Consumer Choice and Demand

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Consumer Choice and Demand
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We Assume

• Consumers (or households) act rationally in order
  to maximize their utility
  
• We use that concept to examine how consumers use
  utility to make decisions
  
• How many slices of pizza should I buy?
• How many Pepsis should I drink with my lunch?
• Should I buy a new pair of running shoes?
• We will use utility calculations to examine
  these decisions

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Tastes and Preferences

• Utility is subjective (each person view
  goods/decisions differently)
  
• Why is utility subjective and not objective?
• Because we all have different tastes and
  preferences
  
• Music
• Food
• Clothes

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Measures of Utility

• Recall that utility means the happiness or
  satisfaction you receive from consuming a good or
  service, but there are two different categories
  of utility
• Total Utility the total amount of satisfaction
  you get from consuming the good (ex. how happy
  you are from eating 6 slices of pizza for
  dinner)
• Marginal Utility the change in total utility
  from changing your consumption by one unit (ex.
  how much extra happiness did that last slice of
  pizza bring me?)

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Decisions at the Margin

• In Economics, we often assume that people make
  decisions at the margin
  
• Should I buy one more pair of jeans?
• Should my firm build a new plant?
• Should I eat one more slice of pizza?
• In all of these cases, we already have consumed
  some amount (a certain number of jeans in our
  closet or we have already eaten three slices of
  pizza) and we are deciding whether one more unit
  is worth it
• Because of this, we are interested in marginal
  utility

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The Law of Diminishing Marginal Utility

• This is one of the most important laws in
  describing consumer behavior
  
• Law of Diminishing Marginal Utility the more of
  a good a person consumes, the smaller the
  increase in total utility (i.e. marginal utility)
  from consuming an additional unit
• What is this saying?
• The first piece of pizza you eat makes you the
  happiest and your marginal utility decreases with
  each extra slice
  
• As consumption goes up, marginal utility goes down

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Utility Maximization

• How do we use utility to make decisions?
• If the good is free (the price is zero), then we
  should consume the amount that maximizes our
  utility
  
• In the Gusburger Eat-Off example, the utility
  maximizing choice is to consume 5 gusburgers
  
• We will keep consuming as long as the marginal
  utility (the extra benefit to us) is positive
  
• Most goods have prices, however, so lets spend
  some time thinking about utility maximization
  with prices greater than zero

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Utility Maximization with Scarcity

• Example Suppose you are deciding how to divide
  your income between consumption of two goods
  Pizza and DVD rentals
  
• Assumptions
• Your income per week is 40
• The price a pizza is 8
• The price of a DVD rental is 4

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Pizza Video Rentals
Marginal Marginal
Utility
Utility of Pizza
of Videos Pizza Total
Marginal per Dollar Video Total
Marginal per Dollar Consumed Utility
Utility Expended Rentals Utility of
Utility of Expended Per Week of Pizza of Piz
za (price8) per Week Videos Videos
(price4) (1) (2) (3) (4)
(5) (6) (7) (8)
0 0 - -
0 0 - -
1 56 56 7 1
40 40 10 2 88
32 4 2 68 28
7 3 112 24 3
3 88 20 5
4 130 18 2¼ 4
100 12 3 5 142 12
1½ 5 108 8
2 6 150 8 1
6 114 6 1½
To get the process going, suppose you start off
spending your entire budget of 40 on pizza ? 5
pizzas per week at a total utility of 142.
If you give up one pizza, you free up enough
money to rent 2 videos. Would total utility
increase from this reallocation? You give up 12
units of utility the marginal utility of the
5th unit of pizza, to get 68 units of utility
from the first 2 videos ? total utility increases
from 142 to 198.
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Pizza Video Rentals
Marginal Marginal
Utility
Utility of Pizza
of Videos Pizza Total
Marginal per Dollar Video Total
Marginal per Dollar Consumed Utility
Utility Expended Rentals Utility of
Utility of Expended Per Week of Pizza of Pi
zza (price8) per Week Videos
Videos (price4) (1) (2) (3)
(4) (5) (6) (7)
(8) 0 0 -
- 0 0 -
- 1 56 56 7 1
40 40 10
2 88 32 4 2
68 28 7 3 112
24 3 3 88 20
5 4 130 18 2¼
4 100 12 3
5 142 12 1½ 5
108 8 2
6 150 8 1 6
114 6 1½
Reduce consumption of pizza to 3 units, you give
up 18 units of utility from the 4th unit of pizza
but gain a total of 32 units of utility from the
3rd and 4th videos, another utility-increasing
move
Further reductions in pizza would reduce total
utility because you would give up 24 units of
utility from the 3rd pizza but gain only 14 from
the 5th and 6th video rentals
Thus, by trial and error, we find that the
utility-maximizing equilibrium condition is 3
pizzas and 4 videos per week, for a total utility
of 212 and an outlay of 24 on pizza and 16 on
videos
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Utility-Maximizing Condition

• As the previous example shows, the
  utility-maximizing decision occurs where the last
  dollar spent on each good yields the same
  marginal utility
• Where MUp is the marginal utility of pizza, pp is
  the price of pizza, MUv is the marginal utility
  of videos, and pv the price of videos
  

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Bang for your Buck

• This mathematical relationship tells us that we
  should spend our final dollar on the product that
  gives us the most bang for our buck
  
• In other words, whichever good gives us the most
  extra utility is the one we should spend our last
  dollar on
  

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Utility-Maximizing Choice

• What is one good gave you more bang for your
  buck? (i.e. if MUx/Px MUz/Pz)
  
• Then you would shift your resources to consume
  MORE of good x
  
• Because of the Law of Diminishing Marginal
  Utility, the increased consumption of good x
  lowers its marginal utility
  
• Eventually, increasing your consumption of good x
  enough will bring you back to the utility
  maximizing rule (that marginal utilities per
  dollar are equal)

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Utility Maximization and Demand Curves

• The purpose of utility analysis is to provide us
  information about quantity demanded
  
• Let us derive a demand curve for pizza
• What have we found so far?
• We found that at price of 8 per pizza, you would
  choose to consume 3 pizzas
  
• This represents a point on your individual demand
  curve for pizza

8
Price per pizza
3
Quantity of Pizzas
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Trace the Demand Curve

• Obviously, this single point doesnt allow us to
  portray the individuals entire demand curve
  
• To get a better picture, lets considering
  changing the price of pizza to 6
  
• This will change our Pizza and DVD rental table
• What will change?
• The Total Utility and Marginal Utility stay the
  same
  
• BUT the marginal utility per dollar has now
  changed

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Pizza Video Rentals
Marginal Marginal
Utility
Utility of Pizza
of Videos Pizza Total
Marginal per Dollar Video Total
Marginal per Dollar Consumed Utility
Utility Expended Rentals Utility of
Utility of Expended Per Week of Pizza of Pi
zza (price8) per Week Videos
Videos (price4) (1) (2) (3)
(4) (5) (6) (7)
(8) 0 0 -
- 0 0 -
- 1 56 56 9 1/3
1 40 40 10
2 88 32 5 1/3 2
68 28 7
3 112 24 4 3
88 20 5
4 130 18 3 4
100 12 3 5 142 12
2 5 108 8
2 6 150 8 1 1
/3 6 114 6
1½
Additionally, based on the new lower price of
pizza we would have 6 unspent. Based on this
new lower price for pizza, we would increase our
consumption to 4 pizzas per week ? total utility
increases by the 18 units derived from the 4th
pizza. We are once again in equilibrium.
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Demand Curve for Pizza

• Now we have enough information to make a rough
  sketch of the individuals demand curve for pizza

8
6
Price per pizza
D
3
4
Quantity of Pizzas
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Example 2 Subway Subs
At price 8, the marginal utility of other
goods is higher than the marginal utility of a
sub ? no subs are purchased. At price 7, the
consumer is willing and able to buy one per
month, at price 6, 2 are purchased ? the
second is worth at least 6. At price 5, 3
are purchased, and so on. In each case, the
value of the last sub purchased must at least
equal the price, otherwise it would not be
purchased. Along the demand curve, the price r
eflects the marginal valuation of the good, or
the dollar value of the marginal utility derived
from consuming each additional unit.
8
7
6
5
Price per Subway
4
3
2
1
D
0
1
2
3
4
5
6
7
8
Subways per month
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Consumer Surplus contd
When price 4, each of the four Subways can be
purchased at this price, even though the consumer
would have been willing to pay more for each of
the first three. The first sandwich provides
marginal utility valued at 7, 6 for the second,
and 5 for the third. Thus, the dollar value of
the total utility of the first four sandwiches is
7 6 5 4 22. A price of 4 confers
a consumer surplus equal to the difference
between the maximum amount we would have been
willing to pay (22) rather than go without
Subways and what we actually paid (16).
8
7
6
5
Price per Subway
4
3
2
1
D
0
1
2
3
4
5
6
7
8
Subways per month
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Consumer Surplus

• Consumer Surplus the difference between the
  maximum amount that a consumer is willing to pay
  for a given quantity of a good and what the
  consumer actually pays
• We will use it as a measure of consumer welfare
  or (how well off is the consumer)
  
• The greater the consumer surplus, the better-off
  the consumer is
  
• We will return to consumer surplus when we
  discuss firm pricing practices

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Individual vs. Market Demand

• The previous examples have focused on finding the
  demand curve for an individual
  
• When we look at market equilibrium, on the other
  hand, we use a market demand curve
  
• How do we find the market demand curve?
• Simply add together each individual demand curve
• This is called horizontal summation
• Graphically, this is how its done

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Deriving Market Demand
(d) Market demand for Subway subs
(b) Brittany
(a) Me
(c) Chris
e
6
6
6
dA dB dC D
6
c
i
r
P
4
4
4
4
2
2
2
2
d
d
d
C
B
A






0 2 6 12

0
2

0
2
4
0

2
4
6






Subways per month
At a price of 4, you demand 4 Subways, Brittany
2, and Chris none. ? the market demand at a pric
e of 4 is 6.
At a price of 2, you demand 6 per month,
Brittany 4, and Chris 2.
? market demand is 12
The market demand shows the total quantity
demanded per period by all consumers at various
prices.
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Overview

• Consumers maximize utility subject to their
  budget constraint
  
• The utility maximizing rule is
• Utility maximization yields an individual demand
  curve
  
• Summing each individual demand curve yields a
  market demand curve