Consumer Behavior Lecture 8 Chapter 7 Mc Graw-Hill Irwin

Chapter Objectives 1. 2. 3. 4. 5. 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 utilitymaximization 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

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

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

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.

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

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.

Theory of Consumer Behavior Key dimensions (assumptions) of the consumer › 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

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

Marginal Utility Per Dollar

Maximizing Marginal Utility per Dollar spent

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 (2) Apple (product A) Price = $1 (b) Marginal (a) Utility Marginal Per Dollar Utility, (MU/Price) Utils (3) Orange (product B) Price = $2 (b) Marginal (a) Utility Marginal Per Dollar Utility, (MU/Price) Utils First Second Third Fourth 10 8 7 6 24 20 18 16 12 10 9 8 Fifth Sixth Seventh 5 4 3 12 6 4 6 3 2 7 -12

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

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 (2) Apple (product A) Price = $1 (b) Marginal (a) Utility Marginal Per Dollar Utility, (MU/Price) Utils (3) Orange (product B) Price = $2 (b) Marginal (a) Utility Marginal Per Dollar Utility, (MU/Price) Utils First Second Third Fourth 10 8 7 6 24 20 18 16 12 10 9 8 Fifth Sixth Seventh 5 4 3 12 6 4 6 3 2 7 -14

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

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

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

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

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

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

The Budget Line: What is attainable? Units of A Units of B Total (Price = $1. 50) (Price = $1) Expenditure 8 6 4 2 0 0 3 6 9 12 $12 12 12 7 -21

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.

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

Indifference Curve Analysis The indifference map Equilibrium position at tangency 12 10 MRS = Quantity of A 8 6 W X 4 PB PA Preferred – But Requires More Income I 4 2 0 I 3 I 1 2 4 6 8 Quantity of B 10 I 2 12 7 -24

Demand Curve Derived 12 At $1 price for B, 6 units of B are purchased Quantity of A 10 8 6 X 4 Record the results 2 I 2 Price of B 0 2 4 6 8 10 Quantity of B 12 $1. 50 I 3 As price of B increases to $1. 50, only 3 units of B are bought Record the results 1. 00. 50 DB 2 4 6 8 10 Quantity of B 12 Connect the points to create the demand curve for B 7 -25

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

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