Transcript Chapter No. 5

19
Consumer
Behavior and
Utility
Maximization
Click to Link to Appendix 19: Indifference Curve Analysis
19-1
Copyright 2008 The McGraw-Hill Companies
Chapter Objectives
• Total Utility, Marginal Utility, and the Law of Diminishing
Marginal Utility
• How Rational Consumers Compare Marginal Utility-to-Price
Ratios for Products in Purchasing Combinations to Maximize
Total Utility
• How to Derive the Demand Curve by Observing Behavior
• How the Utility-Maximization Model Highlights Income and
Substitution Effects of a Price Change
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Copyright 2008 The McGraw-Hill Companies
• We spend billions of dollars on goods and services each
year, yet no two consumers spend their incomes in the same
way. How can this be explained?
• Why does a consumer buy a particular bundle of goods and
services rather than others? Examining these issues will
help us understand consumer behavior and the law of
demand.
Law of Diminishing Marginal Utility
• Although consumer wants in general are insatiable, wants for
specific commodities can be fulfilled. The more of a specific
product that consumers obtain, the less they will desire more
units of that product. This can be illustrated with almost any
item. The text uses the automobile example, but houses,
clothing, and even food items work just as well.
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Copyright 2008 The McGraw-Hill Companies
• Utility is a subjective notion in economics, referring to the
amount of satisfaction a person gets from consumption of a
certain item.
• Marginal utility refers to the extra utility a consumer gets from
one additional unit of a specific product. In a short period of
time, the marginal utility derived from successive units of a
given product will decline. This is known as diminishing
marginal utility.
• Figure 19.1 and the accompanying table illustrate the
relationship between total and marginal utility.
• Total utility increases as each additional tacos is purchased
through the first five, but utility rises at a diminishing rate
since each tacos adds less and less to the consumer’s
satisfaction.
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Copyright 2008 The McGraw-Hill Companies
Law of Diminishing Marginal Utility
(1)
(2)
(3)
Tacos
Total Marginal
Consumed Utility, Utility,
Per Meal Utils
Utils
2
3
4
5
6
7
0
10
18
24
]
]
]
]
28
]
30
]
30
]
28
10
8
4
2
0
-2
30
TR
20
10
0
6
Marginal Utility (Utils)
0
1
Total Utility (Utils)
Total Utility
1
2
3
4
5
6
Units Consumed Per Meal
Marginal Utility
10
8
6
4
2
0
-2
MU
1
2
3
4
5
6
Units Consumed Per Meal
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Copyright 2008 The McGraw-Hill Companies
7
7
• At some point, marginal utility becomes zero and then even
negative at the seventh unit and beyond. If more than six
tacos were purchased, total utility would begin to fall. This
illustrates the law of diminishing marginal utility.
• Theory of consumer behavior uses the law of diminishing
marginal utility to explain how consumers allocate their
income.
Consumer choice and the budget constraint:
• Consumers are assumed to be rational, i.e. they are trying to
get the most value for their money.
• Consumers have clear-cut preferences for various goods
and services and can judge the utility they receive from
successive units of various purchases.
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Copyright 2008 The McGraw-Hill Companies
• Consumers’ incomes are limited because their individual
resources are limited. Thus, consumers face a budget
constraint. (As we saw with the individual budget line in
Chapter 1)
• Goods and services have prices and are scarce relative to
the demand for them. Consumers must choose among
alternative goods with their limited money incomes.
Utility maximizing rule
•
Utility maximizing rule explains how consumers decide to
allocate their money incomes so that the last dollar spent
on each product purchased yields the same amount of
extra (marginal) utility.
• A consumer is in equilibrium when utility is “balanced (per
dollar) at the margin.” When this is true, there is no incentive
to alter the expenditure pattern unless tastes, income, or
prices change.
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Copyright 2008 The McGraw-Hill Companies
• Table 19.1 provides a numerical example of this for an
individual named Holly with $10 to spend. Follow the
reasoning process to see why 2 units of A and 4 of B will
maximize Holly’s utility, given the $10 spending limit.
• It is marginal utility per dollar spent that is equalized; that is,
consumers compare the extra utility from each product with
its cost.
• As long as one good provides more utility per dollar than
another, the consumer will buy more of the first good; as
more of the first product is bought, its marginal utility
diminishes until the amount of utility per dollar just equals
that of the other product.
• Table 19.2 summarizes the step-by-step decision-making
process the rational consumer will pursue to reach the
utility-maximizing combination of goods and services
attainable.
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Copyright 2008 The McGraw-Hill Companies
Theory of Consumer Behavior
Numerical Example:
Utility-Maximizing Combination of Products
A and B Obtainable with an Income of $10
(1)
Unit of
Product
(2)
Product A:
Price = $1
(b)
Marginal
(a)
Marginal
Utility
Utility,
Per Dollar
Utils
(MU/Price)
(3)
Product B:
Price = $2
(b)
Marginal
(a)
Marginal
Utility
Utility,
Per Dollar
Utils
(MU/Price)
First
10
10
24
12
Second
8
8
20
10
Third
7
7
18
9
Compare
Marginal
Utilities
Fourth
6
6
16
8
Then
Compare
Per 5Dollar - MU/Price
Fifth
5
12
6
Choose
the4Highest4
Sixth
6
3
Check
- Proceed
to Next
Item2
Seventh Budget
3
3
4
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Copyright 2008 The McGraw-Hill Companies
Theory of Consumer Behavior
Numerical Example:
Utility-Maximizing Combination of Products
A and B Obtainable with an Income of $10
(1)
Unit of
Product
(2)
Product A:
Price = $1
(b)
Marginal
(a)
Marginal
Utility
Utility,
Per Dollar
Utils
(MU/Price)
(3)
Product B:
Price = $2
(b)
Marginal
(a)
Marginal
Utility
Utility,
Per Dollar
Utils
(MU/Price)
First
10
10
24
12
Second
8
8
20
10
Third
7
7
18
9
Again,
Compare
Per6 Dollar -16
MU/Price8
Fourth
6
Choose
the5Highest5
Fifth
12
6
Buy
Has
Sixth One of 4Each – Budget
4
6 $5 Left
3
Proceed
to 3Next Item
Seventh
3
4
2
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Copyright 2008 The McGraw-Hill Companies
Theory of Consumer Behavior
Numerical Example:
Utility-Maximizing Combination of Products
A and B Obtainable with an Income of $10
(1)
Unit of
Product
(2)
Product A:
Price = $1
(b)
Marginal
(a)
Marginal
Utility
Utility,
Per Dollar
Utils
(MU/Price)
(3)
Product B:
Price = $2
(b)
Marginal
(a)
Marginal
Utility
Utility,
Per Dollar
Utils
(MU/Price)
First
10
10
Second
8
8
Third
7
7
Fourth
6
6
Again,
Compare
Per5 Dollar
Fifth
5
Buy
B – 4Budget
Sixth One More
4
Proceed
to 3Next Item
Seventh
3
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Copyright 2008 The McGraw-Hill Companies
24
12
20
10
18
9
16
8
-12
MU/Price6
Has
6 $3 Left
3
4
2
Theory of Consumer Behavior
Numerical Example:
Utility-Maximizing Combination of Products
A and B Obtainable with an Income of $10
(1)
Unit of
Product
(2)
Product A:
Price = $1
(b)
Marginal
(a)
Marginal
Utility
Utility,
Per Dollar
Utils
(MU/Price)
(3)
Product B:
Price = $2
(b)
Marginal
(a)
Marginal
Utility
Utility,
Per Dollar
Utils
(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
Again,
Compare
Per4 Dollar - MU/Price
Sixth
4
6
3
Buy
One of 3Each – 3Budget Exhausted
Seventh
4
2
19-12
Copyright 2008 The McGraw-Hill Companies
Theory of Consumer Behavior
Numerical Example:
Utility-Maximizing Combination of Products
A and B Obtainable with an Income of $10
(1)
Unit of
Product
(2)
Product A:
Price = $1
(b)
Marginal
(a)
Marginal
Utility
Utility,
Per Dollar
Utils
(MU/Price)
(3)
Product B:
Price = $2
(b)
Marginal
(a)
Marginal
Utility
Utility,
Per Dollar
Utils
(MU/Price)
First
10
10
24
12
Second
8
8
20
10
Third
7
7
18
9
Fourth
6
6
16
8
Fifth
5
12
6
Final
Result
– At 5These Prices,
Sixth
4
4
6
3
Purchase
2 of Item
Seventh
3
3 A and 44 of B 2W 19.1
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Copyright 2008 The McGraw-Hill Companies
Algebraic Restatement:
MU of Product A
Price of A
8 Utils
$1
=
=
MU of Product B
Price of B
16 Utils
$2
Optimum Achieved - Money Income is
Allocated so that the Last Dollar Spent on Each
Product Yields the Same Extra or Marginal Utility
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Copyright 2008 The McGraw-Hill Companies
Utility Maximization and the Demand Curve
•
Determinants of an individual’s demand curve are tastes,
income, and prices of other goods.
•
Deriving the demand curve can be illustrated using item B
in Table 19.1 and considering alternative prices at which B
might be sold. At lower prices, using the utility-maximizing
rule, we see that more will be purchased as the price falls.
•
The utility-maximizing rule helps to explain the substitution
effect and the income effect.
• When the price of an item declines, the consumer will no
longer be in equilibrium until more of the item is purchased
and the marginal utility of the item declines to match the
decline in price. More of this item is purchased rather than
another relatively more expensive substitute.
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Copyright 2008 The McGraw-Hill Companies
• The income effect is shown by the fact that a decline in price
expands the consumer’s real income and the consumer must
purchase more of this and other products until equilibrium is
once again attained for the new level of real income.
19-16
Copyright 2008 The McGraw-Hill Companies
Deriving the Demand Curve
Same Numeric Example:
Price Per Quantity
Unit of B Demanded
$2
4
1
6
Price of Product B
2
1
Income Effects
DB
0
Substitution Effects
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Copyright 2008 The McGraw-Hill Companies
4
6
Quantity Demanded of BO 19.2
Applications and Extensions
A. The digital versatile disk (DVD) takeover:
1. DVDs and DVD players entered the video media market in
1997. Around 320,000 players were sold in the U.S. that
year. In 2002, 17 million were sold, and the total number of
DVD players in the U.S. reached 48 million.
a. Preferences changed due to improved quality and the
amount of video and sound available on one DVD.
b. DVD player prices fell from over $1,000 or more to under
$100. This led to increased purchases of DVDs (a
complementary good).
c. DVDs and videocassettes (VCs) are substitutes.
2. DVD players and DVDs have a higher ratio of marginal utility
to price than do VCRs players and VCs. To maximize their
utility, consumers will switch from VCs to DVDs.
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Copyright 2008 The McGraw-Hill Companies
The diamond-water paradox:
1. Before marginal analysis, economists were puzzled by the
fact that some essential goods like water had lower prices
than luxuries like diamonds.
2. The paradox is resolved when we look at the abundance of
water relative to diamonds.
3. Theory tells us that consumers should purchase any good
until the ratio of its marginal utility to price is the same as that
ratio for all other goods.
a. The marginal utility of an extra unit of water may be low as is
its price, but the total utility derived from water is very large.
b. The total utility of all water consumed is much larger than the
total utility of all diamonds purchased.
c. However, society prefers an additional diamond to an
additional drop of water, because of the abundant stock of
water available.
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Time has a value,
• so this must be considered in decision-making and utility
maximization. The total price of an item must include the
value of the time spent in consuming the product, i.e., the
wage value of an hour of time. When time is considered,
consumer behavior appears to be much more rational.
1. Highly paid doctors may not spend hours hunting for
bargains because their time is more valuable than the
money to be saved from finding the best buy.
2. Foreigners observe that Americans waste material goods
but conserve time. This could be because our high
productivity makes our time more valuable than many of
the goods we waste.
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Copyright 2008 The McGraw-Hill Companies
Buying medical care or eating at a buffet:
1. Most Americans have health insurance for which they pay a
fixed monthly premium, which covers, say, 80 percent of
their health care costs. Therefore, the cost of obtaining
care is only 20 percent of its stated price for the insured
patient.
2. Following the law of demand, people purchase a larger
quantity of medical care than if they had to pay the full price
for each visit.
3. If you buy a meal at an “all-you-can-eat” buffet, you eat
more than if you paid separately for each item.
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Copyright 2008 The McGraw-Hill Companies
Cash and non-cash gifts:
1. Non-cash gifts may yield less utility to the receiver than a
cash gift of equal monetary value because the noncash gift
may not match the receiver’s preferences.
2.
Individuals know their own preferences better than the gift
giver.
3.
Look back at Table 19.1. If Holly had no income and was
given $2 worth, she would rather have the cash transfer to
spend on B than to be given 2 units of A. (She gets more
utility or satisfaction by spending her $2 on B.)
19-22
Copyright 2008 The McGraw-Hill Companies
LAST WORD: Criminal Behavior
A. The theory of consumer behavior can provide some useful
insights into criminal behavior.
B. A person who steals from a store imposes uncompensated costs
on others – the store owner, customers.
C. Whereas a person who is thinking about buying an item weighs
the cost (the price) and the benefit (utility) of a particular
purchase, a person who steals also weighs the cost and benefit
of stealing the item.
D. The cost to the potential criminal is the possible guilt felt, the
tools of the trade, the income forgone while engaging in an
illegitimate activity, and possible fines and imprisonment. The
potential criminal will engage in criminal behavior if the benefits
exceed the costs.
E. Society can reduce criminal behavior by increasing the cost of
guilt through family, educational, and religious efforts and by
increasing the direct costs by using more sophisticated security
systems. Society can also increase the penalties on those who
are19-23
caught.
Copyright 2008 The McGraw-Hill Companies
Key Terms
•
•
•
•
•
•
•
•
•
law of diminishing marginal utility
utility
total utility
marginal utility
rational behavior
budget constraint
utility-maximizing rule
income effect
substitution effect
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Copyright 2008 The McGraw-Hill Companies
Indifference Curve Analysis
Appendix
• Budget Line (Constraint)
–Income Changes
–Price Changes
12
Indifference
Curve Analysis
Demand Curve
Appendix Terms
(Price = $1.50)
(Price = $1)
Expenditure
8
6
4
2
0
0
3
6
9
12
$12
12
12
12
12
10
Quantity of A
Total
Units of A Units of B
Income = $12
PA = $1.50
8
(Unattainable)
6
Income = $12
PB = $1
4
2
0
(Attainable)
2
4
6
8
10
12
Quantity of B
Return to Chapter 19
19-25
Copyright 2008 The McGraw-Hill Companies
Indifference Curve Analysis
• What is Preferred
Appendix
– Downsloping
– Convex to Origin
– Marginal Rate of Substitution
(MRS)
12
j
Indifference
Curve Analysis
Demand Curve
Appendix Terms
j
12
2
k
6
4
l
4
6
m
3
8
10
Quantity of A
Combination Units of A Units of B
8
k
6
l
4
m
2
0
I
2
4
6
8
10
12
Quantity of B
O 19.4
Return to Chapter 19
19-26
Copyright 2008 The McGraw-Hill Companies
Indifference Curve Analysis
Appendix
• The Indifference Map
• Equilibrium Position at Tangency
12
10
Quantity of A
MRS =
Indifference
Curve Analysis
Demand Curve
Appendix Terms
8
6
W
X
4
PB
PA
Preferred –
But Requires
More Income
I4
2
0
I3
I1
2
4
6
8
Quantity of B
10
I2
12
Return to Chapter 19
19-27
Copyright 2008 The McGraw-Hill Companies
Derivation of the Demand Curve
12
Quantity of A
Appendix
• Measurement of Utility
10
Marginal Utility
of A
8
Price of A
6
X
4
2
I2
Indifference
Curve Analysis
Demand Curve
Appendix Terms
Price of B
0
2
4
6
8
10
Quantity of B
12
$1.50
1.00
.50
DB
1 2 3 4 5 6 7 8 9 1011 12
Quantity of B
19-28
Copyright 2008 The McGraw-Hill Companies
I3
=
Marginal Utility
of B
Price of B
At $1 Price for B,
6 Units are Purchased
Record the Results
As Price of B Increases
to $1.50,
Only 3 Units of B are
Bought
Record the Results
Connect the Points to
Create the Demand
Curve
Return to Chapter 19
Next Chapter Preview…
The Costs of
Production
Indifference
Curve Analysis
Demand Curve
Appendix Terms
Return to Chapter 19
19-29
Copyright 2008 The McGraw-Hill Companies
Law of Diminishing Marginal Utility
• Terminology
–Utility
–Total Utility
–Marginal Utility
O 19.1
G 19.1
• Marginal Utility and Demand
Graphically…
19-30
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