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19
C HAPTE R
Consumer Behavior and
Utility Maximization
Chapter 19. Consumer Choice
• Utility
• Consumer surplus
• Budget Constraints
• Indifference Curves
Biscuits
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Choclate
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I. Utility Analysis
• what is utility?
 benefit you get from consuming a
good
 determined by your
tastes/preferences
(assume these are stable)
total utility (TU)
• total benefit from consuming good
• example
 total benefit from 3 cookies
• TU increases as consumption
increases, to a point
TU 2 cookies
<
TU 3 cookies
marginal utility (MU)
• change in TU from
•
consuming one more of a good
example
 how much MORE utility from
an additional pack of gum?
change in TU from
0 to 1 cookie
MU of 1st cookie
=
0
change in TU from
1 cookie to 2 cookies
=
MU of 2nd cookie
diminishing marginal utility
• MU falls as consumption rises
• get sick of cookies
MU of 1st cookie
0
>
MU of 2nd cookie
TU
TU rises at
slower and
slower rate
cookie
MU
as MU
declines
cookie
How to maximize TU?
• use available budget
• equalize MU/$ across goods
• Huh?
•
chose combination of cookies and milk
where
MU cookies
=
price of cookies
MU milk
price of milk
why?
• chose combo of 6 cookies, 1 milk
• suppose MU/$1 of cookies = 4,
•
MU/$1 of milk = 15
by consuming fewer cookies, more
milk…
I would add more to my TU
TU vs. MU
• Diamond-Water paradox
• $10,000
 one carat diamond
 5 million gallons of tap water
why?
• TU of water is greater than TU of
•
•
diamonds
 water is essential for life
BUT water is abundant, diamonds
are rarer
 MU of last diamond is higher
MU determines value
MU and demand
• MU declines as consumption rises
• willing to pay less for each
additional unit
 downward sloping demand
example : pizza
P
willing to pay $15
for 2nd pizza
$15
$10
willing to pay $10
for 4th pizza
D
Q
2 pizza
4 pizzas
II. Consumer Surplus
• difference between what you pay for
a good,
any what you are WILLING to pay for
a good
example
• market price pizza = $10
• my marginal value of 3rd pizza this
week = $12
• my consumer surplus = $2
my demand curve
P
$12
my consumer surplus
$10
D
Q
3
P
total consumer surplus
$10
area between D
and price of pizza
D
Q
10,000
III. The Budget Line
• given:
•
•
 consumer’s budget
 prices
draw a line representing choices
consumption possibilities
example
• 2 goods: milk & cookies
• bottle of milk = $1
• cookie = $.50
• daily budget = $4
possible combinations
cookies
0
2
4
6
8
milk
4
3
2
1
0
budget line
cookies
8
6
4
2
0
milk
1
2
3
4
budget line
cookies
8
6
Unaffordable
4
2
Affordable
0
milk
1
2
3
4
what if prices change?
• changes slope of budget line
• suppose cookies = $1
budget line
cookies
cookie = $.50
8
6
cookie = $1
4
2
0
milk
1
2
3
4
what if budget changes
• budget line shifts
• suppose budget = $5
cookies
10
8
budget = $5
6
4
2
budget = $4
milk
0
1
2
3
4
5
IV. Indifference Curves
• (appendix)
• alternative way to show utility
• curve shows combo of goods
that deliver same total utility
example: milk and cookies
cookies
Every point on
curve has same
total utility
8
6
4
2
Indifference curve
0
milk
1
2
3
4
TU is higher as curve shifts right
cookies
higher TU
lower TU
milk
consumer equilibrium
• maximize TU
• stay on budget
consumer equilibrium
cookies
8
best affordable point
4
milk
2
4
consumer equilibrium
cookies
8
best affordable point
4
milk
2
4
sum it up
• consumer decisions based on
•
 preferences
 budget constraint
consumer decisions made at the
margin
 marginal benefit of one more
 compared to price of one more
•
•
•
•
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
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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 on
the quantity of that product demanded.
You have less
income to buy
An increase in price means that less real
same amount
income is available to buy subsequent
of the product
amounts of the product.
as 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)
•
other
productswill buy less of
Therefore, consumers
are more
cheaper
this product and
of the
now
substitutes, whose
prices are relatively
lower than before.
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• Utility Maximization Rule
Affordable: Px(X) + Py(Y) = I
• Of all different affordable combinations
of goods and services, which
combination will yield the maximum
satisfaction?
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 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)
Product B:
Price = $2
Marginal
Marginal utility per
utility,
dollar
utils
(MU/price)
First
10
10
Second
8
8
1 unit of (A) and 2 units of (B) is
affordable: 7
Third
7
1(1) + 2(2) = 5$
Fourth 6Still $5 left! 6
Fifth
5
5
Sixth
4
4
Seventh 3
3
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.
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An Indifference Curve
An indifference curve is a line that shows all the consumption
bundles that yield the same amount of total utility for an
individual.
An Indifference Curve Map
Properties of Indifference Curves
indifference curves never cross
the farther out an indifference curve is, the higher the total
utility it indicates
Tangency Condition
The tangency condition between the indifference curve and the
budget line holds when the indifference curve and the budget line
just touch. It determines the optimal consumption bundle.
Understanding the Relative Price Rule
At the optimal consumption bundle:
−MUR/MUM = − PR/PM
Differences in Preferences
SCENARIO
• Rats and Rational Choice
Even rats can make rational choices! And
if rats can make rational choices, so can
people!
• Rats and Rational Choice
1.
Refer to the figure below. As described in the textbook,
even a rat would not choose:
A)
point C.
B)
point A.
C) point B.
D) either point A or point B.
• Rats and Rational Choice
1.
Refer to the figure below. As described in the textbook,
even a rat would not choose:
A)
point C.
B)
point A.
C) point B.
D) either point A or point B.
• Rats and Rational Choice
2.
The difference between BL1 and BL2 is likely the result of:
A) a change in the consumer’s income.
B)
a change in the prices of the goods.
C) both a and b.
D) cannot be determined.
• Rats and Rational Choice
2.
The difference between BL1 and BL2 is likely the result of:
A) a change in the consumer’s income.
B)
a change in the prices of the goods.
C) both a and b.
D) cannot be determined.
• Rats and Rational Choice
3.
Which of the following is the expression for the optimal
consumption bundle of two goods, X and Y?
A) MUX = PX and MUY = PY
B) MUX/PY = MUY/PX
C) MUX/PX = MUY/PY
D) none of the above
• Rats and Rational Choice
3.
Which of the following is the expression for the optimal
consumption bundle of two goods, X and Y?
A) MUX = PX and MUY = PY
B) MUX/PY = MUY/PX
C) MUX/PX = MUY/PY
D) none of the above