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AP Economics Chapter 21 : Consumer Behavior and Utility Maximization I. Two Explanations of Law of Demand A. Intro > Why do consumers buy particular goods? > Links consumer behavior with Law of Demand. B. Income Effect > Increase in price means less real income is available to buy product, hence Quantity Demanded decreases. (inverse relationship) C. Substitution Effect > Increase in price of one product means it is relatively more expensive than another product. Thus, the consumer will buy less and Q.D. decreases. (inverse relationship) * Points B & C above are the first explanation of L of D D. Law of Diminishing Marginal Utility > The more of a product consumers attain, the less they will desire of it. 1) Marginal Utility & Total Utility 2) Successive units attained/consumed yield smaller Marginal Utility (MU). Thus, prices must fall to attract more consumer purchase. 3) Inelastic D > If MU falls sharply, D is inelastic and price must fall dramatically to attract consumers. 4) Elastic D > If MU falls modestly, D is elastic and price doesn’t have to fall much to attract consumers. II. Theory of Consumer Behavior A. Consumer Choices & Constraints 1) Are rational & choose 2) Have clear tastes & choose 3) Have limited means & choose 4) Must choose from options B. Utility Maximization Rule (UMR) > explains how consumers spend their $ so that the last dollar spent on each product yields the same MU. The consumer is in equilibrium in amount spent and quantity purchased of each product at this level. 1) No need to change the setup, unless taste, income, or price changes. 2) If good, provides more utility over another good, consumers will purchase that good over the other. MU will eventually decrease and both will be equal MU. 3) See T.21-2, p.430 for hypo ex. 4)Formula> Utility Maximization is where MU of prod. A/price of prod. A = MU of prod. B/price of prod.B. III. Utility Max. & The D Curve A. UMR helps to explain the extent of the… 1. Substitution Effect > when price , equilibrium will only be reached when more of this item is bought. How much more? Depends on how MU interacts with price and the alternative product. 2. Income Effect > how much more is purchased depends on interaction of MU, price, and your income level.