Consumer Behavior. McGraw-Hill/Irwin. Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Law of Diminishing Marginal Utility Utility is the satisfaction one gets from consuming a good or service Not the same as usefulness Subjective Difficult to quantify LO1 6-2

Law of Diminishing Marginal Utility Util is one unit of satisfaction or pleasure Total utility is the total amount of satisfaction Marginal utility is the extra satisfaction from an additional unit of the good MU = ΔTU/ΔQ LO1 6-3

Law of Diminishing Marginal Utility As consumption of a good or service increases, the marginal utility obtained from each additional unit of the good or service decreases Explains downward sloping demand LO1 6-4

Marginal Utility (Utils) Total Utility (Utils) Total Utility and Marginal Utility Total Utility (1) Tacos Consumed Per Meal (2) Total Utility, Utils (3) Marginal Utility, Utils 30 20 TU 0 1 2 3 4 5 6 7 0 10 18 24 28 30 30 28 ] ] ] ] ] ] ] 10 8 6 4 2 0-2 10 0 10 8 6 4 2 0-2 1 2 3 4 5 6 7 1 2 3 4 5 6 7 MU LO1 6-5

Theory of Consumer Behavior Rational behavior Preferences Budget constraint Prices LO2 6-6

Utility Maximizing Rule Consumer allocates his or her income so that the last dollar spent on each product yields the same amount of extra (marginal) utility Algebraically MU of product A Price of A = MU of product B Price of B LO2 6-7

Numerical Example The Utility Maximizing Combination of Apples and Oranges Obtainable with an Income of $10 LO2 (1) Unit of Product (2) Apple (Product A): Price = $1 (a) Marginal Utility, Utils (b) Marginal Utility per dollar (MU/Price) (3) Oranges (Product B): Price = $2 (a) Marginal Utility, Utils (b) Marginal Utility per dollar (MU/Price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 6 16 8 Fifth 5 5 12 6 Sixth 4 4 6 3 Seventh 3 3 4 2 6-8

Decision-Making Process Sequence of Purchases to Achieve Consumer Equilibrium, Given the data in Table 6.1 Choice Number Potential Choices 1 First Apple First Orange Marginal Utility per Dollar 10 12 Purchase Decision Income Remaining First orange for $2 $8 = $10 - $2 2 First Apple Second Orange 10 10 First apple for $1 and Second orange for $2 $5 = $8 -$3 3 Second Apple Third Orange 8 9 Third orange for $2 $3 = $5 - $2 4 Second Apple Fourth Orange 8 8 Second apple for $1 and Fourth orange for $2 $0 = $3 - $3 LO2 6-9

Price of Orange Deriving the Demand Curve $2 Price Per Orange $2 1 Quantity Demanded 4 6 $1 D O 0 4 6 Quantity Demanded of Oranges LO3 6-10

Income and Substitution Effects Income effect The impact that a price change has on a consumer s real income Substitution effect The impact that a change in a product s price has on it s relative expensiveness LO4 6-11

Applications and Extensions New products ipod Diamond-water paradox Opportunity cost and time Medical care purchases Cash and noncash gifts LO5 6-12

Prospect Theory How people actually deal with life s up and downs People judge things relative to the status quo People experience: Diminishing marginal utility for gains Diminishing marginal disutility for losses People are loss adverse LO5 6-13

Losses and Shrinking Packages Consumers see any price increase as a loss relative to the status quo Producers are reducing package size instead of raising prices LO5 6-14

Framing Effects and Advertising Consumers evaluate events in a particular mental frame New information alters the frame in which the consumer defines whether situations are gains or losses LO5 6-15

Anchoring and Credit Card Bills Estimates of value are influenced by recent information no matter how irrelevant Can lead to people altering valuations unconsciously LO5 6-16

Mental Accounting and Warranties Separate purchases into mental accounts rather than looking at the big picture Mental accounting exaggerates any potential loss LO5 6-17

The Endowment Effect Market transactions may be affected by the endowment effect because: The seller has a tendency to demand a higher price The buyer has a tendency to offer a lower price LO5 6-18

Nudging People Using behavioral economics to change people s behavior Subtle manipulations are used to generate socially better outcomes Unaware of being manipulated LO5 6-19