16
Consumer Choice
Modeling Consumer
Satisfaction
• Utility
– A measure of relative levels of satisfaction consumers
enjoy from consumption of goods and services
– Sometimes numerically quantified by a unit of
happiness called a “util”
• Disadvantage of using “utils”
– Cannot be compared across individuals
– Not directly measureable or viewable
• Advantages of using “utils”
– Can maximize utility, just like firms maximize profits
– Internally consistent
Total and Marginal Utility
• Total utility
– Overall amount of happiness from all consumption
– Most of the time, total utility is directly related to
consumption.
• Marginal utility
– Additional utility gained from consuming one more unit
of a good or service
– Recall “marginal” = “additional”
– For most consumption that we rationally choose to do,
marginal utility is positive
Diminishing Marginal Utility
• If more consumption leads to higher utility,
marginal utility is positive.
– However, total utility will not increase at the same rate,
and marginal utility starts to diminish
• Example: you’re very hungry and begin to eat
– Pie slice #1 gives +20 to utility
– Pie slice #2 gives +14 to utility
– Pie slice #3 gives +6 to utility
• At this point:
– Total utility = 40
– The marginal utility of the third slice was six utils
Diminishing Marginal Utility
• Why does marginal utility diminish?
– We still enjoy additional consumption, but we don’t enjoy
it as much as the previous units.
• Notes:
– Diminishing MU is not that same as negative MU
– Diminishing MU does not necessarily imply negative MU
• Can marginal utility be negative?
– If MU < 0, it means that additional consumption makes
you worse off (decreasing total utility)
• Eat too much and feel sick
• Exercise to the point of injury
Total and Marginal Utility
Total and Marginal Utility
Optimizing Consumption
• Consider the following:
– Consumers have limited incomes (budgets)
– We must make choices of how to allocate our income
– We can use utils to measure the marginal utility
additional consumption gives us
– Consumers will be able to optimize consumption by
spending dollars on goods that give the highest
marginal utility per dollar (most “bang for your buck”)
• Consumer optimum
– Combination of goods and services
that maximizes utility for a given income
Deciding What to Buy
• In a simplified setting, we can narrow our
consumption choice to two goods, X and Y
• We can spend each dollar optimally by asking
MUX
Price X
Which is larger?
MUY
Price Y
• In other words:
– Which good will give us the highest marginal utility per
dollar spent?
– This is the “bang for your buck” question
Deciding What to Buy
MU X
Price X
Which is larger?
MU Y
Price Y
• Why do we divide by the price?
– Must account for price differences in goods
– Some goods may give high MU, but are more
expensive!
• If the X side is larger, what do we do?
– Spend next dollar on good X
– X will give us more happiness per dollar
– Important: after this consumption, MUX will fall!
More Than Two Goods
• In the consumer optimum, the marginal utility per
dollar was equal for both goods. At the last
dollar spent, we had
MU Pepsi
MU Pizza

Price Pizza Price Pepsi
• This can easily be extended to multiple goods:
MU C
MU A
MU B
MU Z


 ... 
Price A Price B Price C
Price Z
Optimization in Real Life
MU C
MU A
MU B
MU Z


 ... 
Price A Price B Price C
Price Z
• In real life, does it always work with
perfect exact equality?
– Maybe not, since the MU and prices may not work out
exactly.
– Depends on whether we’re able to buy and consume
fractions of goods
– However, we can still spend each dollar optimally at
the margin where it gives us the most marginal utility
– We’ll get as close to exact equality as possible
Price Changes
• Your individual consumption won’t affect prices,
but they can sometimes change exogenously
• Suppose that you are consuming optimally
MU X
MU Y

Price X Price Y
• What happens if PriceX increases? We then
have
MU X
MU Y

Price X Price Y
Price Changes
MU X
MU Y

Price X Price Y
• In this case, the solution is:
– Consume more of Y and less X
– Your preferences didn’t change, but X now gives less
bang for the buck due to a higher price
– Note that overall utility will decrease, since you are
unable to purchase as many goods as before
• Why not just more Y?
– If we had already consumed optimally and spent all
our budget, we can’t afford more Y
– We have to do a trade-off of Y for X
Price Changes
Further Analysis
• When the price of a good changes, our
consumption will change due to two factors, the
substitution effect and the real-income effect
• Substitution effect
– Occurs when a consumer buys more of a good as a
result of a relative price change
– We sub in more of the relatively cheaper good, and
sub out some of the relatively more expensive goods
– Illustrates that the two goods are at least somewhat
substitutable in consumption
Price Changes
Further Analysis
• Real-income effect
– Occurs when there is a change in purchasing power
as the result of a price change of a good
– When a good gets cheaper, your dollars can buy
more. This is similar to an increase in income.
– Assuming normal goods, an increase in income
means you’ll buy more goods. This affects both
goods, not just the good whose price decreased.
– Real-income effect is usually smaller than substitution
effect (in terms of how greatly if affects consumption)
Diamond-Water Paradox
• Paradox?
– Water is essential to life, yet cheap
– Diamonds are (almost) pragmatically
useless, yet expensive
• What’s wrong?
– Unfair comparison between MU of diamonds and MU
of water. We consume a large amount of water, so
MUwater is smaller.
– Recall that MU is captured in the law of demand, and
therefore by the price
– However, TOTAL utility from water consumption is
much greater than TU of diamond consumption!
Diamond-Water Paradox
• Uses of water
– Cooking, drinking, bathing  high value
– Watering lawns, washing cars  low value
• Prices
– In most places, water is relatively abundant, and
therefore cheap
– Diamonds are relatively scarce and more expensive
– With the high price of diamonds, you will only
consume if you expect to get a high amount of
marginal utility from the diamond
Water and Diamonds, Graphically
Economics in Super Size Me
• Total utility of McDonald’s is high because
they are everywhere, cheap, and serve
millions of people
• Can there be too much consumption?
Discrete Choice Models
• There are some goods in which we only
purchase one of that good. Thus, diminishing
MU may not apply. However, we still try to
maximize our utility.
• Discrete choice model—we buy the one “best”
choice out of many alternatives
–
–
–
–
Airline ticket
House
College education
Spouse!
Conclusion
• Money doesn’t make people happier, but it can
allow them to buy more goods and services
– Due to diminishing marginal utility, the amount of
happiness gained from additional consumption will get
smaller and smaller
• When maximizing utility, consumers face a
budget constraint and must consider income,
prices, and marginal utility
• Exogenous price changes will affect the optimal
consumption bundle chosen by individuals
Practice What You Know
What is true?
A. Marginal utility generally diminishes with
additional consumption of a good
B. Marginal utility generally becomes negative
with additional consumption of a good
C. Marginal utility equals total utility
D. Individuals avoid consuming goods in which
they experience diminishing marginal utility
Practice What You Know
Which of the following would most likely
illustrate an example of negative marginal
utility?
A. Studying for another hour
B. Sleeping in late on a weekend
C. Eating too much food at an all-you-can-eat
buffet
D. Drinking a second glass of juice with a meal
Practice What You Know
If I consume more of good Z, what happens?
A.
B.
C.
D.
The price of good Z will fall
The price of good Z will rise
My marginal utility of good Z will fall
My marginal utility of good Z will rise
Practice What You Know
Suppose that
MU X
MU Y

Price X Price Y
To optimize utility, the consumer should:
A.
B.
C.
D.
Buy more X
Buy less X
Buy more X and less Y
Buy more Y and less X
Practice What You Know
If the price of a good rises, consumers tend to
purchase less of that good and instead
purchase more of another good. This
illustrates:
A.
B.
C.
D.
The real-income effect
The substitution effect
Diminishing marginal utility
The disadvantage of using “utils” to measure
consumption