1.6 Theory of Consumer Behavior

1. 1.6 Theory ofConsumer Behavior Unit Overview Blog posts: "Utility"

2. Introduction to Consumer Behavior • 1.6 Theory ofConsumer Behavior • Introduction to the Theory of Consumer Behavior • Throughout our study of Microeconomics we have examined the behaviors of firms competing in markets of varying levels of competition. We have learned: • How firms decide the profit-maximizing level of output, • How firms decide the revenue-maximizing level of output • How firms know when they should shut down, • When firms will wish to enter or exit a market • This can all be summarized as firm behavior. What we have not focus on yet is Consumer Behavior. In this unit we will examine the THEORY OF CONSUMER BEHAVIOR: • How rational consumers decide on the optimal combination of goods to consume with their limited budget in order to maximize their total utility at any given time. • Utility: In Economics, we refer to the welfare of consumers as utility. To allow us to measure the utility of consumers, we will refer to an imaginary value of happiness, called the UTIL. • One UTIL equals one unit of happiness…

3. Introduction to Consumer Behavior • 1.6 Theory ofConsumer Behavior Introduction to the Theory of Consumer Behavior To introduce the theory of consumer behavior, it helps to think for a moment about your own behavior as a consumer… • Imagine you have $100 to spend this week: • In the table below, identify • 5 goods or services you would spend your money on. • The approximate price of each product, and • The quantity you would buy Questions: How did you decide which items to put in your “basket”? Is your basket identical to your classmates? Why or why not? How would a change in the price of one of the items affect the quantity you buy? How would a change in your budget affect the composition of your basket?

4. Introduction to Consumer Behavior • 1.6 Theory ofConsumer Behavior • Introduction to the Theory of Consumer Behavior • Chances are, every member of your class had entirely different goods in his or her table than you did. Precisely WHY every individual consumes a different “basket of goods” from every other individual in a market economy can be understood by the following: • Every consumer behaves rationally: Consumers try to get the "most for their money" to maximize their total utility • Every consumer has different preferences: Consumers have clear cut preferences and can determine how much marginal utility they get from consuming more units of a product • Every consumer is under a budget constraint: All consumers face a budget constraint, therefore must make decisions about what they buy based on their limited budget • Every product has a price: Every product has a price, so consumers must weigh their purchasing decisions based on their marginal utility from consumption and the price of the goods they consume

5. Total Utility and Marginal Utility • 1.6 Theory ofConsumer Behavior • Total Utility and Marginal Utility • As explained in the introduction to this unit, rational consumers wish to maximize their happiness, or utility when buying goods and services. Otherwise, what is the point of spending money at all? Two concepts that will help us understand HOW consumer maximize utility, therefore, are: • Total Utility (TU): This is the total happiness of a consumer at a particular level of consumption. Total utility will generally increase as total consumption of particular good increases, until the consumer has “had too much” of the good, when total utility will begin to decline. • Marginal Utility (MU): This is the increase in total utility resulting from the consumption of each additional unitof a particular good. • Since MU measures the change in TU, as long as MU is positive at a particular level of output, TU will be increasing. But if MU becomes negative, TU will decrease.

6. Total Utility and Marginal Utility • 1.6 Theory ofConsumer Behavior The Law of Diminishing Marginal Utility Recall from earlier units that demand for a particular good is inversely related to the good’s price. One of the explanations for this relationship was the law of diminishing marginal utility, which states: • The greater the level of consumption of a particular good, the less utility consumers derive from each additional unit of the good. • Consider the total and marginal utility one derives from consuming ice cream. Notice the following: • The first scoop provides you with 5 utils, so TU = 5 at Q=1 • Additional scoops of ice cream provide you with less and less additional happiness. Nothing tastes quite as good as that first scoop! MU declines beyond the first scoop, but TU continues to increase, until… • The fourth scoop: At four scoops your TU is maximized, but the 4th scoop provided you with no additional utility. • Beyond four scoops, you’ve “had too much”. TU begins decreasing while MU becomes negative.

7. The Utility Maximization Rule • 1.6 Theory ofConsumer Behavior • The Utility Maximization Rule • With the law of diminishing marginal utility in mind, we must now determine how a consumer should decide what to buy. Assume the following: • You have a budget of $20 that you wish to spend entirely on two goods • The two goods you are trying to decide between are Widgets (w) and Robotrons (r) • The price of Widgets (Pw) is $5 and the price of Robotrons (Pr) is $2 • To determine how many of each good you should buy, you must consider the utility each good provides. Consider the table below. First, calculate the MU at each level of consumption

8. The Utility Maximization Rule • 1.6 Theory ofConsumer Behavior The Utility Maximization Rule At first glance, it may appear that you should spend all your money on Widgets, because they clearly provide more total utility than Robotrons. But this would be a mistake, because Widgets also cost more than robotrons. Instead, there is a simple rule to follow to maximize utility: The Utility Maximization Rule: To maximize your total utility, you should instead consume the combination of good that maximizes your marginal utility per dollar spent, so that: With this rule in mind calculate the marginal utility per dollar spent on Widgets and Robotrons:

9. The Utility Maximization Rule • 1.6 Theory ofConsumer Behavior The Utility Maximization Rule Now we can study the table to determine how you should spend your $20 to maximize your total utility. Of course, if you had no budget constraint, you would consume 5 Widgets AND 5 Robotrons, but this would cost you $35, more than you have to spend. So choices must be made At 2w and 3r, you’ve maximized your total utility given your limited budget of $20. • How to decide what to buy: The goal for consumers is to always maximize marginal utility per dollar. • You should buy a Robotron first, giving you a MU/$ of 2.5. Remaining budget = $18 • Next you should buy a second Robotron, which gives you an MU/$ of 2. Remaining budget = $16 • Next you should buy a Widget, which gives you an MU/$ of 2. Remaining budget = $11 • A 2nd Widget will now give you an MU/$ of 1.6, compared to 1.5 for a 3rdRobotron. Remaining buget = $6 • A 3rdRobotron now gives you an MU/$ of 1.5, compared to 1.2 for a 3rd Widget: Remaining budget = $4 • Based on the utility maximization rule, you should buy 2w and 3r, where MUw/Pw=MUr/Pr

10. The Utility Maximization Rule • 1.6 Theory ofConsumer Behavior The Utility Maximization Rule Practice Problem Assume you have a budget of $36 to spend on Pizzas and Hamburgers. Pizzas cost $8 and hamburgers cost $4. Complete the table below and answer the questions that follow • Identify the combination of robotrons and widgets you should purchase. Explain your reasoning. • With the prices of pizzas and hamburgers remaining constant, assume that your budget increases to $60. Identify each of the following: • The new combination of robotrons and widgets the consumer will purchase. • The total utility the consumer will enjoy with this combination • With your budget remaining at $60, assume the price of pizzas increases to $16 each. Identify each of the following. • The combination of robotrons and widgets the consumer will purchase • The consumer's total utility at this combination

11. Individual Demand and Market Demand • 1.6 Theory ofConsumer Behavior • Individual Demand and Market Demand • An individual consumer’s marginal utility curve for a particular good represents that individual’s demand for the good. • If we consider demand as a signal of what a consumer is willing to pay for a good, and • We recognize that what consumers are willing to pay is based on the utility they get from a good. • With this in mind, we can see a relationship between consumers’ marginal utilities and market demand. • Consider the market for ice cream: • Assume there are 1,000 consumers in the market, • Each with a similar MU for ice cream. • When we sum the individual MU curves for each consumer, we get the market demand for ice cream. • For 1,000 scoops, consumers would pay $5, based on their high MU for the first scoop. • To sell more ice cream, price must fall, based on consumers’ diminishing marginal utility for ice cream.