Consumer Behavior
• We have already seen and used an individual’s demand curve. Now, want to explain in more detail why it slopes downward
• Why do people demand goods and services? • Receive satisfaction or pleasure from consuming the good. • Economists terms this satisfaction utility.
Introduction • In economics, we are not try to explain why people get utility from certain goods. We take that as a given. • Example: • Some people like jazz, others hate it. • Economists say given an individual’s preferences about jazz, how many jazz music CD’s might they purchase.
Utility The concept of utility can be looked upon from two angles—from the commodity angle and from the consumer’s angle. Looked at it from a commodity angle, utility is the wantsatisfying property of a commodity. Looked at it from a consumer’s angle, utility is the psychological feeling of satisfaction, pleasure, happiness or well-being which a consumer derives from the consumption, possession or the use of a commodity.
Total Utility Assuming that utility is measurable and additive, total utility may be defined as the sum of the utilities derived by a consumer from the various units of goods and services he consumes. Suppose a consumer consumes four units of a commodity, X, at a time and derives utility as u1, u2, u3 and u4. His total utility (TUx) from commodity X can be measured as follows. • TUx = u1 + u2 + u3 + u4
Marginal Utility Marginal utility is another most important concept used in economic analysis. Marginal utility may be defined may be defined as the addition to the total utility resulting from the consumption (or accumulation) of one additional unit. Marginal Utility (MU) thus refers to the change in the Total Utility (i.e., ΔTU) obtainedobtained from the consumption of an additional unit of a commodity. It may be expressed as MU = ^TU/^Q where TU = total utility, and ÄQ = change in quantity consumed by one unit. Another way of expressing marginal utility (MU), when the number of units consumed is n, can be as follows. MU of nth unit = TUn – TUn–1
Total and Marginal Utility • Total Utility (TU) - relates consumption of a good to the utility derived from consuming a good. (This could be many units of a good) • Marginal Utility (MU) - the change in total utility when consumption of a good changes by one unit. • MU = DTU / D Q consumed of a good
Diminishing marginal utility The law of diminishing marginal utility is one of the fundamental laws of economics. This law states that as the quantity consumed of a commodity increases, the utility derived from each successive unit decreases, consumption of all other commodities remaining the same. In simple words, when a person consumes more and more units of a commodity per unit of time, e.g., ice cream, keeping the consumption of all other commodities constant, the utility which he derives from the successive units of consumption goes on diminishing. This law applies to all kinds of consumer goods— durable and non-durable sooner or later.
Law of Diminishing Marginal Utility
• Law of Diminishing Marginal Utility eventually, a point is reached where the marginal utility obtained by consuming additional units of a good starts to decline, ceteris paribus.
Law of Diminishing Marginal Utility • Example • If I’m really hungry, I get a lot of satisfaction from first slice of pizza. • If I keep eating pizza, the satisfaction from the 8th slice would be much less than that of the first slice.
Law of Diminishing MU Notes about the Law of Diminishing MU • Time period must be specified for law. • Law tells us that eventually the marginal utility curve will be downward sloping. • Law tells us that eventually the total utility curve will become “flatter.” • Slope of the total utility curve is equal to marginal utility
Marginal Utility MU
MU
Q
Shape of MU • Eventually downward sloping • Law of diminishing marginal utility
• Positive always • Rational behavior • Consumer only purchases a good if they get some positive utility from it.
Assumptions The law of diminishing marginal utility holds only under certain conditions. These conditions are referred to as the assumptions of the law. The assumptions of the law of diminishing marginal utility are listed below. First, the unit of the consumer good must be a standard one, e.g., a cup of tea, a bottle of cold drink, a pair of shoes or trousers, etc. If the units are excessively small or large, the law may not hold. Second, the consumer’s taste or preference must remain the same during the period of consumption. Third, there must be continuity in consumption. Where a break in continuity is necessary, the time interval between the consumption of two units must be appropriately short. Fourth, the mental condition of the consumer must remain normal during the period of consumption. Given these conditions, the law of diminishing marginal utility holds universally
Total Utility TU TU
DQ
DTU
DTU DQ
Q
Shape of TU • Positive slope • Consumer only purchases a good if gets some positive amount of utility (rational behavior)
• Slope gets flatter as Q increases • Law of diminishing marginal utility
Consumer Equilibrium
Now that we understand the concepts of utility theory - we will use them to explain how consumers make decisions about what to buy
Consumer Equilibrium • For instance, I would much rather have a Jaguar instead of my Honda • If I want to maximize my utility, why don’t I buy a Jaguar? – Because it costs a lot more than the Honda
• So if I want to maximize my utility, I don’t just pick the thing that gives me the most pleasure. I have to weigh the price of the good in my decision as well
Consumer Equilibrium So how can I compare a Jaguar and a Honda? It’s like comparing apples and oranges. Instead, I need to somehow make them both comparable.
Consumer Equilbrium In order to do that I will need to convert utility to utility per dollar. This way, I can see that even though the Jag gives me more utility, I get more utility per dollar from the Honda. So if I want to spend my money wisely, I buy the thing that gives me more utility per dollar.
Consumer Surplus • Consumer Surplus - the difference between the price buyers pay for a good and the maximum amount they would have paid for the good. • Example: • I’m willing to pay $6 for a case of soda • Soda is on sale for $5 a case • Consumer surplus = $1
Consumer Surplus P $9
This is the Consumer Surplus for the second case of soda
S
$7
$5 D 0
1 2
3
Q
Consumer Surplus
Here is the generally accepted method of finding the total Consumer Surplus in a market
Consumer Surplus P
The area of this triangle is the total Consumer Surplus
S
P* D 0
Q*
Q
The Theory of Consumer Behavior The principle assumption upon which the theory of consumer behavior and demand is built is: a consumer attempts to allocate his/her limited money income among available goods and services so as to maximize his/her utility (satisfaction).
Theories of Consumer Choice • The Cardinal Theory – Utility is measurable in a cardinal sense
• The Ordinal Theory – Utility is measurable in an ordinal sense
The Cardinal Approach Nineteenth century economists, such as Jevons, Menger and Walras, assumed that utility was measurable in a cardinal sense, which means that the difference between two measurement is itself numerically significant. UX = f (X), UY = f (Y), ….. Utility is maximized when: MUX / MUY = PX / PY
The Ordinal Approach Economists following the lead of Hicks, Slutsky and Pareto believe that utility is measurable in an ordinal sense--the utility derived from consuming a good, such as X, is a function of the quantities of X and Y consumed by a consumer. U = f ( X, Y )
Assumptions of the Ordinal Utility Approach • • • • •
Complete Ordering; More is Preferred to Less; Transitivity or Consistency; Substitutability or Continuity; and Optimality
Tools of the Ordinal Approach • The Budget Line – Budget line illustrates the consumer’s income constraint by showing all of the combinations of quantities of X and Y that the consumer can buy.
• The Indifference Curves – Indifference curves reveal consumer’s preferences for X and Y by identifying the combinations of X and Y which yield the same level of total utility.
Indifference Curve Analysis
Sophie’s Choice • Sophie eats chocolate bars and drinks soda. • She wants to maximize her utility given a budget constraint.
Graphing the Budget Constraint • Chocolate bars cost $1 and sodas cost 50 cents each. • Sophie has $10 to spend. • She can buy 10 chocolate bars or 20 sodas or some combination of each.
Graphing the Budget Constraint
Graphing the Budget Constraint • The slope of the budget constraint is the ratio of the prices of the two goods. n
The slope changes when the prices change.
Graphing the Indifference Curve • Indifference curve – a curve that shows combinations of goods among which an individual is indifferent. • The slope of the indifference curve is the ratio of marginal utilities of the two goods.
Graphing the Indifference Curve • The absolute value of the slope of an indifference curve is called the marginal rate of substitution.
Graphing the Indifference Curve • Marginal rate of substitution – the rate at which one good must be added when the other is taken away in order to keep the individual indifferent between the two combinations.
Graphing the Indifference Curve • Indifference curves are downward sloping and bowed inward.
Graphing the Indifference Curve • Law of diminishing marginal rate of substitution – as you get more and more of a good, if some of that good is taken away, then the marginal addition of another good you need to keep you on your indifference curve gets less and less.
Graphing the Indifference Curve
A Group of Indifference Curves • Sophie will have a whole group of indifference curves, each representing a different level of happiness.
A Group of Indifference Curves • If she prefers more to less, she is better off with the indifference curve that is farthest to the right.
A Group of Indifference Curves
Why Indifference Curves Cannot Cross • If indifference curves crossed, it would violate the “prefer-more-to-less” principle.
Indifference Curves and Budget Constraints • Sophie will maximize her utility by consuming on the highest indifference curve as possible, given her budget constraint.
Indifference Curves and Budget Constraints • The best combination is the point where the indifference curve and the budget line are tangent.
Indifference Curves and Budget Constraints • The best combination is the point where the slope of the budget line equals the slope of the indifference curve. PS MU S MU C MU S so that PC MU C PC PS
Indifference Curves and Budget Constraints
Deriving a Demand Curve from the Indifference Curve • Demand is the quantity of a good that a person will buy at various prices.
Deriving a Demand Curve from the Indifference Curve • The point of tangency of the indifference curve and the budget line gives the quantity that a person would buy at a given price.
Deriving a Demand Curve from the Indifference Curve • By varying the price of one of the goods while holding the price of other constant, the points of tangency will change. n
This gives alternative price/quantity combinations.
Deriving a Demand Curve from the Indifference Curve
Characteristics of Indifference Curves
• • • •
Indifference Curves are: Continuous and Everywhere Dense; Negatively Sloped; Convex from the Origin; and Indifference Curves Do Not Intersect.
Preference Theory The main merit of the revealed preference theory is that the ‘law of demand’ can be directly derived from the revealed preference axioms without using indifference curves and most of the restrictive assumptions. What is needed is simply to record the observed behaviour of the consumer in the market. The consumer reveals his behaviour by the basket of goods a consumer buys at different prices
Assumptions 1. Rationality. The consumer is assumed to be a rational being. In his order of preferences, the prefers a larger basket of goods to the smaller ones. 2. Transitivity. Consumer’s preferences are assumed to be transitive. That is, given alternative baskets of goods, A, B and C, if he considers A > B and B > C, then he considers A > C. 3. Consistency. It is also assumed that during the analysis consumer’s taste remains constant and consistent. Consistency implies that if a consumer, given his circumstances, prefers A to B he will not prefer B to A under the same conditions. 4. Effective Price Inducement. Given the collection of goods, the consumer can be induced to buy a particular collection by providing him sufficient price incentives. That is, for each collection, there exists a price line which makes it attractive for the consumer.
The Elasticity of Demand
The Concept of Elasticity • Elasticity is a measure of the responsiveness of one variable to another. • The greater the elasticity, the greater the responsiveness.
The Concept of Elasticity • Elasticity is a measure of the responsiveness of one variable to another. • The greater the elasticity, the greater the responsiveness.
Price Elasticity • The price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price.
Percentage change in quantity demanded ED = Percentage change in price
Sign of Price Elasticity • According to the law of demand, whenever the price rises, the quantity demanded falls. Thus the price elasticity of demand is always negative.
• Because it is always negative, economists usually state the value without the sign.
What Information Price Elasticity Provides • Price elasticity of demand and supply gives the exact quantity response to a change in price.
Classifying Demand and Supply as Elastic or Inelastic • Demand is elastic if the percentage change in quantity is greater than the percentage change in price.
E>1
Classifying Demand and Supply as Elastic or Inelastic • Demand is inelastic if the percentage change in quantity is less than the percentage change in price.
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