turns from gift a an excellent utility come a poor one and also the marginal energy of more rain, once it is already flooding, is negative.

Maximizing Utility

Utility values have the right to be identified by an individual ranking his/her choices from least desired to many preferred. The result ranking or energy values room subjective or individual. Castle are additionally ordinal fairly than cardinal. Ordinal means that the energy values simply specify a ranking of choices rather than an yes, really cardinal measurement.

Imagine a course has 10 college student in the class and also the teacher inside wall the college student up according to height. He then numbered them off according to height, assigning the shortest student a 1 and the tallest college student a 10. Is it true that student number 4 is twice tall together student number 2? Of course not. All we recognize from the ranking is the student number 4 is taller 보다 student number 2. Now, imagine that in an additional class another teacher has also ranked 10 students according to height. Is that true that student number 10 native the 2nd classroom is taller than student 1 indigenous the an initial classroom? us cannot say since the ranking is only valid within a certain course. In order come say a student is double as tall as another student or to have the ability to compare students between classes, us would require a cardinal measure up of height like customs or centimeters.

Since energy is ordinal and not cardinal us cannot do interpersonal compare of utility. Go a rich human value a dollar more or less than a poor person? while some would certainly say that a negative person most likely has an ext unmet needs and thus the would worth the disagreement more. The prize is the it all depends on the choices of the individuals. A negative person might prefer to live a much more simplistic life and also place a reduced value on having an extra dollar than a rich human being who has a “love that money” (1 Timothy 6:10). We just cannot do such an interpersonal to compare of utility.

So exactly how does the customer decide what to purchase? Unfortunately everything has a price and also consumers only have so much money come spend. In turn consumers try to spend the restricted money they have actually on what will provide them the best amount the satisfaction. The decision rule for energy maximization is to acquisition those items that provide the greatest marginal energy per dollar and are affordable or within the budget. Countless grocery stores carry out a sign that shows the price per lb for the good. This allows consumers to compare the expense per pound for various brands or different sizes. The same principle is supplied for maximizing utility however we division the marginal energy by the price to gain the marginal energy per dollar.

Let’s to speak that we eat only two goods: milk shakes and also pizza where the price the each slice of pizza is \$2 and also the price of each shake is \$1 and we only have \$11 to spend. Since the price the each good is different we must divide the marginal utility by the price to enable for a usual comparison. We then to compare the marginal energy per dollar for pizzas verses shakes. For the an initial unit the marginal utility per dollar of a shiver is 50 contrasted to only 45 for the pizza, so we would purchase the first shake. We then compare the marginal utility per dollar of the very first pizza (45) to the marginal energy per dollar of the 2nd shake (40) and purchase the an initial slice of pizza. If the marginal energy per disagreement is the same for the two goods and we have actually income to acquisition both then us would do so, as watched in the second slice that pizza and the second shake.

We continue to allocate on spending plan on those items that productivity the highest marginal energy per dollar. In this example, we would certainly purchase 4 slices or pizza and three milkshakes and spend our entire spending plan of \$11. The full utility from this acquisition would be the sum of the marginal utilities: 50 + 90 + 80 + 40 + 70 + 60 + 30 = 420. In ~ the last items purchased the marginal utility per dollar invested on the two products is the same, no other mix of pizzas and milk shakes will provide us better utility given our budget.

Practice

Here is your opportunity to practice. Holly has \$20 to invest on either movies or bowling and wants come maximize her utility. Complete the table and determine how numerous movies and also rounds the bowling will certainly maximize her utility.

Our first step is to divide the marginal utility of every item by the price. Through an income of \$20 she is minimal in what she can purchase. Due to the fact that the marginal utility per dollar for bowling (15) is higher than the marginal utility of the very first movie (12.5) she would initially go bowling, safety \$4. Compare the an initial movie (12.5) to the 2nd round the bowling (10) she would certainly go to the movie spending an additional \$8 and a complete of \$12. The decision is a small harder. Holly has eight dollars still to spend and the marginal energy per dollar is the same for each good. If she choose the movie she will invest all eight dollars, but if she goes bowling she will spend four dollars and still have four to spend. We have assumed that she desires to spend all she money and also gains no energy from hold the cash. Due to the fact that she can’t afford to buy an additional movie however would rather by a 3rd round the bowling, i m sorry only has actually a marginal energy per dissension of 7.5. Therefore we view that to maximize her utility, she would purchase one round of bowling and also two movies providing her a total utility the (60 + 100 + 80) = 240. Recall ours decision dominance is to have the marginal utility per dollar invested on the critical items it is in the same for all goods. In this case, we are unable to have actually that exactly yet we shot to acquire as close as possible. There is no other mix that would offer us better utility given our income.

Deriving Demand

Knowing exactly how the consumer behaves allows us to have a demand curve. Let’s say the Suzette eats either an to apologize or one orange together a snack. She has \$12 come spend. Offered that each fruit prices two dollars, she will certainly maximize her energy by to buy 3 apples and also 3 oranges. If we are looking at the need for oranges, this will provide us one allude on the demand curve. In ~ a price the \$2.00, the quantity demanded the oranges is 3.

Recall that together we relocate along the demand curve, the just thing that transforms is the price of the an excellent (ceteris paribus or holding every else constant). If the price of oranges decreases come \$1, the quantity of oranges demanded boosts to 6.

We can plot the two points and create a demand curve because that oranges. At a price of \$2 the quantity demanded is 3 and also at a price of \$1 the amount demanded is 6. Recall the the need curve mirrors the marginal benefit or the willingness to salary of the consumer.

The need curve can be seen in the diamond-water paradox. Why does water that is essential to sustain life price so much much less than diamonds that space atheistically pleasing, however are fairly unnecessary? Recall that price reflects the scarcity of a good. Overall, the it is provided of water is fairly abundant if the supply of diamonds is relatively limited. For this reason the price we pay for water is low contrasted to the price that diamonds.

Is the logical for someone that is maximizing his utility to acquisition both water and diamonds? once deciding what to acquisition we compare the marginal utility separated by the price. With numerous water consumption, the total utility of water is very large but the marginal utility of the critical gallon spend is fairly low. Few diamonds are purchased therefore while the marginal utility is an extremely large, speak the diamond ring you just purchased for your future spouse, the total utility is short since few diamonds are purchased.

Knowing that people experience diminishing marginal utility, just how do businesses react? recall that consumer surplus is the area listed below the demand curve but over the price. Think the some examples of how businesses react offered the legislation of diminishing marginal utility.

One example is the price every unit based upon package size. An ice cream cream store has three different serving sizes - a 6, 10, and also 12 ounce cup. The price the the the smallest size, "Like It," is \$4.29 or 71.5 cent per ounce. For just 32 cents more, one have the right to have four much more ounces, "Love It," do the marginal cost per ounce 8 cents and also the average cost per ounce 46 cents. Upgrading come the "Gotta have actually It" size adds second two ounces with only 15.5 cent per ounce more and one average price per ounce of just 41 cents. Definitely the big size is cheaper every ounce, yet not everyone wants to eat that large of a serving. For those just wanting a little serving, the store takes benefit of their better willingness come pay because that that part size. Whether its ice cream, eggs, milk, popcorn, or cereal, that is typical practice to fee a greater price every unit because that a smaller sized package size. Yet it pays for consumers to carry out the math due to the fact that businesses will certainly at times fee a greater price on the larger packages size. If customers believe that larger is constantly cheaper and also fail to perform the math, they might get caught paying a greater price per unit.

Services frequently follow a comparable pricing scheme with lower average prices for much more frequent attendance. Because that example, below are the prices because that the “hopper pass” at Disneyland. Ticket to sporting events follow a similar pricing approach with the per video game price being reduced if multiple games are purchased, such together the season pass.

Consider this example. You space on a long airplane ride, seated next to an eccentric feather woman and a businessman. Halfway right into the flight, the woman claims to you and the businessman, that she is an extremely rich and also bored that flying. To break up the monotony, she provides you and the business man a opportunity to break-up \$5,000. The rules are as follows: the businessman renders an offer of how to break-up the money and you either accept or reject. If friend accept, you obtain the agreed upon split. If friend don’t, friend both acquire nothing. This is a one time offer. The businessman thinks and offers the following break-up \$4,995 because that him and \$5 for you. Perform you accept or reject the offer? Why?

The answer come these questions will vary among individuals. Some will accept stating they have 5 dollars an ext than they did before. Rather will refuse the offer, saying the it is worth at least 5 dollars come them to refuse they business man the \$4,995. Mental that when we talk around utility, it consists of not only monetary items but additionally the nonmonetary.

In The theory of moral Sentiments, Adam smith wrote: "How selfish soever male may it is in supposed, there are evidently some values in his nature which interest him in the luck of others and render your happiness important to him though he start nothing from it except the satisfied of see it.” psychic that energy is acquired from many different areas including service and also philanthropic acts.

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

Section 02: Indifference Curves and also Budget Constraints

Indifference Curves

Indifference curves and also budget constraints permit for a more in-depth evaluation of demand. Because that modeling purposes we will certainly look at the 2 goods. An indifference curve mirrors the different combinations the the two goods that yield the same level that utility, live independence of the price that the goods. Due to the law of diminishing marginal utility, the indifference curve in between the two goods is convex to the origin. Every combinations the the two goods (pizza and also shakes) that space on the indifference curve (A, B, and also C) productivity the same level that utility, say utility = 100. Having much more of good, yields a higher level of energy (combination D) and also having much less of the items yields a reduced level of energy (combination E).

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An indifference curve map mirrors the family of indifference curves. There might be an infinite variety of indifference curve that would certainly reflect the level of utility at various combinations the the 2 goods. Simply as a line on a topographical map suggests the various points that room at the very same elevation, the different points follow me an indifference curve, suggest that same level of utility.

Source: U.S. Geological Survey

Marginal price of Substitution

The marginal price of substitution is the steep of the curve and measures the price at i m sorry the consumer would be willing to give up one good for the other while maintaining the same level of utility. For this reason the marginal rate of substitution mirrors the proportion of marginal utilities between the 2 goods.

For example, at suggest A, the customer would be willing to trade one shake because that one extr slice the pizza. At point B, the consumer already has a the majority of pizza but few shakes therefore the marginal utility from secondary pizza is reasonably lower and the marginal energy from the shake that would have to offer up would be fairly large, therefore to maintain the same level of energy he would have to get 3 pizzas to willingly give up one half a shake.

Since any mix of the two products will just yield one level of energy at a specific point in time, indifference curve will never ever cross every other.

Budget Constraint

The spending plan constraint shows the combinations of the two goods that have the right to be purchased given the consumer’s income and prices the the two goods. The intercept point out of the spending plan constraint are computer by splitting the income by the price of the good. Because that example, if the customer had \$8 come spend and also the price of pizza was \$2 and also shakes to be \$1, then the consumer could buy 4 pizzas (\$8/\$2) or eight shakes (\$8/\$1). Any mix of the two goods that room on or beneath the budget plan constraint space affordable, while those come the exterior (farther from the origin) room unaffordable.

A better income will reason a parallel change rightward of the spending plan constraint if a decrease in income will reason a parallel transition leftward.

Changing the price of the goods changes the slope of the spending plan constraint. If the consumer’s revenue is \$8 and the price the pizza is \$2 and the price that shakes is \$1, climate the budget constraint would certainly be BC1. If the price the pizza drops to \$1, then the budget plan constraint would turn out on the x-axis to BC2. Alternatively, if the price the shakes boosted to two dollars climate the spending plan constraint would come to be BC3.

The slope of the budget constraint is the an adverse ratio that the price (-Px/Py). Because that example, given the price that pizza (on the x-axis) is \$2 and also the price of shakes (on the y-axis) is \$1, then the steep of the budget plan constraint would certainly be -2.

Utlity Maximization

Given the goal of consumer is to maximize utility offered their budget constraints, they seek that combination of items that permits them to reach the greatest indifference curve offered their budget plan constraint. This occurs where the indifference curve is tangent come the budget plan constraint (combination A). Note that combine B and also C price the very same amount as A; however, A is ~ above a higher indifference curve. Combination D returns that exact same utility together C and also B however doesn’t use all of the income, for this reason the consumer can boost utility by consuming more. Mix E is wanted to combination A, but is unattainable provided the spending plan constraint.

We previously mentioned that utility is maximized wherein the marginal energy per dollar spent is the same for each of the goods. At the allude where the indifference curve is tangent to the budget plan constraint, the slope of the indifference curve which is the ratio of marginal utilities (-MUx/Muy) is equal to the slope of the spending plan constraint (- Price x / Price y). This equation can be rewritten to display that the marginal energy per dollar spent will it is in the very same for both goods.

The demand curve have the right to be derived from the indifference curves and budget limit by changing the price of the good. For example, if the price that pizza is \$4, the amount demanded that pizza is two. If the price that pizza decreases, the budget constraint becomes flatter and also the consumer can purchase much more pizza, to speak the price of pizza drops come \$2 and also consumer purchases 4 units. If the price drops come \$1.33, the quantity demanded increases to 5. Plotting each of the price and quantity demanded points creates the need curve for pizza.

Income and also Substitution Effects

When pointing out why the need curve is bottom sloping, us outlined the substitution effect and income effect. We have the right to observe the transforms in quantity demanded follow me the need curve due to the readjust in price; however, the indifference curves and budget border can assist us analyze the size of the income and also substitution effects.

For example, speak the consumers revenue is \$15 and the price of apples is \$1 and the price that oranges is \$3. At this prices the consumer purchases six apples and three oranges. As soon as the price of oranges drops to \$1, the consumer purchases eight apples and seven oranges. For this reason on the need curve because that oranges, the consumer purchases 3 oranges once the price is 3 dollars and also seven oranges as soon as the price is one dollar.

Bringing the new budget constraint earlier to the original indifference curve permits us to break down the income and substitution effects. Because the slope of the budget plan constraint shows the proportion of prices, the substitution impact is the increase in the variety of oranges that would be purchased offered the brand-new prices, while remaining on the original indifference curve the is relocating from suggest A to suggest B. The motion from allude B to allude C is the revenue effect, the added consumption the oranges as result of the raised purchasing power. Through a decrease in the price of oranges, the loved one price the apples has increased and also fewer apples would certainly be consumed due to the substitution effect; however, due to increased purchasing power, much more apples room purchased also as much more oranges.

Recall from our elasticity conversation that the revenue elasticity for an inferior an excellent is negative. For example, as income rises the demand for used clothing decreases. Looking at second-hand garments on the x-axis, together the price declines the substitution will be optimistic (movement from allude A to allude B); however, the income result (movement indigenous B come C) will be negative.

Extreme Cases

When examining indifference curves and also budget constraints, we have the right to look in ~ a few extremes. One extreme instance would be if the two goods are perfect complements. For example, you carry out not get additional satisfaction from having an additional right shoe, unless you have actually a left shoe to go with it. In the instance of perfect complements, you constantly consume at the minimum combination of the 2 goods.

Another excessive is perfect substitutes. Girlfriend purchase paper in one of two people the 100 or 200 sheet packs and only worth the number of sheets. You are indifferent between having two one-hundred paper packages or one two-hundred sheet package. In the instance of perfect substitutes, there are three different outcomes that will maximize utility. If the price of one package, returns a lower per paper cost, the consumer will buy just that good, so intake will take place at among the 2 intercepts. The 3rd outcome is when the spending plan constraint has the very same slope together the indifference curve. In this case, any combination along the spending plan constraint will yield the same level that utility.

Government Food Stamps Example

Why walk the government give welfare recipients food stamps instead of cash? Why are food stamps marketed on the black sector for a discount? let’s assume a person has \$75 that income and receives \$75 of food stamps indigenous the government. For simplicity, we will assume that the price of every unit the food and also the price of apparel are each one dollar. The budget constraint enables the consumer to acquisition up to 150 systems of food, but due to the fact that food stamps can only be offered to acquisition food, the consumer is restricted to only being may be to acquisition 75 systems of various other items.

The amount of food and also other goods, the individual will purchase depends top top the form of his indifference curve. Listed that the human spends at the very least 75 dollars on food, the is no constrained by receiving food stamps instead of cash.

Unfortunately, because that those people with strong addictions, such together cigarettes or alcohol, their indifference curve reflect the higher value received from the addict substance. Since food stamps only use to purchase food, the customer is no able to get as much utility and is limited to point A. If the food stamps had been in the kind of cash, the customer would have purchased 40 units of food and also 110 systems of alcohol, suggest B, which would certainly yield a greater level the utility.

If the consumer could transform a part of the food stamps to cash, even at a discount, the would have the ability to reach a greater indifference curve. Assume the he deserve to trade food stamps top top the black industry for 50 cent on the dollar i m sorry extends his budget plan constraint enhancing the quantity of alcohol that deserve to be purchased. Selling food stamps in ~ a discount allows the customer to move to point C, which returns a greater utility than suggest A.

We can also model why individuals purchase items today and also carry the debt on their credit transaction cards paying a high attention rate. Because that example, let’s say the price the each an excellent is \$1. I think Will has \$100 of revenue which he could spend now or invest the money and also receive \$150 in the future. By waiting, will certainly would have a greater purchasing power, but his intake bundle will count on his preferences. If he has a solid preference because that having consumption today, he would certainly be ready to pay a higher price because that those goods today. The exact same is true because that those who buy items on credit. They are willing to salary the acquisition price plus every the interest, so that they deserve to have it this day (so the indifference curve touch the budget constraint in ~ a allude closer come the x-axis as seen in the figure).

Similarly, some individuals are willing to pay to go to the expensive theater to watch a movie when it is first released. Others will certainly wait till it comes to the cheap theater or also until the comes the end on DVD/Blu-ray. Although people are paying for the “movie experience” and not just the movie itself, we deserve to see the time choices of individuals and the price differentials in time (as represented by different placements the the indifference curves).