1

Chapter 4

Theory of Consumer Behavior

2

Utility Theory

Utility– The want-satisfying power of a good or service

Utility Analysis– The analysis of consumer decision making based on

utility maximization

Util– A representative unit by which utility is measured

3

Utility Theory Marginal Utility

– The change in total utility due to a one-unit change in the quantity of a good or service consumed

Total Utility

– Sum-total of satisfaction which a consumer receives by consuming various units of commodity.

Marginal Utility =Change in total utility

Change in number of units consumed

4

Total and Marginal Utility of Downloading and Listening to Digital

Music Albums

5

Total and Marginal Utility of Downloading and Listening

to Digital Music Albums

Total utility ismaximized...

…where marginalutility equals zero.

6

Graphical Analysis

Observations

– Marginal utility falls as more is consumed.

– Marginal utility equals zero when total utility is at its maximum.

7

Diminishing Marginal Utility

Law of Diminishing Marginal Utility

– The principle that as more of any good or service is consumed, its extra benefit declines

– Increases in total utility from consumption of a good or service become smaller and smaller as more is consumed during a given time period.

8

Optimizing Consumption Choices

Consumer Optimum

– A choice of a set of goods and services that maximizes the level of satisfaction for each consumer, subject to limited income

9

Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on

an Income of $26

10

Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on

an Income of $26

(1)Time Period

(2)(TU)Music Album

(3)(MU)

(4)(MU per $ Spent)Price=$5

(5)Time Period

(6)(TU)Sandwich

(7)(MU)

(8)(MU per $ Spent)Price=$3

0 0 ---- ----- 0 0 ____ _____

1 50 50 10 1 25 25 8.3

2 95 45 9 2 47 22 7.3

3 135 40 8 3 65 18 6.0

4 171 36.5 7.3 4 80 15 5.0

5 200 28.5 5.7 5 89 9 3.0

11

12

Total and Marginal Utility from Consuming Music Album Downloads and Sandwiches on

an Income of $26

13

Optimizing Consumption Choices

A consumer’s money income should be allocated so that the last dollar spent on each good purchased yields the same amount of marginal utility (when all income is spent), because this rule yields the largest possible total utility.

14

Optimizing Consumption Choices

Law of Equi-marginal Utility

– The rule of equal marginal utilities per dollar spent

• A consumer maximizes personal satisfaction when allocating money income in such a way that the last dollars spent on good A, good B, good C, and so on, yield equal amounts of marginal utility.

15

A little math– The rule of equal marginal utilities per dollar

spent

Optimizing Consumption Choices

MU of good APrice of good A

=MU of good B

Price of good BMU of good Z

Price of good Z= =...

(1)Time Period

(2)(TU)Music Album

(3)(MU)

(4)(MU per $ Spent)Price=$5

(5)Time Period

(6)(TU)Sandwich

(7)(MU)

(8)(MU per $ Spent)Price=$3

0 0 ---- ----- 0 0 ____ _____

1 50 50 10 1 25 25 8.3

2 95 45 9 2 47 22 7.3

3 135 40 8 3 65 18 6.0

4 171 36.5 7.3 4 80 15 5.0

5 200 28.5 5.7 5 89 9 3.0

16

17

How a Price Change Affects Consumer Optimum

Income = $26

Qd = 4MUd

Pd

36.55

= = 7.3

Qs = 2MUs

Ps

223

= = 7.3

18

How a Price Change Affects Consumer OptimumAssume Price of Music Falls to $4

Qd = 4MUd

Pd

36.54

= = 9.125

Qs = 2MUs

Ps

223

= = 7.3

19

How a Price Change Affects Consumer OptimumAssume Price of Music Falls to $4

Result Buy more downloads and MUd falls

NowMUd

Pd

>MUs

Ps

20

Digital Music Download Prices and Marginal Utility

21

How a Price Change Affects Consumer Optimum

Consumption decisions are summarized in the law of demand

– The amount purchased is inversely related to price.

A consumer’s response to a price change

– At higher consumption rate, marginal utility falls.

First 10 10 24 12

$ 10 income

UTILITY MAXIMIZING COMBINATION

How should the $10 income be allocated?

Unit ofproduct

Product A:Price = $1

Product B:Price = $2

Marginalutility,utils

Marginalutility per

dollar(MU/price)

Marginalutility,utils

Marginalutility per

dollar(MU/price)

First 10 10 24 12

$ 10 income

UTILITY MAXIMIZING COMBINATION

Examine the twomarginal utilities

Unit ofproduct

Product A:Price = $1

Product B:Price = $2

Marginalutility,utils

Marginalutility per

dollar(MU/price)

Marginalutility,utils

Marginalutility per

dollar(MU/price)

First 10 10 24 12

$ 10 income

UTILITY MAXIMIZING COMBINATION

Examine the twomarginal utilities

…per dollar

Unit ofproduct

Product A:Price = $1

Product B:Price = $2

Marginalutility,utils

Marginalutility per

dollar(MU/price)

Marginalutility,utils

Marginalutility per

dollar(MU/price)

First 10 10 24 12

$ 10 income

UTILITY MAXIMIZING COMBINATION

Decision: Buy 1Product B for $2

Unit ofproduct

Product A:Price = $1

Product B:Price = $2

Marginalutility,utils

Marginalutility per

dollar(MU/price)

Marginalutility,utils

Marginalutility per

dollar(MU/price)

First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2

$ 10 income

UTILITY MAXIMIZING COMBINATION

What next?

Unit ofproduct

Product A:Price = $1

Product B:Price = $2

Marginalutility,utils

Marginalutility per

dollar(MU/price)

Marginalutility,utils

Marginalutility per

dollar(MU/price)

First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2

$ 10 income

UTILITY MAXIMIZING COMBINATION

What next?Buy one of each

Unit ofproduct

Product A:Price = $1

Product B:Price = $2

Marginalutility,utils

Marginalutility per

dollar(MU/price)

Marginalutility,utils

Marginalutility per

dollar(MU/price)

First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2

$ 10 income

UTILITY MAXIMIZING COMBINATION

and then...($5 left)

Unit ofproduct

Product A:Price = $1

Product B:Price = $2

Marginalutility,utils

Marginalutility per

dollar(MU/price)

Marginalutility,utils

Marginalutility per

dollar(MU/price)

First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2

$ 10 income

UTILITY MAXIMIZING COMBINATION

third unit of product B

Unit ofproduct

Product A:Price = $1

Product B:Price = $2

Marginalutility,utils

Marginalutility per

dollar(MU/price)

Marginalutility,utils

Marginalutility per

dollar(MU/price)

First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2

$ 10 income

UTILITY MAXIMIZING COMBINATION

$3 left...

Unit ofproduct

Product A:Price = $1

Product B:Price = $2

Marginalutility,utils

Marginalutility per

dollar(MU/price)

Marginalutility,utils

Marginalutility per

dollar(MU/price)

First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2

$ 10 income

UTILITY MAXIMIZING COMBINATION

$3 left...Buy both!

Unit ofproduct

Product A:Price = $1

Product B:Price = $2

Marginalutility,utils

Marginalutility per

dollar(MU/price)

Marginalutility,utils

Marginalutility per

dollar(MU/price)

First 10 10 24 12Second 8 8 20 10Third 7 7 18 9Fourth 6 6 16 8Fifth 5 5 12 6Sixth 4 4 6 3Seventh 3 3 4 2

$ 10 income

UTILITY MAXIMIZING COMBINATION

Income is gone...the last dollar spent on

each good gave the sameutility (8) per dollar

Unit ofproduct

Product A:Price = $1

Product B:Price = $2

Marginalutility,utils

Marginalutility per

dollar(MU/price)

Marginalutility,utils

Marginalutility per

dollar(MU/price)

Algebraic Restatement of theUtility Maximization Rule

MU of product A

Price of A

MU of product B

Price of B=

UTILITY MAXIMIZING COMBINATION

8 Utils

$1

16 Utils

$2=

UTILITY MAXIMIZATION ANDTHE DEMAND CURVE

• Preferences or Tastes• Money Income• Prices of Other Goods

35

How a Price Change Affects Consumer Optimum

The Substitution Effect

– The tendency of people to substitute cheaper commodities for more expensive commodities

– Consumers and producers shift away from goods and resources that become priced relatively higher in favor of goods and resources that are now priced relatively lower.

36

How a Price Change Affects Consumer Optimum

Real-Income Effect

– The value of money for buying goods and services

– The change in people’s purchasing power that occurs when, other things being constant, the price of one good that they purchase changes

– When that price goes up (down), real income, or purchasing power, falls (increases).

37

The Demand Curve Revisited

Question

– How is the demand curve derived?

Answer

– By presuming income, tastes, expectations, and the price of related goods are not changing as the price of the good changes

38

Summary

Total utility versus marginal utility – Total utility is total satisfaction from

consumption.

– Marginal utility is the additional satisfaction from consuming an additional unit.

Law of diminishing marginal utility– Marginal utility ultimately decides as a person

consumes more and more of a good or service.

39

Summary

The consumer optimum

– Occurs when the marginal utility per dollar spent on the last unit consumed is equalized

The substitution effect of a price change

– A person will substitute among goods by buying less of a good when its price increases.

40

Summary

The real-income effect of a price change – A price change affects the purchasing power of

an individual’s available income.

Why the price of diamonds exceeds the price of water even though people cannot long survive without water– Marginal utility, not total utility, determines

how much people are willing to pay.