Chapter 7

Consumer
Behavior

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Objectives
• Total utility and marginal utility
• Law of diminishing marginal utility
• Marginal utility-to-price ratios
• Deriving the demand curve
• Income and substitution effects
• Appendix: the indifference curve
model
7-2
 Utility
• Diminishing marginal utility
(again)
• Satisfaction obtained from
consumption
• Three characteristics
– Differs from usefulness
– Subjective
– Difficult to quantify
7-3
 Utility
• Total utility
– Total satisfaction from a specific
quantity
• Marginal utility
– Extra satisfaction from an
additional unit
• Law of diminishing marginal
utility
– Explains downward sloping
demand 7-4
 Utility Graphically
Total Utility

30

Total Utility (Utils)

(1) (2) (3)
Tacos Total Marginal
Consumed Utility, Utility, TU
Per Meal Utils Utils 20

0 0
] 10 10
1 10
] 8
2 18
] 6 0 1 2 3 4 5 6 7
3 24 Units Consumed Per Meal
] 4

Marginal Utility (Utils)

4 28 Marginal Utility
5 30
] 2 10

6 30
] 0 8
6
7 28
] -2 4
2
0
-2 MU
1 2 3 4 5 6 7
Units Consumed Per Meal
7-5
Theory of Consumer Behavior
• Key dimensions of the consumer
problem
– Rational behavior
– Preferences
– Budget constraint
– Prices

7-6
Theory of Consumer Behavior
• Find utility maximizing
combination of goods
• Utility maximizing rule
– Allocate income
– Last dollar spent on each
good yields same marginal
utility
– Marginal utility per dollar
7-7
 Numerical Example
Combinations of apples and oranges obtainable
with an income of $10
(2) (3)
Apple (product A) Orange (product B)
Price = $1 Price = $2
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility Marginal Utility
Unit of Utility, Per Dollar Utility, Per Dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Compare marginal utilities
Fourth 6 6 16 8
Then compare
Fifth 5
per dollar
5
- MU/Price
12 6
Choose the 4highest 4
Sixth 6 3
Check budget
Seventh 3 - proceed
3 to next4 item 2 7-8
 Numerical Example
Combinations of apples and oranges obtainable
with an income of $10
(2) (3)
Apple (product A) Orange (product B)
Price = $1 Price = $2
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility Marginal Utility
Unit of Utility, Per Dollar Utility, Per Dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Again, compare per dollar - MU/Price
Fourth 6 6 16 8
Choose
Fifth
the highest
5 5 12 6
Buy
Sixth one of each
4 – budget
4 has $5
6 left 3
Proceed
Seventh to next
3 item3 4 2 7-9
 Numerical Example
Combinations of apples and oranges obtainable
with an income of $10
(2) (3)
Apple (product A) Orange (product B)
Price = $1 Price = $2
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility Marginal Utility
Unit of Utility, Per Dollar Utility, Per Dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Again, compare per dollar - MU/Price
Fifth 5 5 12 6
Buy
Sixth
one more4
orange4 – budget6 has $3 3left
Proceed
Seventh to next
3 item3 4 2 7-10
 Numerical Example
Combinations of apples and oranges obtainable
with an income of $10
(2) (3)
Apple (product A) Orange (product B)
Price = $1 Price = $2
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility Marginal Utility
Unit of Utility, Per Dollar Utility, Per Dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Fifth 5 5 12 6
Again,
Sixth
compare
4
per dollar
4
- MU/Price
6 3
Buy one of each
Seventh 3 – budget
3 exhausted
4 2 7-11
 Numerical Example
Combinations of apples and oranges obtainable
with an income of $10
(2) (3)
Apple (product A) Orange (product B)
Price = $1 Price = $2
(b) (b)
(a) Marginal (a) Marginal
(1) Marginal Utility Marginal Utility
Unit of Utility, Per Dollar Utility, Per Dollar
Product Utils (MU/Price) Utils (MU/Price)
First 10 10 24 12
Second 8 8 20 10
Third 7 7 18 9
Fourth 6 6 16 8
Final
Fifth result5 – at these
5 prices,
12 6
Sixth 4 4 6 3
purchase
Seventh
23 apples3 and 4 oranges
4 2 7-12
Algebraic Generalization

MU of product A MU of product B
price of A
= price of B

8 Utils 16 Utils
$1
= $2

Optimum Achieved – Money income

is allocated so that the last dollar spent on
each product yields the same extra or
marginal utility
7-13
 Deriving the Demand Curve

Price of Product B
Price Per Quantity
Unit of B Demanded

$2 4
1 6 1

DB
Income Effects
0
4 6
Substitution Effects Quantity Demanded of B
7-14
Applications and Extensions
• New products increase utility
– iPods
• The diamond-water paradox
• The value of time
• Medical care purchases
• Cash and noncash gifts
7-15
 Behavioral Economics
• Human instinct for variety
• Consume more when there
is more variety
– M&Ms
• Time inconsistency
– Final exams
– Retirement savings

7-16
 Key Terms
• Law of diminishing marginal utility
• Utility
• Total utility
• Marginal utility
• Rational behavior
• Budget constraint
• Utility maximizing rule
• Income effect
• Substitution effect

7-17
Next Chapter Preview…

The Costs of
Production

7-18
 The Budget Line
–Income changes
–Price changes
12
Units of A Units of B Total Income = $12
10 PA = $1.50
(Price = $1.50) (Price = $1) Expenditure

Quantity of A
8 (Unattainable)
8 0 $12
6 3 12 6

4 6 12 4 Income = $12
PB = $1
2 9 12 2 (Attainable)
0 12 12
0
2 4 6 8 10 12
Quantity of B

7-19
 Indifference Curves
What is preferred
– Downsloping and convex
– Marginal rate of substitution
12
j
Combination Units of A Units of B 10

Quantity of A
8
j 12 2
6 k
k 6 4
l
4 m
l 4 6
2 I
m 3 8
0
2 4 6 8 10 12
Quantity of B

7-20
 Indifference Curve Analysis
• The indifference map
• Equilibrium position at tangency
12

10
PB
MRS =
PA
8
Quantity of A

Preferred –
6 W But Requires
More Income
4 X

I4
2 I3
I2
I1
0
2 4 6 8 10 12
Quantity of B
7-21
 Demand Curve Derived
12

10
At $1 price for B,
Quantity of A
8
6 units of B are
purchased
6
X
4
Record the results
2
I3
I2
0
2 4 6 8 10 12
As price of B increases
Quantity of B to $1.50, only 3 units of
B are bought
Price of B

$1.50
Record the results
1.00

.50
DB Connect the points to
2 4 6 8 10 12
create the demand
Quantity of B curve for B 7-22
 Appendix Key Terms

• Budget Line
• Indifference curve
• Marginal rate of substitution (MRS)
• Indifference map
• Equilibrium position

7-23
Next Chapter Preview…

The Costs of
Production

7-24