Law of Diminishing Marginal Utility: Theory of Consumer ...
Microeconomics Notes: Chapter 6
Keely Henesey
Law of Diminishing Marginal Utility:
Law of Diminishing Marginal Utility: each added unit a consumer buys provides less satisfaction than the last unit purchased
Utility : wantsatisfying power o “Utility” & “Usefulness” NOT synonyms o Utility is subjective o Utility is difficult to quantify assume “utils” are units of utility
Total Utility (TU) : total amount of satisfaction derived from the consumption of some specific quantity of a product
Marginal Utility (MU) : change in total utility resulting from the consumption of ONE more unit of a product
Graph Total Utility Marginal Utility
Phase 1
Phase 2
Phase 3
Rises at Diminishing Rate (Conc. Down)
Maximum
Decreasing
MU = 0 (xintercept)
Falling & Negative
Falling & Positive
demanded to increase
Marginal Utility & Demand… law of diminishing marginal utility explains why demand curve has a negative slope o Negative slope of demand curve indicates that price must decrease for quantity
o Because additional units of a good yield diminishing amounts of MU, consumer will only buy additional units if price also falls
WHY? Because consumer would rather spend additional dollars on products that provide more utility
Theory of Consumer Behavior:
Microeconomics Notes: Chapter 3
Assumed Situation of the Typical Consumer: o Rational: consumer tries to use their money to maximize their TU o Preferences: consumer has clearcut preferences and a good idea of the MU they get from extra units of the products they might buy o Budget Constraint: consumer has a fixed, limited income o Prices: all goods carry a price tag (because they are scarce relative to demand for them) and the price of each good is unaffected by the amount bought by any individual person (because individual’s purchase is a tiny part of total demand)
UtilityMaximizing Rule : greatest TU is obtained when consumer allocates income so that the last dollar spent on each product yields the same MU MU of Product A MU of Product B = (¿ income is exhausted) Priceof A Pr ice of B o If Equation Isn’t Fulfilled : dollars are reallocated from good with low MU/P to good with high MU/P (to maximize buyer’s TU) o When choosing between two products, consumer will choose item with the higher MU/P to maximize utility o At consumer equilibrium, consumer has “balanced their margins”
Utility Maximization & The Demand Curve:
UtilityMaximizing Rule Shows Why Demand Curve is DownSloping By… o Using Model to Derive the Demand Curve:
Show how ∆ P of a product results in the reallocation of dollars (resulting in ∆ Q Demanded )
Price
Reallocation of Income…
In Other Words…
Rises Falls
Dollars are Allocated to OTHER Products
QDEMANDED of Product Decreases
MORE Dollars are Allocated to Given Product
QDEMANDED of Product Increase
o Use Model to Provide Insights on Income & Substitution Effects:
Income Effect : impact of ∆ P of a product on consumer’s real income (and consequently on QDemanded ) •
Pricefall frees up additional income for consumption
•
UM model shows where extra income will be spent
Microeconomics Notes: Chapter 3
Substitution Effect : impact of ∆ P of a product on its relative expensiveness (and consequently on QDemanded ) •
Pricefall decreases a product’s relative expensiveness
•
UM model shows why dollars will be allocated toward the product with the decreased price
Applications & Extensions:
iPod Case Study: introduction of iPod severely disrupted consumer equilibrium as consumers concluded that iPod’s had higher MU/P ratios that those of alternative products they therefore shifted spending from alternative products towards iPods o KEY IDEA : new products succeed by enhancing consumers’ TU
“Delivery of Value” generates a revenue stream
If [Revenues > ProductionCosts] , profits result
DiamondWater Paradox: why is water (an “essential” good) so much less expensive than a diamond (an “inessential” good)? o MU of the Last Unit Of…
Water VERY Low ( price of water is so low that people buy LOTS of it)
Diamonds VERY High ( price of diamonds is so high that relatively few are purchased)
o Total Utility Of…
Water VERY High ( so much water is bought due to price that the sum of all MUs is VERY large) •
Keep in Mind: first few units have MUs that are higher than those of diamonds—because life depends on them
Diamonds LOW ( relatively few are bought due to price so sum of MUs is comparatively small)
o KEY IDEA : water has much more total utility (roughly, usefulness) than diamonds even though price of diamonds greatly exceeds price of water [relative prices relate to marginal utility, not total utility]
Opportunity Cost & the Value of Time: time is a valuable economic commodity (an hour can be spent working to make $10 or incurring a $10 opportunity cost)
Microeconomics Notes: Chapter 3 o Opportunity cost of time explains what market prices can’t
Ex. A corporate executive (with VERY valuable time) will rationally spend $300 on a flight ticket, while an unskilled worker/retiree will rationally buy a bus ticket for $20 •
The time saved by the executive is worth more than the $280 he could have saved by taking the bus
o Those of other countries see Americans as wasteful of material goods but overly economical in their use of time///Americans see those of developing countries as wasteful of their time but overly economical with material goods WHY?
NOT Radically Different Temperaments Reflects that in an industrially advanced society, high laborproductivity gives time a high market value while the opposite is true in a lowincome, developing country
Medical Care Purchases: because health insurance covers 80% of all incurred health care costs, people are inclined to purchase more medical care than they would if confronted with the full price this explains today’s astronomical ( and growing) expenditures on health care
Cash Vs. Noncash Gifts: why do people prefer cash? o Noncash gifts may not match recipient’s preferences, thus it will not maximize their total utility
Gift registries, cash refunds/exchanges for gifts, and “regifting” are all ways that people try to combat the “value loss” (or utility loss) of noncash gifts
Prospect Theory:
Behavioral Economics : combines insights from various fields to better explain situations where actual choice behavior deviates from predictions made by theories that incorrectly assumed that consumers are always rational, deliberate, and unemotional
Prospect Theory : (Daniel Kahneman) based on the following facts on how people react to gains & losses… o They judge gains and losses in terms relative to their status quo o They experience diminishing marginal disutility for losses (each successive unit of loss hurts, but less than the previous unit)
Converse of diminishing marginal utility
Microeconomics Notes: Chapter 3 o They are loss averse (losses are felt MUCH more intensely than gains near status quo)
About 2.5 times more intensely
Prospect Theory Explains Various Phenomena… o Producers reduce the product size rather than increasing the price
Consumers view price increases as a loss relative to the status quo price they were used to
They fixate on prices rather than price per quantity and therefore don’t perceive the loss
o Framing Effects : changes in people’s decisionmaking caused by new information that alters the context (or “frame of reference”) they use to judge whether options are gains or losses
Manipulated by advertisers, lawyers, and politicians to try to alter people’s decisions
Ex. [Hamburger is “20% Fat”] Vs. [Hamburger is “80% Lean”]
o Anchoring : a person’s tendency to unconsciously base (or “anchor”) the valuation of an item on previously considered but logically irrelevant information
Ex. Credit card companies show very small minimumpayment amounts on borrowers’ monthly statements •
These act as an anchor that causes people to unconsciously make smaller payments each month
•
THUS: anchors customers into paying off debts slowly, increasing the total interest they will pay
o Mental Accounting : a person’s tendency to look at consumption options in isolation, as if putting certain options into separate “mental accounts” to be dealt with independently of their overall decisionmaking process (which best allocates their limited budgets using the utilitymaximizing rule)
Ex. OverpricedWarranty on $1000 TV people label purchase as an isolated transaction, thus they perceive a broken TV as a potential TOTAL loss •
The big picture shows a relatively minor loss by comparing the potential loss with their ENTIRE future income stream
Microeconomics Notes: Chapter 3 o Endowment Effect : a person’s tendency to place higher valuations on items they own than on identical items they do not own
Perhaps Caused by the People’s Loss Aversion… •
Owners they view parting with an item as a loss (they demand a high price because losses are felt SO intensely)
•
Purchasers feel no loss (they put lower valuations on the item because they do not feel such loss)
A: Consumer Surplus represents general utility in the market (the people who got given product for less than their reservation price) **Iffy to Calculate
A
B: Producer Surplus calculable
B
Q
P
A
Price Ceiling
Q
P Price Floor
B
Q
A: Deadweight Loss of Price Ceiling (results from underproduction)
Microeconomics Notes: Chapter 3
B: Deadweight Loss of Price Floor (results from overproduction)
Keely Henesey
Law of Diminishing Marginal Utility:
Law of Diminishing Marginal Utility: each added unit a consumer buys provides less satisfaction than the last unit purchased
Utility : wantsatisfying power o “Utility” & “Usefulness” NOT synonyms o Utility is subjective o Utility is difficult to quantify assume “utils” are units of utility
Total Utility (TU) : total amount of satisfaction derived from the consumption of some specific quantity of a product
Marginal Utility (MU) : change in total utility resulting from the consumption of ONE more unit of a product
Graph Total Utility Marginal Utility
Phase 1
Phase 2
Phase 3
Rises at Diminishing Rate (Conc. Down)
Maximum
Decreasing
MU = 0 (xintercept)
Falling & Negative
Falling & Positive
demanded to increase
Marginal Utility & Demand… law of diminishing marginal utility explains why demand curve has a negative slope o Negative slope of demand curve indicates that price must decrease for quantity
o Because additional units of a good yield diminishing amounts of MU, consumer will only buy additional units if price also falls
WHY? Because consumer would rather spend additional dollars on products that provide more utility
Theory of Consumer Behavior:
Microeconomics Notes: Chapter 3
Assumed Situation of the Typical Consumer: o Rational: consumer tries to use their money to maximize their TU o Preferences: consumer has clearcut preferences and a good idea of the MU they get from extra units of the products they might buy o Budget Constraint: consumer has a fixed, limited income o Prices: all goods carry a price tag (because they are scarce relative to demand for them) and the price of each good is unaffected by the amount bought by any individual person (because individual’s purchase is a tiny part of total demand)
UtilityMaximizing Rule : greatest TU is obtained when consumer allocates income so that the last dollar spent on each product yields the same MU MU of Product A MU of Product B = (¿ income is exhausted) Priceof A Pr ice of B o If Equation Isn’t Fulfilled : dollars are reallocated from good with low MU/P to good with high MU/P (to maximize buyer’s TU) o When choosing between two products, consumer will choose item with the higher MU/P to maximize utility o At consumer equilibrium, consumer has “balanced their margins”
Utility Maximization & The Demand Curve:
UtilityMaximizing Rule Shows Why Demand Curve is DownSloping By… o Using Model to Derive the Demand Curve:
Show how ∆ P of a product results in the reallocation of dollars (resulting in ∆ Q Demanded )
Price
Reallocation of Income…
In Other Words…
Rises Falls
Dollars are Allocated to OTHER Products
QDEMANDED of Product Decreases
MORE Dollars are Allocated to Given Product
QDEMANDED of Product Increase
o Use Model to Provide Insights on Income & Substitution Effects:
Income Effect : impact of ∆ P of a product on consumer’s real income (and consequently on QDemanded ) •
Pricefall frees up additional income for consumption
•
UM model shows where extra income will be spent
Microeconomics Notes: Chapter 3
Substitution Effect : impact of ∆ P of a product on its relative expensiveness (and consequently on QDemanded ) •
Pricefall decreases a product’s relative expensiveness
•
UM model shows why dollars will be allocated toward the product with the decreased price
Applications & Extensions:
iPod Case Study: introduction of iPod severely disrupted consumer equilibrium as consumers concluded that iPod’s had higher MU/P ratios that those of alternative products they therefore shifted spending from alternative products towards iPods o KEY IDEA : new products succeed by enhancing consumers’ TU
“Delivery of Value” generates a revenue stream
If [Revenues > ProductionCosts] , profits result
DiamondWater Paradox: why is water (an “essential” good) so much less expensive than a diamond (an “inessential” good)? o MU of the Last Unit Of…
Water VERY Low ( price of water is so low that people buy LOTS of it)
Diamonds VERY High ( price of diamonds is so high that relatively few are purchased)
o Total Utility Of…
Water VERY High ( so much water is bought due to price that the sum of all MUs is VERY large) •
Keep in Mind: first few units have MUs that are higher than those of diamonds—because life depends on them
Diamonds LOW ( relatively few are bought due to price so sum of MUs is comparatively small)
o KEY IDEA : water has much more total utility (roughly, usefulness) than diamonds even though price of diamonds greatly exceeds price of water [relative prices relate to marginal utility, not total utility]
Opportunity Cost & the Value of Time: time is a valuable economic commodity (an hour can be spent working to make $10 or incurring a $10 opportunity cost)
Microeconomics Notes: Chapter 3 o Opportunity cost of time explains what market prices can’t
Ex. A corporate executive (with VERY valuable time) will rationally spend $300 on a flight ticket, while an unskilled worker/retiree will rationally buy a bus ticket for $20 •
The time saved by the executive is worth more than the $280 he could have saved by taking the bus
o Those of other countries see Americans as wasteful of material goods but overly economical in their use of time///Americans see those of developing countries as wasteful of their time but overly economical with material goods WHY?
NOT Radically Different Temperaments Reflects that in an industrially advanced society, high laborproductivity gives time a high market value while the opposite is true in a lowincome, developing country
Medical Care Purchases: because health insurance covers 80% of all incurred health care costs, people are inclined to purchase more medical care than they would if confronted with the full price this explains today’s astronomical ( and growing) expenditures on health care
Cash Vs. Noncash Gifts: why do people prefer cash? o Noncash gifts may not match recipient’s preferences, thus it will not maximize their total utility
Gift registries, cash refunds/exchanges for gifts, and “regifting” are all ways that people try to combat the “value loss” (or utility loss) of noncash gifts
Prospect Theory:
Behavioral Economics : combines insights from various fields to better explain situations where actual choice behavior deviates from predictions made by theories that incorrectly assumed that consumers are always rational, deliberate, and unemotional
Prospect Theory : (Daniel Kahneman) based on the following facts on how people react to gains & losses… o They judge gains and losses in terms relative to their status quo o They experience diminishing marginal disutility for losses (each successive unit of loss hurts, but less than the previous unit)
Converse of diminishing marginal utility
Microeconomics Notes: Chapter 3 o They are loss averse (losses are felt MUCH more intensely than gains near status quo)
About 2.5 times more intensely
Prospect Theory Explains Various Phenomena… o Producers reduce the product size rather than increasing the price
Consumers view price increases as a loss relative to the status quo price they were used to
They fixate on prices rather than price per quantity and therefore don’t perceive the loss
o Framing Effects : changes in people’s decisionmaking caused by new information that alters the context (or “frame of reference”) they use to judge whether options are gains or losses
Manipulated by advertisers, lawyers, and politicians to try to alter people’s decisions
Ex. [Hamburger is “20% Fat”] Vs. [Hamburger is “80% Lean”]
o Anchoring : a person’s tendency to unconsciously base (or “anchor”) the valuation of an item on previously considered but logically irrelevant information
Ex. Credit card companies show very small minimumpayment amounts on borrowers’ monthly statements •
These act as an anchor that causes people to unconsciously make smaller payments each month
•
THUS: anchors customers into paying off debts slowly, increasing the total interest they will pay
o Mental Accounting : a person’s tendency to look at consumption options in isolation, as if putting certain options into separate “mental accounts” to be dealt with independently of their overall decisionmaking process (which best allocates their limited budgets using the utilitymaximizing rule)
Ex. OverpricedWarranty on $1000 TV people label purchase as an isolated transaction, thus they perceive a broken TV as a potential TOTAL loss •
The big picture shows a relatively minor loss by comparing the potential loss with their ENTIRE future income stream
Microeconomics Notes: Chapter 3 o Endowment Effect : a person’s tendency to place higher valuations on items they own than on identical items they do not own
Perhaps Caused by the People’s Loss Aversion… •
Owners they view parting with an item as a loss (they demand a high price because losses are felt SO intensely)
•
Purchasers feel no loss (they put lower valuations on the item because they do not feel such loss)
A: Consumer Surplus represents general utility in the market (the people who got given product for less than their reservation price) **Iffy to Calculate
A
B: Producer Surplus calculable
B
Q
P
A
Price Ceiling
Q
P Price Floor
B
Q
A: Deadweight Loss of Price Ceiling (results from underproduction)
Microeconomics Notes: Chapter 3
B: Deadweight Loss of Price Floor (results from overproduction)
