Consumer Choice

Why Do People Buy What They Buy?

Economists use the idea of utility to model how we make purchasing decisions, and this is simply a complicated way of describing how happy or satisfied you are when you use something. However, it isn't about whether you like lattes. It's about how much enjoyment you get from one more latte for each dollar you spend, compared to what else that dollar could get you. That enjoyment per dollar is what the model uses to explain your choice. So, when you spend $15.49 a month on Netflix Standard instead of $10.99 for Spotify Premium, you are, without realizing it, saying that the extra dollar you spend on Netflix gives you more satisfaction than the extra dollar on Spotify. Economists call this extra satisfaction from one more item marginal utility.

No one actually has a 'happiness meter', and it's impossible to directly measure happiness in the real world. But the idea is useful as it makes you think carefully about the compromises you have to make. Because you can't have everything (remember scarcity?), you need to think about what mix of items will give you the most happiness with the money you have.

The Third Slice of Pizza Problem

Think about the first slice of pizza when you haven't eaten since breakfast: absolutely brilliant. The second slice is still good. The third slice is alright, but you aren't jumping for joy. By the fourth or fifth, you're almost forcing it down.

This illustrates the law of diminishing marginal utility: each extra of something gives you less and less extra enjoyment than the one before. The first hour of a new video game is totally absorbing. The eighth hour feels like work.

And this applies to a lot more than just pizza. Diminishing marginal utility is why we divide our money between lots of different things rather than spending all of our pay on one item. If the tenth coffee of the day doesn't give you much enjoyment, then that $5 is better spent on lunch. Eventually, the decreasing enjoyment from each coffee will be less than the enjoyment from food, entertainment, or something else, and you'll change your spending. Look at the utility curve on the graph; the flattening as the amount increases is diminishing marginal utility, shown right on the screen.

It also explains another way to understand why demand curves go down, as you've already seen in the supply and demand section. You'll only buy another one if the price drops enough to make up for the lower enjoyment you'll get from it.

Budget Constraints: The Reality Check

It's easy to want things, but actually paying for them is more complicated. Your budget constraint defines all the possible combinations of things you can buy with your income, given their prices; on a graph, it's a straight line. So, if you have $60 a month for fun and movies cost $15 while books are $10, you could get four movies if you spent it all on them, or six books. Two movies and three books would exactly use up your $60. That budget constraint line connects all those exact spending combinations.

The slope of that line is the negative of the price ratio — in this case -(15/10) or -1.5. This slope represents the rate at which the market lets you trade one thing for another. To get one extra movie you'd need to give up one and a half books, and you have no control over that exchange rate; the market decides.

If your income changes, the whole line moves in or out (remaining parallel), but the slope stays the same. If prices change, the line rotates. For instance, if movie prices fall, the budget line swings outwards along the movie axis — you can now buy more movies, but your ability to buy books isn't affected. This difference between a line moving parallel (income) versus rotating (price) is something you'll be asked about a lot on the AP exam, and mixing them up will lose you points.

The Utility-Maximizing Rule

Someone who thinks rationally will want to get the most total enjoyment from every dollar they spend. And the rule for doing that is quite neat:

Spend your money so the extra enjoyment (marginal utility) per dollar is the same for everything:

MU_A / P_A = MU_B / P_B = MU_C / P_C ...

Here's how this works. You're buying tacos (at $2 each) and burritos ($5 each). The last taco gave you 20 "utils" of satisfaction, meaning 10 utils for each dollar spent. But that last burrito only gave 15 utils, or 3 utils per dollar. You're getting a much better return on tacos. So, take money from burritos and move it to tacos. Moving a dollar from burritos costs you 3 utils, but gives you 10 on tacos. Keep doing this until those ratios are equal.

If MU_A / P_A is higher than MU_B / P_B, buy more of A and less of B. Buying more of A will lower its marginal utility (because of diminishing returns), and buying less of B will raise its marginal utility. Eventually, the enjoyment per dollar will be the same, and you won't be able to improve things.

That point of equality is called consumer equilibrium. It's where you can't rearrange your spending to get even more overall enjoyment. On a graph, it's where the green dot is on the budget line, and if you move it anywhere else, your total enjoyment goes down.

Income and Substitution Effects

When a price changes, two things occur simultaneously. In fact, the 2024 AP Micro free-response question tested this, and it's a concept that seems straightforward until you have to explain it accurately in writing.

Let's say your gym membership goes from $60 a month to $30.

The substitution effect: the gym is now cheaper compared to everything else you could do with that money — like rock climbing, yoga, or getting equipment for home workouts. Compared to those, the gym is a better value for your money, so you'll choose more of it and do less of the other things. This substitution effect always means you'll go for the cheaper item. There are no exceptions.

The income effect: you now have $30 left over from the gym each month. This is just like getting a $30 pay raise; your ability to buy things has increased. What you do with that extra money depends on whether the gym is a normal good (you'd use more of it as your income rises) or an inferior good (you'd use less of it as your income rises — perhaps switching to a more expensive, exclusive fitness studio).

With typical goods, the price decrease and the buying increase both go in the same direction — simpler put, if something costs less, you'll buy more of it. With inferior goods, these two forces work against each other. The substitution effect (because it's cheaper compared to other things) would say to buy more, but the income effect (you're now, in a sense, wealthier) says to buy less of this lower-quality item.

And very, very rarely, the income effect can be stronger than the substitution effect. This is a Giffen good, and with these, demand increases as the price increases. Robert Giffen apparently saw this happen with potatoes in Ireland during the famine of the 1840s. It's mostly just a thing economists think about, but it was on the 2019 AP exam, so it's good to know about.

Worked Example: Finding the Optimal Bundle

A student has $24 to spend on coffee (at $4 a cup) and sandwiches ($6 each). The marginal utility from each unit is:

| Units | MU of Coffee | MU of Sandwich |
|-------|-------------|----------------|
| 1 | 20 | 30 |
| 2 | 16 | 24 |
| 3 | 12 | 18 |
| 4 | 8 | 12 |
| 5 | 4 | 6 |

Step 1: Calculate the satisfaction per dollar for each one. For coffee ($4): the first cup gives 5.0 (20/4), the second 4.0 (16/4), the third 3.0 (12/4), the fourth 2.0 (8/4). For sandwiches ($6): the first gives 5.0 (30/6), the second 4.0 (24/6), the third 3.0 (18/6), the fourth 2.0 (12/6).

Step 2: Buy the things in order of highest satisfaction per dollar. The first cup of coffee and the first sandwich both give 5.0, so buy both (spending $10, leaving $14). Next, the second cup of coffee and the second sandwich also both give 4.0, so buy both (spending $20, leaving $4). The third coffee and the third sandwich are both at 3.0, but you only have $4 left. Coffee is $4, a sandwich is $6, so you can only get the coffee (spending $24, and you're done).

Optimal bundle: 3 coffees and 2 sandwiches. On a graph, the point representing this would be where the lines meet. Spending is 3 × $4 + 2 × $6 = $12 + $12 = $24. You've spent your whole budget. The total satisfaction is (20 + 16 + 12) + (30 + 24) = 48 + 54 = 102 utils. The last cup of coffee gives 12/4 = 3.0 satisfaction per dollar, the last sandwich gives 24/6 = 4.0. They aren't exactly the same, but that's because the budget won't allow for a third sandwich at $6. If you took $4 from the coffee (and lost 12 utils of satisfaction) you still couldn't afford another sandwich. This is the best you can do with your money.