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Cost and Benefit Optimization for Consumers

Cost and Benefit Optimization for Consumers

Author: Kate Eskra
Description:

This lesson will explain the economic idea of cost and benefit optimization for consumers.

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Tutorial

COST AND BENEFIT OPTIMIZATION FOR CONSUMERS

Source: Image of Budget Constraint Graph created by Kate Eskra

Video Transcription

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Hi, welcome to Economics. This is Kate. This tutorial is called Cost and Benefit Optimization for Consumers.

As always, my key terms are in red and my examples will be in green. So after this tutorial, you will be able to explain the choices that we as consumers need to make given the constraints that we face. You'll be able to understand an example of a budget constraint. And you'll be able to examine how we maximize our utility by consuming up to a point, what we call where marginal benefit equals marginal cost. OK.

So a constraint-- this is your first term of the tutorial. A constraint is an element that interrupts production of a firm or consumption by individuals. In this tutorial, we're looking at this part of the definition today-- consumption by individuals.

So what are some constraints that you face in your life? I think most people would agree that time and money are the two biggest constraints that we face. I know that's the case for me.

Right now, we're going to focus on this portion of it though, the income component. So let's look at a budget constraint. Do you have a budget? I know I do. I don't necessarily always follow it. But most of us have a budget. All right.

So I made up an example called Fun for the Month. So Tom and Sue are married. And they put aside $100 a month that they have budgeted where they can either go to the movies with that money or get Chinese take-out. Apparently those are the two things that they consider fun to do. OK.

So the movie's cost them $20 because it's $10 each. The Chinese take-out, they have a really good coupon deal so they can get that for $10. So what are their options?

What we do in economics is we make something called a budget constraint. And this is what it looks like. So they can afford, if we're at the extremes, either five trips to the movies. That would represent right here.

How did I get five? Well, if they're only going to the movies and not eating any Chinese food at all, they're spending all $100 on the movies. And since it's $20 each time, they can go five times.

At the other end of it, if they don't go to the movies at all but instead get Chinese take-out, they could do that 10 times in a month. Because that's only $10. So 10 times 10 would get them to their $100 budget. Any combination along this line is possible. So most people would agree that you probably wouldn't want to do either of the extremes if you enjoyed both of them.

And in fact, if you wanted to save money, anything in green here is affordable because it's within the budget constraint. Anything out here is too much money. You're outside of your budget. OK. So that's what a budget constraint looks like.

So how do they decide how many times to go to the movies versus how many times to eat Chinese meals? Well, what they want to do is maximize their utility. Utility is satisfaction. So they want to get the most out of it that they can.

So utility maximization is achieving the highest amount of satisfaction while spending the least amount of money within a budget constraint. So how can they get the highest amount of satisfaction out of these two activities? All right.

So here are some numbers. I just made these up. Let's just look at the movie situation. Let's say that these are the number of times going to the movies. And then I charted out some numbers. This is the total satisfaction-- it's in dollar amounts-- that they would get out of going to the movies.

So for example, the first time, their total satisfaction is $40 worth by going to movies that first time. The second time they go to the movies, if they go twice, their total satisfaction out of trip one plus trip two would be 70, and so forth. OK.

So let's ignore this column for now. I'll get to that in a second. Notice how total utility continues to increase which makes sense. The more we go to the movies, the more enjoyment we're getting out of our overall number of times we're going. But notice how it starts to slow down.

See it jumps up really high here. Then it's still going up. It's going up. But it's going up by a little bit, only a little bit more this time. And here, it actually slowed completely and didn't increase.

Why is that the case? Well, think about it. If you've already seen every good movie that's out this month maybe you don't need to go a sixth time or even a fifth time. You're not increasing your satisfaction as much once you've already gone to the movies a couple of times.

And that's where this concept of marginal utility comes in. What I want you to do is anytime you see the word marginal in economics from now on, just think the word additional. So this is actually showing the additional satisfaction we get each time.

So from here to here, from trip one to trip two to the movies, that increased my utility by 30. So 40 to 70 is 30. My third time it increased might benefit, or my utility, by 20, and so on. OK.

And that's what marginal benefit is. Marginal benefit is the amount of utility gained by consuming an additional single unit of a product. It's looking at things incrementally.

And then marginal cost-- now we need to look at that. Marginal cost is the additional cost incurred when producing one additional product. In this case, we're not talking about producing, but we're talking about consuming. So now we need to compare it to our cost.

If we look at the first trip to the movies, we're saying that they enjoyed that-- that increased their satisfaction by $40. So technically, they'd be willing to pay up to $40 for that trip to the movies. It's only costing them 20. So they're definitely going to make that decision to go once.

Will they go a second time? Well, it increased their total utility by 30. So they're $30 better off. They will definitely decide to make that trip if they're maximizing their utility. Because it only cost $20. The third trip increases their utility by $20. So their marginal utility equals the marginal cost. And they will make that trip.

But anything in red here, does it make sense? Does it make sense for them to go a fourth time if they're only increasing their satisfaction by $10 if they have to pay $20? No. And that's why I drew this line right here. They would stop because they will consume up to the point where this marginal benefit equals the marginal cost of going to the movies. So that's how we determine how many times they will go.

So consumer optimization is the maximization of consumer utility within the parameters of household income and the price of goods or services. So we took into account the price or the cost of those movies. And again, this is a big, big rule. So I want you to remember it. We will always optimize our choices when we consume up to the point where these two marginals equal one another.

Marginal utility is the same thing as marginal benefit. So as long as that is greater than our marginal cost, we're going to continue consuming. I'm sorry. As soon as marginal cost jumps up above the marginal benefit we're getting out of something, that's where we stop. So we will go up to the point where these two things are equal to one another.

So what did you learn today in this tutorial? You learned how to interpret a budget constraint. You saw that total utility is really our overall satisfaction. And it increases as we consume. But at some point, how much it's increasing begins to slow.

And we will continue to consume as long as our marginal benefit is greater than our marginal cost. And we, finally, optimize our utility where marginal benefit equals marginal cost. I hope that makes sense for you. Thanks for listening. Have a great day.

Notes on "Cost and Benefit Optimization for Consumers"

Terms to Know

Utility Maximization

Achieving the highest amount of satisfaction (utility) subject to an individual's budget constraint.

Constraints

An element that interrupts production of a firm or consumption by individuals.

Consumer Optimization

Maximization of consumer utility within the parameters of household income and price of goods or services.

Marginal Cost

Additional cost incurred when producing one additional product.

Marginal Benefit

Amount of utility gained by consuming an additional single unit of product.