chapter EIGHT
Consumer Behavior and Utility Maximization
After completing this chapter, students should be able to
1. Define and distinguish between the income and substitution effects of a price change.
2. Explain why a consumer will buy more (less) of a commodity when its price falls (rises) by using the income and substitution effects.
3. Define marginal utility and state the law of diminishing marginal utility.
4. Explain how the law of diminishing marginal utility and price elasticity of demand are related.
5. List four assumptions made in the theory of consumer behavior.
6. State the utility‑maximizing rule.
7. Use the utility‑maximizing rule to determine a consumer’s spending when given income, utility, and price data.
8. Use the theory of consumer behavior to define the market shift from videocassettes to DVDs since their introduction in 1997.
9. Explain the diamond-water paradox.
10. Explain how the value of time fits in the theory of consumer behavior and give two examples of the implications that result.
11. Describe how the theory of consumer behavior helps us understand different values placed on time.
12. Explain why a cash gift will give the receiver more utility than a noncash gift costing the same amount.
13. Define and identify terms and concepts listed at the end of the chapter.
After completing the appendix, students should be able to
1. Define a budget constraint line and explain shifts in a budget constraint line.
2. Explain three characteristics of indifference curves.
3. Identify a consumer’s equilibrium position, given a set of indifference curves and a budget constraint line.
4. Use indifference curve analysis to derive an individual’s demand curve for a product by showing consumption responses to a change in the price of the product.
5. Define and identify terms and concepts listed at the end of the appendix
I. Introduction
A. Americans spend trillions of dollars on goods and services each year—more than 95 percent of their after-tax incomes, yet no two consumers spend their incomes in the same way. How can this be explained?
B. Why does a consumer buy a particular bundle of goods and services rather than others? Examining these issues will help us understand consumer behavior and the law of demand.
II. Two Explanations of the Law of Demand
A. Income and substitution effects explain the inverse relationship between price and quantity demanded.
1. The income effect is the impact of a change in price on consumers’ real incomes and consequently on the quantity of that product demanded. An increase in price means that less real income is available to buy subsequent amounts of the product.
2. The substitution effect is the impact of a change in a product’s price on its cost relative to other substitute products’ prices. A higher price for a particular product with no change in the prices of substitutes means that the item has become relatively more expensive compared to its substitutes. Therefore, consumers will buy less of this product and more of the substitutes, whose prices are relatively lower than before.
B. The law of diminishing marginal utility is a second explanation of the downward sloping demand curve. Although consumer wants in general are insatiable, wants for specific commodities can be fulfilled. The more of a specific product that consumers obtain, the less they will desire more units of that product. This can be illustrated with almost any item. The text uses the automobile example, but houses, clothing, and even food items work just as well.
1. Utility is a subjective notion in economics, referring to the amount of satisfaction a person gets from consumption of a certain item.
2. Marginal utility refers to the extra utility a consumer gets from one additional unit of a specific product. In a short period of time, the marginal utility derived from successive units of a given product will decline. This is known as diminishing marginal utility.
3. Figure 21-1 and the accompanying table illustrate the relationship between total and marginal utility.
a. Total utility increases as each additional taco is purchased through the first five, but utility rises at a diminishing rate since each taco adds less and less to the consumer’s satisfaction.
b. At some point, marginal utility becomes zero and then even negative at the seventh unit and beyond. If more than six tacos were purchased, total utility would begin to fall. This illustrates the law of diminishing marginal utility.
4. The law of diminishing marginal utility is related to demand and elasticity.
a. Successive units of a product yield smaller and smaller amounts of marginal utility, so the consumer will buy more only if the price falls. Otherwise, it is not worth it to buy more.
b. If marginal utility falls sharply as successive units are consumed, demand is predicted to be inelastic. That is, price must fall a relatively large amount before consumers will buy more of an item.
5. CONSIDER THIS … Vending Machines and Marginal Utility
III. The theory of consumer behavior uses the
law of diminishing marginal utility to explain how consumers allocate their
income.
A. Consumer choice and the budget constraint.
1. Consumers are assumed to be rational, i.e. they are trying to get the most value for their money.
2. Consumers have clear‑cut preferences for various goods and services and can judge the utility they receive from successive units of various purchases.
3. Consumers’ incomes are limited because their individual resources are limited. Thus, consumers face a budget constraint.
4. Goods and services have prices and are scarce relative to the demand for them. Consumers must choose among alternative goods with their limited money incomes.
B. The utility maximizing rule explains how consumers decide to allocate their money incomes so that the last dollar spent on each product purchased yields the same amount of extra (marginal) utility.
1. A consumer is in equilibrium when utility is “balanced (per dollar) at the margin.” When this is true, there is no incentive to alter the expenditure pattern unless tastes, income, or prices change.
2. Table 21-1 provides a numerical example of this for an individual named Holly with $10 to spend. Follow the reasoning process to see why 2 units of A and 4 of B will maximize Holly’s utility, given the $10 spending limit.
3. It is marginal utility per dollar spent that is equalized; that is, consumers compare the extra utility from each product with its cost.
4. As long as one good provides more utility per dollar than another, the consumer will buy more of the first good; as more of the first product is bought, its marginal utility diminishes until the amount of utility per dollar just equals that of the other product.
5. Table 21-2 summarizes the step-by-step decision‑making process the rational consumer will pursue to reach the utility‑maximizing combination of goods and services attainable.
6. The algebraic statement of this utility-maximizing state is that the consumer will allocate income in such a way that.
MU of product A/price of A = MU of product B/price of B = etc.
IV. Utility Maximization and the Demand Curve
A. Determinants of an individual’s demand curve are tastes, income, and prices of other goods.
B. Deriving the demand curve can be illustrated using item B in Table 21-1 and considering alternative prices at which B might be sold. At lower prices, using the utility‑maximizing rule, we see that more will be purchased as the price falls.
C. The utility‑maximizing rule helps to explain the substitution effect and the income effect.
1. When the price of an item declines, the consumer will no longer be in equilibrium until more of the item is purchased and the marginal utility of the item declines to match the decline in price. More of this item is purchased rather than another relatively more expensive substitute.
2. The income effect is shown by the fact that a decline in price expands the consumer’s real income and the consumer must purchase more of this and other products until equilibrium is once again attained for the new level of real income.
V. Applications and Extensions
A. The digital versatile disk (DVD) takeover.
1. DVDs and DVD players entered the video media market in 1997. Around 320,000 players were sold in the U.S. that year. In 2002, 17 million were sold, and the total number of DVD players in the U.S. reached 48 million.
a. Preferences changed due to improved quality and the amount of video and sound available on one DVD.
b. DVD player prices fell from over $1,000 or more to under $200. This led to increased purchases of DVDs (a complementary good).
c. DVDs and videocassettes (VCs) are substitutes.
2. DVD players and DVDs have a higher ratio of marginal utility to price than do VCR players and VCs. To maximize their utility, consumers will switch from VCs to DVDs.
B. The diamond-water paradox.
1. Before marginal analysis, economists were puzzled by the fact that some essential goods like water had lower prices than luxuries like diamonds.
2. The paradox is resolved when we look at the abundance of water relative to diamonds.
3. Theory tells us that consumers should purchase any good until the ratio of its marginal utility to price is the same as that ratio for all other goods.
a. The marginal utility of an extra unit of water may be low as is its price, but the total utility derived from water is very large.
b. The total utility of all water consumed is much larger than the total utility of all diamonds purchased.
c. However, society prefers an additional diamond to an additional drop of water, because of the abundant stock of water available.
C. Time also has a value, so this must be considered in decision making and utility maximization. The total price of an item must include the value of the time spent in consuming the product, i.e., the wage value of an hour of time. When time is considered, consumer behavior appears to be much more rational.
1. Highly paid doctors may not spend hours hunting for bargains because their time is more valuable than the money to be saved from finding the best buy.
2. Foreigners observe that Americans waste material goods but conserve time. This could be because our high productivity makes our time more valuable than many of the goods we waste.
D. Buying medical care or eating at a buffet.
1. Most Americans have health insurance for which they pay a fixed monthly premium, which covers, say, 80 percent of their health care costs. Therefore, the cost of obtaining care is only 20 percent of its stated price for the insured patient.
2. Following the law of demand, people purchase a larger quantity of medical care than if they had to pay the full price for each visit.
3. If you buy a meal at an “all-you-can-eat” buffet, you eat more than if you paid separately for each item.
E. Cash and noncash gifts.
1. Noncash gifts may yield less utility to the receiver than a cash gift of equal monetary value because the noncash gift may not match the receiver’s preferences.
2. Individuals know their own preferences better than the gift giver.
3. Look back at Table 21-1. If Holly had no income and was given $2 worth, she would rather have the cash transfer to spend on B than to be given 2 units of A. (She gets more utility or satisfaction by spending her $2 on B.)
VI. LAST WORD: Criminal Behavior
A. The theory of consumer behavior can provide some useful insights into criminal behavior.
B. A person who steals from a store imposes uncompensated costs on others – the store owner, customers.
C. Whereas a person who is thinking about buying an item weighs the cost (the price) and the benefit (utility) of a particular purchase, a person who steals also weighs the cost and benefit of stealing the item.
D. The cost to the potential criminal is the possible guilt felt, the tools of the trade, the income forgone while engaging in an illegitimate activity, and possible fines and imprisonment. The potential criminal will engage in criminal behavior if the benefits exceed the costs.
E. Society can reduce criminal behavior by increasing the cost of guilt through family, educational, and religious efforts and by increasing the direct costs by using more sophisticated security systems. Society can also increase the penalties on those who are caught.
I. The Budget Constraint Line
A. Show various combinations of two products that can be purchased with a given money income with knowledge of the prices of the two products. Table 1 and Figure 1.
B. A decrease in money income shifts the budget constraint line inward to the left in Figure 1; an increase in money income shifts the budget constraint line outward to the right in Figure 1.
C. Price changes in either of the two products will rotate the budget constraint line. For example, in Figure 1, if the price of A rises, less of A will be purchased at each of the possible combinations of A and B, so the curve will fan downward along the vertical A‑axis. A decrease in A’s price would have the curve fanning upward along the A‑axis. See Figure 5 (a).
II. Indifference curves
show all combinations of two products that will yield the same level of
satisfaction or utility to the consumer.
(Figure 2)
A. Curves are downward sloping because the consumer will be able to maintain the same level of total utility by substituting more of B for less of A.
B. Curves are convex to the origin.
1. The slope of the curve measures the marginal rate of substitution of one good for the other (B for A) for the consumer to have a constant level of satisfaction.
2. Rationale for this shape is related to diminishing marginal utility. If the consumer has a lot of A and very little of B, B is more valuable at the margin, while A has a lower marginal utility. The consumer will then be willing to give up a substantial amount of product A to get more units of B. However, as the consumer obtains more and more of B and gives up more and more A, this relationship changes. The consumer will not be willing to give up much A to get more of B. In other words, the slope of the curve diminishes, and the curve is, by definition, convex to the origin.
3. An
indifference map refers to successive indifference curves where each entails a
different level of utility. As one moves
away from the origin on the map, the level of utility increases. See Figure 21A-3, and CONSIDER THIS …
Indifference Maps and Topographical Maps.
C. The consumer’s utility‑maximizing combination of A and B will occur on the highest attainable indifference curve. This is where the budget constraint line is tangent to an indifference curve, which is the highest attainable level of utility. Higher levels will be unattainable or off the budget line. See Figure 4. (Key Question 4)
D. The measurement of utility is not necessary when decisions are being made on a relative basis. The marginal rate of substitution is the ratio of the prices of the two goods, A and B. Also, the ratio of the marginal utilities at the maximizing point is equivalent to the ratio of the two prices. Therefore, the marginal rate of substitution is equivalent to the ratio of marginal utilities of two goods, and it is not necessary to find the absolute measure of marginal utility.
E. The demand curve can be derived using the indifference curve approach and determining how the quantity purchased will change when the price of one good changes to various levels. Figure 21A-5 illustrates this procedure.