## Saturday, April 28, 2012

### Theory of Consumer Choice

When dealing with consumers' choices, it is important to think about utility, which is a measure of satisfaction. The more utility a consumer has, the more satisfied they are with the goods or services that they have received.

Total Utility and Marginal Utility
These two terms are relatively straightforward. Total utility refers to the total amount of satisfaction that a consumer has gained from a certain amount of goods or services. On the other hand, marginal utility refers to the additional satisfaction that a consumer gets for the consumption of one extra unit of good.

Having a positive marginal utility means that the total utility is increasing, since marginal utility is the additional satisfaction. Similarly, having a negative marginal utility will result in a decrease in total utility.

Diminishing Marginal Utility
In most situations, we experience a diminishing marginal utility. That is, as we consume more and more of one good, our additional satisfaction from each unit of the good begins to be less and less. For example, if a person consumes one unit of a food that they like, they would be extremely satisfied from that unit of food. However, suppose they go on and consume 100 more units of the food, then one can imagine the person growing more and more tired of that food as they continue to consume it. Their marginal utility decreases.

However, it is important to note that even if marginal utility decreases, the total utility would still be increasing if MU is positive. It's just that the consumer is getting more satisfied at a slower rate.

Utility Maximization
Evidently, everyone wants to maximize their utility; everyone wants to get as much satisfaction as possible from a certain amount of spending. The problem is: how?

Well, the Utility Maximization rule states: in order to maximize utility, consumers should allocate their money so that the last dollar spent on each product yields the same amount of marginal utility.

The logic behind this: suppose my last dollar spent of products A and B yielded 1 and 10 utils, respectively.  Then obviously I enjoyed product B a lot more than product A. So I should have spent less money on A and more money on B, because I probably would have gotten a greater satisfaction out of it. So as long as there exists an inequality between the marginal utility per dollar for the products, there's probably something I could have done to increase my total utility.

Demand Curves
Using the law of decreasing marginal utility, we can get some insight into why the demand curve is downward-sloping.

Since the marginal utility decreases as quantity increases, consumers' desire for the product decrease as well. As a result, they won't be willing to pay the same price for it, and higher quantities tend to correspond with lower prices.

Income and Substitution Effect
Income and substitution effects explain why consumers tend to buy less of a product when its price has increased.
Substitution Effect: As the price of good increases, it becomes more expensive relative to its alternative. Therefore,

Income effect: As the price of a good increases, it now takes up a larger portion of our budget. As a result, it seems as if our income has decreased, since our purchasing power is decreased. For normal goods, the income effect is negative, because as we have less money, we are going to buy fewer things.