Chapter 10 The Rational Consumer Utility Getting Satisfaction satisfaction deals with subjective feelings utility of a consumer is a measure of the satisfaction the consumer derives from consumption of goods and services Utility and Consumption individuals utility depends on everything that individual consumes individuals consumption bundle is the collection of all the goods and services consumed by that individual individuals utility function gives the total utility generated by his or her consumption bundle utility function is a personal matter two people with different tastes will have different utility function utility function is a way of representing the fact that when people consume they take into account their preferences and tastes in a more or less rational way util unity of utility to maximize total utility consumers must focus on marginal utility The Principle of Diminishing Marginal Utility marginal utility of a good or service is the change in total utility generated by consuming one additional unit of that good or service marginal utility curve shows how marginal utility depends on the quantity of a good or service consumed generally the marginal utility curve slopes downward that consumption of most goods and services is subject to diminishing marginal utility principle of diminishing marginal utility each successive unit of a good or service consumed adds less to total utility than the previous unit the more of a good or service you consume the closer you are to being satisfied reaching a point at which an additional unit of the good adds nothing to your satisfaction Budgets and Optimal Consumption under ordinary circumstances it costs some additional resources to consume more of a good and consumers must take that cost into account when making choices the fundamental measure of cost is opportunity cost Budget Constraints and Budget Lines budget constraint requires that the cost of a consumer s consumption bundle be no more than the consumer s income a consumer can t spend more than the total amount of income available to them consumer s consumption possibilities is the set of all consumption bundles that can be consumed given the consumer s income and prevailing prices budget line shows the consumption bundles available to a consumer who spends all of his or her income downward sloping line because they are consuming all of their income Optimal Consumption Choice optimal consumption bundle is the consumption bundle that maximizes the consumer s total utility given his or her budget constraint Spending the Marginal Dollar choosing an optimal consumption bundle ask how much to spend on each good the marginal decision is a question of how to spend the marginal dollar how to allocate an additional marginal utility per dollar spent on a good or service is the additional utility from spending one more dollar in a way that maximizes utility dollar on that good or service Marginal utility per dollar next step is to drive marginal utility per dollar for each good which is done by dividing the marginal utility of the good by its price in dollars marginal utility per dollar spent on each good declines as the quantity of that good consumed rises because of diminishing marginal utility Optimal Consumption utility maximizing principle of marginal analysis the marginal utility per dollar spent must be the same for all goods and services in the optimal consumption bundle for any two goods C and P the optimal consumption rule says that at the optimal consumption bundle MUc MUp Pc Pp in the optimal consumption bundle the marginal utilities per dollar spent for each and every good or service in that bundle are equal From Utility to the Demand Curve the main reason for studying consumer behavior is to go behind the market demand curve to explain how the utility maximizing behavior of individual consumers leads to the downward slope of the market demand curve Marginal Utility the Substitution Effect and the Law of Demand suppose the price of clams rises the price increase doesn t change the marginal utility a consumer gets from an additional pound of clams at any given level of clam consumption however it does reduce the marginal utility per dollar spent on clams and the decrease in marginal utility per dollar spent on clams gives the consumer an incentive to consume fewer clams when the price of clams rises it s the opposite for decreasing when the price of a good increases an individual will normally consume less of that good and more of other goods when the price decreases of a good then people will normally consume more of that good and less of other goods this is why the individual demand curve which relates an individual s consumption of a good to the price of that good normally slopes downward it obeys the law of demand example when the price of clams decreases an individual doesn t have to give up as many units of other goods in order to buy one more unit of clams substitution effect of a change in the price of a good is the change in the quantity of that good consumed as the consumer substitutes other goods that are now relatively cheaper in place of the good that has become relatively more expensive when a good absorbs only a small share of the consumer s spending the substitution effect is essentially the complete explanation of why the individual demand curve of that consumer slopes downward The Income Effect income effect of a change in the price of a good is the change in the quantity of that good consumed that results from a change in the consumer s purchasing power due to the change in the price of the good for the majority of goods and services the income effect is not important and has no significant effect on individual consumption so market demand curves slope downward solely because of the substitution effect when it matters at all the income effect usually reinforces the substitution effect that is when the price of a good that absorbs a substantial share of income rises consumers of that good become a bit poorer because their purchasing power falls this effective reduction in income leads to a reduction in the quantity demanded and reinforces the substitution effect in the case of an inferior good a good for which demand increases when income falls the income and substitution effects work in opposite directions although the substitution effect tends to produce a decrease in the quantity of any good demanded as its price increases in the case of an inferior