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Consumer Behavior

06

McGraw-Hill/Irwin

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Law of Diminishing Marginal Utility

Utility is the satisfaction one gets from consuming a good or service

Not the same as usefulness
Subjective
Difficult to quantify

LO1

6-*

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Law of Diminishing Marginal Utility

Util is one unit of satisfaction or pleasure
Total utility is the total amount of satisfaction
Marginal utility is the extra satisfaction from an additional unit of the good MU = ΔTU/ΔQ

LO1

6-*

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Law of Diminishing Marginal Utility

As consumption of a good or service increases, the marginal utility obtained from each additional unit of the good or service decreases
Explains downward sloping demand

LO1

6-*

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Total Utility and Marginal Utility

LO1

0

10

20

30

10

8

6

4

2

0

-2

1

2

3

4

5

6

7

1

2

3

4

5

6

7

Total Utility (Utils)

Marginal Utility (Utils)

(2)

Total

Utility,

Utils

(3)

Marginal

Utility,

Utils

0

1

2

3

4

5

6

7

0

10

18

24

28

30

28

10

8

6

4

2

0

-2

Total Utility

TU

(1)

Tacos

Consumed

Per Meal

MU

]

6-*

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Theory of Consumer Behavior

Rational behavior
Preferences
Budget constraint
Prices

LO2

6-*

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Utility Maximizing Rule

Consumer allocates his or her income so that the last dollar spent on each product yields the same amount of extra (marginal) utility
Algebraically

MU of product A MU of product B

Price of A Price of B

LO2

=

6-*

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Numerical Example

LO2

The Utility Maximizing Combination of Apples and Oranges Obtainable with an Income of $10
	(2) Apple (Product A): Price = $1		(3) Oranges (Product B): Price = $2
(1) Unit of Product	(a) Marginal Utility, Utils	(b) Marginal Utility per dollar (MU/Price)	(a) Marginal Utility, Utils	(b) Marginal Utility per dollar (MU/Price)
First	10	10	24	12
Second	8	8	20	10
Third	7	7	18	9
Fourth	6	6	16	8
Fifth	5	5	12	6
Sixth	4	4	6	3
Seventh	3	3	4	2

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Decision-Making Process

LO2

Sequence of Purchases to Achieve Consumer Equilibrium, Given the data in Table 6.1
Choice Number	Potential Choices	Marginal Utility per Dollar	Purchase Decision	Income Remaining
1	First Apple First Orange	10 12	First orange for $2	$8 = $10 - $2
2	First Apple Second Orange	10 10	First apple for $1 and Second orange for $2	$5 = $8 -$3
3	Second Apple Third Orange	8 9	Third orange for $2	$3 = $5 - $2
4	Second Apple Fourth Orange	8 8	Second apple for $1 and Fourth orange for $2	$0 = $3 - $3

6-*

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Deriving the Demand Curve

LO3

Price of Orange

0

$1

$2

4

6

Quantity Demanded of Oranges

$2

1

4

6

Quantity

Demanded

Price Per

Orange

D_O

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Income and Substitution Effects

Income effect

The impact that a price change has on a consumer’s real income

Substitution effect

The impact that a change in a product’s price has on it’s relative expensiveness

LO4

6-*

The substitution effect and income effect work simultaneously. Income effect is the impact that a price change has on a consumer’s real income and, consequently, on the quantity demanded of the good. If the price of a good falls, income is freed up and can be used to buy more of both, or either, good under consideration. The income effect is shown by the fact that a decline in price expands the consumer’s real income and the consumer can purchase more of this and other products until equilibrium is once again attained for the new level of real income.

Substitution effect is the impact that a change in a product’s price has on its relative expensiveness and on the quantity demanded. If the price of a product falls, this decreases its relative expensiveness and thus the consumer will now substitute more of this good for the other. When the price of an item declines, the consumer will no longer be in equilibrium until more of the item is purchased and the marginal utility of the item declines to match the decline in price. More of this item is purchased rather than another relatively more expensive substitute.

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Applications and Extensions

New products

iPod

Diamond-water paradox
Opportunity cost and time
Medical care purchases
Cash and noncash gifts

LO5

6-*

iPods were a new product perceived by consumers as having a greater marginal utility to price ratio than the older portable CD players and other similar products, and thus resulted in a major shift in demand for the new product as consumers attempted to restore their consumer equilibrium.

Why do some goods that are essential to life have low prices and goods that are not essential to life have high prices? The marginal utility of the last unit of water consumed is small because we consume a lot of water. The marginal utility of the last diamond is large because we consume few diamonds.

Time also has a value, so this must be considered in decision making and utility maximization. When time is considered, consumer behavior appears to be much more rational. Highly skilled people, like doctors, earn high wages and therefore incur a higher opportunity cost whenever they use their time in some other way. They are more likely to buy goods over the internet and pay higher prices for things that will save them time. Unskilled workers or retirees have low opportunity costs for their time and therefore will use time to search out ways to save money. They are more likely to search for bargains and take longer trips if it saves them money. Foreigners observe that Americans waste material goods but conserve time. This could be because our high productivity makes our time more valuable than many of the goods we waste.

With medical care purchases we pay an upfront fixed charge each month and this charge is not affected by the amount we consume. The additional marginal benefit is higher than the marginal cost of additional use. This explains why we use so much more than if we had to pay full price.

Noncash gifts result in a loss of utility and we then take action to maximize our utility, such as taking it back and exchanging it, etc. Noncash gifts may yield less utility to the receiver than a cash gift of equal monetary value because the noncash gift may not match the receiver’s preferences. Individuals know their own preferences better than the gift giver.

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Prospect Theory

How people actually deal with life’s up and downs
People judge things relative to the status quo
People experience:

Diminishing marginal utility for gains
Diminishing marginal disutility for losses

People are loss adverse

LO5

6-*

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Losses and Shrinking Packages

Consumers see any price increase as a loss relative to the status quo
Producers are reducing package size instead of raising prices

LO5

6-*

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Framing Effects and Advertising

Consumers evaluate events in a particular mental frame
New information alters the frame in which the consumer defines whether situations are gains or losses

LO5

6-*

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Anchoring and Credit Card Bills

Estimates of value are influenced by recent information no matter how irrelevant
Can lead to people altering valuations unconsciously

LO5

6-*

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Mental Accounting and Warranties

Separate purchases into “mental accounts” rather than looking at the big picture
Mental accounting exaggerates any potential loss

LO5

6-*

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The Endowment Effect

Market transactions may be affected by the endowment effect because:

The seller has a tendency to demand a higher price
The buyer has a tendency to offer a lower price

LO5

6-*

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Nudging People

Using behavioral economics to change people’s behavior
Subtle manipulations are used to generate socially better outcomes
Unaware of being manipulated

LO5

6-*