Chapter 6 Consumer Behavior.docx

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Published on 16 Apr 2013
School
McGill University
Department
Economics (Arts)
Course
ECON 208
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of 4
1
Chapter 6 Human Behavior
6.1 Marginal Utility and Consumer Choice
Utility: the satisfaction/well-being that a consumer receives from consuming some good/service
Total utility: the total satisfaction resulting from the consumption of a given commodity by a
consumer
Marginal utility: the additional satisfaction obtained from consuming 1 additional unit of
commodity
Diminishing Marginal Utility
Law of diminishing marginal utility: The utility that any consumer derives from successive units
of a particular product consumed over some period of time diminishes as total consumption of
the product increases (if the consumption of all other products is unchanged)
Min quantity of water = would pay a lot for it = marginal utility of water is high (the fewer L you
are already using, the higher the marginal utility of one more L of water); if consume more than
min = marginal utility of successive L of water declines steadily
Utility Schedules and Graphs
Total utility rises as increased consumption of coke; but the utility from each additional
coke/day is < that of the previous one marginal utility declines as the quantity consumed^
i.e. total utility rises, but marginal utility declines, as consumption increases
Maximizing Utility
economists assume that consumers seek to maximize their total utility subject to the constraints
they face in particular, their income, and the market prices of various products
The Consumer’s Decision
to maximize utility a consumer should consume any two goods, or any number of goods, until
the marginal utility per dollar spent on the last product1 is equal to the marginal utility per
dollar spent on the last product2 consumed
A utility-maximizing consumer allocates expenditures so that the utility obtained from the last
dollar spent on each product is equal
Ex: B = $3; C = $1; utility from the last $ spent on C is 3x utility from last $ spent on B; ^ total
utility by switching a $ of expenditure from B to C and by gaining the difference between the
utilities of a dollar spent on each. To maximize utility, continue switching expenditure from B to
C as long as last $ spent on C yields more utility than last $ spent on B. This switching, however,
reduces the quantity of B consumed and, given the law of diminishing marginal utility, ^the
marginal utility of B. At the same time, switching ^the quantity of C consumed and thereby
lowers the marginal utility of C. When marginal utilities changed so that the utility received from
the last $ spent on C is = to utility from last $ spent on B, gain of nothing from further switches
(rather there is reduction of total utility)
The condition required for a consumer to be maximizing utility, for any pair of products, is
MUx = MUy : utility-maximizing consumer will allocate expenditure so that the utility gained
Px Py from the last dollar spent on any other product
A consumer w/ a given amount of income to spend demands each good up to the point at which
the marginal utility per $ on it is the same as the marginal utility per $ spent on every other
2
good. When this condition is met for all goods, the consumer cant ^ utility further by
reallocating expenditure (utility maximized)
An Alternative Interpretation
MUx = Px; right side is the relative price of the two goods, determined by the market
MUy Py left side is the relative ability of the two goods to add to utility, within control of
consumer b/c in determining the quantities of diff goods to buy, consumer also determines their
marginal utilities
if the two sides of eqn not equal, consumer can increase total utility by rearranging purchases of
X and Y (until the two sides are equal, at which point consumer cant ^ total utility any further by
rearranging purchases between the 2 products)
Is This Realistic?
Utility theory used by economists to predict how consumers will behave when faced with such
events as changing prices and incomes.
The Consumer’s Demand Curve
Price of X rises, but Y stays constant MUx < Px
MUy Py
To restore equality, buy less X, marginal utility of X will rise, increasing ratio on left side,
therefore, with Y price constant, reduction of consumption of X until MU of X rises so =eqn
A rise in the price of a product (with all other determinants of demand held constant) leads each
consumer to reduce the quantity demanded of the product
If this is what happens, then the theory of consumer behaviour that we have considered
predicts a vely sloped market demand curve and a vely sloped demand curve for each
individual consumer
Market demand curves show how much is demanded by all purchasers; it is the horizontal sum
of demand curves of individual consumers; since we want to add quantities demanded at a
given price, and quantities are measured in the horizontal direction on a conventional demand
curve (add the quantities demanded by all consumers at each price = market demand curve)
6.2 Income and Substitution Effects of Price Changes
Real income: income expressed in terms of the purchasing power of money income that is, the
quantity of goods and services that can be purchased with the money income
The Substitution Effect
Utility maximization requires the ratio of MU to P be the same for all goods
Increase consumption = reduce marginal utility
Substitution effect: the change in the quantity of a good demanded resulting from a change in
its relative price (holding real income constant)
The substitution effect increases the quantity demanded of a good whose price has fallen and
reduces the quantity demanded of a good whose price has risen
The Income Effect
Income effect: the change in the quantity of a good demanded resulting from a change in real
income (holding relative prices constant)
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The income effect leads consumers to buy more of a product whose price has fallen, provided
that the product is a normal good
The size of the income effect depends on the amount of income spent on the good whose price
changes and on the amount by which the price changes
The Slope of the Demand Curve (p.129)
B/c of the combined operation of the income and substitution effects, the demand curve for any
normal commodity will be vely sloped. Thus, a fall in the price will ^ the quantity demanded
In each case, the substitution effect increases the quantity demanded, but the size and sign of
the income effect differs.
The sum of the income and substitution effects determines how overall quantity demanded
responds to the price reduction
All normal goods and most inferior goods have vely sloped demand curves; for inferior good,
the income effect must be very strong in order to generate a +vely sloped demand curve
Demand curves for inferior goods are vely sloped unless the income effect outweighs the
substitution effect.
For a normal good, the income and substitution effects work in the same direction; reduction in
price ^real income and leads to further ^ in quantity demanded
For inferior goods, reduction in price causes ^ in real income that leads to reduction in quantity
demanded. If the goods make up a small fraction of the consumer’s total expenditure, then this
income effect will be small
For most inferior goods, the income effect only partially offsets the substitution effect; income
effect reduces quantity demanded
For a few inferior goods Giffen goods the income effect outweighs the substitution effect;
income effect reduces quantity demanded
Giffen Goods
Sir Robert Giffen (1837 1910) refuted law of demand; observed ^price of imported wheat =
^price bread = ^consumption of bread = demand curve for bread +ve slope
Giffen good: an inferior good for which the income effect outweighs the substitution effect so
that the demand curve is +vely sloped
o has to be an inferior good, meaning that a reduction in real income leads households to
purchase more of that good
o the good must take a large portion of total household expenditure and have a large
income effect
Conspicuous Consumption Goods
Thorstein Veblen (1857 1929): suggested that the more expensive a commodity became, the
greater might be its ability to confer status on its purchaser (buying because its expensive); fall
in price might lead them to stop buying that commodity; violation of law of demand
Holding this status constant, ppl would still probably buy more at lower prices, suggesting a
downward-sloping demand curve
Countless lower-income consumers would be glad to buy diamonds if these commodities were
sufficiently inexpensive suggests that +vely sloped demand curves for a few individual wealthy

Document Summary

Utility: the satisfaction/well-being that a consumer receives from consuming some good/service. Total utility: the total satisfaction resulting from the consumption of a given commodity by a consumer. Marginal utility: the additional satisfaction obtained from consuming 1 additional unit of commodity. Economists assume that consumers seek to maximize their total utility subject to the constraints they face in particular, their income, and the market prices of various products. A utility-maximizing consumer allocates expenditures so that the utility obtained from the last dollar spent on each product is equal. To maximize utility, continue switching expenditure from b to. C as long as last $ spent on c yields more utility than last $ spent on b. This switching, however, reduces the quantity of b consumed and, given the law of diminishing marginal utility, ^the marginal utility of b. The condition required for a consumer to be maximizing utility, for any pair of products, is.