Consumer Behavior & Utility Maximization ECO 2023 Chapter 7 Fall 2007 Created by: M. Mari Terminology • Utility – the satisfaction or enjoyment that you receive from a choice or consumption of a good – subjective • Total utility – total amount of satisfaction or pleasure from consuming some specific quantity of a good • Marginal utility – the extra utility from consuming one more unit of the good Utility Analysis • Utility – Satisfaction or enjoyment from an action – Subjective – Depends on tastes – Economists assumes simply that tastes are given and are relatively stable Law of Diminishing Marginal Utility The law states: that as a consumer consumes more units of product, the marginal or additional utility that he or she will receive from the product declines Graphically Utility increases as consumption increases until it reaches a maximum and begins to drop. Total Utility Units consumed Law of Diminishing Marginal Utility • Explains why the demand curve for a given product slopes downward. • If successive units of a good yield smaller and smaller amounts of marginal, or extra, utility, then the consumer will buy additional units of a product only if its price falls. Theory of Consumer Behavior • The law of diminishing marginal utility explains how consumers allocate their money incomes among the many goods and services available for purchase. Consumer Choice and Budget Constraint – A typical consumer’s situation has the following dimensions • Rational behavior • Preferences – clear cut preferences for certain of the goods and services that are available in the market • Budget constraint – consumer has a fixed or limited amount of money income • Prices – Different individuals will choose different mixes of goods and services that most satisfy him or her Utility Maximizing Rule: • To maximize satisfaction, the consumer should allocate his or her money income so that the last dollar spent on each product yield the same amount of extra utility Example • Product A: Price = $1 • Product B: Price = $2 Units Marginal Utility (units) MU/P Marginal Utility MU/P 1 10 10 24 12 2 8 8 20 10 3 7 7 18 9 4 6 6 16 8 5 5 5 12 6 6 4 4 6 3 7 3 3 4 2 Income and Substitution Effects • Income Effect: is the impact that a change in the price of a product has on a consumer’s real income and consequently on the quantity demanded of the good • Substitution Effect: is the impact that a change in a product’s price has on its relative expensiveness and consequently on the quantity of the good demanded. • The income and substitution effect combine to increase a consumer’s ability and willingness to buy more a specific good when price falls.