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21
C HAPTE R
Consumer Behavior and
Utility Maximization
• I. Introduction
• A. We spend Millions of KDs on goods and services
each. 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.
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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 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.
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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 on the
You have
less
quantity of that income
producttodemanded.
buy
same amount of
the product
as less real income
• An increase in price
means that
before
is available to buy subsequent
amounts of the
product.
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• 2. The substitution effect
• A higher price for a particular product means
that the item has become relatively more
expensive compared to its substitutes. (i.e. Tea
and Coffee)
• Therefore, consumers will buy less of this
product and more of the substitutes, whose
prices are relatively lower than before.
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• 2. The substitution effect
• A higher price for a particular product means
that the item has become relatively more
expensive compared to its substitutes. (i.e. Tea
and Coffee)
• Therefore, consumersother
will buy less of this
are
product and moreproducts
of the substitutes,
whose
cheaper
prices are relatively
lower now
than before.
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B. The
law of diminishing marginal utility
This 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.
Can you give 1?
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 Utility (U) is a subjective notion in economics,
referring to the amount of satisfaction a person
gets from consumption of a certain item.
 Marginal utility (MU) 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
(MU) derived from successive units of a given
product will decline.
 This is known as diminishing marginal utility.
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TOTAL AND MARGINAL UTILITY
0
10
Total Utility (utils)
0
1
30
20
10
0
Marginal Utility (utils)
Tacos
Total Marginal
consumed Utility, Utility,
per meal Utils
Utils
1
2
3
4
5
6
7
Units consumed per meal
10
8
6
4
2
0
-2
1
2
3
4
5
6
7
Units consumed per meal
9
TOTAL AND MARGINAL UTILITY
0
10
10
Total Utility (utils)
0
1
30
20
10
0
Marginal Utility (utils)
Tacos
Total Marginal
consumed Utility, Utility,
per meal Utils
Utils
1
2
3
4
5
6
7
Units consumed per meal
10
8
6
4
2
0
-2
1
2
3
4
5
6
7
Units consumed per meal
10
TOTAL AND MARGINAL UTILITY
0
10
18
10
8
Total Utility (utils)
0
1
2
30
20
10
0
Marginal Utility (utils)
Tacos
Total Marginal
consumed Utility, Utility,
per meal Utils
Utils
1
2
3
4
5
6
7
Units consumed per meal
10
8
6
4
2
0
-2
1
2
3
4
5
6
7
Units consumed per meal
11
TOTAL AND MARGINAL UTILITY
0
10
18
24
10
8
6
Total Utility (utils)
0
1
2
3
30
20
10
0
Marginal Utility (utils)
Tacos
Total Marginal
consumed Utility, Utility,
per meal Utils
Utils
1
2
3
4
5
6
7
Units consumed per meal
10
8
6
4
2
0
-2
1
2
3
4
5
6
7
Units consumed per meal
12
TOTAL AND MARGINAL UTILITY
0
10
18
24
28
10
8
6
4
Total Utility (utils)
0
1
2
3
4
30
20
10
0
Marginal Utility (utils)
Tacos
Total Marginal
consumed Utility, Utility,
per meal Utils
Utils
1
2
3
4
5
6
7
Units consumed per meal
10
8
6
4
2
0
-2
1
2
3
4
5
6
7
Units consumed per meal
13
TOTAL AND MARGINAL UTILITY
0
10
18
24
28
30
10
8
6
4
2
Total Utility (utils)
0
1
2
3
4
5
30
20
10
0
Marginal Utility (utils)
Tacos
Total Marginal
consumed Utility, Utility,
per meal Utils
Utils
1
2
3
4
5
6
7
Units consumed per meal
10
8
6
4
2
0
-2
1
2
3
4
5
6
7
Units consumed per meal
14
TOTAL AND MARGINAL UTILITY
0
10
18
24
28
30
30
10
8
6
4
2
0
Total Utility (utils)
0
1
2
3
4
5
6
30
20
10
0
Marginal Utility (utils)
Tacos
Total Marginal
consumed Utility, Utility,
per meal Utils
Utils
1
2
3
4
5
6
7
Units consumed per meal
10
8
6
4
2
0
-2
1
2
3
4
5
6
7
Units consumed per meal
15
TOTAL AND MARGINAL UTILITY
0
10
18
24
28
30
30
28
10
8
6
4
2
0
-2
30
Total Utility (utils)
0
1
2
3
4
5
6
7
TU
20
10
0
Marginal Utility (utils)
Tacos
Total Marginal
consumed Utility, Utility,
per meal Utils
Utils
1
2
3
4
5
6
7
Units consumed per meal
10
8
6
4
2
0
-2
MU
1
2
3
4
5
6
7
Units consumed per meal
16
TOTAL AND MARGINAL UTILITY
0
10
18
24
28
30
30
28
10
8
6
4
2
0
-2
30
Total Utility (utils)
0
1
2
3
4
5
6
7
TU
20
10
0
Marginal Utility (utils)
Tacos
Total Marginal
consumed Utility, Utility,
per meal Utils
Utils
Observe
Diminishing
Marginal
Utility
1
2
3
4
5
6
7
Units consumed per meal
10
8
6
4
2
0
-2
MU
1
2
3
4
5
6
7
Units consumed per meal
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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.
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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.
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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.
5. 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.
6. Table 21-1 provides a numerical example of this for an
individual named Hamad with $10 to spend. Follow the
reasoning process to see why 2 units of A and 4 of B will
maximize Hamad’s utility, given the $10 spending limit.
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• Utility Maximization Rule
• Of all different affordable combinations of
goods and services, which combination will
yield the maximum satisfaction?
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• Utility Maximization Rule
• Of all different affordable combinations of
goods and services, which combination will
yield the maximum satisfaction?
Affordable: Px(X) + Py(Y) = I
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• Utility Maximization Rule
• Of all different affordable combinations of
goods and services, which combination will
yield the maximum satisfaction?
Px/Mux = Py/MUy
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• Utility Maximization Rule
• Of all different affordable combinations of
goods and services, which combination will
yield the maximum satisfaction?
Affordable: Px(X) + Py(Y) = I
Px/Mux = Py/MUy
The consumer will allocate (I) so
that the last $ spent on a product
= the same amount of MU
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• Utility Maximization Rule
• Of all different affordable combinations of
goods and services, which combination will
yield the maximum satisfaction?
Affordable: Px(X) + Py(Y) = I
Px/Mux = Py/MUy
Utility
maximizing
rule
The consumer will allocate (I) so
that the last $ spent on a product
= the same amount of MU
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UTILITY MAXIMIZING COMBINATION
$ 10 income
Unit of
product
Product A:
Price = $1
Marginal
Marginal utility per
utility,
dollar
utils
(MU/price)
First
10
Second 8
Third
7
Fourth 6
Fifth
5
Sixth
4
Seventh 3
10
8
7
6
5
4
3
Product B:
Price = $2
Marginal
Marginal utility per
utility,
dollar
utils
(MU/price)
24
20
18
16
12
6
4
12
10
9
8
6
3
2
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UTILITY MAXIMIZING COMBINATION
$ 10 income
Unit of
product
Product A:
Price = $1
Marginal
Marginal utility per
utility,
dollar
utils
(MU/price)
First
10
10
Second
8
8
1 unit of (A) and 2 units of (B) is
affordable: 7
Third
7
1(1) + 2(2) = 5$
Fourth 6Still $5 left! 6
Fifth
5
5
Sixth
4
4
Seventh 3
3
Product B:
Price = $2
Marginal
Marginal utility per
utility,
dollar
utils
(MU/price)
24
20
18
16
12
6
4
12
10
9
8
6
3
2
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UTILITY MAXIMIZING COMBINATION
$ 10 income
Unit of
product
Product A:
Price = $1
Marginal
Marginal utility per
utility,
dollar
utils
(MU/price)
First
10
4 of (A) and 5 of (B)
1(4) + 2(5)=$11 8
Second
Not affordable
Third
7
Fourth 6
Fifth
5
Sixth
4
Seventh 3
10
8
7
6
5
4
3
Product B:
Price = $2
Marginal
Marginal utility per
utility,
dollar
utils
(MU/price)
24
20
18
16
12
6
4
12
10
9
8
6
3
2
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UTILITY MAXIMIZING COMBINATION
$ 10 income
Unit of
product
Product A:
Price = $1
Marginal
Marginal utility per
utility,
dollar
utils
(MU/price)
First
10
Second 8
Third
7
Fourth 6
Fifth
5
2 of (A) and 4 of (B)
Sixth
4
1(2) + 2(4) =$10
Seventh 3
10
8
7
6
5
4
3
Product B:
Price = $2
Marginal
Marginal utility per
utility,
dollar
utils
(MU/price)
24
20
18
16
12
6
4
12
10
9
8
6
3
2
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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.
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Next…
The Costs of Production
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