Chapter 4: Consumer Behavior & Utility Maximization

Consumer

Who is a consumer? A consumer is one who demands goods and services. Without consumption
(households), there is no need for production (firm). The consumer is the king in a capitalist or free-
market economy. Producers, for their own interests, have to satisfy the needs and wants of consumers
in order to earn profits. In this perspective, all of us are consumers because as we live our daily lives we
demand goods and services the moment we wake up in the morning until we retire to our bed at night.

Our power to determine what is produced since we are the ultimate purchasers of goods and services is
referred to as consumer sovereignty. In general terms if we, as consumers, demand more of a good then
more of it will be supplied or vice versa. The producers simply obey the wishes and desires of
consumers. This therefore implies that producers are ‘passive agents’ (Pass and Lowes 1993) in the price
system, simply responding to what we want. However, in certain kinds of market (notably oligopoly and
monopoly), producers are so powerful vis-à-vis consumers that it is they who effectively determine the
range of choice open to us consumers. Nevertheless, our freedom to satisfy our human wants is not
completely unlimited. Nevertheless, for the good of society and the individual consumers, the
government restricts consumer sovereignty. For example, the government prohibits the use of
dangerous drugs and substances and regulates the use of products that are health hazards like alcoholic
beverages and cigarettes. It also regulates products that are destructive to the environment.

Goods and Services

Goods refer to anything that provides satisfaction to the needs, wants, and desires of the consumer.
They can be any tangible economic products (like cars, books, clothes, etc.) that contribute directly (final
goods) or indirectly (intermediate goods) to the satisfaction of human needs and wants. Services, on the
other hand, are any intangible economic activities (such as hairdressing, catering, insurance, banking,
telecommunications, etc.), that likewise contribute directly or indirectly to the satisfaction of human
wants.

Tangible goods can be classified according to, but not limited to, the following:

Consumer goods

These are the goods that yield satisfaction directly to any consumer. These goods are primarily sold for
consumption, and not to be used for further processing or as an input/raw material needed in producing
another good. Usually, these are the goods that are easily accessible to consumers (e.g. soft drinks,
bread, crackers, cellular phone loads).
Essential or necessity goods vs. luxury goods

Essential or necessity goods are goods that satisfy the basic needs of man. In other words these are
goods that are necessary in our daily existence as human beings. These are also goods that we cannot
live without such as food, water, shelter, clothing, electricity, medicine, etc.

Economic and free good

Conversely, luxury goods are those which men may do without, but which are used to contribute to his
comfort and well being. Examples of luxury goods are private jet, yacht, luxury cars, perfumes, jewelry,
etc.

An economic good is that which is both useful and scarce. It has value attached to it and a price has to
be paid for its use. If a good is so abundant that there is enough of it to satisfy everyone’s needs without
anybody paying for it, that good is free.

Water from our faucet is an economic good, because we are not utilizing it for free, we have to pay to its
distributor. The air that we breathe and the sunlight coming from the sun are examples of free good.

Tastes and Preferences

Consumers have various tastes and preferences. Generally, tastes and preferences are determined by
age, income, education, gender, occupation, customs and traditions as well as culture. Preferences are
the choices made by us consumers as to which products or services to consume. The strength of our
preferences will determine which products to buy given our limited disposable income and thus the
demand of products. As well as which product to buy, we as consumers also express preferences as to
which particular brand of a product to purchase. Even in the choice of food, clothing and shelter, for
instance, we differ in our choices and preferences. Some prefer bread than rice, others like fish and
vegetables than meat. In fact, we can generalize that no two consumers have exactly the same likes and
dislikes. Some individuals have simple taste and few preferences; others are sophisticated and
extravagant.

Before we leave this discussion, it is also important to understand what brand is. Simply defined, a brand
is the name, term or symbol given to a Product by a supplier in order to distinguish his offering from that
of similar Products supplied by competitors. Brand names are used as a focal point of Product
differentiation between suppliers. Examples of brand names include

Coca Cola for the soft drink products; Guess, Levi’s, and Lacoste for RTW Products, etc. Now, can you
identify other brands that you usually buy or consume?
Consumers have various tastes and preferences. Generally, tastes and preferences are determined by
age, income, education, gender, occupation, customs and traditions as well as culture. Preferences are
the choices made by us consumers as to which products or services to consume. The strength of our
preferences will determine which products to buy given our limited disposable income and thus the
demand of products. As well as which product to buy, we as consumers also express preferences as to
which particular brand of a product to purchase. Even in the choice of food, clothing and shelter, for
instance, we differ in our choices and preferences. Some prefer bread than rice, others like fish and
vegetables than meat. In fact, we can generalize that no two consumers have exactly the same likes and
dislikes. Some individuals have simple taste and few preferences; others are sophisticated and
extravagant.

Before we leave this discussion, it is also important to understand what brand is. Simply defined, a brand
is the name, term or symbol given to a product by a supplier in order to distinguish his offering from that
of similar products supplied by competitors. Brand names are used as a focal point of product
differentiation between suppliers. Examples of brand names include Coca Cola for the soft drink
products; Guess, Levi’s, and Lacoste for RTW products, etc. Now, can you identify other brands that you
usually buy or consume?

Maslow’s Hierarchy of Needs

Maslow’s hierarchy Of needs identifies the basic prioritieS Of COnSUmer. Maslow saw human needs in
the form of a hierarchy, ascending from the lowest to the highest. He concluded that when one set of
needs is satisfied, this kind of need ceases. The basic human needs placed by Maslow in an ascending
order of importance (like a pyramid) are: (a) physiological needs; (b) security, or safety needs; (c) social
needs; (d) esteem needs; and € self-actualization needs.

Physiological needs

These are the basic needs for sustaining human life itself, such as food, water, warmth, shelter, sex and
sleep. According to Maslow, until these needs are satisfied to the degree necessary to maintain life,
other higher needs will not stimulate people.
Safety needs

These are the needs to be free of physical danger and the fear of losing ones work, property, food, or
shelter.

Social needs

These needs cover the value of the sense of belongingness, love, care, acceptance and understanding of
family, relatives and friends, and to be accepted by others.

Esteem needs

These needs explain the importance of self-esteem, recognition, status of an individual and the general
acceptance of the society to an individual. This kind of need produces such satisfaction as power,
prestige, status, and self-confidence.

Self-actualization needs

These needs explain the worth of a person’s self-development, growth and realization and achievement.
According to Maslow, this is the highest need in the hierarchy. It is the desire to become what is capable
of becoming — to maximize one’s potential and to accomplish something.

The Economics of Satisfaction

You might be wondering by now how economics can explain the behavior of consumers in order to
attain maximum level of satisfaction on the goods and services that they generally consume. In this
section we try to explain how consumers attain maximum satisfaction level on the many goods and
services available to them for consumption. However, we have to remember at this point that
satisfaction is a relative term. This is because we differ in the way we are satisfied as well as the degree
of our satisfaction. As we have said earlier, no two consumers have the same likes and dislikes. This
section will discuss to you some of the theories that economists have devised to explain how consumers
are able to attain maximum level of satisfaction when consuming a particular good or service.

Utility Theory

Utility, in economics, refers to the satisfaction or pleasure that an individual or consumer gets from {he
consumption of a good or service that (s)he purchases. For purposes of economic analysis, utility is also
measured by how much a consumer is willing to pay for a good/service.

Table 4.1 presents a hypothetical demand schedule for siopao. You will notice in the table that the
amount of money that you are willing to buy for an additional unit of siopao declines. What is the
reason for this? As you might have experienced the more siopao you eat, the more you become satiated
so that you are not willing to spend more for the next siopao that you wish to consume. In other words,
the satisfaction or utility that you derive in the consumption of siopao declines as you consume more
and more of it.

The hypothetical example that we just illustrated is what the utility theory is all about. It simply tries to
explain how our satisfaction or utility as consumers decline when we try to consume more and more of
the same good at a particular point in time.

Two important concepts need to be explained before we totally understand the utility theory. These are:
the marginal utility and total utility concepts.

Marginal utility is defined as the additional satisfaction that an individUal derives from consuming an
extra unit of a good or service. Marginal means ‘additional’ or ‘extra’. In economics, we use marginal
analysis in the examination of the effects of adding one extra unit to, or taking away one unit from’
some economic variable. For this purpose, we are interested in the incremental or additional utility
derived from an additional consumption of a commodity. Thus, the marginal utility of a commodity is
the increase in total utility or satisfaction derived from the consumption of an additional or extra unit Of
such commodity; it is the loss of utility or satisfaction if one unit less is consumed.

No description available.
Total utility, on the other hand, is the total satisfaction that a consumer -derives from the consumption
of a given quantity of a good or service in a particular time period. Our total utility usually increases as
we consume more and more of a good or service, but generally the increase is at a slower or declining
rate. This implies that each extra unit consumed adds less marginal utility than the previous unit as we
become satiated with the good or service we are consuming.

Let us illustrate this using the hypothetical utility schedule presented in Table 4.2. Assume that at the
end of our class, you are too hungry so that you went directly to the cafeteria. In the cafeteria, you
bought and consumed one siopao for your merienda. In this case, your total and marginal utility are 40
utils. Assume further that you consumed another siopao because you are too hungry after the class.
Your total utility now increases to 90 utils so that marginal utility increases by 50 utils. Let us now
assume that you have consumed five siopao. Take note in that table that your total utility for the fifth
unit is 350 utils. However what is more important is the marginal utility. As we can observe, marginal
utility has declined to only 80 utils. Why is this so? This is because of the Law of Diminishing Marginal
Utility.

This Law states that as a consumer gets more satisfaction in the long-run, he experiences a decline in his
satisfaction for goods and services. This means that consumption of more successive units of the same
good increases total utility, but at a decreasing rate because marginal utility diminishes. In other words,
as we consume more and more of a good or service, we like it less and less, and as we consume
increasing amounts of a good or service, we derive diminishing utility, or satisfaction, from each
additional unit consumed.

No description available.

Mathematical Derivation of Marginal Utility

How do we derive marginal utility? Marginal utility is simply the change in total utility divided by the
change in quantity. Thus,

No description available.

Expanding our equation, we can solve for marginal utility using the following equation:
No description available.

Applying the formula, we can derive the marginal utility for the total utility presented in Table 4.2. Thus,
if we want to determine the marginal utility from the consumption of two pieces of siopao to three
pieces, we can simply apply the formulated presented above.

No description available.

You may try the other combination of quantity and total utility and solve for the marginal utility.

Graphical Illustration of Total Utility and Marginal Utility

Figure 4.1 and 4.2 are graphical presentations of the total and marginal utility concepts. As we have
discussed earlier, when we consume more and more of a good or service, our total utility increases but
at a decreasing rate. This is illustrated in Figure 4.1 where we have a convex utility curve. We can see
from the curve, as indicated by the dashed lines, that the initial consumption of 1 unit of Q to 2 units of
Q has a larger angle than the next consumption (from 2 units to 3 units). We can therefore imply that
the consumption from 1 unit of Q to 2 units of Q has a total utility of 10 utils or an incremental increase
of 5 utils, while for the next consumption it only increased to utils, or only an additional 1 util.

No description available.

The marginal utility curve illustrated in Figure 4.2 is a concave curve. This is because marginal utility
starts at high level but as consumption of the same good increases, marginal utility declines.

No description available.

Until when do we stop consuming the same good? As consumers, we have our own unique way of
maximizing our utility or satisfaction. We are given the opportunity to maximize our satisfaction by
continuously consuming more units of a certain good until our satisfaction falls down to zero. Thus, we
can say that we have already reached the peak of our satisfaction if our marginal utility is already zero.
Beyond this point (negative MU), we have already exceeded our satisfaction so that we stop consuming
the same good.

Consumer Surplus
We have already encountered the term surplus in our discussion of price equilibrium in the previous
chapter. We have to remember that the term surplus is used in economics for several related quantities.
For this section, our interest is to understand what consumer surplus is.

In general, consumer surplus is a measure of the welfare we gain from the consumption of goods and
services, or a measure of the benefits that we derive from the exchange of goods. In specific term,
consumer surplus is the difference between the total amount that we are willing and able to pay for a
good or service and the total amount that we actually pay for that good or service.

Let us illustrate this through an example. Suppose you are interested in buying a new pair of maong
pants. So you went to the mall to look for the pants that you wanted so much. Your budget for the pants
is P3,OOO.OO. When you went to the boutique, you found out that the pants that you liked most cost
only P2,500.00. Immediately, you bought the pants. What is now your consumer surplus?

Take note in our example that you are willing to pay for the pants at P3,OOO.OO. However, when you
bought the pants your actual cost was only P2,500.OO, therefore you have a consumer surplus of
P500.00. Why? Because consumer surplus is simply the difference between what you pay (for the pants
and all other goods or services that you buy) and what you would have been

We can also illustrate our example of the consumer surplus using a graph. Since the consumer surplus is
the difference between what you pay and the price you would have been willing to pay, then the
consumer surplus in Figure 4.3 is the area between P2,500.OO (the actual price) and P3,OOO.OO (the
price that you are willing to pay for the pants).