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Topic 4
Consumer Behavior
Utility
 Like elasticity, Utility is another fancy
name for satisfaction or happiness
 Utility refers to satisfaction derived
from consumption of goods and
services.
 To understand consumer behavior,
we must know the difference
between Total Utility and Marginal
Utility
7-2
Total Utility
Cumulative satisfaction derived
from consumption of a specific
quantity of goods or services.
Example:
 Lets look at Bob’s satisfaction schedule
from ice cream consumption.
7-3
Total Utility
Number of Ice Cream
Total Utility
0
0 util
1
10 util
2
18 util
3
24 util
4
28 util
7-4
Total Utility
Ice
Cream
0
Total
Utility
0 util
1
10 util
2
18 util
3
24 util
4
28 util
Note:
 No consumption
provides no utility.
 Higher consumption
implies higher utility.
 Total utility is always
rising.
7-5
Marginal Utility
Marginal utility
 Extra satisfaction from the consumption
one additional unit.
 It is not the total cumulative satisfaction
from consumption of all previous units.
 It is rather the satisfaction of just one
(the last) unit consumed.
 Lets look at Bob’s marginal utility.
7-6
Marginal Utility
Number of Ice
Cream
0
Total Utility
0 util
Marginal
Utility
Undefined
1
10 util
10 util
2
18 util
8 util
3
24 util
6 util
4
28 util
4 util
7-
Marginal Utility
Ice
Cream
0
Marginal
Utility
Undefined
1
10 util
2
8 util
3
6 util
4
4 util
Note:
 Needs two units to
compare marginal
utility.
 Marginal utility falls
with consumption.
 Can be even negative.
 When MU is negative,
TU must fall from
previous TU
7-8
Law of Diminishing Marginal Utility
 Bob’s marginal utility is falling with
higher unit consumed.
 This is not an accident.
 This is in fact a behavioral
assumption that economists make
and call it:
The Law of Diminishing
Marginal Utility
7-9
Utility Graphically
TU
(1)
(2)
(3)
Tacos
Total Marginal
Consumed Utility, Utility,
Per Meal Utils
Utils
0
1
2
3
4
5
6
7
0
10
18
24
]
]
]
]
28
]
30
]
30
]
28
10
Total Utility
30
TU
20
10
8
6
0
4
MU
2
0
-2
1
2
3
4
5
6
Q
7
Marginal Utility
10
8
6
4
2
0
-2
Q
MU
1
2
3
4
5
6
Units Consumed Per Meal
7
7-10
Theory of Consumer Behavior
 This theory tells us how consumers
maximize utility.
 It tells us how much of each goods or
services consumer should buy to
maximize total utility.
 It finds utility maximizing:
 Quantities (or Q*)
 When Income (or M) is fixed
 When Prices (or P) are fixed
7-11
Theory of Consumer Behavior
Assume that
 A consumer’s income M=40
 Wants to purchase pizza and Video
rental, where
 Price of Pizza, Pp =$8
 Price of Video Rental, Pv =$4
 TU and MU for good Pizza and Video
rental are known
 This theory tells us how much of Pizza
and video rental this consumer should
purchase
Theory of Consumer Behavior
 We need a stable preference for Pizza
 This preference is expressed by TU and MU
Pizza
(1)
Consumed
per
week
(2)
Total
Utility
0
0
1
56
2
88
3
112
4
130
5
142
6
150
(3)
Marginal
Utility
Theory of Consumer Behavior
Pizza
(1)
Consumed
per
week
(2)
Total
Utility
(3)
Marginal
Utility
0
0
1
56
56
2
88
32
3
112
24
4
130
18
5
142
12
6
150
8
Theory of Consumer Behavior
 Similarly we need a stable Preference for Video
Rental expressed by TU and MU
Video Rental
(1)
Viewed
per
week
(2)
Total
Utility
0
0
1
40
2
68
3
88
4
100
5
108
6
114
(3)
Marginal
Utility
Theory of Consumer Behavior
Video Rental
(1)
Viewed
per
week
(2)
Total
Utility
0
0
1
40
40
2
68
28
3
88
20
4
100
12
5
108
8
6
114
6
(3)
Marginal
Utility
Theory of Consumer Behavior
 Which one would you consume first?
 Is it your first pizza (with 56 MU)?
Pizza
(1)
Consumed
per
week
(2)
Total
Utility
0
0
1
56
2
Video Rental
(3)
Marginal
Utility
(1)
Viewed
per
week
(2)
Total
Utility
(3)
Marginal
Utility
0
0
56
1
40
40
88
32
2
68
28
3
112
24
3
88
20
4
130
18
4
100
12
5
142
12
5
108
8
6
150
8
6
114
6
Theory of Consumer Behavior
 We can’t say that yet because pizza provides
higher MU, but it is more expensive
 We need to take price into account, some how
Pizza (PP=$8)
(1)
Consumed
per
week
(2)
Total
Utility
0
0
1
56
2
Video Rental (PV=$4)
(3)
Marginal
Utility
(1)
Viewed
per
week
(2)
Total
Utility
(3)
Marginal
Utility
0
0
56
1
40
40
88
32
2
68
28
3
112
24
3
88
20
4
130
18
4
100
12
5
142
12
5
108
8
6
150
8
6
114
6
Theory of Consumer Behavior
Pizza (PP=$8)
(1)
Consumed
per
week
(2)
Total
Utility
(3)
Marginal
Utility
Video Rental (PV=$4)
(4)
Marginal
Utility
per $
(1)
Viewed
per
week
(2)
Total
Utility
(3)
Marginal
Utility
MU
P
(4)
Marginal
Utility
per $
MU
P
0
0
---
---
0
0
---
---
1
56
56
7
1
40
40
10
2
88
32
4
2
68
28
7
3
112
24
3
3
88
20
5
4
130
18
2.25
4
100
12
3
5
142
12
1.5
5
108
8
2
6
150
8
1
6
114
6
1.5
Theory of Consumer Behavior
Pizza (PP=$8)
(1)
Consumed
per
week
(4)
Marginal
Utility
per $
Video Rental (PV=$4)
(1)
Viewed
per
week
MU
P
(4)
Marginal
Utility
per $
MU
P
0
---
0
---
1
7
1
10
2
4
2
7
3
3
3
5
4
2.25
4
3
5
1.5
5
2
6
1
6
1.5
Comparing Per dollar MU or
MU
P
This consumer should
consume in the following
sequence:
1. First Video rental
2. First Pizza and Second
Video rental (one of each)
3. Third video rental
4. Second Pizza
5. Third Pizza and Fourth
Video Rental (one of each)
6. And no more, why?
Theory of Consumer Behavior
This consumption sequence indicates that
to maximize utility you must consume in a way
that
MU for the last pizza consumed
P
is exactly equal to
MU for the last video rentals
P
In this case, MUPizza
MUVideo rental
=
Ppizza
PVideo rental
= 3
Utility Maximizing Condition
MUPizza
PPizza
MUVideo rental
=
PVideo rental
This condition simply means that the last dollar
spent on each good must provide the same
marginal utility
This constitutes the condition for utility
maximization
Utility Maximizing Condition
MUPizza
=
PPizza
Pizza (PP=$8)
Video Rental (PV=$4)
(1)
Quantity of
Pizza
(4)
MU
P
(1)
Quantity of
Video Rental
(4)
MU
P
0
---
0
---
1
7
1
10
2
4
2
7
3
3
3
5
4
2.25
4
3
5
1.5
5
2
6
1
6
1.5
MUVideo rental
PVideo rental
However note that the above
condition is fulfilled at three
quantity combinations:
1 pizza and 2 video
[per $ MU is 7]
3 pizza and 4 video
[per $ MU is 3]
5 pizza and 6 video
[per $ MU is 1.5]
Utility Maximizing Condition
Among these three combinations, which
one is really utility maximizing:
A. 1 pizza and 2 video [per $ MU is 7]
B. 3 pizza and 4 video [per $ MU is 3]
C. 5 pizza and 6 video [per $ MU is 1.5]
To know that we need think about the Budget
Comb. A cost [1x$8 + 2x$4] $16 (Money left)
Comb. B cost [3x$8 + 4x$4] $40 (Exactly)
Comb. C cost [5x$8 + 6x$4] $64 (Unaffordable)
Equilibrium Quantity
 When the last dollar spent on each good
yields the same marginal utility, there is no
way to increase utility by reallocating the
budget to buy some other quantity
combination
 This is why quantity choice at which the
utility maximized is also called Equilibrium
quantity
Equilibrium Quantity
 How do we check that equilibrium quantity
indeed provided highest level of utility
possible
 To see that we need to go back to the total
utility table
 Let’s compare another bundle that also
costs $4o in the utility table
Equilibrium Quantity
Pizza (PP=$8)
Video Rental (PV=$4)
(1)
Quantity
(2)
TU
(4)
MU
P
(1)
Quantit
y
(2)
TU
(4)
MU
P
0
0
---
0
0
---
1
56
7
1
40
10
2
88
4
2
68
7
3
112
3
3
88
5
4
130
2.25
4
100
3
5
142
1.5
5
108
2
6
150
1
6
114
1.5
At the equilibrium
combination TU is
212
Equilibrium Quantity
suggests that no
other affordable
quantity choice will
yield higher TU
Note, 2 pizza and 6
video also cost $40
But the TU is 202
Violation of Utility Max. Condition
 The utility maximizing condition is violated
when at the current quantity choice one of
the following happens:
MUPizza
PPizza
MUPizza
PPizza
>
MUVideo rental
PVideo rental
<
MUVideo rental
PVideo rental
Violation of Utility Max. Condition
 When Utility maximization condition is
violated:
 Clearly the consumer is not maximizing
satisfaction
 Therefore, not consuming equilibrium
quantities
 Which means, by reallocating budget across
pizza and video or buying a different
combination consumer can increase
satisfaction
Violation of Utility Max. Condition
 Assume that at the current level of pizza
and video consumption, we have
MUP
MUV
>
PP
PV
 What specifically would you suggest this
consumer to increase satisfaction?
Utility-Maximizing Conditions
 Note, this situation implies that per $ MU
for pizza is higher
MUP
MUV
>
PP
PV
 Which means, pizza has a bigger bang for
the buck
 Therefore, this consumer should buy more
pizza and less video
Utility-Maximizing Conditions
MUP
MUV
>
PP
PV
 How does buying more pizza and less video
restore utility maximizing condition
 What happens to MUP when more pizza is
consumed? It goes down!
 What happens to MUV when less video is
consumed? It goes up!
 Therefore, by reallocating this way
consumer will reach equilibrium
Where does Demand Curve Come
From
 Recall, demand is a relationship between:
 Price and
 Quantity demanded at that price
 Keeping all else constant
 The law of demand says that this
relationship is inverse or negative
 Which means:
 Quantity demanded is lower at higher price and
 Quantity demanded is higher at lower price
 Utility theory explains why that is so
Where does Demand Curve Come
From
 Utility Theory or Consumer Behavior says
that higher quantity demanded at lower
price is an equilibrium choice
 The law of demand comes from consumers’
utility maximizing behavior
 In other words, what we will observe in few
slides that when price changes MU per $
changes as well
 When that happens consumers’ utility
maximizing bundles changes
Where does Demand Curve Come
From
 The utility maximizing bundle changes in
such a way that price and quantity choice
becomes negatively related
 Let’s see that using an example that we
already are familiar with
Theory of Consumer Behavior
Pizza (PP=$8)
(1)
Consumed
per
week
(2)
Total
Utility
(3)
Marginal
Utility
Video Rental (PV=$4)
(4)
Marginal
Utility
per $
(1)
Viewed
per
week
(2)
Total
Utility
(3)
Marginal
Utility
MU
P
(4)
Marginal
Utility
per $
MU
P
0
0
---
---
0
0
---
---
1
56
56
7
1
40
40
10
2
88
32
4
2
64
24
7
3
112
24
3
3
84
20
5
4
130
18
2.25
4
96
12
3
5
142
12
1.5
5
106
10
2
6
150
8
1
6
114
8
1.5
Where does Demand Curve Come
From
 Based on this table, from our previous
analysis we know that this consumer will
choose 3 pizza and 4 video rental
 This is because that choice is utility
maximizing equilibrium quantity choice
 Now, if I want to draw the demand curve
for video rental for this consumer, I will
have one point of his demand curve
 That is PV=4 and Q*V=4
Where does Demand curve come
from
 We can plot that point (4, 4)as follows:
Price
4
4
Quantity Demanded
Where does Demand curve come
from
 However one point is not enough even for
a linear demand curve. We need at least
another point
 To get that point, let’s increase the price of
video rental from $4 to $8
 If we do so, we need to update our MU
table. Especially the MU/p column
Theory of Consumer Behavior
Pizza (PP=$8)
Video Rental (PV=$4)
(1)
(2)
(3)
(4)
(1)
(2)
(3)
(4)
(5)
Quantity
TU
MU
MU
P
Quantity
TU
MU
MU
P
MU
P
When
P=4
When
P=8
0
0
---
---
0
0
---
---
---
1
56
56
7
1
40
40
10
5
2
88
32
4
2
64
24
6
3
3
112
24
3
3
84
20
5
2.5
4
130
18
2.25
4
96
12
3
1.5
5
142
12
1.5
5
108
8
2
1.25
6
150
8
1
6
114
6
1.5
1
Where does Demand curve come
from
 Consumer utility maximization rule tells us
that this consumer will choose a different
quantity combination under new price
 Specifically, based on his preference table
(TU and MU) the consumer will choose
 3 pizza and 2 video rental
 This gives us another point on the demand
curve for video rental of this consumer
 Which is PV=8 and Q*V=2
Where does Demand curve come
from
Price
8
4
D
2
4
Quantity Demanded