Consumer Behavior and Utility Maximization 21 C H A P T E R Consumer Behavior and Utility Maximization

I. Introduction A. We spend Millions of KDs on goods and services. 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. The law of diminishing marginal utility The law of diminishing marginal utility explains 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.

Marginal Utility (MU) can be measured as : Utility is a subjective notion in economics, referring to the amount of satisfaction a person gets from consumption of a certain item. 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. Marginal Utility (MU) can be measured as : MU= change in Total Utility/Change in Quantity consumed MU= TU2-TU1/Q2-Q1

1 10 TOTAL AND MARGINAL UTILITY Quantity of Apple consumed Total 30 20 10 1 10 Total Utility 0 1 2 3 4 5 6 7 Units consumed 10 8 6 4 2 -2 Marginal Utility 1 2 3 4 5 6 7 Units consumed

1 10 10 TOTAL AND MARGINAL UTILITY Quantity of Apple consumed Total 30 20 10 1 10 Total Utility 10 0 1 2 3 4 5 6 7 Units consumed 10 8 6 4 2 -2 Marginal Utility 1 2 3 4 5 6 7 Units consumed

1 2 10 18 10 8 TOTAL AND MARGINAL UTILITY Quantity of Apple consumed 30 20 10 1 2 10 18 Total Utility 10 8 0 1 2 3 4 5 6 7 Units consumed 10 8 6 4 2 -2 Marginal Utility 1 2 3 4 5 6 7 Units consumed

1 2 3 10 18 24 10 8 6 TOTAL AND MARGINAL UTILITY Quantity of Apple consumed Total Utility, Marginal Utility, 30 20 10 1 2 3 10 18 24 Total Utility 10 8 6 0 1 2 3 4 5 6 7 Units consumed 10 8 6 4 2 -2 Marginal Utility 1 2 3 4 5 6 7 Units consumed

1 2 3 4 10 18 24 28 10 8 6 4 TOTAL AND MARGINAL UTILITY Quantity of Apple consumed Total Utility, Marginal Utility, 30 20 10 1 2 3 4 10 18 24 28 Total Utility 10 8 6 4 0 1 2 3 4 5 6 7 Units consumed 10 8 6 4 2 -2 Marginal Utility 1 2 3 4 5 6 7 Units consumed

1 2 3 4 5 10 18 24 28 30 10 8 6 4 2 TOTAL AND MARGINAL UTILITY Quantity of Apple consumed Total Utility, Marginal Utility, 30 20 10 1 2 3 4 5 10 18 24 28 30 Total Utility 10 8 6 4 2 0 1 2 3 4 5 6 7 Units consumed 10 8 6 4 2 -2 Marginal Utility 1 2 3 4 5 6 7 Units consumed

1 2 3 4 5 6 10 18 24 28 30 10 8 6 4 2 TOTAL AND MARGINAL UTILITY Quantity of Apple consumed Total Utility, Marginal Utility, 30 20 10 1 2 3 4 5 6 10 18 24 28 30 Total Utility 10 8 6 4 2 0 1 2 3 4 5 6 7 Units consumed 10 8 6 4 2 -2 Marginal Utility 1 2 3 4 5 6 7 Units consumed

1 2 3 4 5 6 7 10 18 24 28 30 10 8 6 4 2 -2 TOTAL AND MARGINAL UTILITY TU Quantity of Apple consumed Total Utility, Marginal Utility, 30 20 10 1 2 3 4 5 6 7 10 18 24 28 30 Total Utility 10 8 6 4 2 -2 0 1 2 3 4 5 6 7 Units consumed 10 8 6 4 2 -2 Marginal Utility MU 1 2 3 4 5 6 7 Units consumed

Observe Diminishing Marginal Utility TOTAL AND MARGINAL UTILITY TU Quantity of Apple consumed Total Utility, Marginal Utility, 30 20 10 Observe Diminishing Marginal Utility 1 2 3 4 5 6 7 10 18 24 28 30 Total Utility 10 8 6 4 2 -2 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility MU 1 2 3 4 5 6 7 Units consumed

According to the Figures and the table above, the relationship between total and marginal utility can be illustrated. a. Total utility increases as each additional apple is purchased through the first five, but utility rises at a diminishing rate since each apple 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 apple were purchased, total utility would begin to fall. This illustrates the law of diminishing marginal utility.

The law of diminishing marginal utility is related to demand and elasticity. 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.

III. The theory of consumer behavior uses the law of III. The theory of consumer behavior uses the law of diminishing marginal utility to explain how consumers allocate their income. Consumer choice and the budget constraint. Consumers are assumed to be rational, i.e. they are trying to get the most value for their money. Consumers have clear‑cut preferences for various goods and services and can judge the utility they receive from successive units of various purchases. Consumers’ incomes are limited because their individual resources are limited. Thus, consumers face a budget constraint. 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.

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 utility(marginal utility) .

-Compare Marginal Utilities -Then Compare Per Dollar - MU/Price Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (2) Product A: Price = $1 (3) Product B: Price = $2 (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, (1) Unit of Product First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 24 20 18 16 12 10 8 7 6 5 4 3 12 9 2 -Compare Marginal Utilities -Then Compare Per Dollar - MU/Price -Choose the Highest -Check Budget - Proceed to Next Item

-Again, Compare Per Dollar - MU/Price Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (2) Product A: Price = $1 (3) Product B: Price = $2 (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, (1) Unit of Product First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 24 20 18 16 12 10 8 7 6 5 4 3 12 9 2 -Again, Compare Per Dollar - MU/Price -Choose the Highest -Buy One of Each – Budget Has $5 Left -Proceed to Next Item

Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (2) Product A: Price = $1 (3) Product B: Price = $2 (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, (1) Unit of Product First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 24 20 18 16 12 10 8 7 6 5 4 3 12 9 2 -Again, Compare Per Dollar - MU/Price -Buy One More B – Budget Has $3 Left -Proceed to Next Item

Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (2) Product A: Price = $1 (3) Product B: Price = $2 (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, (1) Unit of Product First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 24 20 18 16 12 10 8 7 6 5 4 3 12 9 2 -Again, Compare Per Dollar - MU/Price -Buy One of Each – Budget Exhausted

Numerical Example: Utility-Maximizing Combination of Products A and B Obtainable with an Income of $10 (2) Product A: Price = $1 (3) Product B: Price = $2 (b) Marginal Utility Per Dollar (MU/Price) (a) Marginal Utility, (1) Unit of Product First Second Third Fourth Fifth Sixth Seventh 10 8 7 6 5 4 3 24 20 18 16 12 10 8 7 6 5 4 3 12 9 2 -Final Result At These Prices, Purchase 2 of Item A and 4 of B

= = Algebraic Restatement: MU of Product A Price of A MU of Product B Price of B = 8 Utils $1 16 Utils $2 = Optimum Achieved - Money Income is Allocated so that the Last Dollar Spent on Each Product Yields the Same Extra or Marginal Utility

Graphically… IV. UTILITY MAXIMIZATION AND THE DEMAND CURVE Deriving the Demand Schedule and Curve Create a demand schedule from the purchase decisions as the price of the product is varied ... Example: Deriving the demand curve can be illustrated using item B 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. Price per unit of B Quantity Demanded $2 4 1 6 Graphically…

UTILITY MAXIMIZATION AND THE DEMAND CURVE Deriving the Demand Schedule and Curve $2 Price per unit of Good B 1 DB 4 6 Quantity Demanded of Good B

The utility-maximizing rule helps to explain the substitute effect and the income effect Substitute effect : 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. 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.

KEY TERMS income effect substitution effect utility total utility marginal utility law of diminishing marginal utility rational behavior budget constraint utility-maximizing rule Copyright McGraw-Hill/Irwin, Inc. 2005 BACK END