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Consumer Behavior and

Utility Maximization
THE LAW OF DEMAND
A Closer Look…
The Income Effect
A lower price frees income
for additional purchases -
and vice versa
The Substitution Effect
A lower price relative to other
goods attracts new buyers -
and vice versa
LAW OF DIMINISHING
MARGINAL UTILITY
• Utility Defined
• Subjective Nature
• Difficult to Quantify
Total Utility
Marginal Utility
graphically examined..
TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)


per meal Utils Utils
20
0 0
1 10 10

0 1 2 3 4 5 6 7

Units consumed per meal

Marginal Utility (utils)


10
8
6
4
2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)


per meal Utils Utils
20
0 0
10
1 10 10

0 1 2 3 4 5 6 7

Units consumed per meal

Marginal Utility (utils)


10
8
6
4
2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)


per meal Utils Utils
20
0 0
10
1 10 10

8
2 18
0 1 2 3 4 5 6 7

Units consumed per meal

Marginal Utility (utils)


10
8
6
4
2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)


per meal Utils Utils
20
0 0
10
1 10 10

8
2 18
6
3 24 0 1 2 3 4 5 6 7

Units consumed per meal

Marginal Utility (utils)


10
8
6
4
2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)


per meal Utils Utils
20
0 0
10
1 10 10

8
2 18
6
3 24 0 1 2 3 4 5 6 7

4
4 28
Units consumed per meal

Marginal Utility (utils)


10
8
6
4
2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)


per meal Utils Utils
20
0 0
10
1 10 10

8
2 18
6
3 24 0 1 2 3 4 5 6 7

4
4 28
Units consumed per meal

Marginal Utility (utils)


10
2 8
5 30 6
4
2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
TOTAL AND MARGINAL UTILITY
Tacos Total Marginal
consumed Utility, Utility, 30

Total Utility (utils)


per meal Utils Utils
20
0 0
10
1 10 10

8
2 18
6
3 24 0 1 2 3 4 5 6 7

4
4 28
Units consumed per meal

Marginal Utility (utils)


10
2 8
5 30 6
0 4
6 30 2
0
-2
1 2 3 4 5 6 7
Units consumed per meal
TOTAL AND MARGINAL UTILITY
Tacos Total Marginal TU
consumed Utility, Utility, 30

Total Utility (utils)


per meal Utils Utils
20
0 0
10
1 10 10

8
2 18
6
3 24 0 1 2 3 4 5 6 7

4
4 28
Units consumed per meal

Marginal Utility (utils)


10
2 8
5 30 6
0 4
6 30 2
-2 0
MU
7 28 -2
1 2 3 4 5 6 7
Units consumed per meal
TOTAL AND MARGINAL UTILITY
Tacos Total Marginal TU
consumed Utility, Utility, 30

Total Utility (utils)


per meal Utils Utils

0 0
20
Observe
10 Diminishing
1 10 10

8
2 18 Marginal
6
3 24 0 1
Utility
2 3 4 5 6 7

4
4 28
Units consumed per meal

Marginal Utility (utils)


10
2 8
5 30 6
0 4
6 30 2
-2 0
MU
7 28 -2
1 2 3 4 5 6 7
Units consumed per meal
THEORY OF CONSUMER BEHAVIOR
Consumer Choice and
Budget Constraint
• Rational Behavior
• Clear-Cut Preferences
• Subject to a Budget
Constraint
• Responds to Price
Changes
THEORY OF CONSUMER BEHAVIOR
Utility Maximizing Rule
The consumer’s money
income should be allocated
so that the last dollar spent
on each product yields the
same amount of extra
(marginal) utility.
Illustrated...
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)

First 10 10 24 12

How should the $10


income be allocated?
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)

First 10 10 24 12

Examine the two


marginal utilities
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)

First 10 10 24 12

Examine the two


marginal utilities
…per dollar
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)

First 10 10 24 12

Decision: Buy 1
Product B for $2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth What
6 next?
6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth What
6 next?
6 16 8
Fifth 5 5 12 6
Buy one of each
Sixth 4 4 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth
and
5
then...
5 12 6
Sixth ($5 left)
4 4 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth third
5 unit
5 of
12 6
Sixth product
4 4 B 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6
$3 left... 6 16 8
Fifth 5 5 12 6
Sixth 4 4 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6
$3 left... 6 16 8
Fifth 5 5 12 6
Buy
Sixth both!
4 4 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION
Product A: Product B:
$ 10 income Price = $1 Price = $2
Marginal Marginal
Marginal utility per Marginal utility per
Unit of utility, dollar utility, dollar
product utils (MU/price) utils (MU/price)

First 10 10 24 12
Second 8 8 20 10
Third 7
Income is gone... 7 18 9
Fourth
the last dollar 6spent on6 16 8
each good gave the same
Fifth 5 5 12 6
utility (8) per dollar
Sixth 4 4 6 3
Seventh 3 3 4 2
UTILITY MAXIMIZING COMBINATION

Algebraic Restatement of the


Utility Maximization Rule

MU of product A MU of product B

Price of A
= Price of B

8 Utils 16 Utils

$1
= $2
UTILITY MAXIMIZATION AND
THE DEMAND CURVE
Deriving the Demand Schedule
and Curve
Given from the previous example schedule:
• Preferences or Tastes
• Money Income
• Prices of Other Goods
UTILITY MAXIMIZATION AND
THE DEMAND CURVE
Deriving the Demand Schedule
and Curve
Create a demand schedule from the
purchase decisions as the price of
the product is varied ...
Price per unit of B Quantity Demanded
$2 4
1 6
Graphically…
UTILITY MAXIMIZATION AND
THE DEMAND CURVE
Deriving the Demand Schedule
and Curve

Price per unit of Good B


$2

DB
0
4 6
Quantity Demanded of Good B
UTILITY MAXIMIZATION AND
THE DEMAND CURVE
Deriving the Demand Schedule
and Curve
Income
$2
and
Price per unit of Good B
Substitution Effects
Revisited
1

DB
0
4 6
Quantity Demanded of Good B
APPLICATIONS AND EXTENSIONS

• DVDs and DVD Players


• The Diamond-Water
Paradox
• The Value of Time
• Medical Care
Purchases
• Cash and Noncash
Gifts
DVDs and DVD Players
 DVD and DVD players made their debut in 1997 in
the U.S
 In 2002 the annual sales reached 17 million and the
cumulative number of players in the U.S was 48
million.
 Although the price of dvds has declined slightly the
price of dvd players has nose-dived. Now they sell
for as low as 40$.
 Dvd and dvd players are complementary goods. The
lower price of dvd players has increased demand of
dvd movies.
 Dvd and video cassettes are substitutes. Has lead to
substitution away from videos to dvds because of
greater satisfaction.
 Therefore dvds have higher ratio of MU and price
compared to VC’s.

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