Chapter 6. Consumer Behavior. In this chapter you will learn to. Marginal Utility and Consumer Choice

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1 Chapter 6 Consumer Behavior In this chapter you will learn to 1. Describe the difference between marginal and total utility. 2. Explain why utility-maximizing consumers adjust their expenditure until the marginal utility per dollar spent is equalized across products. 3. Explain how changes in price generate both an income and a substitution effect on quantity demanded. 4. Describe consumer surplus as the bargain consumers get by paying less for the product than the maximum price they are willing to pay. 5. Describe the difference between total value and marginal value. 6-2 Marginal Utility and Consumer Choice Utility the satisfaction or well-being that a consumer receives from consuming some good or service. Theory of consumer behavior is based on the idea of utility maximization. Total utility the total satisfaction resulting from the consumption of a given commodity by a consumer. Marginal utility the additional satisfaction obtained by a consumer from consuming one additional unit of a commodity

2 Diminishing Marginal Utility The law of diminishing marginal utility is the central hypothesis of utility theory. The utility that any consumer derives from successive units of a particular product is assumed to diminish as total consumption of the product increases (if the consumption of all other products is unchanged). Marginal utility falls as the level of consumption rises. 6-4 Figure 6.1 Alison s Total and Marginal Utility from Drinking Soda 6-5 Maximizing Utility Consumers must decide how to adjust their expenditure to maximize total utility. A utility-maximizing consumer allocates expenditures so that the utility obtained from the last dollar spent on each product is equal. An example? Consider a consumer whose utility from the last dollar spent on Coke is more than from the last dollar spent on burritos. She could increase her total utility by switching a dollar of expenditure from burritos to Coke

3 Maximizing Utility and continuing until the marginal utility per dollar spent on Coke equals the marginal utility per dollar spent on burritos. For two products, X and Y, the utility-maximizing condition is: MU X p X = MU Y p Y 6-7 Example of the consumer s decision: The last unit of X increases utility by 20 and costs $2, its marginal utility per dollar is 10 (=20/2). The last unit of Y increases utility by 10 and costs $1, its marginal utility per dollar is 10 (=10/1) = 10 1 = Alternative Interpretation We can understand more about consumer behavior by rearranging the terms in the above equation: MU X MU Y = p X p Y In this equation, the consumer adjusts her consumption (and thus the ratios of MUs) in response to changes in relative prices

4 Another look at the consumer s decision: Last example: The price of X is $2 and the price of Y is $1. The consumer can purchase X and Y such that the marginal utility for X is 20 and the marginal utility for Y is = 2 1 = The Consumer s Demand Curve What happens when there is a change in the product s price? If the price of Coke (X) rises, then at the previous utilitymaximizing consumption bundle, we have: MU X p X < MU Y As the consumer reduces consumption of Coke, the marginal utility of Coke rises and this increases the ratio on the lefthand side of the equation. p Y 6-11 Income and Substitution Effects of Price Changes A change in price has two distinct effects -- it alters relative prices and it changes consumers real income. The Substitution Effect The substitution effect increases the quantity demanded of a good whose (relative) price has fallen and reduces the quantity demanded of a good whose (relative) price has increased

5 The Income Effect For a normal good, the income effect leads consumers to buy more of a product that has fallen in price. For an inferior good, the income effect is for consumers to buy fewer units when its price falls. Example: compare a 10% price reduction of gasoline or a 10% price reduction of coffee. For which would your income effect be larger? Why? EXTENSIONS IN THEORY 6.1 Market and Individual Demand Curves 6-13 The Slope of the Demand Curve The overall effect of a price change is the combination of the income and substitution effects. For a price increase: - the substitution effect is to reduce quantity demanded - the income effect could go either way But for a normal good, the two effects work in the same direction and so the demand curve is downward sloping. Giffen goods: An inferior good for which the negative income effect outweighs the substitution effect so that the demand curve is positively sloped Figure 6.2 Income and Substitution Effects of a Price Change

An Interesting Application to Taxation The logic of breaking down a price change into separate income and substitution effects is not limited to the analysis of demand.

6 An Interesting Application to Taxation The logic of breaking down a price change into separate income and substitution effects is not limited to the analysis of demand. Two important examples involve the supply of labor and the supply of household saving -- changes in wages and interest rates have both income and substitution effects. How do changes in income-tax rates affect the incentives to work and the incentives to save? 6-16 Consumer surplus The Concept Glasses of Milk per Week First Second Third Fourth Fifth Sixth Seventh Eighth Ninth Tenth Amount Consumer is Willing to Pay for This Glass $ Consumer Surplus if the Price is $.30 per Glass $ Figure 6.3 Moira s Consumer Surplus on Milk Consumption

The consumer may be asked how much he or she would be willing to pay to consume the total amount if the alternative were to consume none.

7 Consumer Surplus The value placed by a consumer on the total consumption of some product can be estimated in two ways: 1. The valuations that the consumer places on each unit may be summed. 2. The consumer may be asked how much he or she would be willing to pay to consume the total amount if the alternative were to consume none. It is important to fully understand the difference between marginal value and total value to the consumer Figure 6.4 Consumer Surplus for the Market 6-20 Figure 6.5 Resolving the Paradox of Value Because the market price of a product depends on both demand and supply, there is no paradox in having a product with a high total value (such as water) selling for a low price and hence a low marginal value

8 Attitude Surveys Surveys often ask people about their preference, revealing their total rather than marginal utilities. Examples of how surveys can be misinterpreted: 1. A market survey found that households named vacuum cleaners as the most important appliance (total utility), yet they did not respond to a sales promotion (marginal utility) as they already have one. 2. People rated unemployment benefits (total utility) as a priority in a survey, but were hostile to a party advocating an increase in unemployment benefits (marginal payments)

Chapter 21. Consumer Choice

Chapter 21. Consumer Choice Consumer Choice Utility is most closely defined as a) extra. b) marginal. c) usefulness. d) satisfaction. e) opportunity cost. Copyright Houghton Mifflin Company. All rights reserved. 21 2 Utility is most