The Theories on Consumer Behavior CONTENT Theory on consumer’s utility The principle of diminishing marginal utility Consumer’s surplus Consumer’s preferences Budget constraint Utility maximizing choice Copyright © 2014 by Quan Hong NGUYEN I The Theories on Consumer Utility Utility Theory 1.1 Utility (U) - The benefit or satisfaction that a person gets from the consumption of a good or service - An abstract concept - Unit –free - Subjectivity (depends on consumer’s perception) Copyright © 2014 by Quan Hong NGUYEN I The Theories on Consumer Utility Utility Theory 1.2 Total utility (TU) - The total benefit or satisfaction that a person gets from the consumption of goods and services - Depends on the person’s level of consumption – more consumption generally gives more total utility Copyright © 2014 by Quan Hong NGUYEN I The Theories on Consumer Utility Utility Theory A numerical indicator of a person’s satisfaction If one item is preferred to some alternative, the utility from the item is greater than the alternative Actual unit of measurement for utility is not important (ordinal, not cardinal, ranking is sufficient) Consumers try to obtain the largest possible total satisfaction (utility) from the market basket that they buy with their incomes Copyright © 2014 by Quan Hong NGUYEN I The Theories on Consumer Utility Utility Theory 1.3 Marginal utility (MU) - The change in total utility resulting from a oneunit increase in the quantity of a good consumed U MU Q Copyright © 2014 by Quan Hong NGUYEN I The Theories on Consumer Utility E.g Utility for beer Number of cups Utility Marginal utility 0 6 10 13 15 16 Copyright © 2014 by Quan Hong NGUYEN I The Theories on Consumer Utility Principle of Diminishing marginal utility: In a certain time period, continuous consumption will tend to the increase in total utility but a decrease in marginal utility => As more good is consumed, additional utility consumer gains will be smaller and smaller Copyright © 2014 by Quan Hong NGUYEN I The Theories on Consumer Utility Application 1: Diminishing marginal utility and demand curve To a consumer, the larger marginal utility, the higher willingness to pay The smaller MU, the lower willingness to pay The diminishing marginal utility explains the slope downward demand curve Willingness to Pay: The maximum price that a buyer is willing and able to pay for a good Measures how much the buyer values the good or service Copyright © 2014 by Quan Hong NGUYEN I The Theories on Consumer Utility Application 2: Diminishing marginal utility and Consumer surplus Consumer Surplus: the maximum amount a consumer will be willing to pay for a good depends upon the expected utility (benefits) of that good CS = MUx – Px A lower market price will increase consumer surplus A higher market price will reduce consumer surplus Copyright © 2014 by Quan Hong NGUYEN I The Theories on Consumer Utility Maximum Price = $11 Market Price = $6 Quantity Purchased = Assume: Price drops $1 for every additional unit sold Consumer Surplus = $15 $51 - $36 = $15 ($11+$10+$9+$8+$7+$6) - ($6 x 6) = $15 10 Copyright © 2014 by Quan Hong NGUYEN The Budget Line I PX X PY Y I PX X PY Y I PX X Y PY PY Copyright © 2014 by Quan Hong NGUYEN Budget Constraints The Budget Line The vertical intercept (I/PC), illustrates the maximum amount of C that can be purchased with income I The horizontal intercept (I/PF), illustrates the maximum amount of F that can be purchased with income I Copyright © 2014 by Quan Hong NGUYEN The Budget Line As we know, income and prices can change As incomes and prices change, there are changes in budget lines We can show the effects of these changes on budget lines and consumer choices Copyright © 2014 by Quan Hong NGUYEN The Budget Line - Changes The Effects of Changes in Income An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant) Can buy more of both goods with more income Copyright © 2014 by Quan Hong NGUYEN The Budget Line - Changes The Effects of Changes in Income A decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant) Can buy less of both goods with less income Copyright © 2014 by Quan Hong NGUYEN The Budget Line - Changes in Income Clothing (units per week) A increase in income shifts the budget line outward 80 60 A decrease in income shifts the budget line inward 40 20 L3 (I = $40) 40 L1 L2 (I = $80) 80 120 (I = $160) 160 Copyright © 2014 by Quan Hong NGUYEN Food (units per week) The Budget Line - Changes in Price Clothing (units per week) A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward 40 L3 (PF = 2) L2 L1 (PF = 1/2) (PF = 1) 40 80 120 160 Copyright © 2014 by Quan Hong NGUYEN Food (units per week) Optimal consumption combination Given preferences and budget constraints, how consumers choose what to buy? Consumers choose a combination of goods that will maximize their satisfaction, given the limited budget available to them Copyright © 2014 by Quan Hong NGUYEN Optimal consumption combination The maximizing market basket must satisfy two conditions: It must be located on the budget line They spend all their income – more is better It must give the consumer the most preferred combination of goods and services Copyright © 2014 by Quan Hong NGUYEN Optimal consumption combination Graphically we can see different indifference curves of a consumer choosing between clothing and food Consumer wants to choose highest utility within their budget Copyright © 2014 by Quan Hong NGUYEN Optimal consumption combination Copyright © 2014 by Quan Hong NGUYEN Optimal consumption combination Recall, the slope of an indifference curve is: C MRS F Further, the slope of the budget line is: PF Slope PC Copyright © 2014 by Quan Hong NGUYEN Optimal consumption combination Therefore, it can be said at consumer’s optimal consumption point, PF MRS PC Copyright © 2014 by Quan Hong NGUYEN Optimal consumption combination It can be said that satisfaction is maximized when marginal rate of substitution (of F and C) is equal to the ratio of the prices (of F and C) Note this is ONLY true at the optimal consumption point Copyright © 2014 by Quan Hong NGUYEN Review A consumer decides to spend his income of 200$ on X and Y a P = 4$, P = 2$ Draw this consumer’s budget line b Due to the decrease in quantity supplied,Y’s price goes up to 4$ Draw new budget line c There is a promotion from the seller Buying 20 units of Y at price of 2$, consumer will get 10 units more free of charge This is applied on the first 20 units of Y only The following units are still applied the price of 2$ (except the bonus) Draw new budget line Copyright © 2014 by Quan Hong NGUYEN ... consumer behavior Budget constraints also limit an individual’s ability to consume in light of the prices they must pay for various goods and services Copyright © 2014 by Quan Hong NGUYEN Budget... $15 10 Copyright © 2014 by Quan Hong NGUYEN I The Theories on Consumer Utility Market Price $11 $10 $9 $8 $7 $6 D 11 Quantity Purchased Copyright © 2014 by Quan Hong NGUYEN I The Theories on Consumer... between having more left shoes only Must have one right for one left Copyright © 2014 by Quan Hong NGUYEN Consumer Preferences Left Shoes Perfect Complements 1 Copyright © 2014 by Quan Hong NGUYEN