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Chapter 6

Chapter 6 - Consumer Behavior.docx

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University of British Columbia
ECON 101
Robert Gateman

6.1 Marginal Utility & Consumer Choice 10-15-2012  Consumers are motivated to maximize their utility  Utility – satisfaction that a consumer gets from consuming some good or service o Will tell you how consumer makes his/her decisions  Theory of Consumer Behavior – based on utility maximization  Total utility – full satisfaction from the consumption of that product  Marginal utility – additional satisfaction from consuming one more unit of that product 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.) Utility Schedules and Graphs  Assumption: utility can be measured  Total utility vs. Marginal utility  Consumption increases: TU increases even when MU decreases Maximizing Utility  Assumption: consumers try to be as well off as they possibly can be; maximize their total utility subject to the constraints they face  Constraints: income and market prices The Consumer’s Decision o The utility maximizing consumer should consume product A and product B to the point at which the MU per dollar spent on each of the products is equal o A utility-maximizing consumer allocates expenditures so that the utility obtained from the last dollar spent on each product is equal. o Remember: when switching between products – Law of Diminishing Marginal Utility – the MU of what you’re switching out of will rise and the MU of what you’re switching into will fall  MU falls when you consume more o There will be a point where switching further will reduce total utility o MUx/Px = MUy/Py (fundamental equation of MU theory)  When this is met, there is no way you can increase utility further by reallocating expenditure = utility is maximized An Alternative Interpretation o MUx/MUy = Px/Py o Right side: relative price of two goods – determined by the market, out of consumers’ control (can only react to but not change it) o Left side: relative ability of the two goods to add to the consumer’s utility – within consumers’ control because they can determine the MU’s for each product o Consumer can increase her TU by rearranging their purchases of X and Y o When there is a change in the right side, consumer must adjust the ratio on the left side to balance the equation again Is this realistic? o Predict how consumers will behave when faced with such events as changing prices and incomes o Economist is not concerned with actual thought process o Does not tell us how they react, but rather the implications of their reactions The Consumer’s Demand Curve  Let X represent Coke and Y be all other products MU Coke/MUy = Price Coke/Price Y  What if the price of Coke rises? o Should the consumer spends less on everything else and increase their spending on Coke in order to hold their Coke consumption constant? No. o (Based on LDMU) If she buys fewer Cokes, MU of Coke will rise and therefore balance out the equation again.  A rise in the price of a product (with all other determinants of demand held constant) leads each consumer to reduce the Qd of the product. 6.2 Income and Substitution Effects of Price Changes 10-16-2012  Relationship between Law of Diminishing Marginal Utility and the slope of consumer’s demand curve (6.1) o Think about slope of market demand curve  Reduction of price A = reduction in the relative price of product A  substitute away from other products towards product A  Reduction of price A = more purchasing power or real income  Real income – quantity of goods and services that can be purchased with the money income The Substitution Effect  Isolate the effect of the change in relative price  Utility maximization requires that the ratio of MU to price be the same for all goods  Price decrease  increase consumption of that product, decrease consumption of all other products  MU for that product decreases  utility maximization o Substitute away from other goods and toward the product whose price has just fallen  Purchasing power is held constant  Substitution Effect - Change in the Qd of a good whose relative price has changed  The Substitution Effect increases the Qd of a good whose price has fallen and reduces the Qd of a good whose price has risen. The Income Effect  Holding relative prices constant at their new value  For normal goods: if income goes up  increase consumption of a certain good  The Income Effect leads consumers to buy more of a product whose price has fallen, provided that the product is a normal good.  Size of the income effect depends on the amount of income spent on the good and on the amount by which the price changes The Slope of the Demand Curve  When price changes, we move from the initial consumption pattern to the final one, and we don’t see the steps in between  Break movement into two parts  Total change in Qd = response to a change in relative prices + response to a change in real income  Because of the combined operation of the income and substitution effects, the demand curve for any normal commodity will be negatively sloped. Thus, a fall in price will increase Qd. Duh.  Combination or Sum of the substitution and income effects determines the slope and determines how overall Qd responds  Size and sign of income effect differs in each case o Inferior good: income effect must be very strong in order to generate a positively sloped demand curve  Giffen Good Giffen Goods o Positively sloped demand curve o Inferior good o Reduction in real income = increase in Qd  Because the good takes a large proportion of total household expenditure  large income effect o Income effect outweighs the substitution effect Conspicuous Consumption Goods o The Theory of the Leisure Class, Thorstein Veblen o Products were consumed not for their qualities but because of their “snob appeal” (premium prices) o The more expensive a commodity was, the greater the ability to confer status on its purchaser o Buying the product because it’s expensive // Buy more goods at a higher price because of the higher price o Violation of the Law of Demand o Appeal: “other people think I paid a high price” (snob appeal) o BUT these people would still buy more at a lower price if other people thought they paid more for it. An Interesting Application to Taxation  Applies to two things that most individuals supply – work efforts (to labour markets) and their savings (to financial markets)  To understand the overall effect of the change in tax rates, we need to use the important distinction between the income and substitution effects. What. 6.3 Consumer Surplus 10-16-2012  Must be able to make a distinction between marginal utility and total utility The Concept  Consumer surplus – difference between the total value that consumers place on all the units consumed of some product (can be seen on from the demand curve) and the payment they actually make to purchase that amount o Maximum price consumer is willing to pay – market price  Direct consequence of negatively sloped demand curves  Individual’s demand curve = willingness to pay for successive units  Total value – sum of the values that is placed on all the units of a product o Amount consumer is willing to pay if she was charged one unit at a time and charged the maximum she was willing to pay for each unit o BUT consumers don’t have to pay different prices for successive units  Total consumer surplus = sum of the surplus on each unit  For any unit consumed, consumer surplus is the difference between the maximum amount the consumer is prepared to pay for that unit and the price the consumer actually
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