CHAPTER 7: CONSUMER BEHAVIOR Introduction The consumer is central to a market economy, and understanding how consumers make their purchasing decisions is the key to understanding demand. Chapter 7 explains how consumers maximize their utility through purchases and how that knowledge can be used to determine product demand. The Law of Diminishing Marginal Utility takes numeric and graphic form to illustrate why consumers respond as they do in markets. Material from Chapter 7 consistently appears in a multiple-choice question or two on the AP microeconomics exam and has appeared infrequently as part of a free-response question. The Law of Diminishing Marginal Utility The Law of Diminishing Marginal Utility explains that the more of a good a person gets, the less utility he gets from each additional unit. Scarcity still exists, because we want more than resources are available to produce. But at a particular time, our wants for a good can be satisfied and additional consumption can even reduce our well-being. Utility is difficult to quantify, and it differs between people and situations. A blanket holds great utility for someone living in Maine in January but little for a camper in Arizona in July. Total and Marginal Utility Economists attempt to quantify utility by measuring the units of satisfaction in terms of "utils." Total utility is the total amount of satisfaction a consumer receives from his total consumption of the product. Marginal utility is the increase in satisfaction (the increase in total utility) the consumer receives from consuming one more unit of the product. 2 3 4 5 6 7 Units consumed per meal (b) Marginal utility Total and marginal utility It is important to note that marginal utility begins to fall after the very first product consumed. Your first taco holds great utility, and while a second taco is useful, it doesn't bring as much Chapter 7: Consumer Behavior 55
utility as the first one. The third holds even less. At some point, marginal utility becomes negative, as you're worse off by consuming more. Total utility increases for the first several units consumed. Even though each extra taco brings you less utility than the one before, it still adds to the total utility for all of the tacos together. However, as the marginal utility decreases, the growth of the total utility curve slows, until it peaks at the point where the marginal utility of the next unit is zero. As marginal utility begins to fall into negative utils, the total utility begins to fall, as well. Marginal Utility and Demand The Law of Diminishing Marginal Utility is one reason demand slopes downward. If consumers gain less marginal utility from each additional unit, they will only buy more products if the price falls. So at lower prices, consumers buy more-the Law of Demand. The Utility Maximizing Rule The theory of consumer behavior begins with the assumptions that people act rationally in their self-interest, have preferences for some products over others, are limited by their budget constraints, and must pay the price of products to obtain goods. Given those assumptions, consumers find the mix of goods and services that bring them the greatest utility within the budget they have available-consumer equilibrium. Let's assume Brett can choose to buy either orange juice or coffee. He measures his marginal utility for each cup of drink in "utils," or units of utility. Of course people don't sit down to calculate their utils when deciding whether to order juice or coffee. But they act as though they do. Remember the smiley ( )? Once Brett has found his marginal utility per cup of each drink, he needs to divide that utility by the price per cup to make the units comparable. In this case, orange juice costs $2 per cup, while coffee costs $4 per cup. Therefore, Brett's table looks like this: Number of Marginal Utility MU per Dollar Marginal Utility MU per Dollar Goods of Orange Juice of Orange Juice of Coffee of Coffee First 10 5 24 6 Second 8 4 20 5 Third 6 3 12 3 Fourth 4 2 4 1 If Brett has $18 of income to spend, how much orange juice and coffee should he buy to maximize his utility? According to the utility maximizing rule, consumers maximize their satisfaction by consuming products in a way that the last dollar spent on each of two products brings the consumer the same amount of marginal utility per dollar spent. Step 1: The first cup of juice brings Brett 5 utils per dollar, while the first cup of coffee yields 6 utils per dollar. Brett is better off buying a cup of coffee first, which earns him 24 utils at a cost of$4. Step 2: Next, Brett must choose between buying the first cup of juice for 5 utils per dollar or buying a second cup of coffee, which will also bring 5 utils per dollar. Because he is indifferent between them, he will buy one of each. The cup of juice adds 10 utils for a total utility of 34 utils 56 Chapter 7: Consumer Behavior
at a total of $6 spent. The second cup of coffee adds 20 utils for a total utility of 54 utils, with the $4 price of the coffee added to total $10 spent. Step 3: Brett's next choice is between a second cup of juice for 4 utils per dollar or a third cup of coffee for 3 utils per dollar. He is better offbuying a second juice for 8 additional utils, bringing total utility to 62 for the $12 spent. Step 4: Next, Brett must decide between buying a third cup of juice for 3 utils per dollar or a third cup of coffee for 3 utils per dollar. Brett is indifferent between the two choices, so he buys one of each, exhausting his $18. He adds 6 utils from the juice and 12 utils from the coffee to his total. Brett maximizes his utility by buying of.3 cups of juice and 3 cups of coffee for a total utility of 80 utils. He has reached consumer equilibrium. Taking the EEK! Out of Economics One common mistake students make is to try to determine whether a consumer should buy a product strictly by comparing the marginal utility of products, rather than comparing the marginal utility per dollar of the products. It is crucial that you calculate that column in order to take relative prices into consideration. Another common mistake when calculating the total utility of all of the purchases is to instead add up the marginal utilities per dollar rather than the marginal utilities. One way to avoid this mistake is to complete your analysis and determine how many of each product the consumer will buy, and after that, add up the marginal utilities of those purchases to find the total utility. Bear in Mind In both multiple-choice and free-response questions, you will need to be able to construct this table. Given the quantities, total utilities, and prices of two products, you must be able to calculate the marginal utilities and MU per dollar. You must also be able to recalculate these numbers if the price of one product changes and to determine how the demand for each product changes as a result of the price change. You will not be allowed to use a calculator on the exam, but the numbers are chosen to keep the math simple. Mathematical Equation for the Utility Maximizing Rule Utili -maximizin consumer e uilibrium can also be ex ressed as an e uation: MU of Product A MU of Product B Price of Product A Price of Product B To maximize utility, a consumer should buy Products A and B until the ratios are equal and the consumer's income is spent. If the ratio is unequal, the consumer would be better off reallocating his purchases to increase total utility. In the example above, Brett could have bought 2 juices and 4 cups of coffee, but he would only have gained 78 units of total utility compared to the 80 he received by maximizing his utility. Using the equation, had Brett bought 2 juices and 4 cups of I coffee, the equati:n WO:d have I:Oked like this: I Chapter 7: Consumer Behavior 57
Because the marginal utility per dollar spent for orange juice is clearly larger than the marginal utility per dollar spent for coffee, Brett would be better off buying more orange juice and less coffee until the marginal utilities per dollar become equal. Utility Maximization and the Demand Curve The demand curve for orange juice can be calculated by first setting one point where the price of juice is $2 per cup (a quantity of3). Then change the price of orange juice and develop a new column for MU per dollar at the other price, determine how much juice would be purchased at that price, and then connect the two points into a demand curve. We can see the income and substitution effects in the downward-sloping demand curve as well. With the income effect, when the price of orange juice lowers, Brett has some income left with which he could buy more juice (or coffee). With the substitution effect, when the price of orange juice falls, Brett buys more juice as a substitute for coffee. In the utility maximization formula, you can see that a lower price reduces the denominator, increasing the marginal utility per dollar and increasing the consumer's utility. Bear in Mind While the textbook discusses indifference curve analysis, those concepts are not critical to the AP economics exams and will not be covered here. Multiple-Choice Questions 1. As DeShawn eats his Halloween treats, he gains less and less satisfaction with each additional treat he eats. This situation can be explained by the (A) Law of Supply. (B) Law of Diminishing Returns. (C) Law of Diminishing Marginal Utility. (D) Law of Increasing Opportunity Costs. (E) Law of Comparative Advantage. 2. Which of the following statements correctly describes the relationship between marginal utility and total utility? (A) When marginal utility is greater than total utility, total utility rises. (B) When total utility is greater than marginal utility, marginal utility rises. (C) Marginal utility rises with each unit purchased, while total utility falls with each unit purchased.. (D) Marginal utility falls with each unit purchased, while total utility first rises but begins to fall when marginal utility becomes negative. (E) Marginal utility and total utility consistently rise and fall together. 3. When Lauren consumes her third bowl of fried rice, her total utility falls. This can only occur if (A) the fried rice is an inferior good. (B) the third bowl of fried rice is free. (C) Lauren's demand for fried rice is inelastic. (D) the marginal utility of her second bowl of fried rice was zero. (E) the marginal utility of the third bowl of fried rice is negative. 58 Chapter 7: Consumer Behavior
4. Because of the Law of Diminishing Marginal Utility, (A) firms must lower prices to sell more products. (B) prices must rise to entice firms to produce more products. (C) government must impose mandatory taxes to avoid the free-rider problem. (D) wages must rise to entice more workers to enter the labor force. (E) consumers tend to buy more inferior goods when wages rise. 5. The Law of Diminishing Marginal Utility explains why (A) the supply curve is upward-sloping. (B) the demand curve is downward-sloping. (C) a perfectly inelastic demand'curve is vertical. (D) the production possibilities curve is downward-sloping. (E) a perfectly elastic demand curve is horizontal. 6. When Kim owns 3 candles, she has 20 units of total utility. After she purchases another candle, she has 24 units of total utility. What is the marginal utility of the fourth candle? (A) 116 of a unit of utility (B) 4 units of utility (C) 11 units of utility (D) 20 units of utility (D) 44 units of utility 7. Utility-maximizing consumer equilibrium is found where the marginal utility per dollar spent for Product A equals (A) the marginal utility for consuming that quantity of Product A. (B) the total utility from consuming units of Product A. (C) zero. (D) the marginal utility per dollar spent for Product B. (E) the total utility from the combined units of Products A and B consumed. 8. Justin gained 12 units of marginal utility from the last Pepsi he purchased at a price of $2. He gained 10 units of marginal utility from the last bottle of water he purchased for $1. Which statement most accurately describes Justin's situation? (A) Justin has achieved consumer equilibrium. (B) Justin gains more marginal utility from Pepsi than from water, so he should have purchased more Pepsi and less water. (C) Justin gains more marginal utility per dollar from water than from Pepsi, so he should have purchased more water and less Pepsi. (D) Justin gains more utility from Pepsi than from water, so he should only purchase Pepsi. (E) Water is less expensive than Pepsi, so he should only purchase water. Chapter 7: Consumer Behavior 59
l Free-Response Question The table below shows the total utility Janet gains from consuming cookies and cupcakes. Quantity of Total Utility of Quantity of Total Utility of Cookies Cookies Cupcakes Cupcakes 0 0 0 0 I 10 1 26 2 18 2 46 3 24 3 62 4 26 4 66 Assume the price ofa cookie is $1 and the price ofa cupcake is $2. Janet will spend her entire income of $8 on cookies and cupcakes. (a) Determine the marginal utility of the third cookie. (b) Using the marginal utility per dollar spent for cookies and cupcakes, identify the utility maximizing quantity of cookies and cupcakes Janet wiil purchase. (i) Use the mathematical equation for utility maximization to show Janet has maximized her utility by purchasing that combination of goods. (ii) IdentifY the total utility Janet gains from this total purchase. (c) If Janet's income increases by $2, will she purchase one more cupcake or two more cookies to maximize her utility? Explain your reasoning. Multiple-Choice Explanations 1. (C) The marginal utility falls with each product consumed. 2. (D) As long as marginal utility is positive, it adds to total utility, but if marginal utility is negative, it subtracts from total utility. 3. (E) A negative marginal utility lowers the total utility from consuming goods. 4. (A) Because the consumer gains less utility from each additional unit of product, he wiil only pay a lower price to obtain that next unit. S. (B) Because marginal utility falls, price must fall for consumers to buy more. 6. (B) Total utility increased by 4 units, which is the marginal utility. 7. (D) MUIP for Product A = MUfP for Product B is the definition of consumer equilibrium. 8. (C) Because Justin's MUfP for water is greater than his MUfP for Pepsi, he should have consumed more water and less Pepsi. Both the marginal utility and the price per product must be used to compare products. Free-Response Explanation Ca 11' cu atlons 0 f margma '1'1' uti Ity an d MU f P necessary to answer the fr ee response: MUlDollar Qof TUof MUof MUlDollar Qof TUof MUof of Cookies Cookies Cookie of Cookie Cupcakes Cupcakes Cupcake Cu}!cake 0 0 - - 0 0 - - 1 10 10 10 1 26 26 13 2 18 8 8 2 46 20 10 3 24 6 6 3 62 16 8 4 26 2 2 4 66 4 2 60 Chapter 7: Consumer Behavior
6 points (1 + 3 + 2) (a) 1 point: 1 point is earned for stating that the marginal utility of the third cookie is 6 utils. (b) 3 points: 1 point is earned for stating that Janet will maximize her utility by buying 2 cookies and 3 cupcakes. 1 point is earned for showing the mathematical formula 811 = 16/2. 1 point is earned for stating that Janet's total utility from this purchase is 80 utils. (c) 2 points: 1 point is earned for stating that Janet will buy 2 more cookies. 1 point is earned for stating that Janet's total utility will increase by 8 utils if she buys the cookies but only 4 utils if she buys the cupcake. Chapter 7: Consumer Behavior 61