Household Behavior and Consumer Choice
(Part B)
by
Charles Lamson
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The Basis of Choice: Utility
Somehow, from the millions of things that are available, each of us manages to sort out a set of goods and services to buy. When we make our choices, we make specific judgments about the relative worth of things that are very different. During the nineteenth century, the weighing of values was formalized into a concept called utility. Whether one item is preferable to another depends on how much utility, or satisfaction, it yields relative to its alternatives. How do we decide on the relative worth of a new puppy or a stereo? A trip to the mountains or a weekend in New York City? Working or not working? As we make our choices, we are effectively weighing the utilities we would receive from all the possible available goods. Certain problems are implicit in the concept of utility. First, it is impossible to measure utility. Second, it is impossible to compare the utilities of different people---that is, one cannot say whether person A or person B has a higher level of utility. Despite these problems, however, the idea of utility helps us understand the process of choice better. Diminishing Marginal Utility In making their choices, most people spread their incomes over many different kinds of goods. One reason people prefer variety is that consuming more and more of one good reduces the marginal, or extra, satisfaction they get the from further consumption of the same good. Formally, marginal utility (MU) is the additional satisfaction gained by the consumption or use of one more unit of something.  It is important to distinguish marginal utility from total utility. Total utility is the total amount of satisfaction obtained from consumption of a good or service. Marginal utility comes only from the last unit consumed; total utility comes from all units consumed. Suppose that you live next to a store that sells homemade ice cream that you are crazy about. Even though you get a great deal of pleasure from eating ice cream, you do not spend your entire income on it. The first cone of the day tastes heavenly. The second is merely delicious. The third is still very good, but it is clear that the glow is fading. Why? The answer is because the more of any one good we consume in a given period, the less satisfaction, or utility, we get from each additional, or marginal, unit. In 1890, Alfred Marshall called this "familiar and fundamental tendency of human nature" the law of diminishing marginal utility. Consider this simple example, Frank loves country music, and a country band is playing seven nights a week at a club near his house. Table 2 shows how the utility he derives from the band might change as he goes to the club more and more frequently. The first visit generates 12 "utils," or units of utility. If Frank goes again another night he enjoys it, but not quite as much as the first night. The second night by itself yields 10 additional utils. Marginal utility is 10, while the total utility derived from two nights at the club is 22. Three nights per week at the club provide 28 total utils; the marginal utility of the third night is six, because total utility rose from 22 to 28. Figure 5 graphs total and marginal utility using the data in Table 2. Total utility increases up through Frank's fifth trip to the club, but levels off on the sixth night. Marginal utility, which has declined from the beginning, is now at zero.  Allocating Income to maximize utility How many times in one week would Frank go to the club to hear his favorite band? The answer depends on three things: Frank's income, the price of admission to the club, and the alternatives available. If the price of admission were zero and no alternatives existed, he would probably go to the club five nights a week. (Remember, the sixth does not increase his utility, so why should he bother to go?) However, Frank is also a basketball fan. His city has too many good high school and college teams, and he can go to games six nights a week if he wants to.  Let us say for now that admission to both the country music club and the basketball games is free---that is, there is no price income constraint. There is a time constraint, however, because there are only seven nights in a week. Table three lists Frank's total and marginal utilities from attending basketball games and going to country music clubs. From column 3 of the table we can conclude that on the first night Frank will go to a basketball game. The game is worth far more to him (21 utils) than a trip to the club (12 utils).  On the second night, Frank's decision is not so easy. Because he has been to one basketball game this week, the second is worth less (12 utils, as compared to 21 for the first basketball game). In fact, it is worth exactly the same as a first trip to the club, so he is indifferent to whether he goes to the game or the club. So he splits the next two nights: one night he sees ball game number 2 (12 utils); the other he spends at the club (12 utils). At this point, Frank has been to two ball games and spent one night at the club. Where will Frank go on evening four? He will go to the club again, because the marginal utility from a second trip to the club (10 utils) is greater than the marginal utility from attending a third basketball game (9 utils). Frank is splitting his time between the two activities to maximize total utility. At each successive step, he chooses the activity that yields the most marginal utility. Continuing with this logic, you can see that spending three nights at the club and 4 nights watching basketball produces total utility of 76 utils each week (28 + 48). No other combination of games and club trips can produce as much utility. So far, the only cost of a night of listening to country music is a foregone basketball game, and the only cost of a basketball game is a foregone night of country music. Now let us suppose that it costs $3 to get into the club and $6 to go to a basketball game. Suppose further that after paying rent and taking care of other expenses Frank has only $21 left over to spend on entertainment. Typically, consumers allocate limited incomes, or budget, over a large set of goods and services. Here we have a limited income ($21) being allocated between only two goods, but the principle is the same. Income ($21) and prices ($3 and $6) define Frank's budget constraint. Within that constraint, Frank chooses to maximize utility.  The Utility Maximizing Rule In general, utility maximizing consumers spread out their expenditures until the following condition holds:   You can see how the utility maximizing rule works in Frank's choice between country music and basketball. At each stage, Frank chooses the activity that gives him the most utility per dollar. If he goes to a game, the utility he will derive from the next game---marginal utility---falls. If he goes to the club, the utility he will derive from his next visit falls, and so forth.  Diminishing Marginal Utility and Downward-Sloping Demand The concept of diminishing marginal utility offers us one reason why people spread their incomes over a variety of goods and services instead of spending them all on one or two items. It also leads us to conclude that demand curves slope downward. To see why this is so, let us return to our friends Ann and Tom from last post, the struggling graduate students. Recall that they chose between meals at a Thai restaurant and trips to a jazz club. Now think about their demand curve for Thai meals, as shown in Figure 6. When the price of a meal is $40 they decide not to buy any Thai meals. What they are really deciding is that the utility gained from even that first scrumptious meal each month is not worth the utility that would come from the other things that $40 can buy.  Now consider a price of $25. At this price, Anna and Tom buy five Thai meals. The first, second, third, fourth, and fifth meals each generate enough utility to justify the price. Tom and Ann "reveal" this by buying five meals. After the fifth meal, the utility gained from the next meal is not worth $25. Ultimately, every demand curve hits the quantity (horizontal) axis as a result of diminishing marginal utility in other words, demand curves slope downward. How many times will Ann and Tom go to the Thai restaurant if meals are free? Twenty-five times is the answer and after 25 times a month, they are so sick of Thai food that they will not eat anymore even if it is free. That is, marginal utility---the utility gained from the last meal---has dropped to zero. If you think this is unrealistic, ask yourself how much water you drank today.  *MAIN SOURCE: CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 108-112* end |
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