1CONSUMER THEORYA more in-depth look at the forcesthat shape our demandConsumption• so far, we have looked at demand/supply, but have not looked at the true influences of either; we will focus on demand in this section • We know that household consumption choices are limited by:1) Income available 2) Price of the product BUDGET CONSTRAINTS• BUDGET CONSTRAINT: represents the possible combinations of 2 commodities that a consumer can purchase, given: • 1) market price of the products • 2) consumer's income This is a consumer’s “consumption possibilities” frontier2Shifts of Budget Constraints• What happens when we shift the budget constraint by:• Changing income • Change one price • Change both prices • Allow for borrowing (credit cards, etc.)PREFERENCES AND UTILITYQ: What determines your actions in every facet of life???A: The notion of "rational self-interest" - What helps fuel self-interest??? “Benefit vs. price" - get the most benefit you can,but there is a constraint (income/price) How does one measure pleasure - "UTILITY" Utility• Measure of pleasure or satisfaction one gets from consuming a product • - measured in "utils" So, the consumers objective is to maximize utility given their budget constraints3Utility•TOTAL UTILITY (TU)Number of units of utility a person gets by consuming a given quantity of the product during a particular timeMARGINAL UTILITY (MU)amount by which an additionalunit of the product increases a consumer's total utility Why can marginal utility be viewed as more important in thedecision making process than total utility?LAW OF DIMINISHING MARGINAL UTILITYBeyond some level of consumption, the marginal utility of aproduct will decline as the quantity consumed increases MAXIMIZING UTILITYGoal of consumer is to maximize utility subject to its budget constraint PROBLEM: How to allocate income among the possible consumption choices. Each time I buy a good, what happens? 1) utility increases, but at a declining rate 2) give up opportunity to buy other goods Marginal Decisions• Decisions are made “on the margin”Gains in utility possible when marginal utility per dollarof one good exceeds that of another good. How do we compare the MU of two different goods?Can we look at just the MU of each product Decision rule: MUX/ PX≥ MUY/ PYFor two goods (X,Y), the consumption decision rule is:Consume good X as long as its MU/$ is greater or equal to thatof good Y4Consumption Decision• As long as MU/ $ is not the same for all goods, the consumer can reallocate income to buy more of the goods that have higher MU/$ than the others. Consumer Equilibrium and Total Utility Maximization•CONSUMER EQUILIBRIUMThe consumer purchases goods until MU/$ is the same for all goods. When this occurs, and all available income is spent, total utility is maximized. Total Utility is maximized by marginal decisionsDEMAND CURVE REVISITED• We've discussed that the law of demand dictates that the demand curve is downward sloping - here is another way to prove it• Use of the law of diminishing marginal returns and consumer equilibrium to show this. Diamond-Water Paradox: Why do diamonds cost so much morethan water, when water is essential to life?5CRITICISMS OF MARGINAL UTILITY THEORY• Utility cannot be observed • People aren't "smart enough" - aren't "rational thinkers" • Forces people to put a $value on