Consumer Behavior

Law of Diminishing Marginal Utility

• The simplest theory of consumer behavior rests squarely on the law
of diminishing marginal utility.
• Utility is want-satisfying power. The utility of a good or service is the
satisfaction or pleasure one gets from consuming it.
• Characteristics of Utility:
• "Utility" and "usefulness" are not synonymous.
• Utility is subjective (may vary from person to person).
• Utility is difficult to qualify (for purposes of illustration we assume that people
can measure satisfaction with units called utile).
Total Utility and Marginal Utility
• Total utility is the total amount of satisfaction or pleasure a person
derives from consuming some specific quantity—for example, 10
units—of a good or service.
• Marginal utility is the extra satisfaction a consumer realizes from an
additional unit of that product—for example, from the eleventh unit.
Alternatively, marginal utility is the change in total utility that results
from the consumption of 1 more unit of a product.
Example: Total and Marginal Utility
Law of Demand and Diminishing
Marginal Utility
• Diminishing marginal utility provides a simple rationale for the law of
demand.
Theory of Consumer Behavior
• The idea of diminishing marginal utility also explains how consumers
allocate their money incomes among the many goods and services
available for purchase.
Consumer Choice and Budget
Constraint
• For simplicity, we will assume that the situation for the typical
consumer has the following dimensions:
• Rational Behavior: Consumers want to get “the most for their money” or,
technically, to maximize their total utility. They engage in rational behavior.
• Preferences. Each consumer has clear-cut preferences for certain of the goods
and services that are available in the market.
• Budget constraint. At any point in time the consumer has a fixed, limited
amount of money income.
• Prices. Goods are scarce relative to the demand for them, so every good
carries a price tag. We assume that the price of each good is unaffected by
the amount of it that is bought by any particular person.
Utility Maximizing Rule
• To maximize satisfaction, the consumer should allocate his or her
money income so that the last dollar spent on each product yields the
same amount of extra (marginal) utility. We call this the utility-
maximizing rule.
• When the consumer follows the utility-maximizing rule, he achieves
consumer equilibrium and has no incentive to alter his expenditures
pattern. In fact, any person who has achieved consumer equilibrium
would be worse off - total utility would decline - if there were any
alteration in the bundle of goods purchased, providing there is no
change in taste, income, products, or prices.
Marginal Utility Per Dollar
Algebraic Generalization
Utility Maximization and the
Demand Curve
Income and Substitution Effects
• The income effect is the impact that a change in the price of a product
has on consumer's real income and consequently on the quantity
demanded of that good.
• It is likely that the increase in real income caused by the reduction in the price
of oranges (at the lower $1 price for oranges, Holly would have to spend only
$6 rather than $10 to buy that particular combination of goods) will cause
Holly to end up buying more oranges than before the price reduction.
• In contrast, the substitution effect is the impact that a change in a product's
price has on its relative expensiveness and consequently on the quantity
demanded. o When the price of oranges declines, the substitution effect
causes Holly to buy more oranges in order to restore consumer equilibrium.
Applications and Extensions
• IPods. The swift ascendancy of the iPod resulted mainly from a
leapfrog in technology. Apple's introduction of iPod severely disrupted
consumer equilibrium. Consumers en masse concluded that iPods had
a higher marginal-utility-to-price ratio (= MU/P) than the ratios for
alternative products. They therefore shifted spending away from
those other products and toward iPods as a way to increase total
utility. CONCLUSION: New products succeed by enhancing consumers'
total utility. This "delivery of value" generates a revenue stream.
Applications and Extensions
• The diamond-water paradox. Why do some "essential" goods have much
lower prices than some "unimportant" goods? The paradox is resolved when
we acknowledge that water is in great supply relative to demand and thus
has a very low price per gallon. Diamonds, in contrast, are rare (thus supply is
smaller, price per carat is high).
• Although the marginal utility of the last unit of water consumed is low and the
marginal utility of the last diamond purchased is high, the total utility of water is very
high and the total utility of diamonds is quite low. The total utility derived from the
consumption of water is large because of the enormous amounts of water consumed.
• Water has much more total utility than diamonds even though the price of diamonds
greatly exceeds the price of water. These relative prices relate to marginal utility, not
total utility.
Applications and Extensions
Applications and Extensions
• Opportunity cost and the value of time. Time is valuable economic
commodity; by using an hour in productive work a person can earn
wages. By using that hour for leisure or in consumption activities, the
individual incurs the opportunity cost of forgone income.
• Medical care purchases. People in the United States who have health
insurance pay a fixed premium once a month that covers, say, 80
percent of all incurred health care costs. This means that when they
actually need health care, its price to them will be only 20 percent of
the actual market price. Thus it is likely that people would likely
purchase a great deal more medical care than they would if they were
confronted with the full price.
Applications and Extensions
• Cash and noncash gifts. The noncash gift yields less utility to the
beneficiary than does the cash gift. Since giving noncash gifts is
common, a considerable value of those gifts is potentially lost
because they do not match their recipients' tastes.
Prospect Theory
• Prospect theory assumes that losses and gains are valued differently,
and thus individuals make decisions based on perceived gains instead
of perceived losses. Also known as the "loss-aversion" theory, the
general concept is that if two choices are put before an individual,
both equal, with one presented in terms of potential gains and the
other in terms of possible losses, the former option will be chosen.
Prospect Theory
• People judge good things and bad things in relative terms, as gains
and losses relative to their current situation, or status quo.
• People experience diminishing marginal utility both for gains and
losses.
• People are loss averse, meaning that for losses and gains near the
status quo, losses are felt much more intensely than gains.
• People can be very sensitive to the mental frame that they use to
evaluate whether a possible outcome should be viewed as a gain or a
loss.
Prospect Theory
• Framing effects are important to recognize because they can be
manipulated by advertisers, lawyers, and politicians to try to alter
people's decisions. If a frame alters people's valuations of marginal
utility, it will affect their consumption decisions.
• Before people can calculate their gains and losses, they must define
the status quo from which to measure those changes.
• Irrelevant information can unconsciously influence people's feelings about
the status quo. Psychologists and behavioral economists refer to this
phenomenon as anchoring.
Prospect Theory
• The utility-maximizing rule assumes that people will look at all of their
potential consumption options simultaneously when trying to
maximize the total utility that they can get from spending their
limited incomes. But the fact that people sometimes look at
consumption options in isolation gives rise to mental accounting.
• Human brains appear wired to put a higher value on things we own
than on things we don't (endowment effect).
Indifference Curve Analysis
• Cardinal utility is measured in units such as 1, 2, 3, and 4 and can be
added, subtracted, multiplied, and divided, just like the cardinal
numbers in mathematics.
• An ordinal utility function is a function representing the preferences
of an agent on an ordinal scale.
• The model of consumer behavior that is based upon such ordinal
utility rankings is called indifference curve analysis.
Budget Lines
• Budget lines reflect "objective" market data, specifically income and
prices. They reveal combinations of products A and B that can be
purchased, given current money income and prices. Significant
characteristics of a budget line:
• The location of the budget line varies with money income (an increase in
money income shifts the budget line to the right).
• A change in product prices also shifts the budget line:
• a decline in the prices of both products - the equivalent of an increase in real
income - shifts the curve to the right);
The Budget Line: What Is Attainable
Indifference Curves: What is
Preferred
• Indifference curves are downsloping
• Indifference curves are convex to the origin
• Technically, the slope of an indifference curve at each point measures the
marginal rate of substitution (MRS) of the combination of two goods
represented by that point.
• As amount of B increases, the marginal utility of additional units of B
decreases.
The Indifference Map
• Each curve on an indifference map reflects a different level of total
utility and therefore never crosses another indifference curve. As we
move from the origin, each successive indifference curve represents a
higher level of utility.
• The consumer is in equilibrium position (utility is maximized) at the
point on the budget line that lies on the highest attainable
indifference curve. At that point the budget line and indifference
curve are tangent. Because the slope of the indifference curve reflects
the MRS and the slope of the budget line is PB/PA , the consumer’s
optimal or equilibrium position is the point where
Equivalency at Equilibrium
The Derivation of the Demand Curve