SAD - Consumer Theory Lesson

Consumer Theory Lesson

 

Cost-Benefit Analysis

Rational agents consider opportunity costs, whether implicit or explicit, when calculating the total economic costs of any decision. Total benefits form the metric “utility” for consumers and total revenue for firms. Total net benefits, the difference between total benefits and total costs, are maximized at the optimal choice. Some decisions permit rational agents to look at only marginal benefit and marginal cost. Other decisions cannot be broken down into increments in this way and must be evaluated by looking at total benefits and total costs.

Marginal Utility

Individuals consume goods and services because they render utility to the individual. By utility, we mean satisfaction or usefulness. The law of diminishing marginal utility helps explain why price must be lowered to induce a consumer to purchase more of a good. The following video explains marginal utility in more detail.  

View the video below to learn more. To make the video full screen, select the double arrows at the bottom right corner of the object.

 

Example: Total and Marginal Utility from Consuming Hamburgers

Total and Marginal Utility

Quantity of Hamburgers	Total Utility	Marginal Utility (ΔTU/ΔQ)
0	0	------
1	50 utils	50 utils
2	80 utils	30 utils
3	90 utils	10 utils
4	92 utils	2 utils
5	82 utils	-10 utils

As you can see, for each of the first four hamburgers consumed, total utility increases. This is because the additional utility, or marginal utility, gained from consuming one more hamburger is positive. Notice, however, that the marginal utility (while positive) is decreasing with each additional hamburger. That means each hamburger is providing less utility than the hamburger before it. Considering that as you eat hamburgers, you become less hungry, it makes sense that the third hamburger would not be as satisfying to you as the first or second hamburgers. Technically, a consumer could continue to eat hamburgers until the marginal utility became negative and total utility would decrease, as seen with hamburger #5. Perhaps the consumer ate until he was sick to his stomach. While this could happen, in reality, we would not expect to experience this as it would not be rational to consume in such a manner.  

Marginal utility is most useful in determining the marginal benefit (which is a dollar amount) a consumer perceives an item as being worth. The two are very closely related. Since marginal utility decreases for each additional unit, the marginal benefit - or the price a consumer is willing to pay for the unit - will decrease.  

Reaching Consumer Equilibrium

As consumers, we don't just purchase one good. We purchase many different goods. The consumer's main goal is to purchase the combination of goods and services that will render the most utility. Usually, a consumer is faced with a budget constraint. That is, our income is limited. Therefore, consumers want to get the most utility possible from a given amount of income. Think of this as trying to get the most "bang for your buck".  

To keep the example simple, assume the consumer only purchases two items - Good A and Good B. The rule for reaching consumer equilibrium is to consume until the Marginal Utility per $1 from the last unit of Good A equals the Marginal Utility per $1 from the last unit of Good B. That is:

MU_A/P_A = MU_B/P_B

    

View the full text from the image here.

    

        

Consumer Equilibrium Example

Jen spends her entire budget on a combination of Good X and Good Y. With her current combination of these two goods, her marginal utility from her last unit of X is +300utils, and her marginal utility from her last unit of Y is +420utils. The prices of X and Y are $3.00 and $3.50, respectively. Is she in a position of consumer equilibrium?

She is in consumer equilibrium if the MUx/Px = MUy/Py

So, does +300/$3.00 = +420/$3.50?

NO!

Good X is rendering 100utils per $1 spent on the last unit, while Good Y is rendering 120utils per $1 spent on the last unit. How should Jen change consumption to maximize her total utility?

    

 

From the example above, Jen is not in a position of consumer equilibrium. By changing her consumption of the two goods, she can increase her total utility given her budget. How should she change consumption? She should purchase more of the good that is rendering a greater amount of utility per dollar and less of the good that is providing less utility per dollar.  

Consumer Equilibrium Practice Activity

Read through the scenario and then answer the questions using the tables below. Choose the Check Answer button to see if your answer is correct.

Paul spends his entire income of $10 on the following goods. Using the concepts of marginal utility per dollar and consumer equilibrium, answer the following questions:

Paul should consume ______ unit(s) of Good A and _____unit(s) of Good B.

Check Answer

 

What is the maximum utility of his $10 budget that he would attain?

Check Answer

 

Marginal Analysis

Marginal analysis involves comparing the additional benefit of increasing a given activity with the additional cost. Comparing marginal benefit (MB) with marginal cost (MC) helps individuals (firms) decide whether to increase, decrease, or maintain their consumption (production) levels. The optimal quantity at any point in time does not depend on fixed costs (sunk costs) or fixed benefits that have already been determined by past choices. The optimal quantity is achieved when marginal benefit is equal to marginal cost or where total benefit is maximized.

 

IMAGES CREATED BY GAVS (Creative Commons License Attribution)