Utility

1 Notes on Utility Based on Economics for Today Irvin B. Tucker Lecture Slides © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 What does this lecture cover? It expands the understanding of demand by investigating why people buy goods and services Why we buy more of a good when its price falls, and less when its price rises © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 What does utility mean? The satisfaction, or pleasure, that people receive from consuming a good or service © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Utility relates to Satisfaction derived from consuming a good Kindness Costliness of a good How much of a good one buys 4 5 What is total utility? The (total) amount of satisfaction received from all the units of a good or service consumed © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Why does a consumer buy one bundle of goods, rather than another? Consumers make one choice over another depending on their marginal utility How it will affect their current situation Which one brings me more satisfaction for what I am paying for it © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 What is marginal utility? The change in total utility from one additional unit of a good or service © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 What is the law of diminishing marginal utility? The principle that the extra satisfaction of a good or service declines as people consume more in a given period © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Jessi likes peanuts. Total satisfaction is 200 after 1oz. Total satisfaction after 2oz is 300. What is the marginal utility she received from second oz? 300 200 100 0 Cannot tell from information given 9 8 6 4 2 Exhibit 1(a) Marginal Utility MU Marginal Utility per Big Mac (utils) Quantity of Big Macs (number consumed per day) 0 1 2 3 4 8 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 When is total utility maximized? When the marginal utility per dollar of each good is equal and the entire budget is spent © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12 What is consumer equilibrium? A condition in which total utility cannot increase by spending more of a given budget on one good and spending less on another good. Consumer is doing the best they can do. They are maximizing their total utility given their circumstances. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13 Even though water provides a greater utility than diamonds, why are diamonds more expensive? Water is plentiful in most of the world, so its marginal utility is low © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 0 Exhibit 2(a) Marginal Utility of Diamonds MU Marginal Utility per Carat (utils) S MUd Quantity of Diamonds (carats per year) 13 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 0 Exhibit 2(b) Marginal Utility of Water MU Marginal Utility per gallon (utils) S MUw Quantity of Water (gallons per year) 14 © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 Exhibit 3 Marginal Utility for Big Macs and Milkshakes (utils per day) Quantity MU MU/P MU MU/P 1 2 3 4 8 4 2 1 4 2 1 1/2 6 4 1 0 3 2 1/2 0 BIG MACS MILKSHAKES Note: The price per Big Mac and per milkshake is $2. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 MU A price A MU B price B Consumer Equilibrium MU Z price Z = = © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18 MU of Big Mac price of Big Mac MU of milkshake price of milkshake Consumer Equilibrium Price of Big Mac = $2 4 utils $2 4 utils $2 = = © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19 MU of Big Mac price of Big Mac > MU of milkshake price of milkshake Consumer Equilibrium Price of Big Mac = $1 4 utils $1 4 utils $2 > © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20 What happens to the number of Big Macs bought when the price drops? To restore maximum total utility, the consumer spends more on Big Macs. Recall the schedule of total and marginal utility (shown again in next slide). © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21 Exhibit 3 Marginal Utility for Big Macs and Milkshakes (utils per day) Quantity MU MU/P MU MU/P 1 2 3 4 8 4 2 1 4 2 1 1/2 6 4 1 0 3 2 1/2 0 BIG MACS MILKSHAKES Note: The price per Big Mac and per milkshake is $2. © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Change in consumption to restore equilibrium So consumer now has to consume 3 units of Big Macs. Why? Because at 3 units, MU of Big Macs is 2, so that 22 MU of Big Mac price of Big Mac MU of milkshake price of milkshake = 2 utils $1 = 4 utils $2 = 23 What does this discussion of utility reveal? The law of demand, that is, as the price of a good declines, consumers will buy more units of the good, and vice versa © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24 What are two alternative explanations of demand? Income effect Substitution effect © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25 What is the income effect? The change in quantity demanded of a good or service caused by a change in real income (purchasing power) © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26 What does the income effect show? As prices decline, your real income increases, increasing your buying power, so you buy more units, ceteris paribus © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27 Price of good X falls Real purchasing power increases Quantity of good X demanded increases © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28 What is the substitution effect? The change in quantity demanded of a good or service caused by the change in its price relative to substitutes © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29 What does the substitution effect show? Suppose the price of a Pepsi falls and the price of a Coke remains unchanged; you will buy more Pepsi, because relatively, it is less expensive than Coke © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30 Price of competing good Y rises Consumers switch from good Y to good X Quantity of good X demanded increases © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31 What do the substitution and income effects prove? The law of demand, that is, as the price of a good declines, consumers will buy more units of the good, and vice versa © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 32 END © 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted, in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.