Question

[Uses the Marginal Utility Approach] Now go back to the original assumptions of problem 1 (novels cost \(\$ 8,\) CDs cost \(\$ 6,\) and income is \(\$ 120\) ). Suppose that Parvez is spending \(\$ 120\) monthly on paperback novels and used CDs. For novels, \(M U / P=5 ;\) for CDs, \(M U / P=4 .\) Is he maximizing his utility? If not, should he consume (1) more novels and fewer CDs or (2) more CDs and fewer novels? Explain briefly.

Short answer

No, Parvez is not maximizing his utility. He should consume more novels and fewer CDs to maximize his utility.

Step-by-step solution

Understand Marginal Utility to Price Ratio

The MU (Marginal Utility) to P (Price) index is a representation of the additional satisfaction compared to the cost of one more unit of a good. It's calculated by dividing the Marginal Utility of the good by its Price. Good allocation of resources follows the rule of equating the MU/P for all goods.

Evaluate Marginal Utilities to Price Ratios

We know that for novels, the MU/P ratio is 5 and for CDs, the MU/P ratio is 4. In a well-allocated resource scheme, these values should be equal.

Comparison and Conclusion

Comparing the calculated MU/P ratios, the MU/P for novels is greater than MU/P ratio for the CDs. This implies that consuming another novel provides more utility compared to its cost than an additional CD. This concludes that Parvez is not maximizing his utility.

Recommendation

As the MU/P ratio for novels is greater than the MU/P for CDs, to maximize utility, Parvez should consume more novels and fewer CDs till the MU/P ratio for both the goods turn out to be equal.

Key concepts

Utility Maximization

Utility maximization is the idea that consumers strive to get the highest satisfaction, or "utility," from their available resources—specifically, their income. In Parvez's case, he's spending a total of $120 each month on paperback novels and used CDs. To ensure he's making the best possible use of his funds, he must look at the satisfaction he receives, or marginal utility (MU), divided by the cost for each good, known as the MU/P ratio. That's why it's important to compare these ratios for novels and CDs; they help show where he gets more "bang for his buck" from his spending.

To identify the best allocation, Parvez should ideally have the MU/P for novels equal to that of CDs. If they aren't equal, he's not maximizing his utility, meaning there might be a better way to spread his $120 to get more satisfaction. In this problem, Parvez finds the MU/P for novels (5) is greater than that for CDs (4). Hence, by adjusting his spend to buy more novels and fewer CDs until these ratios align, he can make sure he's getting the most pleasure from each dollar spent.

Resource Allocation

Resource allocation involves distributing your resources—money, time, effort—among various goods and services you want or need. The aim is always to achieve the best possible outcome, which in terms of consumer theory, is the greatest utility or satisfaction. For Parvez, this means deciding how much to spend on novels versus CDs to achieve the highest combined satisfaction.

• When the MU/P for used CDs is lower than that for novels, it indicates CDs offer less satisfaction per dollar spent at the current consumption level.
• By reallocating resources, Parvez could potentially increase his total utility by buying more of the item that has a higher MU/P ratio.

Comparing the novel's MU/P value of 5 and CDs' 4 reveals that his current allocation isn't optimal. Thus, adjusting his spending towards more novels and fewer CDs will better align his resource allocation with utility maximization.

Consumer Choice Theory

Consumer choice theory is a key economic principle that explores how consumers decide what to buy given their preferences and budget constraints. It considers how individuals, like Parvez, prioritize their options to achieve the highest possible satisfaction.

Parvez's decision-making process involves evaluating his options (novels vs. CDs) through the lens of marginal utility—a measure of the added satisfaction received from consuming an extra unit of a good. With a limited budget of $120, consumer choice theory suggests Parvez should spend in such a way that the marginal utility per dollar spent is the same for all goods. This ensures there is no opportunity to increase total utility without spending more.

• When MU/P ratios are equal, no further adjustment in his spending pattern will increase his overall satisfaction.
• It is this balancing act that defines optimal consumer choice.

The outcome for Parvez, according to consumer choice theory, indicates a shift towards consuming more novels will better meet his needs, given the MU/P ratio disparity with CDs.