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CHAPTER 5: Consumer Behavior

Law of Diminishing Marginal Utility


Utility is the satisfaction one gets from
consuming a good or service
Not the same as usefulness
Subjective
Difficult to quantify
NOTE: Utility is a subjective notion in economics,
referring to the amount of satisfaction a person gets
from consumption of a certain item. Utility and
usefulness are not the same thing. Items that are
essentially useless can provide a lot of utility.
Util is one unit of satisfaction or pleasure
Total utility is the total amount of satisfaction
Marginal utility is the extra satisfaction from
an additional unit of the good MU = TU/Q
NOTE: Utility is measured in utils. Total utility is
the total amount of satisfaction one gets from the
consumption of a single product or a combination of
products. Total utility can be derived by adding up the
utils of successive units consumed. 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.
As consumption of a good or service increases,
the marginal utility obtained from each
additional unit of the good or service decreases
Explains downward sloping demand
NOTE: Although consumers 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. Theory of consumer behavior uses

the law of diminishing marginal utility to explain how


consumers allocate their income.

Total Utility and Marginal Utility

NOTE: Curves TU and MU are graphed from the data


in the table. As more of a product is consumed, total
utility increases at a diminishing rate, reaches a
maximum, and then declines. Marginal utility, by
definition, reflects the changes in total utility. Thus,
marginal utility diminishes with increased
consumption, becomes zero when total utility is at a
maximum, and is negative when total utility declines.
As shown by the shaded rectangles, marginal utility is
the change in total utility associated with each
additional taco. Or, alternatively, each new level of
total utility is found by adding marginal utility to the
preceding level of total utility.
Theory of Consumer Behavior
Rational behavior
Preferences
Budget constraint

Prices
NOTE: Rational behavior The consumer tries to
use his or her money income to derive the greatest
satisfaction from it.
Preferences Each consumer has clear cut
preferences for certain goods and services available in
the market.
Budget constraint At any point in time the
consumer has a limited, fixed amount of money to
spend.
Prices Every good has a price and prices are
unaffected by amounts purchased by the consumer.
Goods and services have prices and are scarce
relative to the demand for them.

Utility Maximizing Rule


Consumer allocates his or her income so that
the last dollar spent on each product yields the
same amount of extra (marginal) utility
Algebraically
MU of product A
MU of product
B
Price of A
Price of B
NOTE: A consumer is in equilibrium when utility is
balanced (per dollar) at the margin. When this is
true, there is no incentive to alter the expenditure
pattern unless tastes, income, or prices change. When
using the utility maximizing rule, it is important to
express the marginal utility of the good as marginal
utility per dollar spent since the two goods probably
have different prices. Therefore, we cant just
compare utilities because its like comparing apples to
oranges. So, we have to find the marginal utility per

dollar by dividing the marginal utility of the good by


the price.
Numerical Example

NOTE: It is assumed in this table that the amount of


marginal utility received from additional units of each
of the two products is independent of the quantity of
the other product. For example, the marginal utility
schedule for apples is independent of the number of
oranges obtained by the consumer. When determining
whether to buy the apples or oranges, we will compare
the marginal utility per dollar.
Decision-Making Process

NOTE: This illustration shows how consumers must


choose among alternative goods with their limited
money incomes. As long as one good provides
more utility per dollar than another, the consumer
will buy more of the first good; as more of the first
product is bought, its marginal utility diminishes
until the amount of marginal utility per dollar just
equals that of the other product. This table
summarizes the step-by-step decision making
process the rational consumer will pursue to reach
the utility maximizing combination. The algebraic
statement of this utility-maximizing state is that
the consumer will allocate income in such a way
that: MU of apples/price of apples = MU of
oranges/price oranges
Deriving the Demand Curve

NOTE: At a price of $2 the consumer represented


by the data in the table maximizes utility by
purchasing 4 oranges. The decline in the price of
oranges to $1 disrupts the consumers initial utilitymaximizing equilibrium. The consumer restores
equilibrium by purchasing 6 rather than 4 oranges.
Thus, a simple price-quantity schedule emerges,
which creates two points on a downsloping demand
curve.
Income and Substitution Effects
Income effect

The impact that a price change has on a


consumers real income
Substitution effect
The impact that a change in a products
price has on its relative expensiveness
NOTE: The substitution effect and income effect work
simultaneously. Income effect is the impact that a
price change has on a consumers real income and,
consequently, on the quantity demanded of the good.
If the price of a good falls, income is freed up and can
be used to buy more of both, or either, good under
consideration. The income effect is shown by the fact
that a decline in price expands the consumers real
income and the consumer can purchase more of this
and other products until equilibrium is once again
attained for the new level of real income.
Substitution effect is the impact that a change in a
products price has on its relative expensiveness and
on the quantity demanded. If the price of a product
falls, this decreases its relative expensiveness and
thus the consumer will now substitute more of this
good for the other. 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.
Applications and Extensions
New products
iPod
Diamond-water paradox
Opportunity cost and time
Medical care purchases
Cash and noncash gifts
NOTE: iPods were a new product perceived by
consumers as having a greater marginal utility to price

ratio than the older portable CD players and other


similar products, and thus resulted in a major shift in
demand for the new product as consumers attempted
to restore their consumer equilibrium.
Why do some goods that are essential to life have low
prices and goods that are not essential to life have
high prices? The marginal utility of the last unit of
water consumed is small because we consume a lot of
water. The marginal utility of the last diamond is large
because we consume few diamonds.
Time also has a value, so this must be considered in
decision making and utility maximization. When time
is considered, consumer behavior appears to be much
more rational. Highly skilled people, like doctors, earn
high wages and therefore incur a higher opportunity
cost whenever they use their time in some other way.
They are more likely to buy goods over the internet
and pay higher prices for things that will save them
time. Unskilled workers or retirees have low
opportunity costs for their time and therefore will use
time to search out ways to save money. They are
more likely to search for bargains and take longer trips
if it saves them money. Foreigners observe that
Americans waste material goods but conserve time.
This could be because Americans high productivity
makes their time more valuable than many of the
goods they waste.
With medical care purchases Americans with health
insurance pay an upfront fixed charge each month and
this charge is not affected by the amount we
consume. The additional marginal benefit is higher
than the marginal cost of additional use. This explains
why Americans use so much more than if they had to
pay full price.
Noncash gifts result in a loss of utility and we then
take action to maximize our utility, such as taking it

back and exchanging it, etc. Noncash gifts may yield


less utility to the receiver than a cash gift of equal
monetary value because the noncash gift may not
match the receivers preferences. Individuals know
their own preferences better than the gift giver.
Prospect Theory
How people actually deal with lifes up and
downs
People judge things relative to the status quo
People experience:
Diminishing marginal utility for gains
Diminishing marginal disutility for losses
People are loss adverse
NOTE: Daniel Kahnemman was awarded the Nobel
Prize in economics for this work. People judge good
things and bad things relative to the status quo or the
situations they are used to.
People are loss adverse meaning we feel losses of
some amount much more acutely than gains of the
same amount.
Losses and Shrinking Packages
Consumers see any price increase as a loss
relative to the status quo
Producers are reducing package size instead of
raising prices
NOTE: Producers have to be careful about increasing
prices because consumers are aware of the price
changes and view higher prices as a loss. When
producers faced sharply higher input costs a few years
ago, instead of increasing prices, they responded by
decreasing the package size. Some industries who
have varied the size of their packages are cereal,
soap, candy, and paper towels.
Framing Effects and Advertising
Consumers evaluate events in a particular
mental frame

New information alters the frame in which the


consumer defines whether situations are gains
or losses
NOTE: An example of framing would be labeling, such
as 20% fat, or 80% lean meat, which are actually
describing the same thing. However, one describes a
loss (20% fat) and the other description is a gain (80%
lean). If a new frame is introduced it can alter the
consumers valuation of marginal utility and it will
affect the consumption decision.
Anchoring and Credit Card Bills
Estimates of value are influenced by recent
information no matter how irrelevant
Can lead to people altering valuations
unconsciously
NOTE: An example of anchoring is when credit card
companies print out small minimum due payments.
The small minimum payments serve as an anchor. This
results in people making smaller payments over a
longer period of time than they would otherwise.
Mental Accounting and Warranties
Separate purchases into mental accounts
rather than looking at the big picture
Mental accounting exaggerates any potential
loss
NOTE: Mental accounting explains the suboptimal
tendency of people to view consumption purchases in
isolation rather than all of their consumption options
simultaneously. When making a TV purchase, the
price of the new television is in the purchasers mind
rather than their future income streams and their
ability to pay in the case of the low probability of a
television breaking down. People then buy an

overpriced warranty on the TV (or some other


electronics) even though new TVs (electronics) rarely
break down past the expiration of the regular
warranty.
The Endowment Effect
Market transactions may be affected by the
endowment effect because:
The seller has a tendency to demand a
higher price
The buyer has a tendency to offer a lower
price
NOTE: People have a tendency to put a higher
economic value on things that they currently possess
rather than identical items that they might purchase.
The loss adverse effect on the seller will be stronger
than the gain effect on the buyer. Sellers put higher
valuations on things they own and buyers put lower
valuations on things they do not own.
Nudging People
Using behavioral economics to change peoples
behavior
Subtle manipulations are used to generate
socially better outcomes
Unaware of being manipulated
NOTE: Examples: By changing the default option on
retirement plans to automatically enroll instead of not
enroll, the number of people enrolled rose
dramatically. An electric company used smiley faces
on bills with below average usage and frowney faces
on bills with above average usage to encourage
people to conserve more energy.