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Chapter 6Consumer Behavior

Microeconomics

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Chapter 6 More of the law of demand

The substitution effect The income effect

Utility Law of diminishing marginal utility Total and Marginal Utility Maximizing utility subject to a budget constraint Utility Maximization and Demand Indifference curves and budget constraint curves

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Learning objectives Discuss how the income effect and substitution

effect lead to a downward sloping demand curve. Explain why marginal utility diminishes. Practice the step by step utility-maximizing process. Apply the rule of utility maximization Relate utility maximization to the demand curve. Understand indifference curves and budget

constraints.

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Law of demand revisited When we studied demand, we saw it was downward

sloping

Here are 2 effects that affect demand:

1. The substitution effect – a lower price of a good causes a person to buy more of that good instead of alternative goods.

2. The income effect – the change in the quantity demanded caused by a price change’s effect on real income which measure’s a person’s purchasing power.

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The substitution effect

At higher prices, people buy less of a good; at lower prices, people buy more of a good

One reason for this is the substitution effect When the price of a good falls, people will

substitute that good for alternative goods The opportunity cost of buying this good has

now decreased

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The substitution effect At higher prices, people will buy more of a substitute

good than the good with the higher price The opportunity cost of buying the higher priced

good has increased If the price of Nike shoes increases, people will start

to buy Adidas and Reebok instead, substituting away from Nike

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The income effect For a normal good, the income effect also

causes demand to be downward sloping When the price of a good decreases, your

real income (purchasing power) increases You can now buy more of everything

THE HICKSIAN METHOD

X2

X1

I1

I2

xa xc xb

Sub Effect

IncomeEffect

EaEb

Ec

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HICKSIAN ANALYSIS and DEMAND CURVES

22111 xpxpM

P1

P1*

22111 xpxpM A

A

B

B

C

Hicksian Demand Curve (A & C)

Marshallian Demand Curve (A & B)

P

X1

X1

P

A fall in price from p1 to p1

*

C

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HICKSIAN ANALYSIS and DEMAND CURVES

Hicksian (compensated) demand curves cannot be upward-sloping (i.e. substitution effect cannot be positive)

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Utility Before, we looked at the idea of marginal

benefit and consumer surplus We saw that marginal benefit was the

additional value that one received from consuming one more unit of a good

A similar (almost exact same!) concept is utility

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Utility Why do we buy goods? In order to gain utility Utility – satisfaction received from

consumption of a good. (This satisfaction can translate directly to the

value, or marginal benefit, we get from the good)

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Utility Though utility is not measurable, we can act as

though it were

We’ll use a “util” as a measure of the amount of utility we get from consuming a good

Util – unit of measurement of utility; used for illustration only.

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Utility Total utility – the satisfaction a person receives from

consuming a specific quantity of a good.

Marginal utility – the increments to total utility from changes in consumption.

In other words: it is the additional utility we get from consuming one more

unit of a good (You can see this is the same thing as marginal benefit)

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Total and Marginal Utility

Marginal Utility = Change in total utilityChange in number of

units consumed

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Total and Marginal Utility

0

50

100

150

Utils

First Slice Second Slice Pizza

Marginal utility

TotalUtility

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Law of diminishing marginal utility As we saw with marginal benefit, marginal

utility is going to be decreasing The first unit of a good is the most satisfying The second unit provides less utility The third even less utility Etc.

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Law of diminishing marginal utility

At the satiation point, there is no more utility from consuming additional units.

Satiation point – quantity for which an additional unit consumed provides zero marginal utility; associated with maximum total utility.

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Law of diminishing marginalutility If you continue to consume, you will actually

feel sick, experiencing negative utility, or disutility.

Disutility – a negative value for marginal utility; associated with consuming too much of a good.

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Total and Marginal Utility

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Utility

Utility

Satiation point

Satiation point

Total Utility is maximized whenmarginal utility is zero.

Total and Marginal Utility

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Maximizing utility subject to a budget constraint Consumers want to maximize their utility but

CANNOT spend more than their income The budget constraint, a consumer’s income, limits

the amount of total utility that a person can get Utility maximization is achieved when the

consumer’s choices provide the greatest amount of utility for a specific amount of income.

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Utility and Choice Each consumer allocates a specific budget to expenditure, and

then allocates the expenditure to maximize utility. Equimarginal principle: To maximize utility, consumers allocate

their incomes among goods so as to equate the marginal utilities per dollar (MU/P) of the expenditure on the last unit of each good purchased. This is also referred to as the consumer equilibrium.

X

X

movie

movie

gas

gas

CD

CD

PMU

PMU

PMU

PMU

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Maximizing utility subject to a budget constraint We can divide the marginal utility by price We will call this marginal utility per Rupee

The Rule Of Utility Maximixation: To maximize utility, a consumer adjusts

spending until the marginal utility from the last rupee spent on each good is the same.

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Algebraic Statement of the Utility Maximizing Rule

Marginal Utility of X Price of X =

Marginal Utility of YPrice of Y

If the marginal utility per rupee of product X is greaterthan the marginal utility per rupee of product, consumersshould purchase more of product X. Conversely, if the marginal per rupee of product Y is greater than the marginal utility of product Y, consumers shouldpurchase more of product Y.

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Maximizing utility subject to a budget constraint

1 2 3 4 5 6Number of

Movie Tickets Bought

Marginal Utility of Movies (in utils)

Marginal Utility per dollar for

movies (Marginal Uitlity/Price)

Number of Bottles of

Water Bought

Marginal Utility of Bottled Water

(in utils)

Marginal Utility per dollar for bottled water

(Marginal 1 30 10 1 8 82 27 9 2 7 73 24 8 3 6 64 18 6 4 5 55 8 2.67 5 4 46 1 0.33 6 3 3

DENISE’S PREFERENCES FOR MOVIES AND BOTTLED WATER[Price of movie ticket = $3; Price of water = $1 per bottle; Income = $15 per week]

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Maximizing utility subject to a budget constraint Denise will spend ALL of her money. Denise will buy four movie tickets and three

bottles of water. At this combination the utility per rupee she

receives from buying the last ticket is equal to the utility per rupee she receives from buying the last bottle of water, so her total utility is also maximized.

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Number of Movie Tickets Bought

Marginal Utility of Movies (in utils)

Marginal Utility per dollar , Price =

$3 (Marginal Uitlity/Price)

Marginal Utility per dollar, Price = $2

(Marginal Uitlity/Price)

1 30 10 152 27 9 13.53 24 8 124 18 6 95 8 2.67 46 1 0.33 0.5

A LOWER PRICE FOR MOVIE TICKETS INCREASES MARGINAL UTILITY PER DOLLAR

Utility Maximization and Demand

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$3

4 Quantity of movies

$

$2

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Utility maximization causes demand to slope downward.

Denise’s demand

Utility Maximization and Demand

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The Downward Slope of the Demand Curve Consumers allocate their income among goods and services in

order to maximize utility according to the equimarginal principle. A change in the price of any good disturbs the consumer’s

equilibrium—the ratio of MU to P on the last unit of each good will no longer be equal.

The consumer must reallocate income across goods. With income fixed, if the price of one good rises, the consumer is

able to buy fewer goods and services, causing demand to fall.

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Utility Maximization and Demand We now know three reasons why demand is

downward sloping: 1. The substitution effect 2. The income effect 3. The law of diminishing marginal utility

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Indifference Curves In economic terms, when people are

indifferent to the choices before them, they obtain the same amount of utility from each of those choices.

An indifference curve shows the combinations of two goods that provide an individual with equal amounts of utility.

An indifference curve slopes downward.

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Indifference Curves The marginal rate of substitution is the quantity of one

good that must be given up as the consumption of the other good increases by one unit and total utility remains constant.

The marginal rate of substitution can be expressed as:

Marginal rate of substitution

= Change in the consumption of one goodChange in the consumption of another good

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Indifference Curves So far we’ve only been focusing on one indifference

curve This curve has shown all the different combinations

of two goods that will yield the same total utility But consumers have many different indifference

curves, showing the many different levels of total utility they will enjoy at different levels of consumption

This idea can be shown by an indifference map

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Indifference Maps

More is better

Good 1

Good 2

Indifference curves

••

•

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Budget Constraints Consumer choice is limited by the amount of money

that people can spend and the prices of the goods they buy.

The budget constraint is a curve that shows a consumer’s consumption possibilities for two goods.

Points outside the budget constraint require more income than is currently available and thus cannot be purchased now.

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Indifference Curves and Budget Constraints

So how do consumers decide what combination to buy?

The choose the goods that will maximize their satisfaction, given the limited budget they face

This means consumers will consume: 1. on the budget line, NOT below it and NOT

above it 2. on the highest possible indifference curve

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Indifference Curves and Budget Constraints

Apple (Rs.)

Oranges (Rs.)

10203040

102 4 6 8

C is better than B but is outside the budget so it is not possible.

B is on the highest indifference curve that is within the budget, so it is the best we can afford.

A B C

A is within the budget but is not as good as B.

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Case:An engineering firm recently conducted a study to determine its revenue and cost structure. The results of the study are as follows:TR(Q) = 300 Q – 6 Q2

TR = Total RevenueQ = Output

TC(Q) = 4 Q2

TC = Total CostQ = Output

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Case (continued):

MR (Marginal Revenue) =?MC (Marginal Cost) =?Optimal Y? (when MR?……MC?).Profit?

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Case (continued):MR (Marginal Revenue) =?MC (Marginal Cost) =?Optimal Y? (when MR?……MC?).Profit?

MR = 300 – 12QMC = 8QMR = MC300 -12Q = 8Q

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Case (continued):

300 -12Q = 8Q-12Q-8Q = -300-20Q = -30020Q = 300Q = 300/20 = 15

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Case (continued):Profit = TR – TCTR = 300Q – 6Q2

TR = (300.15) – (6.152)TR =

TC = 4Q2

TC = 4(15)2

TC =

Profit = 2250