McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Consumer Behavior

Chapter 7

Chapter Objectives

• Total utility and marginal utility• Law of diminishing marginal utility• Marginal utility-to-price ratios • Deriving the demand curve • Income and substitution effects • Appendix: the indifference curve

model

7-2

Utility

• Diminishing marginal utility (again)

• Satisfaction obtained from consumption

• Three characteristics–Differs from usefulness–Subjective–Difficult to quantify

7-3

Utility

• Total utility–Total satisfaction from a specific

quantity• Marginal utility

–Extra satisfaction from an additional unit

• Law of diminishing marginal utility –Explains downward sloping

demand7-4

Utility Graphically

0

10

20

30

1086420

-2

1 2 3 4 5 6 7

1 2 3 4 5 6 7

To

tal U

tilit

y (U

tils

)M

arg

inal

Uti

lity

(Uti

ls)

(1)Tacos

ConsumedPer Meal

(2)Total

Utility,Utils

(3)MarginalUtility,Utils

0

1

2

3

4

5

6

7

0

10

18

24

28

30

30

28

]]]]]]]

10

8

6

4

2

0

-2

TU

MU

Total Utility

Marginal Utility

Units Consumed Per Meal

Units Consumed Per Meal

7-5

Theory of Consumer Behavior

• Key dimensions of the consumer problem–Rational behavior–Preferences –Budget constraint–Prices

7-6

Theory of Consumer Behavior

• Find utility maximizing combination of goods

• Utility maximizing rule–Allocate income–Last dollar spent on each

good yields same marginal utility

–Marginal utility per dollar

7-7

Numerical ExampleCombinations of apples and oranges obtainable with an income of $10

(1)Unit of

Product

(a)MarginalUtility,Utils

(a)MarginalUtility,Utils

(b)Marginal

UtilityPer Dollar(MU/Price)

(b)Marginal

UtilityPer Dollar(MU/Price)

(2)Apple (product A)

Price = $1

(3)Orange (product B)

Price = $2

First

Second

Third

Fourth

Fifth

Sixth

Seventh

10

8

7

6

5

4

3

24

20

18

16

12

6

4

10

8

7

6

5

4

3

12

10

9

8

6

3

2

Compare marginal utilitiesThen compare per dollar - MU/PriceChoose the highestCheck budget - proceed to next item

7-8

Numerical ExampleCombinations of apples and oranges obtainable with an income of $10

(1)Unit of

Product

(a)MarginalUtility,Utils

(a)MarginalUtility,Utils

(b)Marginal

UtilityPer Dollar(MU/Price)

(b)Marginal

UtilityPer Dollar(MU/Price)

(2)Apple (product A)

Price = $1

(3)Orange (product B)

Price = $2

First

Second

Third

Fourth

Fifth

Sixth

Seventh

10

8

7

6

5

4

3

24

20

18

16

12

6

4

10

8

7

6

5

4

3

12

10

9

8

6

3

2

Again, compare per dollar - MU/PriceChoose the highestBuy one of each – budget has $5 leftProceed to next item

7-9

Numerical ExampleCombinations of apples and oranges obtainable with an income of $10

(1)Unit of

Product

(a)MarginalUtility,Utils

(a)MarginalUtility,Utils

(b)Marginal

UtilityPer Dollar(MU/Price)

(b)Marginal

UtilityPer Dollar(MU/Price)

(2)Apple (product A)

Price = $1

(3)Orange (product B)

Price = $2

First

Second

Third

Fourth

Fifth

Sixth

Seventh

10

8

7

6

5

4

3

24

20

18

16

12

6

4

10

8

7

6

5

4

3

12

10

9

8

6

3

2

Again, compare per dollar - MU/PriceBuy one more orange – budget has $3 leftProceed to next item

7-10

Numerical ExampleCombinations of apples and oranges obtainable with an income of $10

(1)Unit of

Product

(a)MarginalUtility,Utils

(a)MarginalUtility,Utils

(b)Marginal

UtilityPer Dollar(MU/Price)

(b)Marginal

UtilityPer Dollar(MU/Price)

(2)Apple (product A)

Price = $1

(3)Orange (product B)

Price = $2

First

Second

Third

Fourth

Fifth

Sixth

Seventh

10

8

7

6

5

4

3

24

20

18

16

12

6

4

10

8

7

6

5

4

3

12

10

9

8

6

3

2

Again, compare per dollar - MU/PriceBuy one of each – budget exhausted

7-11

Numerical ExampleCombinations of apples and oranges obtainable with an income of $10

(1)Unit of

Product

(a)MarginalUtility,Utils

(a)MarginalUtility,Utils

(b)Marginal

UtilityPer Dollar(MU/Price)

(b)Marginal

UtilityPer Dollar(MU/Price)

(2)Apple (product A)

Price = $1

(3)Orange (product B)

Price = $2

First

Second

Third

Fourth

Fifth

Sixth

Seventh

10

8

7

6

5

4

3

24

20

18

16

12

6

4

10

8

7

6

5

4

3

12

10

9

8

6

3

2

Final result – at these prices, purchase 2 apples and 4 oranges

7-12

Algebraic Generalization

MU of product A

price of A

MU of product B

price of B=

8 Utils

$1

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

7-13

Pri

ce

of

Pro

du

ct

B

0

1

2

4 6

Quantity Demanded of B

Deriving the Demand Curve

$2

1

4

6

Price Per Unit of B

QuantityDemanded

DBIncome Effects

Substitution Effects7-14

Applications and Extensions

• New products increase utility

–iPods

• The diamond-water paradox

• The value of time

• Medical care purchases

• Cash and noncash gifts

7-15

Behavioral Economics

• Human instinct for variety• Consume more when there

is more variety–M&Ms

• Time inconsistency–Final exams–Retirement savings

7-16

Key Terms

• Law of diminishing marginal utility• Utility• Total utility• Marginal utility• Rational behavior• Budget constraint• Utility maximizing rule• Income effect• Substitution effect

7-17

Next Chapter Preview…

The Costs ofProduction

7-18

The Budget Line

–Income changes–Price changes

2 4 6 8 10 12

Qu

anti

ty o

f A

6

8

10

12

4

2

0

Quantity of B

Units of A(Price = $1.50)

Units of B(Price = $1)

TotalExpenditure

8

6

4

2

0

0

3

6

9

12

$12

12

12

12

12(Attainable)

(Unattainable)

Income = $12PA = $1.50

Income = $12PB = $1

7-19

Indifference CurvesWhat is preferred

– Downsloping and convex– Marginal rate of substitution

2 4 6 8 10 12

Qu

anti

ty o

f A

6

8

10

12

4

2

0

Quantity of B

Combination Units of A Units of B

j

k

l

m

12

6

4

3

2

4

6

8

j

k

lm

I

7-20

Indifference Curve Analysis• The indifference map• Equilibrium position at tangency

2 4 6 8 10 12

Qu

anti

ty o

f A

6

8

10

12

4

2

0

Quantity of B

I1

I2

I3

I4

X

WPreferred – But RequiresMore Income

MRS = PB

PA

7-21

Demand Curve Derived

Pri

ce o

f B

$1.50

1.00

.50

2 4 6 8 10 12Quantity of B

X

2 4 6 8 10 12

Qu

anti

ty o

f A

6

8

10

12

4

2

0

Quantity of B

I2

I3

DB

At $1 price for B, 6 units of B 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 tocreate the demand curve for B 7-22

Appendix Key Terms

• Budget Line

• Indifference curve

• Marginal rate of substitution (MRS)

• Indifference map

• Equilibrium position

7-23

Next Chapter Preview…

The Costs ofProduction

7-24