THEORY OF CONSUMER BEHAVIOR

WHAT AM I THINKING WHEN I MAKE A PURCHASE?

Objectives: At the end of the discussion the students will be able to:
 

study the consumption choices of people; analyze the preferences of the goods, how higher utility satisfaction is achieved and maximized given a certain level of income; • know the concepts of: total utility, marginal utility, and the law of diminishing marginal utility. • understand how rational consumers compare marginal utility-to-price ratios for products in purchasing combinations of products that maximize their utility.

Outline:

  

The Concept of Utility -Utility -Measuring Utility - Total Utility - Marginal Utility Law of Diminishing Marginal Utility Utility Maximization The paradox of value

Consumer Behavior and Utility Maximization
Quick write: Fill your shopping cart with all the goods and services you plan to buy in the next two months, including quantities 1. What factors determine the items you placed in your cart? 2. Why does your cart contain different items than the person sitting next to you? 3. If your income were to change in the next six months, would your cart contain different items? Why or why not? 4. If the price of some of the goods in your cart were to change, would the contents of your cart change? Why or why not?

Theory of Consumer Behavior
 Useful

for understanding the demand side of the market.  Study consumer behavior to answer: “How do consumers respond to marketing efforts the company might use?”

Consumer Buying Behavior refers to the buying behavior of final consumers (individuals & households) who buy goods and services for personal consumption.

Characteristics Affecting Consumer Behavior
Culture Social Personal Psychological

Buyer Buyer

Interpersonal Determinants of Consumer Behavior * Why People Buy new Products

Behavior: Culture
 Most basic cause of a person's wants  Most basic cause of a person's wants

and behavior. and behavior.  Values  Values  Perceptions  Perceptions
Subculture Subculture

Social Class Social Class
••People within a social class People within a social class tend to exhibit similar buying tend to exhibit similar buying behavior. behavior. ••Occupation Occupation ••Income Income ••Education Education ••Wealth Wealth

••Groups of people with shared Groups of people with shared value systems based on value systems based on common life experiences. common life experiences. ••North Indian Consumers North Indian Consumers ••African American Consumers African American Consumers ••Asian American Consumers Asian American Consumers ••Mature Consumers Mature Consumers

Behavior: Social
Groups Groups ••Membership Membership ••Reference Reference Family Family ••Husband, wife, kids Husband, wife, kids ••Influencer, buyer, user Influencer, buyer, user

Social Factors Social Factors

Roles and Status Roles and Status

Behavior: Personal
Personal Influences Personal Influences
Age and Family Life Cycle Age and Family Life Cycle Stage Stage Economic Situation Economic Situation Occupation Occupation Personality & Self-Concept Personality & Self-Concept

Lifestyle Identification Lifestyle Identification
Activities Activities Interests Interests Opinions Opinions

Personal Determinants of Consumer Behavior

Needs and Motives Need: an imbalance between a consumer’s actual and desired states Motives: inner states that direct a person toward the goal of satisfying a felt need

UTILITY THEORY . . .
What

comes to your mind when you hear the word - UTILITY?

UTILITY is…
Dictionary

defines UTILITY as usefulness, service, value, worth or benefit In Economics, UTILITY means the benefit or satisfaction that aperson gets from the consumption of a good or service. UTILITY is the basis of choice

 The

concept of utility helps us make predictions about consumption choices.

CAN YOUR SATISFACTION BE MEASURED?

Jollibee’s sausage-egg Pandesal Meal

Mcdonald’s Sausage-egg Pandesal meal

The theory faces 2 major problems
1. It is impossible to MEASURE satisfaction or utility

I CAN GET NO SATISFACTION… BUT I TRY, AND I TRY…

2. It is impossible to COMPARE the satisfaction or utilities of two persons or among individuals
VS

There

is a way in Economics that will quantify or measure utility or satisfaction through the concept of UTIL UTIL is an artificial construct or arbitrary number used to measure utility or satisfaction

Measuring Utility (Utility Cocepts)

Cardinal Utility Approach - refers to the measurement of utility by assigning numerical values, referred to as utils, such as 1 util, 12 utils, 140 utils or -35 utils. - assumes that we can assign values for utility, (Jevons, Walras, and Marshall). E.g., derive 100 utils from eating a slice of pizza - attaches specific numbers to different levels of satisfaction

Ordinal Utility Approach - measures utility in terms of ranks, such as those indicating levels from most satisfying to least satisfying, best to worst, and highest to lowest.
 -does not assign values, instead works

with a ranking of preferences (ordinal ranking preferences) (Pareto, Hicks, Slutsky)

EXAMPLE …

What did you eat for breakfast?

+
30 utils 20 utils

+
50 utils

This just shows that one can ASSIGN a number of UTILs to each GOOD. This is a subjective value because it depends on the person’s level of SATISFACTION derived from CONSUMING a GOOD.

THE CONCEPT OF UTILITY
 The

concept of utility helps us to make predictions about consumption choices.  But Marginal Utility Theory is NOT as precise as the concept of Utility.

TOTAL VS. MARGINAL UTILITY
TOTAL

UTILITY – The TOTAL satisfaction a person receives from consuming a particular quantity of a good MARGINAL UTILITY – The ADDITIONAL utility a person receives from consuming an ∆TU extra unit of a particular good. MU =
∆Q

TOTAL UTILITY
 Depends

on the quantity of the good consumed – more consumption generally gives more total utility.  Total utility generally increases as the quantity consumed of a good increases.

Total utility and marginal utility
Example (Table 4.1): Q 0 1 2 3 4 5 6 7 TU 0 20 27 32 35 35 34 36 MU --20 7 5 3 0 -1 -4
   

TU, in general, increases with Q At some point, TU can start falling with Q (see Q = 6) If TU is increasing, MU > 0 From Q = 1 onwards, MU is declining ⇒ principle of diminishing marginal utility ⇒ As more and more of a good are consumed, the process of consumption will (at some point) yield smaller and smaller additions to utility

TU2 – TU1 = MU1 (extra utils derived from consuming one more cup of coffee
CUPS OF COFFEE TOTAL UTILITY MARGINAL UTILITY

0 1 2 3 4 5

TU1 0 TU2 10 19 27 34 40

TU2 – TU1 = MU1 (extra utils derived from consuming one more cup of coffee
CUPS OF COFFEE TOTAL UTILITY MARGINAL UTILITY

0 1 2 3 4 5

TU1 0 TU2 10 19 27 34 40

10 - 0= 10 19 - 10= 9 27 – 19 = 8 34 – 27 = 7 40 – 34 = 6

LET’S FOCUS ON THE MARGINAL UTILITY OF COFFEE…
THE MARGINAL UTILITY DECREASES AS MORE CUPS OF COFFE IS CONSUMED OR THE UTILITY IS DIMINISHING OR DECREASING THIS IS CALLED…LAW OF DIMINISHING MARGINAL UTILITY

MARGINAL UTILITY

10 - 0= 10 19 - 10= 9 27 – 19 = 8 34 – 27 = 7 40 – 34 = 6

DIMINISHING MARGINAL UTILITY

=The general tendency of marginal utility to decrease as the quantity of a good consumed increases.

The law of diminishing marginal utility

The gains in satisfaction will decline as successive units of a given product are consume

:

Consumers will buy as much as pleases them, with their income. As each additional unit is purchased, the excess satisfaction gained from each purchase decreases, until it becomes irrational to continue purchasing.

.

For example, one slice of pizza may give you much satisfaction, as does the second slice. The third slice makes you extremely full, while the fourth slice makes you nauseous. At this point, it becomes irrational for you to purchase additional slices of pizza.

Total Utility Curve
TU 35

Total utility(in utils)

30 25 20 15 10 5 0 1 2 3 4 5 Quantity 6 Q Figure 4.1

Marginal Utility Curve
MU

Marginal utility (in utils)

20 15 10 5 0 -5 1 2 3 4 5 6 Quantity Q

Figure 4.2

WHY DEMAND CURVE IS DOWNWARD SLOPING
 One

of the reasons is the LAW OF DIMINISHING MARGINAL UTILITY  The inverse relationship of price and quantity demanded is partly explained by the law of diminishing marginal utility.  As one consumes successive units of a specific good, the less will be the utility it can give. Therefore, since this will give lower utilities, the price of the good must decrease.

DEMAND CURVE…once again!
P D

I will only buy more units of the good if you will give me a discount! Or make the good cheap so that I can buy large quantities of the good. Since the satisfaction I get from consuming extra units of good decreases, I will only buy the good at a lower price!

P1 P2

Q1

Q2

Q

Consumer Equilibrium
 So

far, we have assumed that any amount of goods and services are always available for consumption  In reality, consumers face constraints (income and prices):
 Limited

consumers income or budget  Goods can be obtained at a price

WHO IS THE CONSUMER?
 RATIONAL

– wants to get the most for his money or maximize total utility  PREFERENCES – desires certain goods Clear cut preference for goods and services. Buyers have a good idea of how much marginal utility they may have in successive units of the various products they might purchase.  BUDGET CONSTRAINT - faces budget limitation because of limited money income  PRICES – considers the prices of goods

Consumer Behavior and Utility Maximization
An economic explanation for how different consumers allocate their money income among different goods and services: · rational behavior: · preferences: · budget constraint: · prices: Consumers try to get the "most for their money" to maximize their total utility Consumers have clear cut preferences and can determine how much marginal utility they get from consuming more units of a product All consumers face a budget constraint, therefore must make decisions about what they buy based on their limited budget 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

 The

goal of a consumer is to maximize satisfaction or utility given the limited income.  This is accomplished by applying the marginal utility concept.  Given the limited income and the prices of goods, the consumer would want to obtain the highest utility possible.

Maximizing Total Utility
 Utility

Maximizing Rule: -The rule that leads to the greatest total utility from all the goods and services consumed. The rule is: 1. Allocate the entire available budget. 2. Make the Marginal utility per peso spent the same for all goods.

Some simplifying assumptions
 Consumer’s

objective: to maximize his/her utility subject to income constraint  2 goods (X, Y)  Prices Px, Py are fixed  Consumer’s income (I) is given

Consumer Equilibrium
 Marginal

utility per peso ⇒ additional utility derived from spending the next peso on the good

MU M U p e r p e=s o P

Consumer Equilibrium
 Optimizing

condition:
X

M U PX
 If

M U = P Y

Y

⇒ spend more on good X and less of Y

M X M Y U U > PX P Y

Efficiency, Price, and Value
 Marginal

Utility theory helps us to deepen our understanding of the concept of efficiency and to see more clearly the distinction between value and price. Let’s see how . . .

Utility Maximization Rule:  to maximize satisfaction, a consumer should allocate his or her money income so that the last peso spent on each product yields the same amount of extra utility. Marginal Utility per peso should be equal for each product you buy!

Simple Illustration
 Suppose:

X = fishball Y = siomai  Assume: PX = 2 PY = 10

Numerical Illustration
Qx 1 2 3 4 5 6 TUX 30 39 45 50 54 56 MUX 30 9 6 5 4 2 MUx Px 15 4.5 3 2.5 2 1 QY 1 2 3 4 5 6 TUY 50 105 148 178 198 213 MUY 50 55 43 30 20 15 MUy Py 5 5.5 4.3 3 2 1.5

2

potential optimum positions  Combination A: → X = 3 and Y =4
 TU

= TUX + TUY = 45 + 178 = 223

 Combination

B:

Y=5
 TU

X = 5 and

= TUX + TUY = 54 + 198 = 252

Presence of 2 potential equilibrium positions suggests that we need to consider income. To do so let us examine how much each consumer spends for each combination. Expenditure per combination  Total expenditure = PX X + PY Y
 Combination

A: 3(2) + 4(10) = 46  Combination B: 5(2) + 5(10) = 60

 Scenarios:
 If

consumer’s income = 46, then the optimum is given by combination A. .…Combination B is not affordable  If the consumer’s income = 60, then the optimum is given by Combination B….Combination A is affordable but it yields a lower level of utility

The Paradox of Value
More than two centuries ago, in The Wealth of Nations, Adam Smith posed the paradox of value: “Nothing is more useful than water; but it will scarce purchase anything. A diamond on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.”

The Paradox of Value
Why water is vital is cheap while diamonds are relatively useless but expensive.

The Paradox of Value
The more there is of a commodity, the less is the relative desirability of its last little unit. It is therefore clear why water has a low price and why an absolute necessity like air become a free good. In both cases, it is the large quantities that pull the marginal utilities so far down and thus reduce the prices of these vital commodities.

 Water

is more valuable than a diamond because water is more essential to life itself. Yet water is much cheaper than a diamond. Why?  Adam Smith tried to solve this paradox, but it was not until marginal utility theory had been developed that anyone give satisfactory answer.

Consumer Surplus

The paradox of value emphasizes that the recorded monetary value of a good may be a misleading indicator of the total economic value of that good. The measured economic value of the air we breathe is zero, yet air’s contribution to welfare is immeasurably large. The gap between the total utility of a good and its total market value is called consumer surplus. The surplus that arises because we “receive more than we pay for” as a result of the law of diminishing marginal utility. We have consumer surplus basically because we pay for the same amount for each unit of a commodity that we buy, from the first to the last.

Activity:
Answer the following questions briefly: 1. Do we always have limitations in consuming goods? Defend your answer. 2. Why do people go for more expensive goods rather than cheaper goods? 3. When you get stranded in a desert for a long time, which do you think has more value, water or diamond? Discuss your answer. 4. 4. Why is it necessary for us to spend our budget wisely?

HAVE A BLESSED DAY!

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