Transcript Chapter 6

Chapter 6
Consumer
Behavior
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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.
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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.
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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.
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Figure 6.1 Alison’s Total and Marginal
Utility from Drinking Soda
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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...
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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:
MUX
=
pX
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MUY
pY
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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).
20
10
=
2
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= 10
1
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Alternative Interpretation
We can understand more about consumer behavior by
rearranging the terms in the above equation:
MUX
pX
=
MUY
pY
In this equation, the consumer adjusts her consumption (and
thus the ratios of MUs) in response to changes in relative
prices.
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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 10.
20
2
=
10
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= 2
1
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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:
pX
MUX
<
MUY
pY
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.
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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.
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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
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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.
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Figure 6.2 Income and Substitution
Effects of a Price Change
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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?
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Consumer surplus
The Concept
Glasses
of Milk
per Week
Amount
Consumer is
Willing to Pay
for This Glass
First
Second
Third
Fourth
Fifth
Sixth
Seventh
Eighth
Ninth
Tenth
$3.00
1.50
1.00
0.80
0.60
0.50
0.40
0.30
0.25
0.20
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Consumer
Surplus if the
Price is $.30 per
Glass
$2.70
1.20
0.70
0.50
0.30
0.20
0.10
0.00
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Figure 6.3 Moira’s Consumer
Surplus on Milk Consumption
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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.
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Figure 6.4 Consumer Surplus
for the Market
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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.
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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).
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