Micro Economics - Consumer Behavior

8/3/2019 Micro Economics - Consumer Behavior

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MICROECONOMICS

P R O F R U S H E N C H A H A L

Consumer Behavior

2/12/2012Prof. Rushen Chahal


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Chapter 6

y More of the law of demand The substitution effect

The income effect

y Utility

y Law of diminishing marginal utility

y Total and Marginal Utility

y Maximizing utility subject to a budget constraint

y Utility Maximization and Demand

y Indifference curves and budget constraint curves



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Learning objectives

y Discuss how the income effect and substitutioneffect lead to a downward sloping demand curve.

y Explain why marginal utility diminishes.y

Practice the step by step utility-maximizingprocess.yApply the rule of utility maximizationy Relate utility maximization to the demand curve.y Understand indifference curves and budget

constraints.



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Law of demand revisited

yWhen we studied demand, we saw it wasdownward sloping

y

Here are 2 effects (noun) that affect (verb) demand: 1. The substitution effect a lower price of a good causesa person to buy more of that good instead of alternativegoods.

2. The income effect the change in the quantitydemanded caused by a price changes effect on realincome which measures a persons purchasing power.



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The substitution effect

y At higher prices, people buy less of a good; atlower prices, people buy more of a good

y

One reason for this is the substitution effecty When the price of a good falls, people will

substitute that good for alternative goods

y The opportunity cost of buying this good has now

decreased



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The substitution effect

yAt higher prices, people will buy more of asubstitute good than the good with the higher price

y The opportunity cost of buying the higher priced

good has increasedy If the price of Nike shoes increases, people will

start to buy Adidas and Reebok instead,substituting away from Nike



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The income effect

y For a normal good, the income effect also causesdemand to be downward sloping

y When the price of a good decreases, your real income

(purchasing power) increasesy You can now buy more of everything



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The income effect

y Lets say you buy 25 gallons of gas a week, and theprice of gas is $2 a gallon

yYoure spending $50 a week on gas

y Now the price of gas decreases to $1 a gallon

yYou can now buy 50 gallons of gas a week for thesame amount of money, or you can buy 25 gallons

of gas and more of other goods



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Utility

y Before, we looked at the idea of marginal benefit andconsumer surplus

y We saw that marginal benefit was the additional

value that one received from consuming one moreunit of a good

y A similar (almost exact same!) concept is utility



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Utility

y Why do we buy goods?

y In order to gain utility

y Utility satisfaction received from consumption of a

good.

y (This satisfaction can translate directly to the value,or marginal benefit, we get from the good)



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Utility

y Though utility is not measurable, we can act asthough it were

yWell use a util as a measure of the amount ofutility we get from consuming a good

y Util unit of measurement of utility; used for

illustration only.



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Utility

y Total utility the satisfaction a person receivesfrom consuming a specific quantity of a good.

y Marginal utility the increments to total utilityfrom changes in consumption.

y In other words: it is the additional utility we get from consuming one

more unit of a good (You can see this is the same thing asmarginal benefit)



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T

otal and MarginalU

tility

Marginal Utility = Change in total utilityChange in number of

units consumed



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T

otal and MarginalU

tility

0

50

100

150

Utils

First Slice Second Slice Pizza

Marginalutility

Total

Utility



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Law of diminishing marginal utility

y As we saw with marginal benefit, marginal utility isgoing to be decreasing

y The first unit of a good is the most satisfying

yThe second unit provides less utility

y The third even less utility

y Etc.



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y Law of diminishing marginal utility asconsumption of a good increases, marginal utility

will eventually decrease.

Marginal utility decreases over a short period of time, butafter a long time it can increase again.

Tomorrow I will want to eat more dumplings when I am hungryagain. They will no longer have negative marginal utility.



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y Remember the dumpling example?

y We can apply diminishing marginal utility to this

y The first dumpling gave the most satisfaction, thus

the greatest utilityy The second gave me less satisfaction, thus less

marginal utility (total utility is still rising though)



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y The 6th dumpling gave me no utility.

y This is what we call the satiation point.

y At the satiation point, there is no more utility fromconsuming additional units.

y Satiation point quantity for which an additionalunit consumed provides zero marginal utility;associated with maximum total utility.



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utility

y The 7th made me want to barf.

y If you continue to consume dumplings, you willactually feel sick, experiencing negative utility, ordisutility.

y Disutility a negative value for marginal utility;associated with consuming too much of a good.



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Total and Marginal Utility



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Total and Marginal Utility

Utility

Utility

Satiation point

Satiation point

Total Utility is

maximized when

marginal utility is

zero.



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Maximizing utility subject to a budgetconstraint

y Consumers want to maximize their utility butCANNOT spend more than their income

y The budget constraint, a consumers income, limits

the amount of total utility that a person can gety Utility maximization is achieved when the

consumers choices provide the greatest amount ofutility for a specific amount of income.



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yWe can consider utility, and we can consider price

y E.g. I buy a movie ticket for $3

y Say the marginal utility I get from that movie ticket

is 30 utilsyWe could say Im getting 10utils/dollar

yWhat if I buy a second movie ticket, and receive 27utils from buying it

y The second ticket is providing me with9utils/dollar

y So how do we use this information?



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y We can divide the marginal utility by price

y We will call this marginal utility per dollar

y The Rule Of UtilityMaximixation:

To maximize utility, a consumer adjusts spendinguntil the marginal utility from the last dollar spenton each good is the same.



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Algebraic Statement of the UtilityMaximizing Rule

Marginal Utility of X

Price of X=

Marginal Utility of Y

Price of Y

If the marginal utility per dollar of product X is greater

than the marginal utility per dollar of product, consumers

should purchase more of product X.

Conversely, if the marginal per dollar of product Y is greaterthan the marginal utility of product Y, consumers should

purchase more of product Y.



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budget constraint

1 2 3 4 5 6

Number ofMovie

Tickets

Bought

Marginal Utility

of Movies

(in utils)

Marginal Utilityper dollar for

movies (Marginal

Uitlity/Price)

Number of

Bottles of

Water Bought

Marginal Utility of

Bottled Water

(in utils)

Marginal Utilityper dollar for

bottled water

(Marginal

1 30 10 1 8 8

2 27 9 2 7 73 24 8 3 6 6

4 18 6 4 5 5

5 8 2.67 5 4 4

6 1 0.33 6 3 3

DENISES PREFERENCES FOR MOVIES AND BOTTLED WATER

[Price of movie ticket = $3; Price of water = $1 per bottle; Income = $15 per week]



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budget constraint

y Denise will spend ALL of her money.

y Denise will buy four movie tickets and three bottlesof water.

y

At this combination the utility per dollar she receivesfrom buying the last ticket is equal to the utility perdollar she receives from buying the last bottle of

water, so her total utility is also maximized.



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Utility Maximization and

Demand

Number of

Movie

Tickets

Bought

Marginal Utility

of Movies

(in utils)

Marginal Utility

per dollar , Price =

$3 (Marginal

Uitlity/Price)

Marginal Utility per

dollar, Price = $2

(Marginal

Uitlity/Price)

1 30 10 15

2 27 9 13.5

3 24 8 12

4 18 6 9

5 8 2.67 4

6 1 0.33 0.5

A LOWER PRICE FOR MOVIE TICKETS INCREASES

MARGINAL UTILITY PERDOLLAR



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Utility Maximization and Demand

$3

4 Quantity of movies

$

$2

5

Utility maximization

causes demand toslope downward.

Denise

sdemand



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Utility Maximization and Demand

y We now know three reasons why demand isdownward sloping:

1. The substitution effect

2.T

he income effect 3. The law of diminishing marginal utility



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Indifference Curves

y In economic terms, when people are indifferenttothe choices before them, they obtain the sameamount of utility from each of those choices.

y An indifference curve shows the combinations of twogoods that provide an individual with equal amountsof utility.

y An indifference curve slopes downward.



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Indifference Curves

Rays indifference curve

between shrimp and

chicken wings reveals

combinations of the two

products that would leave

him equally satisfied. 2/12/2012Prof. Rushen Chahal


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Indifference Curves

y The marginal rate of substitution is the quantity ofone good that must be given up as the consumptionof the other good increases by one unit and total

utility remains constant.

y The marginal rate of substitution can be expressedas:

Marginal rate

of substitution=

Change in the consumption of one good

Change in the consumption of another good



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T

he marginal rate of substitution decreases

(A) (B) (C) (D)

BETWEEN

POINTS:

CHANGEIN

CONSUMPTION

OF JUMBO

SHRIMP

CHANGEIN

CONSUMPTION

OF CHICKEN

WINGS

MARGINAL

RATE OF

SUBSTITUTION

= (C/B)

A and B (2-1) = 1 (5-8) = -3 3

B and C (3-2) = 1 (3-5) = -2 2

C and D (4-3) = 1 (2-3) = -1 1

Indifference Curves



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Indifference Curves

y So far weve only been focusing on one indifferencecurve

y This curve has shown all the different

combinations of two goods that will yield the sametotal utility

y But consumers have many different indifferencecurves, showing the many different levels of totalutility they will enjoy at different levels ofconsumption

y This idea can be shown by an indifference map



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Indifference Maps

More is

better

Good 1

Good 2

Indifference

curves



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Budget Constraints

y Consumer choice is limited by the amount of moneythat people can spend and the prices of the goodsthey buy.

y T

heb

udget constraintis a curve that shows aconsumers consumption possibilities for two goods.

y Points outside the budget constraint require moreincome than is currently available and thus cannot

be purchased now.



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Budget Constraints

The budget constraint will be a downward-sloping straight line, with the slopeequal to -(price of one good/price of another good).

The slope of Rays budget

constraint is

-(price of shrimp/price of wings)= -1/.25 = -4.2/12/2012Prof. Rushen Chahal


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Constraints

y So how do consumers decide what combination tobuy?

y The choose the goods that will maximize theirsatisfaction, given the limited budget they face

y This means consumers will consume: 1. on the budget line, NOT below it and NOT above it

2. on the highest possible indifference curve



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Indifference Curves and

Budget ConstraintsDumplings(1.5 Yuan)

DVDs(6 Yuan)

10

20

30

40

102 4 6 8

C is better than B but isoutside the budget so itis not possible.

B is on the highestindifference curve thatis within the budget,so it is the best we can

afford.A B C

A is within the budgetbut is not as good as B.


Micro Economics - Consumer Behavior

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