1. 1.6 Theory of Consumer Behavior Blog posts: "Utility" Theory of Consumer Behavior (AP only unit) Total Utility and Marginal Utility Utility Maximization – equalizing marginal utility per dollar spent on various goods Individual demand and market demand curves Income and substitution effects The Theory of Consumer Behavior Online: Utility Utility maximization Practice Activities Unit Overview

2. 1.6 Theory of Consumer Behavior Introduction to the Theory of Consumer Behavior Throughout our study of Microeconomics we have examined the behaviors of firms competing in markets of varying levels of competition. We have learned: How firms decide the profit-maximizing level of output, How firms decide the revenue-maximizing level of output How firms know when they should shut down, When firms will wish to enter or exit a market This can all be summarized as firm behavior. What we have not focus on yet is Consumer Behavior. In this unit we will examine the THEORY OF CONSUMER BEHAVIOR: How rational consumers decide on the optimal combination of goods to consume with their limited budget in order to maximize their total utility at any given time. Utility: In Economics, we refer to the welfare of consumers as utility. To allow us to measure the utility of consumers, we will refer to an imaginary value of happiness, called the UTIL. One UTIL equals one unit of happiness… Introduction to Consumer Behavior

3. 1.6 Theory of Consumer Behavior Introduction to the Theory of Consumer Behavior To introduce the theory of consumer behavior, it helps to think for a moment about your own behavior as a consumer… Imagine you have $100 to spend this week: In the table below, identify 5 goods or services you would spend your money on. The approximate price of each product, and The quantity you would buy ItemPriceQuantity Questions: 1.How did you decide which items to put in your “basket”? 2.Is your basket identical to your classmates? Why or why not? 3.How would a change in the price of one of the items affect the quantity you buy? 4.How would a change in your budget affect the composition of your basket? Introduction to Consumer Behavior

4. 1.6 Theory of Consumer Behavior Introduction to the Theory of Consumer Behavior Chances are, every member of your class had entirely different goods in his or her table than you did. Precisely WHY every individual consumes a different “basket of goods” from every other individual in a market economy can be understood by the following: Every consumer behaves rationally: Consumers try to get the "most for their money" to maximize their total utility Every consumer has different preferences: Consumers have clear cut preferences and can determine how much marginal utility they get from consuming more units of a product Every consumer is under a budget constraint: All consumers face a budget constraint, therefore must make decisions about what they buy based on their limited budget Every product has a price: Every product has a price, so consumers must weigh their purchasing decisions based on their marginal utility from consumption and the price of the goods they consume Introduction to Consumer Behavior

5. 1.6 Theory of Consumer Behavior Total Utility and Marginal Utility

6. 1.6 Theory of Consumer Behavior The Law of Diminishing Marginal Utility Recall from earlier units that demand for a particular good is inversely related to the good’s price. One of the explanations for this relationship was the law of diminishing marginal utility, which states: The greater the level of consumption of a particular good, the less utility consumers derive from each additional unit of the good. Consider the total and marginal utility one derives from consuming ice cream. Notice the following: The first scoop provides you with 5 utils, so TU = 5 at Q=1 Additional scoops of ice cream provide you with less and less additional happiness. Nothing tastes quite as good as that first scoop! MU declines beyond the first scoop, but TU continues to increase, until… The fourth scoop: At four scoops your TU is maximized, but the 4 th scoop provided you with no additional utility. Beyond four scoops, you’ve “had too much”. TU begins decreasing while MU becomes negative. Total Utility and Marginal Utility

7. 1.6 Theory of Consumer Behavior The Utility Maximization Rule With the law of diminishing marginal utility in mind, we must now determine how a consumer should decide what to buy. Assume the following: You have a budget of $20 that you wish to spend entirely on two goods The two goods you are trying to decide between are Widgets (w) and Robotrons (r) The price of Widgets (Pw) is $5 and the price of Robotrons (Pr) is $2 To determine how many of each good you should buy, you must consider the utility each good provides. Consider the table below. First, calculate the MU at each level of consumption Quantity Widgets: Pw=$5Robotrons: Pr=$2 TUMUTUMU 1105 2189 32412 42814 53015 The Utility Maximization Rule

8. 1.6 Theory of Consumer Behavior Quantity Widgets: Pw=$5Robotrons: Pr=$2 TUMUMU/PTUMUMU/P 110 55 218894 3246123 4285142 5302151 The Utility Maximization Rule

9. 1.6 Theory of Consumer Behavior The Utility Maximization Rule Now we can study the table to determine how you should spend your $20 to maximize your total utility. Of course, if you had no budget constraint, you would consume 5 Widgets AND 5 Robotrons, but this would cost you $35, more than you have to spend. So choices must be made Quantity Widgets: Pw=$5Robotrons: Pr=$2 TUMUMU/PTUMUMU/P 110 2552.5 21881.6942 32461.21231.5 42840.81421 53020.41510.5 How to decide what to buy: The goal for consumers is to always maximize marginal utility per dollar. You should buy a Robotron first, giving you a MU/$ of 2.5. Remaining budget = $18 Next you should buy a second Robotron, which gives you an MU/$ of 2. Remaining budget = $16 Next you should buy a Widget, which gives you an MU/$ of 2. Remaining budget = $11 A 2 nd Widget will now give you an MU/$ of 1.6, compared to 1.5 for a 3 rd Robotron. Remaining buget = $6 A 3 rd Robotron now gives you an MU/$ of 1.5, compared to 1.2 for a 3 rd Widget: Remaining budget = $4 Based on the utility maximization rule, you should buy 2w and 3r, where MUw/Pw=MUr/Pr At 2w and 3r, you’ve maximized your total utility given your limited budget of $20. The Utility Maximization Rule

10. 1.Identify the combination of robotrons and widgets you should purchase. Explain your reasoning. 2.With the prices of pizzas and hamburgers remaining constant, assume that your budget increases to $60. Identify each of the following: a.The new combination of robotrons and widgets the consumer will purchase. b.The total utility the consumer will enjoy with this combination 3.With your budget remaining at $60, assume the price of pizzas increases to $16 each. Identify each of the following. a.The combination of robotrons and widgets the consumer will purchase b.The consumer's total utility at this combination 1.6 Theory of Consumer Behavior Quantity Pizza: Pw=$8Hamburgers: Pr=$4 TUMUMU/PTUMUMU/P 11624 22844 33656 44064 54268 The Utility Maximization Rule Practice Problem Assume you have a budget of $36 to spend on Pizzas and Hamburgers. Pizzas cost $8 and hamburgers cost $4. Complete the table below and answer the questions that follow The Utility Maximization Rule

11. 1.6 Theory of Consumer Behavior Individual Demand and Market Demand An individual consumer’s marginal utility curve for a particular good represents that individual’s demand for the good. If we consider demand as a signal of what a consumer is willing to pay for a good, and We recognize that what consumers are willing to pay is based on the utility they get from a good. With this in mind, we can see a relationship between consumers’ marginal utilities and market demand. Consider the market for ice cream: Assume there are 1,000 consumers in the market, Each with a similar MU for ice cream. When we sum the individual MU curves for each consumer, we get the market demand for ice cream. For 1,000 scoops, consumers would pay $5, based on their high MU for the first scoop. To sell more ice cream, price must fall, based on consumers’ diminishing marginal utility for ice cream. Individual Demand and Market Demand