HOW DO WE MODEL CONSUMER SATISFICATION?

 UTILITY = measure of relative levels of satisfaction consumers enjoy from

consumption of goods and services
o Your satisfaction is quantified with utils
o The goal of the consumer is to maximize her utility
 Utility and interpersonal comparison
o Suppose Adam says he gets 10 utils from eating an Apple and Eve
says she gets 20 utils from doing the same. What can you tell me?
o Suppose Adam says he gets 10 utils from eating an apple and 20 utils
from eating a banana. What can you tell me?
UTILY
 Cardinal utility:
o We can state with numbers how much more we prefer one good to
another:
 Ordinal utility
o We can rank goods in order of preference, but we can’t say by how
much we like one good over another?
 Which approach seems more reasonable?

UTILITY: consumer preferences

 Complete preferences = when we can compare any two objects
 Transitive preferences = if preferences are internally consistent

UTILY: marginal utility

 Total utility = overall amount of happiness from consumption
 Marginal utility = additional utility gained from consuming one more unit of
a good or service
 Diminishing marginal utility:
o Occurs when marginal utility declines as consumption increases
OPTIMIZATION: how to maximize utility?
 A simple rule to maximize utility:
o Allocate income by choosing goods that give you the most utility per
dollar spent.
o You want the biggest bang for your buck.

o
OPTIMIZATION: how to maximize utility?
 All the consumer optimum, two conditions are satisfied:
o All income is spent
o For the last unit purchased:

More Than Two Goods

 The previous rule can easily be extended to multiple goods

 In real life:
o Conditions might not hold with perfect equality.
o Do people really behave this way?

OPTIMIZATION: price changes

 How does a change in prices affect your optimal consumption bundle?
 Suppose that you are consuming optimally:

 What happens if Price(x) decreases?

 Lower prices increase the marginal utility per dollar, so consumers buy
more of the good
 Higher prices decrease the marginal utility per dollar, so consumers buy less
of the good

 A lower price has two effects:

o Substitution effect:
 Occurs when consumers substitute a product that has become
relatively less expensive as the result of a price change
o Real-income effect:
 Occurs when there is a change in purchasing power as a result
of a change in the price of a good

 Which effect matters more?

o For most goods the real-income effect is very small and negligible
o Either the price change would have to be substantial
OR
o The good takes up a large part of a consumer’s budget.
Diamond-Water Paradox
 Nothing is more useful than water, but it will purchase scarcely anything;
scarcely anything can be had in exchange for it. A diamond, on the contrary,
has scarcely any use value, but a very great quantity of other goods may
frequently be had in exchange for it.
• Adam Smith, 1776
 What’s the confusion?
o Mixes up the value in use with the value in exchange
o Compares the marginal utility of a very scarce good (diamond) with
the marginal utility of an abundant good (water)
  Uses of water:
o Cooking, drinking, bathing -> high value
o Watering lawns, washing cars -> low value
 Prices:
o In most places, water is relatively abundant, and therefore cheap
o Diamonds are relatively scarce and more expensive
o With the high price of diamonds, you will only consume if you expect
to get a high amount of marginal utility from the diamond

DISCRETE CHOICE MODELS

 There are some goods in which we only purchase one of that good. Thus,
diminishing MU may not apply. However, we still try to maximize our utility.
 Discrete choice model = we buy the one “best” choice out of many
alternatives
o Airline ticket
o House
o College education
o Spouse

KEY TAKEAWAYS
 UTILITY = measure of relative levels of satisfaction consumers enjoy from
consumption of goods and services
 Diminishing marginal utility: the amount of happiness gained from
additional consumption will get smaller and smaller
 When maximizing utility, consumers face a budget constraint and must
consider income, prices, and marginal utility
 Lower prices increase the marginal utility per dollar, so consumers by more
of the good
 Utilize maximizing rule: