consumer decision making frederick university 2014
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Consumer Decision Making Assumptions Consumers want to derive maximum satisfaction from goods and services in consumption Consumers always prefer more satisfaction to less satisfaction Consumers are aware of their own taste and preferences Preferences are transitiveTRANSCRIPT
Consumer Decision Making
Frederick University2014
Determinants of Household Demand
• The price of the product in question.• The income available to the household.• The household’s amount of accumulated wealth.• The prices of related products available to the
household.• The household’s tastes and preferences.• The household’s expectations about future
income, wealth, and prices.
Factors that influence the quantity of a given good or Factors that influence the quantity of a given good or service demanded by a single household include:service demanded by a single household include:
Consumer Decision MakingAssumptions Consumers want to derive maximum
satisfaction from goods and services in consumption
Consumers always prefer more satisfaction to less satisfaction
Consumers are aware of their own taste and preferences
Preferences are transitive
Constraints of the Consumer ChoiceObjective constraints: consumer’s income prices of the goods in consumptionSubjective constraints: individual taste individual preferences
The Basis of Choice: Utility Utility – the satisfaction derived from
a product or service in consumption Marginal Utility – the extra utility,
derived from an extra unit of the good in consumption (MU)
TU derived from n units of the good in consumption = MU1 + MU2 + … + MUn
The Law of Diminishing Marginal Utility
For any good or service, the marginal utility of that good or service decreases as the quantity of the good increases
TU and MUUnits of the good
Marginal Utility MU
Total UtilityTU
1
6
6
5
2
11
3
4
15
4
3
18
TU and MU MU of wine
TU of wine
MU
Q1
6
2
5
02468
1012141618202224
0 1 2 3 4 5 6 7 8 9
Q
TU
The Model of Consumer Choice Assumptions The consumer consumes only two goods –
wine and movies The consumer wants to derive maximum TU
from the goods in consumption Wine and movies are substitutable, but not
perfectly substitutable Consumption is affected by the law of
diminishing marginal utility The prices of the goods and the consumer’s
income are given
Budget Constraint MU reveals the ordering of consumer
preferences among bundles of goods. It tells us what the consumer is willing to buy.
It does not tell us what the consumer is able to buy. It does not tell us anything about the consumer’s buying power.
The budget constraint shows all the combinations of goods that can be purchased with a given level of income.
The Budget ConstraintY = € 100; Pw = € 10; P m = € 10
The Budget Linew M Y10 0 10
09 1 10
08 2 10
07 3 10
06 4 10
05 5 10
04 6 10
0
W
M
Optimal Consumption Choice Given an income and prices, we want
to choose the optimal consumption bundle (the bundle the consumer likes best)
Choice must be feasible – i.e. in the budget set
But: more is better – the choice must be on the budget line
We choose the most-preferred point on the budget line – the one associated with the highest satisfaction (Total Utility)!
Consumer’s EquilibriumMaximum TUIf prices of wine and movies are equal,MUw = MumIf the price of wine is twice as great as the price of movies,MUw = 2 Mum
W TU MU M TU MU1 60 60 1 100 100
2 110 50 2 180 80
3 150 40 3 240 60
4 180 30 4 280 40
5 200 20 5 300 20
6 210 10 6 310 10
MUw : MUm = Pw : Pm
Or MUw : Pm = Pw : MUm
Optimal Consumption ChoiceConsumer Equilibrium The Consumer is in equilibrium when MUW/PW = MUM/PM
If MUW/PW > MUM/PM the consumer will be motivated to rearrange his/her purchases and buy more wine and fewer movies. The MU of the next bottle of wine, however, will be lower, while the MU of the last movie will be greater and the equation will be achieved
The Income Effect of a Price Change
When the price of a product falls, a consumer has more purchasing power with the same amount of income.
When the price of a product rises, a consumer has less purchasing power with the same amount of income.
The Substitution Effect of a Price Change
When the price of a product falls, that product becomes more attractive relative to potential substitutes.
When the price of a product rises, that product becomes less attractive relative to potential substitutes.
Income and Substitution Effects
The income effect: Consumption changes because purchasing power changes.
The substitution effect: Consumption changes because opportunity costs change.
Price changes affect households in two ways:Price changes affect households in two ways:
Income Effect and Substitution Effect
Incomeeffect
QSubstitutioneffect
Price effect
Q
P Normalgoods
Inferior Goodsregular Giffen
goods
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q = const
Consumer SurplusAny is willing to pay ₤5 for the first hamburger, but since she will derive
less satisfaction from the second hamburger, she will be willing to pay less, say, ₤4.75 for it
Marginal willingness to pay – the maximum amount the consumer is willing to pay for one extra unit of a good in consumption
QMWP
1
5
2
4.75
3
4.50
4
4
5
3.50
6
2.50
7
1.50
8
0.25
9
0
P = ₤ 2.50
MWP - P 2.50 2.25 2 1.50 1 0 -1
Consumer surplus = ∑ (MWP – P) = 2.50 + 2.25 + 2 + 1.50 + 1= ₤8.25
The Diamond/Water Paradox
The diamond/water paradox states that:
1. the things with the greatest value in use frequently have little or no value in exchange, and
2. the things with the greatest value in exchange frequently have little or no value in use.
The Diamond/Water Paradox Total utility of water is high, while total
utility of diamonds is low People are willing to pay a lot of money for
a piece of a diamond and just a little money for a drop of water, because the Marginal Utility of a diamond is very high, while the Marginal Utility of water is very low
The choice is made on the basis of Marginal Utility, not total utility