Consumer Behavior

1. Consumer Behavior Lecture 8 [Chapter 7]

2. Chapter Objectives • About total utility, marginal utility, and the law of diminishing marginal utility. • How rational consumers compare marginal utility-to-price ratios for products in purchasing combinations of products that maximize their utility. • How a demand curve can be derived by observing the outcomes of price changes in the utility-maximization model. • How the utility-maximization model helps highlight the income and substitution effects of a price change. • About budget lines, indifference curves, utility maximization, and demand derivation in the indifference curve model of consumer behavior. (Appendix) 7-2

3. Utility • Utility is want-satisfying power a good possesses or the satisfaction or pleasure one receives from consuming a good or service. • Diminishing marginal utility (again) • Three characteristics • Differs from usefulness • Subjective • Difficult to quantify 7-3

4. Law of Diminishing Marginal UItility • Explains downward sloping demand • Predicts that added satisfaction declines as a consumer acquires additional units of a given product. 7-4

5. Total Utility and Marginal Utility • Total utility is the total amount of satisfaction or pleasure a person derives from consuming some specific quantity of a good or service. • Marginal utility is the extra satisfaction a consumer realizes from an additional unit of that product. • Alternatively, marginal utility is the change in total utility that results from the consumption of 1 more unit of a product.

6. 30 20 Total Utility (Utils) ] ] ] ] ] ] ] 10 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7 10 8 6 Marginal Utility (Utils) 4 2 0 -2 Utility Graphically Total Utility (1) Tacos Consumed Per Meal (2) Total Utility, Utils (3) Marginal Utility, Utils TU 0 10 18 24 28 30 30 28 0 1 2 3 4 5 6 7 10 8 6 4 2 0 -2 Units Consumed Per Meal Marginal Utility MU Units Consumed Per Meal 7-6

7. Marginal Utility & Demand • The law of diminishing marginal utility explains why the demand curve for a given product slopes downward. • In the event successive units of a good are consumed with each unit yielding smaller amounts of marginal utility, then the only way a consumer will buy additional amounts of the good is if the price falls.

8. Theory of Consumer Behavior • Key dimensions of the consumer (assumptions) • Consumers engage in Rational behavior • Each consumer has clear cut Preferences • Every consumer faces a Budget constraint • Changes in Prices will alter consumer choices. 7-8

9. Utility Maximizing Rule • Allocate income so that the last dollar spent on each good yields same amount of extra (marginal) utility. • When a consumer has ‘balanced his or her margins’ using this rule, he or she has received consumer equilibrium. 7-9

10. Marginal Utility Per Dollar

11. Maximizing Marginal Utility per Dollar spent

12. (2) Apple (product A) Price = $1 (3) Orange (product B) Price = $2 (b) Marginal Utility Per Dollar (MU/Price) (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, Utils (a) Marginal Utility, Utils First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 10 8 7 6 5 4 3 24 20 18 16 12 6 4 12 10 9 8 6 3 2 Numerical Example Combinations of apples and oranges obtainable with an income of $10 Compare marginal utilities Then compare per dollar - MU/Price Choose the highest Check budget - proceed to next item (1) Unit of Product 7-12

13. (3) Orange (product B) Price = $2 (2) Apple (product A) Price = $1 (b) Marginal Utility Per Dollar (MU/Price) (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, Utils (a) Marginal Utility, Utils First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 10 8 7 6 5 4 3 24 20 18 16 12 6 4 12 10 9 8 6 3 2 Numerical Example Combinations of apples and oranges obtainable with an income of $10 Again, compare per dollar - MU/Price Choose the highest Buy one of each – budget has $5 left Proceed to next item (1) Unit of Product 7-13

14. (3) Orange (product B) Price = $2 (2) Apple (product A) Price = $1 (b) Marginal Utility Per Dollar (MU/Price) (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, Utils (a) Marginal Utility, Utils First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 10 8 7 6 5 4 3 24 20 18 16 12 6 4 12 10 9 8 6 3 2 Numerical Example Combinations of apples and oranges obtainable with an income of $10 Again, compare per dollar - MU/Price Buy one more orange – budget has $3 left Proceed to next item (1) Unit of Product 7-14

15. (3) Orange (product B) Price = $2 (2) Apple (product A) Price = $1 (b) Marginal Utility Per Dollar (MU/Price) (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, Utils (a) Marginal Utility, Utils First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 10 8 7 6 5 4 3 24 20 18 16 12 6 4 12 10 9 8 6 3 2 Numerical Example Combinations of apples and oranges obtainable with an income of $10 Again, compare per dollar - MU/Price Buy one of each – budget exhausted (1) Unit of Product 7-15

16. (2) Apple (product A) Price = $1 (3) Orange (product B) Price = $2 (b) Marginal Utility Per Dollar (MU/Price) (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, Utils (a) Marginal Utility, Utils First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 10 8 7 6 5 4 3 24 20 18 16 12 6 4 12 10 9 8 6 3 2 Numerical Example Combinations of apples and oranges obtainable with an income of $10 Final result – at these prices, purchase 2 apples and 4 oranges (1) Unit of Product 7-16

17. MU of product B MU of product A price of B price of A 16 Utils 8 Utils $1 $2 Algebraic Generalization = = Optimum Achieved– Money income is allocated so that the last dollar spent on each product yields the same extra or marginal utility 7-17

18. 2 Quantity Demanded Price Per Unit of B Price of Product B 1 0 4 6 Quantity Demanded of B Deriving the Demand Curve 4 $2 6 1 Income Effects Substitution Effects DB 7-18

19. Income & Substitution Effects • Income effect: the impact that a change in a product’s price has on a consumer’s real income and on the quantity demanded of that good. • Substitution effect: the impact that a change in a product’s price has on its relative expensiveness and on the quantity demanded

20. Applications and Extensions • New products increase utility • iPods • The diamond-water paradox • The value of time • Medical care purchases • Cash and noncash gifts 7-20

21. Total Expenditure Units of B (Price = $1) Units of A (Price = $1.50) The Budget Line: What is attainable? 0 3 6 9 12 8 6 4 2 0 $12 12 12 12 12 7-21

22. Characteristics of the Budget Line • Changes in Money income • An increase in money income shifts the budget line to the right; a decrease in money income shifts it to the left • Changes in Prices • a change in product prices also shifts the budget line.

23. 12 10 Combination Units of A Units of B 8 Quantity of A 6 4 2 0 2 4 6 8 10 12 Quantity of B Indifference Curves What is preferred • Downsloping and convex • Marginal rate of substitution j j k l m 12 6 4 3 2 4 6 8 k l m I 7-23

24. MRS = 12 10 8 Quantity of A 6 4 PB 2 PA 0 2 4 6 8 10 12 Quantity of B Indifference Curve Analysis • The indifference map • Equilibrium position at tangency Preferred – But Requires More Income W X I4 I3 I2 I1 7-24

25. 12 10 8 Quantity of A 6 X 4 2 I3 I2 0 2 4 6 8 10 12 Quantity of B $1.50 1.00 .50 Demand Curve Derived At $1 price for B, 6 units of B are purchased Record the results As price of B increases to $1.50, only 3 units of B are bought Record the results Connect the points to create the demand curve for B Price of B DB 2 4 6 8 10 12 Quantity of B 7-25

26. Key Terms • Law of diminishing marginal utility • Utility • Total utility • Marginal utility • Rational behavior • Budget constraint • Utility maximizing rule • Income effect • Substitution effect 7-26

27. Appendix Key Terms • Budget Line • Indifference curve • Marginal rate of substitution (MRS) • Indifference map • Equilibrium position 7-27