Consumer Behavior & Utility Maximization

1. Consumer Behavior & Utility Maximization ECO 2023 Chapter 7 Fall 2007 Created by: M. Mari

2. Terminology • Utility – the satisfaction or enjoyment that you receive from a choice or consumption of a good • subjective • Total utility – total amount of satisfaction or pleasure from consuming some specific quantity of a good • Marginal utility – the extra utility from consuming one more unit of the good

3. Utility Analysis • Utility • Satisfaction or enjoyment from an action • Subjective • Depends on tastes • Economists assumes simply that tastes are given and are relatively stable

4. Law of Diminishing Marginal Utility • The law states: • that as a consumer consumes more units of product, the marginal or additional utility that he or she will receive from the product declines

5. Graphically Utility increases as consumption increases until it reaches a maximum and begins to drop. Total Utility Units consumed

6. Law of Diminishing Marginal Utility • Explains why the demand curve for a given product slopes downward. • If successive units of a good yield smaller and smaller amounts of marginal, or extra, utility, then the consumer will buy additional units of a product only if its price falls.

7. Theory of Consumer Behavior • The law of diminishing marginal utility explains how consumers allocate their money incomes among the many goods and services available for purchase.

8. Consumer Choice and Budget Constraint • A typical consumer’s situation has the following dimensions • Rational behavior • Preferences – clear cut preferences for certain of the goods and services that are available in the market • Budget constraint – consumer has a fixed or limited amount of money income • Prices • Different individuals will choose different mixes of goods and services that most satisfy him or her

9. Utility Maximizing Rule: • To maximize satisfaction, the consumer should allocate his or her money income so that the last dollar spent on each product yield the same amount of extra utility

10. Example • Product A: Price = $1 • Product B: Price = $2

11. Income and Substitution Effects • Income Effect: is the impact that a change in the price of a product has on a consumer’s real income and consequently on the quantity demanded of the good • Substitution Effect: is the impact that a change in a product’s price has on its relative expensiveness and consequently on the quantity of the good demanded. • The income and substitution effect combine to increase a consumer’s ability and willingness to buy more a specific good when price falls.