MGEA01 - Ch.6.pdf

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University of Toronto Scarborough
Economics for Management Studies
Michael Ho

MGEA01 – Ch. 6 1 Chapter 6: Consumer Behaviour 6.1: MARGINAL UTILITY AND CONSUMER CHOICE Utility - The satisfaction that a consumer receives from consuming some good or service - Utility Maximization o Consumers are motivated to maximize their utility - Total Utility o The total satisfaction resulting from the consumption of a given commodity by a consumer o Total utility of consuming 5 cokes = satisfaction provided by 5 cokes all together - Marginal Utility o The additional satisfaction obtained from consuming one additional unit of a commodity th o The additional utility provided by the consumption of the 5 coke Law of Diminishing Marginal Utility - The utility that any consumer derives from successive units of a product consumed over some period of time diminishes as total consumption of the product increases (holding constant the consumption of all other products) Utility Schedules and Graphs - Assuming that utility could be measured o As consumption increases, total utility increases, and marginal utility decreases o Marginal Utility = the difference in 2 successive Total Utility Bottles Total Marginal Consumed Utility Utility 0 0 (30 – 0) = 30 1 30 (50 – 30) = 20 2 50 (65 – 50) = 15 3 65 10 4 75 8 5 83 6 6 89 4 7 93 3 8 96 2 9 98 1 10 99 2 MGEA01 – Ch. 6 Maximizing Utility - Consumers try to maximize their total utility subject to the constraints they face o Income o Market prices of various products - A utility maximizing consumer allocates expenditures so that the marginal utility obtained from the last dollar spent on each product is equal o If the marginal utility of product A is higher than that of product B, the consumer should buy less of product B and use that money to buy more of product A. o However, marginal utility decreases as consumption increases, so when marginal utility of 2 products are equal, we say that the utility is maximized. Further switching will in fact decrease the total utility - To maximize utility for any pair of product X & Y: ▯▯ ▯ ▯▯ ▯ ▯▯ ▯ ▯▯ ▯ = ▯ ▯▯ ▯▯ = ▯ ▯ ▯ ▯ ▯ ▯▯ = ▯▯▯▯▯▯▯▯ ▯▯▯▯▯▯▯ ▯▯ ▯ℎ▯ ▯▯▯▯ ▯▯▯▯ ▯▯ ▯▯▯▯▯▯▯ ▯ = ▯▯▯▯▯ ▯▯ ▯▯▯▯▯▯▯ - In the latter equation, the right hand side is the relative price of the 2 goods which a consumer cannot control. The left hand side is the relative ability of the 2 goods to add to a consumer’s utility, which he or she can control. The Consumer’s Demand Curve - A rise in the rice of a product (with all other determinants of demand held constant) leads each consumer to reduce the quantity demanded of the product - When price of X increases, the ratio on the right hand side becomes larger ▯▯ ▯ ▯ < ▯ ▯▯ ▯ ▯▯ - Consumer can buy less units of X, which increases the marginal utility of X, making the ratio on the left hand side larger and the equation is restored The Consumer’s Demand Curve - The market demand curve is the horizontal sum of the individual demand curves MGEA01 – Ch. 6 3 6.2: INCOME AND SUBSTITUTION EFFECTS OF PRICE CHANGES Effect of Changes in Product’s Price - Alters relative price - Changes a consumers purchasing power or real income o 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 - The change in the quantity of a good demanded resulting from a change in its relative price (holding real income/purchasing power constant) - When price of X falls, the ratio on the right decreases ▯▯ ▯ ▯ ▯ > ▯▯ ▯ ▯ ▯ - To restore the equation, the marginal utility of X must decrease as well; more units of X has to be consumed, and consumption of other goods has to be reduced - In other words, the consumer must substitute away from other goods and towards X - The substitution effect increases the quantity demanded of a good whose (relative) price has fallen and reduces the quantity demanded of a good whose (relative) price has risen The Income Effect - The change in the quantity demanded resulting from a change in real income (holding relative prices constant) - Normal Good o The income effect leads consumers to buy more of a product whose price has fallen - Inferior Good o The income effect leads consumers to buy less of a product whose price has fallen - 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 - The overall effect of a price change is the combination of the income and substitution effects Substitution Effect on
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