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    Chapter 7 Study Guide

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    aazizk

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    CHAPTER 7 Consumer Behavior and Utility Maximization Previous chapters explained that consumers typically buy ‘more of a product as its price decreases and less of a prod- uct as its price increases. Chapter 7 looks behind this law (of demand to explain why consumers behave that way. The chapter first explains the law of diminishing marginal utility and uses it to explain why the demand curve slopes downward. This explanation is based on the Concept of marginal utlty. In this view, the additional sat- 'sfaction (or marginal utility) a consumer obtains from the ‘consumption of each additional unit of @ product tends to decline; therefore, a consumer will have an incentive to purchase additional units of a product only i its price falls. (Another explanation of the law of demand that is ‘more complete but more complex is based on indiference curves and is presented in the appendix to this chapter.) ‘Most ofthis chapter presents the marginal-utility view of consumer behavior. This explanation requires that you Understand the concepts and assumptions on which this theory of consumer behavior rests and then do some rig- orous reasoning using those concepts and assumptions. itis an exercise in logic, but be sure that you follow the reasoning. To help you, the text provides several numerical ‘examples for you to follow. No one believes that consumers actually perform these ‘mental gymnastics bofore they spend their incomes or make purchases. But we study the marginal-utity ap- ‘proach to consumer behavior because consumers behave as if they made their purchases on the basis of very fine calculations. Thus, this approach explains what we do in fact observe and makes it possible for us to predict with a good deal of precision how consumers will react to changes in thelr incomes and the prices of products. ‘The final section of the chapter describes how the theory ‘of consumer behavior can be used to explain many eco- nomic events in the real world, The five applications dis- cussed are the takeover by DVDs of the market fr recorded ‘music, the water-diamond paradox, the value of time in consumption, the reasons for increased consumer pur- chases of medical care, and the economic effects of cash, land noncash gifts. Be sure you understand how consimer theory is used to explain these five phenomena. m= CHECKLIST When you have studied this chapter you should be able to CD Describe the law of diminishing marginal utility. 1 Define utlity, marginal utlity, and total utility. 1D Explain the relationship of the law of diminishing ‘marginal uility to demand. CD List four ‘dimensions of the typical consumer's situation. D State the utilty:maximizing rule. Cl When you are given utily and price data, use the utlty-maximizing rule to determine how consumers will ‘spend their fixed incomes. CI Explain how a consumer decides between an optimal land an inferior solution to a ullity-maximization problem. Cl Give an algebraic restatement ofthe utiity-maximizing rule that is based on an example using two products, A and B. 11 Derive @ consumer's demand schedule for a product ‘rom utility income, and price data. 11 Explain how the income and substitution effects are involved in utility maximization and the derivation of the demand curve for a product. * 1 Give examples of how consumer theary can be used 10 explain such economic situations as the popularity of DVDs and DVD players; the diamond-water paradox; the value of time in consumption; consumer purchases of ‘medical care; and tradeoffs between cash and noncash its, 1D Discuss how economic analysis can be used to explain property crimes (Last Word), CHAPTER OUTLINE. 1. The law of diminishing marginal utility can be used to explain why the demand curve slopes downward. a. Utility is subjective and dificult to quantity. For the purposes of this chapter, it wll be assumed that utility Is tho satisfaction or pleasure a person gets from con- ‘summing a product. It will be measured in hypothetical Units called utis. . Total utility is the total amount of satistaction a ‘consumer obtains from consuming a product. Marginal utility's the extra satistaction a consumer obtains from ‘consuming an additional or extra unit ofa product. The principle that the marginal utility of a product falls as ‘a consumer uses (consumes) adaltional units of that product is the law of diminishing marginal utility. There {sa relationship between total utlity and marginal tity. ‘As shown in text Figure 7.1, total util increases, but at a decreasing rate, until it reaches a maximum and then declines. Marginal ullty decreases as total uti- ity increases. Waen total utllty reaches @ maximum, 75 78 CHAPTER 7 marginal utility is zero, When total utlty déctines, mar- ginal utility is negative, €. The law of diminishing marginal utility explains why the demand curve for a product slopes downward. AS ‘more and more of a product Is consumed, each ad- ditional unit consumed provides less satisfaction. The ‘consumer will uy more of the product only ifthe price falls, 2. The law of diminishing marginal utity is also the basis of the theory of consumer behavior, which explains how ‘consumers spend their incomes for Particular goods and services, ‘In the simple case, it Is assumed that the typi- cal consumer engages in rational behavior, knows ‘marginal-uility schedules for the various goods avall- able (has preferences), has a limited money income to ‘spend (a budget constraint), and must pay a price to ‘acquire each of the goods that yield utility. ». Given these assumptions, the consumer maximizes the total utlity obtained when the marginal utility of the last dollar spent on each product is the same for all Products (the utility-maximizing rule). ©. A numerical example is employed to illustrate the Tule, using two products, A and B, and assuming that all money income is spent on one of the two products. In making the decision, the rational consumer must ‘compare the extra or marginal utilty from each product with its added cost (as measured by its price). Thus, ‘marginal utlty is compared on a per-dollar basis d. The allocation rule states that consumers will maxi- mize their satisfaction when they allocate thelr money income s0 that the last dollar spent on each product yields the same marginal utility: In the two-product ccase, this can be stated algebraically as Marginal utlty of A _— Marginal utlity of B Price of A Price of B ‘Total utility is at a maximum when the marginal utility of the last unit of a product purchased divided by its pice is the same for all products. 3. The utlty-maximizing rule can be applied to determine the amount of a product a consumer will purchase at dit- ferent prices with income, tastes, and the prices of other products remaining constant. ‘a. The numerical example that is used is based on ‘one price for a product. If the price of the product falls, Its possible to use the utilty-maximizing rule to de- termine how much more of the product the consumer will purchase. Based on this exercise, it is possible to show the inverse relationship between price and ‘quantity demanded as shown by a demand curve, b. Ustity maximization can also be understood in terms of the income and substitution effects to explain the law of demand. As the price of @ product drops, a ‘consumer increases the amounts purchased to restore equibrium, folowing the utilty-maximizing rule. The ‘change can be viewed as the consumer substituting ‘more of the now less expensive product for another product and having more real income to spend. 4, Five of the many applications and extensions of ‘consumer theory for the real world are discussed in this chapter. ‘a. DVDs have gained popularity among consum- fers relative to videocassettes (VCs) because many ‘consumers have concluded that DVDs have a ratio of ‘marginal utlty to price that is higher than the ratio for Ves. . Diamonds are high in price but are of limited use- fulness, whereas water is low in price but essential for life. The diamond-water paradox is explained by distinguishing between marginal utlity and total uty. Water is low in price because itis generally in plent- ful supply and thus has low marginal utility. Diamonds are high in price because they are relatively scarce and thus have high marginal utility. Water, however, is ‘considered more useful than’diamonds because it has ‘much greater total utility cc. The facts that consumption takes time and time is a scarce resource can be included in the marginal-utility theory. The full price of any consumer good ar service is ‘equal to its market price plus the value of time taken to consume it (.., the inoome the consumer could have earned if he or she had used that time for work). d. Expenditures on medical care have increased because of its financing through Insuréince, Under this, system, the. consumer does not pay the full price of ‘medical care services and thus has an incentive to ‘consume more than would be the case ifthe consumer paid the fll price €. Cash gifts tend to be more efficient for consumers, because they are more likely to match consumer preferences and increase the total utilty compared to honcash gifts that restrict consumer choice. 5, (Last Word). The theory of consumer behavior can be applied to criminal behavior involving property crimes. A criminal compares the marginal benefit ofa theft with the ‘marginal cost or “price” Most people, even those inclined toward criminal behavior, find the benefits to be low and the costs high (such as uit, the direct cost of criminal ‘equipment, and forgone Income from being in prison), but ‘some do not and thus engage in eriminal activity. Criminal activity can be reduced by raising the marginal cost (such ‘as more security and rhore penalties). HINTS AND TIPS 41. Utility is simply an ‘abstraction that is useful for explaining consumer behavior. Do not become overly ‘concerned with the precise measurement of utility oF satisfaction. What you should focus on is the relative ‘comparison of the additional satisfaction (marginal utility) {rom a dollar spent on one good to the addtional satis- faction obtained from a dollar spent on another good, The choice of producing more additional utlity satisfac- tion from one good than from the other'will maximize consumer satisfaction. Thus, you just need to know which good won the contest, not the final score (how much ‘additional utity was added) 2. Master the difference between marginal utlty and total tity. Once you think you understand the difference, use the concepts to explain to someone the dlamond-water paradox at the end of the chapter. 3. The utlty-maximization model provides insights into the income and substitution effects that occur with a change in price. For most products, @ price decrease sgives consumers more income to spend on that prod- uct and other products, and so the quantity demanded of that product increases. The three steps in the logic for ‘ypical product A are (1) Pal, (2) incomet, and (8) Qua} A price decrease also makes product A more attractive to buy relative to its substitutes, and so the demand for those substitutes decreases and the quantity demanded for product A increases. Again, there are three stops in the logie: (1) Pal, (2) demand for substitutes|, and (8) Qzat In both cases, the end result is the same: Qyat. Solity your understanding by showing the logie for an increase in the price of product A. 1 IMPORTANT TERMS. law of diminishing marginal ‘budget constraint tity utlty-maximizing rule utty Income effect total utility ‘substitution effect marginal tity rational behavior CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION 77 6. The marginal-utlity theory of consumer behavior as- ‘sumes that the consumer is (wealthy, rational) land has certain (preferences, discounts) for various goods. 7. A consumer cannot buy every good and ser vice desired because income is (subsidized, limited) and goods and services are (unlimited, In relation to the demand for them; 3) scarce) thus, they have (prices, quant attached to them. 8. When a consumer is maximizing the utlity his or her income will obtain, the ratio of the marginal utility of the (frst, last) nit purchased of @ product tots price is (the same, greater than) {or all the products bought. 9. If the marginal utility of the last dollar spent on one product is greater than the marginal utlty of the last dollar spent on another product, the consumer should purchases purchases of the (increase, decrease) of the first and second product. 410. Assume there are only two products, X and Y, that ‘a consumer can purchase with a fixed income. The con- ‘sumer is maximizing utllty algebraically when: a, ce ‘SELF-TEST 1m FILLIN QUESTIONS: 1. The reason demand curves slope downward can be explained by the law of (comparative advantage, diminish- ing marginal utility) 2. Theoveralisatistacionaconsumergets romconsuming ‘a good or service is (marginal, total) ultilly, andthe extra or additional satisfaction that @ con- sumer gets from a good or service is (marginal, total) tity, 3. Uillty Is (an objective, a subjective) concept and ('s, is not) 2s usefulness. ‘the same thing 4. The law of diminishing marginal uly states that mar- inal utility wil (increase, decrease) asa consumer increases the quantity consumed of a product 5. A graph of total utility and marginal utity shows that when total utility is increasing, marginal utility Is (positive, negative) and when total utility is at a maximum, marginal utilty is at (a maximum, zero, @ minimum) b a 111. In deriving a consumer's demand fora particular prod- ct, the two factors (other than the preferences or tastes of the consumer) that are held constant are a b 12. The utity-taximizing rule and the demand curve are logically (consistent, inconsistent) . Because marginal utility declines, a lower price is needed to get the consumer to buy (less, mare) ofa particular product, 19. A fall in the price of a product tends to (Increase, decrease) and a tise in its price tends to real income. This is called the (substitution, income) fect. ‘consumers real income, 14, When the price of a product increases, the product becories relatively (more, less) expensive than it was and the prices of other products become rela- tively (higher, lower) _ than they were; the ‘consumer therefore will buy (less, more) of the 78 CHAPTER product in question and of the other products. ‘This is called the (substitution, income) effect. 15. When consumer preferences changed from vides- cassette tapes to DVDs and the prices of DVD players (increased, decreased) significantly, this ‘led to (Increased, decreased) purchaises of DVDs. ; 16. Water is low in price because its (total, marginal) utlty is low, whereas diamonds are highin price because their_ utility shigh. Water, however, is more useful than diamonds because’ the (otal, marginal) _uilty of water Is much greater than the Utity of diamonds. 17, The theory of consumer behavior has been general- ized to account for (supply, time) This is valuable economic resource because its (limited, unim= ited) Its value is (greater than, equal CO) _ the income that can be earned with it The full price to the consumer of any product is, therefore, the market (time, price) plus the value of the consumption 18. With health insurance coverage, the price consumers pay for health care services is less than the “rue” value or opportunity (benefit, cost) The lower price to consumers encourages them to consume (more, less) —_ health care services. 19. A comparison of food consumption at an alle you-can-eat buffet with that ata pay-per-item cafeteria would ‘show that people tend to eat (less, more) _ at the buffet because the marginal utlily of an extra food item is (positive, zero) _ and its price 20. Noncash gifts are (less, more) preferred than cash gifts because thay yield (less, more) total utlty to consumers, 1 TRUE-FALSE QUESTIONS Circle T ifthe statement is true, F it tis false, 1. Utility is the benefit or satisfaction a person receives from consuming a good or service. Tr 2. Utility and usefuiness are not synonymous. TF 3. Marginal uilty is the change in total utilty from eon= suming one more unit of a product. Tr 4, Because utility cannot actually be measured, the marginal-utlty theory cannot really explain how consum- cers will behave. TF 5. The law of diminishing marginal utility indicates that {gains in satisfaction become smaller as successive nits of a specific product are consumed. Tr 6. Aconsumer's demand curve fora productis downslop- ing because total utlity decreases as more ofthe product is consumed. Tr 7. tot utlty is increasing, then marginal utlit is posi- tive and may be either increasing or decroasing. TF 8. The theory of consumer behavior assumies that con- sumers act rationally to get the mast for their money. TF 9. All consumers are subject to budget constraints, TE 10. To find a consumer's demand for a product, the price of the product is varied while tastes, income, and the prices of other products remain unchanged. TF 11. The theory of consumer behavior assumes that con- sumers attempt to maximize marginal utility TE 12, I the marginal uility per dollar spent on product A is

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