Consumer Behaviour 6.1 Marginal Utility and Consumer Choice Economists assume that in making their choices, consumers are motivated to maximize their utility. Utility → The satisfaction that a consumer receives from consuming some good or service. Total Utility → The full satisfaction resulting from the consumption of that product by a consumer. Marginal Utility → The additional satisfaction resulting 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 (holding constant the consumption of all other products). Utility Schedules and Graphs Total utility rises, but marginal utility declines, as consumption increases. Maximizing Utility 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 Maximizing Decision “A utility-maximizing consumer allocates expenditures so that the marginal utility from the last dollar spent on each product is equal.” The condition required for a consumer to be maximizing utility, for any pair of products, is… An Alternative Interpretation The left side is the relative ability of the two products to add to a consumer’s utility. The right side of this equation is the relative price of the two products. (consumers have no control over the price) e.g., if the right side of the equation = 2 and the left side = 3, consumers can increase their total utility by adjusting the quantities of the various products they purchase until the amount on the left side is equal to 2 (the same ratio as the prices). Is This Realistic? ● Utility theory is used by economists to predict how consumers will behave when faced with such events as changing prices and incomes. ● The theory is just a convenient way of discovering the implications of their maximizing behaviour. ● Utility-maximization theory leads to predictions that can be tested empirically. The Consumer’s Demand Curve “A rise in the price of a product (with all other determinants of demand held constant) leads each utility-maximizing consumer to reduce the quantity demanded of the product.” Market Demand Curves The market demand curve is the horizontal sum of the demand curves of all individual consumers. 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 Substitution Effect → The change in the quantity of a product demanded resulting from a change in its relative price (holding real income constant). “The substitution effect increases the quantity demanded of a product whose price has fallen and reduces the quantity demanded of a product whose price has risen.” The Income Effect Income Effect → The change in the quantity of a product demanded resulting from a change in real income (holding relative prices constant). “The income effect leads consumers to buy more of a product whose price has fallen, provided that the product is a normal good.” The Slope of the Demand Curve “Because of the combined operation of the income and substitution effects, the demand curve for any normal good will be negatively sloped. A fall in price will increase the quantity demanded.” “Demand curves for normal goods are negatively sloped. Demand curves for inferior goods are negatively sloped unless the income effect outweighs the substitution effect.” Giffen Goods Giffen Good → An inferior good for which the income effect outweighs the substitution effect so that the demand curve is positively sloped. Conspicuous Consumption Goods Conspicuous Consumption Goods → Higher priced products consumed for their “snob appeal”. 6.3 Consumer Surplus The Concept Consumer Surplus → The difference between the total value that consumers place on all units consumed of a product and the payment that they actually make to purchase that amount of the product. “consumer surplus is the difference between the maximum amount the consumer is willing to pay for that unit and the price the consumer actually pays.” The Paradox of Value The market price of a product does not just reflect the total value that consumers place on that product; supply also matters. “The paradox of value can be resolved by understanding (1) the market price of a good depends on both demand and supply, and (2) the difference between the total and marginal value that consumers place on a good. Water has a low price and low marginal value, but a high total value. Diamonds have a high price and high marginal value, but a low total value.” Summary 6.1 Marginal Utility and Consumer Choice ● Marginal utility theory distinguishes between the total utility from the consumption of all units of some product and the marginal utility derived from consuming one more unit of the product. ● The basic assumption in marginal utility theory is that the utility consumers derive (over some given time period) from the consumption of successive units of a product diminishes as the number of units consumed increases. ● Utility-maximizing consumers make their choices such that the utilities derived from the last dollar spent on each product are equal. For two goods X and Y, utility will be maximized when… ● ● Demand curves have negative slopes because when the price of one product falls, consumers respond by increasing purchases of that product sufficiently to restore the ratio of that product’s marginal utility to its now lower price (MU/p) to the same level achieved for all other products. Market demand curves for any product are derived by horizontally summing all of the individual demand curves for that product 6.2 Income and Substitution Effects of Price Changes A change in the price of a product generates both an income effect and a substitution effect… ● The substitution effect is the reaction of the consumer to the change in relative prices, with purchasing power (real income) held constant. The substitution effect leads the consumer to increase purchases of the product whose relative price has fallen. ● The income effect is the reaction of the consumer to the change in purchasing power (real income) that is caused by the price change, holding relative prices constant at their new level. A fall in one price will lead to an increase in the consumer’s real income and thus to an increase in purchases of all normal goods. ● The combined income and substitution effects ensure that the quantity demanded of any normal good will increase when its price falls, other things being equal. Normal goods, therefore, have negatively sloped demand curves. ● Most inferior goods have negatively sloped demand curves. The income and substitution effects work in opposite directions, but the income effect is too small to offset the substitution effect. ● Giffen goods are rare. They are inferior goods with an income effect strong enough to dominate the substitution effect. The demand curve for a Giffen good is positively sloped. 6.3 Consumer Surplus ● For each unit of a product, consumer surplus is the difference between the maximum price consumers are willing to pay for that unit and the price consumers actually pay for that unit. ● Consumer surplus arises because demand curves are negatively sloped and consumers purchase units of a product up to the point where the marginal value equals the market price. On all units before the marginal unit, consumers value the product more than the price and hence they earn consumer surplus. ● In market equilibrium, the marginal value to consumers from having one more unit of the product is given by the market price. This need not reflect the total value that consumers place on all units of product consumed. The paradox of value involves a confusion between total value and marginal value. Key Concepts ● ● ● ● ● ● ● ● ● Total utility and marginal utility Utility maximization Equality of MU/p across different products Slope of the demand curve Market and individual demand curves Income effect and substitution effect Giffen goods and conspicuous consumption goods Consumer surplus The paradox of value Learning Objectives (LO) 1. Distinguish between marginal and total utility. 2. Explain how utility-maximizing consumers adjust their expenditure until the marginal utility per dollar spent is equalized across products. 3. Explain how the income and substitution effects of a price change determine the slope of a demand curve. 4. See that consumer surplus is the “bargain” the consumer gets by paying less for the product than the maximum price he or she is willing to pay. 5. Explain the “paradox of value.”
