Wk5 & 6 / Theory of consumer behavior MARGINAL UTILITY

- Utility and behavioral factors  Marginal utility measures the added satisfaction
- The utility functions derived from 1-unit increase in consumption of a
- Consumption particular good and services, holding consumption of
- The law of Diminishing marginal utility and shape of the curve other goods and service constant. (Satisfaction
- Hierarchy of indifference curve diminished)
 The nonsatiation assumption requires that marginal
UTILITY THEORY utility is positive (unlimited wants), MU (X) > 0.
 Marginal utility tends to diminish as consumption
The ability of goods and services to satisfy customer wants
increase within a given time interval
is the basis for consumer demand.
 Satisfaction for every additional consumption
Basic assumption in utility theory: / demand analysis
MARGINAL UTILITY
1. More is better
- Consumers always prefer more to less of any good
and service. Referred as the nonsatiation principle.
- Nonsatiation principle is best considered with the
context of money income where more money
brings additional satisfaction or well-being.
2. Preferences are complete
- Consumers are able to compare and rank the
benefits tied to consumption (1st only)
Indifference implies equivalent in the eyes of the
consumer where 2 products yield the same amount of
satisfaction to customer.

3. Preferences are transitive (ex 1st coke 2nd sprite 3rd

royal / hierarchy)
- Consumers are able to rank order the desirability of
various goods and services
If a consumer prefers good X than good Y, and
good Y than good Z also good X better than good
Z
- (1st 2nd 3rd) Ordinal utility makes possible a rank
order of preferred goods and services
- (Ratio) Cardinal utility they would know much spice
chicken wraps are preferred say 2:1 or 3:1 over
vegetarian wraps LAW OF DIMINISHING MARGINAL UTILITY
Utility function is a descriptive statement that relates
satisfaction or well-being to the consumption of goods  The law of diminishing marginal utility states that as
and services and can be written in general form: you consume more, your satisfaction per unit is
decreasing until you will reach zero (0) util.
Utility (satisfaction gained) = f multiply by (quantity of  This law gives rise to a downward-sloping demand
goods or services) curve for all goods and services.
 To a greater or lesser degree, goods and services
Utility or total utility means satisfaction gained or
can be substituted for one another.
received by consumption of any goods or services.

MARKET BASKET

 Bundle of items desired by the consumers that reflect

the combinations of goods and services available in
the marketplace.
Utility is intangible
 Tangible evidence of utility reveal through purchase
decisions by preference of customer (repeat order)
INDIFFERENCE CURVE
 Indifference curve analysis is an alternative to the
marginal utility analysis or demand analysis.
 This approach assigns an order to consumer
preferences than measure them in terms of money.
Indifference curves represent all market baskets that
provide a given consumer the same amount of utility or
satisfaction. Hence, combinations give the same amount
of satisfaction, consumers prefer them equally.
Example:
Miguel has 1 unit of food and 12 units of shoes. How many
units of shoes is he willing to give up in exchange for an
additional unit of food so satisfaction level is the same?
INDIFFERENCE MAP
 Set of indifference curves that represent complete
picture of a consumer’s preference.
Marginal rate of substitution (MRS)
Miguel gives up 6 units of shoes to get an extra unit of food.
So, MRS is 6. Therefore, MRS of X (food) for Y (shoes) is the
amount of Y whose loss can be compensated by a unit
gain of X (Satisfaction the same). Possible reasons, the
intensity of desire for add units of food decreases and
goods are imperfect substitute (MRS remains constant).
Combination Food Shoes MRS
A 1 12 -
B 2 6 6
C 3 4 2
D 4 3 1
ESSENTIAL PROPERTIES INDIFFERENCE CURVE (IC)
 Higher indifference curve are the better
Consumer prefer more to less, so they prefer higher
indifference curves that represent greater
combinations of goods and services to lower
indifference curves that represent smaller combinations
of goods and services
 Indifference curve do not intersect
Holding goods constant, an indifference curve
involving greater amount of service must give greater
satisfaction.
Holding services constant, an indifference curve involving
greater amount of goods must give greater satisfaction.
This stems from the fact that good and services both
provide consumer benefits, and reflect the more is better
principle.
“Ceteris paribus” = other things being equal
 Indifference curves slope downward
Because consumers like both goods and services, if the
quantity of one is reduced, the quantity of the other
must increase to maintain the same degree of utility.
 Indifference curves bend inward (convex to the origin)
When goods are relatively scarce, the law of marginal
utility means that the added value of another unit of
goods will be large in relation to the added value of
another unit of service
Conversely, when goods are relatively abundant the
added value of another unit of goods will be small in
relation to the added value of another unit of services.
- Substitutes are goods and services that can be used
to fulfill a similar need or desire.
- Perfect substitutes are goods and services that
satisfy the same need or desire.
Perfect substitutes are reflected in straight-line indifference
curves.
Perfect substitute example if same satisfaction from 2
different goods
PROPERTIES OF INDIFFERENCE CURVE (IC)
 IC slopes downward to the right
 IC is always convex to the origin
 IC never intersect each other
 Higher IC indicates higher level of satisfaction
compared to a lower IC
 IC does not touch the axis
 Perfect complement are goods and services that
become more desirable when consumed together.
 Perfect complements are good and services consumed
together in the same combination.

BUDGET = SPENDING ON GOODS + SERVICES
Budget Line - higher IC represents higher level of
satisfaction, consumer will try to reach highest level of IC to
maximize satisfaction. Might encounter possible constraints
/ limitations.
BUDGET CONSTRAINTS
 Budget constraints represents all combinations of
products that can be purchased for a fixed amount. To
derive a budget constraint, add up the amount of
spending on goods and services that is feasible with a
given budget.
 The effect of a budget increase is to shift a budget
constraint outward and to the right.
 The effect of a budget decrease is to shift a budget
constraint inward and to the left.
 So long as the relative prices of goods and services
remain constant, budget constraint remain parallel.
 A fall in the price of goods and services permits an
increase in consumption and consumer welfare.
INCOME EFFECT
 The income effect of a
price change in the
increase in overall
consumption made
possible by a price cut,
or decrease in overall
consumption that
follows a price increase.
 The income effect shifts buyers to a higher indifference
curve following a price cut or shifts them to a lower
indifference curve following a price increase.
SUBSTITUTION EFFECT
 The substitution effect of a price change describe the
change in relative consumption that occurs as
consumers substitute cheaper products for more
expensive products.
 The substitution effect results in a upward or downward
movement along a given indifference curve.
 The total effect of a price change on consumption is
the sum of income and substitution effect.
 The best allocation of a budget is the allocation to
maximize the utility or satisfaction derived from
consumption.
 The resulting optimal market basket of goods and
services must satisfy two important conditions
Optimal market basket lies on the budget line
 The budget line represents all combinations of goods
and services that can be purchased for a fixed amount.
Market basket combinations that lie above and to the
right of the budget lines
 Purchase of market baskets that lie below and to the
left of these budget lines would leave funds unspent
and reduced consumption of valuable goods and
services.
 The most feasible market basket combination lies on
the budget line
Optimal market basket reflects consideration of marginal
benefits and marginal costs
 Marginal analysis involves a comparison between
added costs and added benefits. In terms of
consumption decisions, consumers must weigh the
relative marginal benefits and relative marginal costs
derived from consumption.
 At the margin, if consumers derive twice as much
satisfaction from the consumption of goods as from the
consumption of services then the consumers would be
willing to pay twice the marginal cost (price) for goods
as opposed to service.
MARGINAL RATE OF SUBSTITUTION
 The change in consumption of Y (goods) necessary to
offset a given change in the consumption of X
(services) if the consumer’s overall level of utility is to
remain constant. This can be stated as
 MRS = ∆Y / ∆X = slope of an Indifference curve
Marginal Rate of Substitution
 Utility is maximized when the marginal utility derived
from each individual product is proportional to the
price paid
 Utility is maximized when products are purchased at
relative prices that equal the relative marginal utility
derived from consumption.
Value perceived - refers to the perspective or opinion of a
customer towards a product or service. Also called
customer perceived value.