Section 01: Consumer Behavior

Utility

In this section, we are going to take a closer look at what is behind the demand curve and also the actions of consumers. How does a customer decide to spfinish his/her income on the many kind of various things that he/she wants, i.e., food, apparel, housing, entertainment? We assume that the goal of the customer is to maximize his/her level of satisfactivity or joy, constrained by his/her earnings.

Economists use the term utility as a meacertain of satisfactivity, joy, or happiness. How a lot satisfaction does a perchild acquire from eating a pizza or watching a movie? Measuring utility is based solely on the choices of the individual and also has actually nopoint to carry out with the price of the good. Let’s perform an experiment in energy.

Step 01: Get some of your favorite candy, pastries, or cookies.

Tip 02: Take a bite and also evaluate, on a range from 0 to 100 (through 100 being the biggest utility), the level of energy from that bite. Record the marginal energy of that bite (i.e., just how a lot you get from that one extra bite).

Tip 03: Repeat action 02. It is essential to be continual through each unit consumed, i.e., the same size and also no drinking milk or water component means though. When you run out of candy or your marginal utility goes to zero you can sheight.

You are watching: The decision-making process followed by consumers to maximize utility assumes that

Law of Diminishing Marginal Utility

The legislation of diminishing marginal utility claims that as even more of the excellent is consumed, the additional satisfactivity from one more bite will eventually decrease. The marginal energy is the satisfaction obtained from each extra bite. As more of the excellent is consumed, we acquire much less extra satisfaction from consuming another unit. Therefore even if a great were cost-free and you can consume as a lot as you wanted, tbelow would certainly be a limit to the amount you would consume because of the legislation of diminishing marginal energy.

Summing the marginal utilities gives us the full energy. For instance, let’s say the first cacao was an 85 and also the second chocolate had a marginal utility of 79, then the total energy from consuming two chocolates is 164. The full energy from consuming three chocolates is 85+79+73 = 237. As long as our marginal energy is positive our total energy boosts although with diminishing marginal utility it increases at a decreasing rate.

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Can marginal utility be negative? Yes. At a holiday dinner, you might overeat and also endure from indigestion after that to a allude wright here you regret having consumed too a lot, however at the moment of the dinner, you expected greater energy from eating the last of the meal. We would not willingly consume an item that gave us negative marginal energy. Then why would certainly an individual stuff themselves throughout a warm dog eating dispute wbelow clearly the last warm dogs consumed are making them worse off? Although the marginal utility from the last warm dog itself makes the person worse off, the energy from winning the contest is better making the marginal energy positive.

The marginal utility of a things deserve to adjust. For example, during a drought water provides a high positive marginal energy, and also via even more rain the marginal energy declines. At some allude, tbelow is also a lot rain, it turns from being a great energy to a negative one and the marginal utility of even more rain, as soon as it is already flooding, is negative.

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Maximizing Utility

Utility worths deserve to be established by an individual ranking his/her preferences from least wanted to many wanted. The resulting ranking or utility values are subjective or individual. They are likewise ordinal fairly than cardinal. Ordinal implies that the energy worths ssuggest specify a ranking of preferences quite than an actual cardinal measurement.

Imagine a course has actually 10 students in the class and also the teacher lined the students up according to elevation. He then numbered them off according to elevation, assigning the shortest student a 1 and also the tallest student a 10. Is it true that student number 4 is twice tall as student number 2? Of course not. All we understand from the ranking is that student number 4 is taller than student number 2. Now, imagine that in an additional course an additional teacher has likewise ranked 10 students according to elevation. Is it true that student number 10 from the second classroom is taller than student 1 from the first classroom? We cannot say because the ranking is just valid within a particular course. In order to say a student is twice as tall as one more student or to have the ability to compare students between classes, we would certainly require a cardinal measure of height prefer inches or centimeters.

Because utility is ordinal and not cardinal we cannot make interpersonal comparisons of energy. Does a wealthy perchild worth a dollar more or less than a negative person? While some would say that a negative perboy most likely has actually more unmet requirements and for this reason he would worth the dollar even more. The answer is that it all relies on the preferences of the individuals. A poor perchild may prefer to live an extra simplistic life and also area a lower value on having an added dollar than a wealthy person that has actually a “love of money” (1 Timothy 6:10). We simply cannot make such an interindividual comparikid of utility.

So exactly how does the customer decide what to purchase? Unfortunately every little thing has actually a price and also consumers only have so a lot money to spfinish. Consequently consumers attempt to spend the limited money they have on what will certainly provide them the greatest amount of satisfaction. The decision dominance for energy maximization is to purchase those items that provide the best marginal energy per dollar and are affordable or within the budobtain. Many type of grocery stores carry out a tag that shows the price per pound for the excellent. This enables consumers to compare the price per pound for different brands or different sizes. The very same idea is offered for maximizing energy but we divide the marginal energy by the price to gain the marginal energy per dollar.

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Let’s say that we eat only two goods: milk shakes and also pizza where the price of each slice of pizza is $2 and the price of each shake is $1 and also we only have $11 to spend. Since the price of each great is different we have to divide the marginal energy by the price to enable for a common comparikid. We then compare the marginal utility per dollar for pizzas verses shakes. For the initially unit the marginal utility per dollar of a shake is 50 compared to only 45 for the pizza, so we would purchase the first shake. We then compare the marginal utility per dollar of the first pizza (45) to the marginal energy per dollar of the second shake (40) and purchase the initially slice of pizza. If the marginal energy per dollar is the exact same for the two goods and also we have income to purchase both then we would certainly do so, as viewed in the second slice of pizza and also the second shake.

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We proceed to alfind on budget on those goods that yield the highest possible marginal energy per dollar. In this example, we would purchase 4 slices or pizza and three milkshakes and also spend our entire budacquire of $11. The total utility from this purchase would certainly be the sum of the marginal utilities: 50 + 90 + 80 + 40 + 70 + 60 + 30 = 420. At the last items purchased the marginal utility per dollar spent on the 2 products is the same, no various other combination of pizzas and also milk shakes will certainly give us better utility provided our budget.

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Practice

Here is your possibility to practice. Holly has $20 to spend on either movies or bowling and desires to maximize her utility. Complete the table and recognize how many type of movies and also rounds of bowling will maximize her utility.

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Our initially step is to divide the marginal utility of each item by the price. With an earnings of $20 she is restricted in what she have the right to purchase. Since the marginal energy per dollar for bowling (15) is better than the marginal utility of the first movie (12.5) she would certainly initially go bowling, spending $4. Comparing the first movie (12.5) to the second round of bowling (10) she would go to the movie spending an additional $8 and a full of $12. The decision is a little harder. Holly has eight dollars still to spfinish and the marginal energy per dollar is the exact same for each good. If she chooses the movie she will spfinish all eight dollars, yet if she goes bowling she will spfinish four dollars and also still have 4 to spfinish. We have actually assumed that she wants to spfinish all her money and also gains no energy from holding the cash. Because she can’t afford to buy another movie however would rather by a 3rd round of bowling, which just has actually a marginal utility per dollar of 7.5. Therefore we view that to maximize her energy, she would certainly purchase one round of bowling and also two movies giving her a full utility of (60 + 100 + 80) = 240. Respeak to our decision preeminence is to have actually the marginal utility per dollar invested on the last items be the same for all items. In this situation, we are unable to have that precisely yet we try to gain as close as feasible. There is no other combination that would certainly offer us higher energy offered our income.

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Deriving Demand

Knowing just how the customer behaves allows us to derive a demand also curve. Let’s say that Suzette eats either an apple or an orange as a snack. She has $12 to spfinish. Given that each fruit costs two dollars, she will maximize her utility by purchasing 3 apples and 3 ovarieties. If we are looking at the demand also for ovarieties, this will offer us one allude on the demand also curve. At a price of $2.00, the amount demanded of ovarieties is 3.

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Respeak to that as we relocate along the demand curve, the just point that alters is the price of the excellent (ceteris paribus or holding all else constant). If the price of ovarieties decreases to $1, the quantity of ovarieties demanded increases to 6.

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We can plot the two points and create a demand also curve for oarrays. At a price of $2 the amount demanded is 3 and also at a price of $1 the quantity demanded is 6. Recall that the demand also curve shows the marginal benefit or the willingness to pay of the consumer.

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The demand curve deserve to be seen in the diamond-water paradox. Why does water that is important to sustain life cost so a lot much less than diamonds that are atheistically pleasing, but are fairly unnecessary? Respeak to that price mirrors the scarcity of a great. Overall, the supply of water is relatively abundant while the supply of diamonds is relatively limited. Hence the price we pay for water is low compared to the price of diamonds.

Is it logical for someone that is maximizing his utility to purchase both water and diamonds? When deciding what to purchase we compare the marginal energy split by the price. With several water intake, the full utility of water is incredibly huge but the marginal utility of the last gallon consumed is reasonably low. Few diamonds are purchased so while the marginal utility is extremely big, say the diamond ring you simply purchased for your future spousage, the full energy is low because few diamonds are purchased.

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How Businesses React

Knowing that people experience diminishing marginal energy, how perform businesses react? Respeak to that consumer excess is the location below the demand curve but over the price. Think of some examples of just how businesses react given the regulation of diminishing marginal utility.

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One example is the price per unit based upon package dimension. An ice cream save has actually 3 different serving sizes - a 6, 10, and 12 ounce cup. The price of the smallest size, "Like It," is $4.29 or 71.5 cents per ounce. For simply 32 cents more, one can have actually 4 even more ounces, "Love It," making the marginal price per ounce 8 cents and the average expense per ounce 46 cents. Upgrading to the "Gotta Have It" dimension adds a second two ounces through just 15.5 cents per ounce more and an average price per ounce of only 41 cents. Undoubtedly the huge dimension is cheaper per ounce, but not everyone desires to eat that big of a serving. For those just wanting a small serving, the keep takes benefit of their higher willingness to pay for that percent dimension. Whether its ice cream, eggs, milk, popcorn, or grain, it is widespread practice to charge a higher price per unit for a smaller sized package size. However before it pays for consumers to do the math since businesses will certainly at times charge a greater price on the bigger packages dimension. If customers believe that bigger is always cheaper and fail to perform the math, they might get captured paying a greater price per unit.

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Services frequently follow a comparable pricing plan through reduced average prices for more frequent attendance. For instance, below are the prices for the “hopper pass” at Disneyland. Tickets to sporting events follow a similar pricing method through the per game price being reduced if multiple games are purchased, such as the seaboy pass.

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Consider this example. You are on a long plane ride, seated alongside an eccentric looking womale and also a businessmale. Halfway into the trip, the woguy claims to you and also the businessmale, that she is extremely affluent and bored of flying. To break up the monotony, she provides you and also the businessmale a opportunity to separation $5,000. The rules are as follows: the businessguy renders an offer of just how to separation the money and you either accept or disapprove. If you accept, you gain the agreed upon separation. If you don’t, you both acquire nopoint. This is a one time offer. The businessman thinks and supplies the complying with split $4,995 for him and also $5 for you. Do you accept or disapprove the offer? Why?

The answer to these inquiries will certainly vary among individuals. Some will certainly accept stating they have five dollars even more than they did before. Others will certainly reject the sell, saying that it is worth at leastern five dollars to them to deny they businessguy the $4,995. Remember that as soon as we talk around utility, it contains not just monetary items but also the nonfinancial.

In The Theory of Mdental Sentiments, Adam Smith wrote: "How selfish soever before guy may be supposed, there are evidently some principles in his nature which interemainder him in the fortune of others and render their happiness essential to him though he derives nopoint from it other than the pleacertain of seeing it.” Remember that energy is acquired from many different areas including company and also philanthropic acts.

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

Section 02: Indifference Curves and Spending Plan Constraints

Indistinction Curves

Indistinction curves and budget constraints enable for an extra thorough evaluation of demand also. For modeling purposes we will certainly look at the two products. An indistinction curve reflects the different combinations of the two goods that yield the same level of energy, independent of the price of the goods. Due to the law of diminishing marginal utility, the indistinction curve in between the 2 goods is convex to the beginning. All combinations of the two goods (pizza and also shakes) that are on the indifference curve (A, B, and C) yield the exact same level of utility, say Utility = 100. Having more of great, returns a greater level of energy (combination D) and having much less of the items yields a lower level of utility (combicountry E).

See more: Sorrow Of The Sorrows Of The King Henri Matisse 'S The Sorrowss Of The King

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An indistinction curve map mirrors the family of indifference curves. Tright here might be an limitless number of indifference curves that would reflect the level of energy at different combicountries of the 2 goods. Just as a line on a topographical map suggests the different points that are at the exact same elevation, the different points alengthy an indistinction curve, show that exact same level of energy.

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Source: UNITED STATE Geological Survey

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Marginal Rate of Substitution

The marginal price of substitution is the slope of the curve and also measures the rate at which the consumer would certainly be willing to provide up one great for the various other while maintaining the exact same level of energy. Hence the marginal price of substitution mirrors the ratio of marginal utilities between the two products.

For example, at allude A, the consumer would be willing to trade one shake for one added slice of pizza. At suggest B, the customer currently has the majority of pizza however few shakes so the marginal utility from an additional pizza is relatively reduced and also the marginal utility from the shake he would need to give up would certainly be fairly large, therefore to maintain the exact same level of utility he would certainly need to gain 3 pizzas to willingly offer up one half a shake.

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Due to the fact that any type of combination of the two goods will just yield one level of utility at a specific suggest in time, indifference curves will never before cross each other.

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Budget Plan Constraint

The budobtain constraint indicates the combicountries of the two products that have the right to be purchased given the consumer’s income and prices of the two items. The intercept points of the budgain constraint are computer by splitting the earnings by the price of the great. For instance, if the customer had $8 to spend and also the price of pizza was $2 and shakes were $1, then the consumer can buy 4 pizzas ($8/$2) or eight shakes ($8/$1). Any combination of the two goods that are on or beneath the budobtain constraint are affordable, while those to the outside (farther from the origin) are unaffordable.

A greater revenue will certainly reason a parallel shift rightward of the budgain constraint while a decrease in earnings will cause a parallel shift leftward.

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Changing the prices of the products transforms the slope of the budobtain constraint. If the consumer’s income is $8 and the price of pizza is $2 and the price of shakes is $1, then the budobtain constraint would be BC1. If the price of pizza drops to $1, then the budget constraint would certainly revolve out on the x-axis to BC2. Conversely, if the price of shakes enhanced to two dollars then the budgain constraint would end up being BC3.

The slope of the budacquire constraint is the negative ratio of the prices (-Px/Py). For example, offered the price of pizza (on the x-axis) is $2 and the price of shakes (on the y-axis) is $1, then the slope of the budgain constraint would be -2.

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Utlity Maximization

Given the goal of consumers is to maximize energy offered their budobtain constraints, they look for that combination of items that enables them to reach the highest indifference curve provided their budget constraint. This occurs wright here the indifference curve is tangent to the budacquire constraint (combicountry A). Note that combinations B and C expense the same amount as A; however, A is on a higher indifference curve. Combination D yields that exact same energy as C and also B however doesn’t use every one of the earnings, thus the customer ca boost utility by consuming more. Combination E is desired to combicountry A, however is unattainable provided the budobtain constraint.

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We abovementioned that energy is maximized wbelow 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 budobtain constraint, the slope of the indifference curve which is the proportion of marginal utilities (-MUx/Muy) is equal to the slope of the budobtain constraint (- Price x / Price y). This equation can be recomposed to display that the marginal energy per dollar spent will be the very same for both goods.

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The demand curve can be derived from the indistinction curves and budgain constraints by altering the price of the excellent. For example, if the price of pizza is $4, the amount demanded of pizza is 2. If the price of pizza decreases, the budgain constraint becomes flast and also the customer have the right to purchase even more pizza, say the price of pizza drops to $2 and customer purchases 4 devices. If the price drops to $1.33, the quantity demanded boosts to 5. Plotting each of the price and amount demanded points creates the demand curve for pizza.

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Income and Substitution Effects

When pointing out why the demand curve is downward sloping, we outlined the substitution effect and revenue impact. We can observe the alters in amount demanded alengthy the demand curve as a result of the adjust in price; however, the indifference curves and also budobtain constraints have the right to assist us analyze the dimension of the earnings and also substitution impacts.

For example, say the consumers revenue is $15 and the price of apples is $1 and also the price of ovarieties is $3. At these prices the consumer purchases six apples and three oarrays. When the price of oranges drops to $1, the consumer purchases eight apples and also seven oranges. Therefore on the demand also curve for oranges, the customer purchases 3 ovarieties when the price is 3 dollars and also seven oranges when the price is one dollar.

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Bringing the brand-new budgain constraint back to the original indistinction curve permits us to break down the income and substitution effects. Because the slope of the budget constraint shows the ratio of prices, the substitution result is the increase in the number of oranges that would be purchased offered the new prices, while continuing to be on the original indistinction curve that is relocating from point A to suggest B. The movement from point B to suggest C is the revenue effect, the additional intake of oranges as a result of the enhanced purchasing power. With a decrease in the price of oranges, the relative price of apples has raised and also fewer apples would certainly be consumed because of the substitution effect; however, as a result of enhanced purchasing power, even more apples are purchased and also more ovarieties.

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Recall from our elasticity conversation that the revenue elasticity for an inferior excellent is negative. For instance, as revenue rises the demand also for used apparel decreases. Looking at second-hand also garments on the x-axis, as the price declines the substitution will certainly be positive (activity from allude A to suggest B); yet, the revenue effect (motion from B to C) will certainly be negative.

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Extreme Cases

When studying indifference curves and also budobtain constraints, we deserve to look at a few extremes. One extreme instance would be if the two items are perfect complements. For instance, you carry out not acquire additional satisfaction from having actually another best shoe, unmuch less you have actually a left shoe to go through it. In the case of perfect complements, you always consume at the minimum combicountry of the two goods.

Another extreme is perfect substitutes. You purchase paper in either the 100 or 200 sheet packs and also only value the number of sheets. You are indifferent in between having actually 2 one-hundred sheet packeras or one two-hundred sheet package. In the instance of perfect substitutes, there are three various outcomes that will certainly maximize energy. If the price of one package, yields a reduced per sheet expense, the customer will certainly buy just that excellent, so intake will take location at one of the 2 intercepts. The third outcome is when the budget constraint has the exact same slope as the indistinction curve. In this instance, any kind of combicountry alengthy the budget constraint will certainly yield the exact same level of utility.

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Government Food Stamps Example

Why does the government offer welfare recipients food stamps rather of cash? Why are food stamps sold on the babsence industry for a discount? Let’s assume a perkid has $75 of income and receives $75 of food stamps from the federal government. For simplicity, we will certainly assume that the price of each unit of food and the price of garments are each one dollar. The budobtain constraint allows the consumer to purchase approximately 150 systems of food, yet since food stamps can just be supplied to purchase food, the customer is limited to just being able to purchase 75 units of other items.

The amount of food and also various other items, the individual will purchase counts on the form of his indifference curve. Provided that the perboy spends at least 75 dollars on food, he is not constrained by receiving food stamps rather of cash.

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Unfortunately, for those individuals through solid addictions, such as cigarettes or alcohol, their indifference curves reflect the better value obtained from the addict substance. Because food stamps only apply to purchasing food, the customer is not able to gain as a lot energy and also is limited to suggest A. If the food stamps had been in the develop of cash, the consumer would certainly have actually purchased 40 systems of food and also 110 devices of alcohol, allude B, which would yield a greater level of energy.

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If the customer could transform a part of the food stamps to cash, also at a discount, he would certainly be able to reach a higher indifference curve. Assume that he can trade food stamps on the black market for 50 cents on the dollar which extends his budget constraint increasing the amount of alcohol that deserve to be purchased. Selling food stamps at a discount permits the customer to relocate to suggest C, which yields a greater energy than point A.

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We have the right to also version why individuals purchase items now and also lug the debt on their credit cards paying a high interemainder price. For example, let’s say the price of each great is $1. Assume Will has actually $100 of earnings which he might spfinish this day or invest the money and receive $150 later. By waiting, Will would certainly have actually a better purchasing power, but his intake bundle will certainly depfinish on his choices. If he has actually a solid preference for having actually usage this particular day, he would be willing to pay a higher price for those goods this particular day. The exact same is true for those who buy items on crmodify. They are willing to pay the purchase price plus all the interemainder, so that they have the right to have it today (so the indifference curve touches the budacquire constraint at a point closer to the x-axis as checked out in the figure).

Similarly, some people are willing to pay to go to the expensive theaters to watch a movie when it is first released. Others will wait till it involves the cheap theaters or even until it comes out on DVD/Blu-ray. Although individuals are paying for the “movie experience” and not simply the film itself, we have the right to watch the time preferences of individuals and also the price differentials over time (as stood for by different placements of the indistinction curves).