Consumer Behavior & Utility Maximization Chapter 8 9/21/2018

Income & Substitution Effects Income Effect- Impact of a product price change on a consumer’s real income and on quantity demanded. Substitution Effect- Impact of a product price change and your willingness to buy that product as opposed to a substitute item. In Chapter 3, we mentioned two explanations of the down-sloping demand curve (income & substitution effect). As prices decline for specific products, your purchasing power increases. This means that you can buy more with the same money income. When the price of a product falls, that product becomes cheaper relative to all other products. Consumers will substitute the cheaper product for other products that are now more expensive. 9/21/2018

Utility Satisfaction or pleasure one gets from consuming a product. Utility for a product varies from person to person Difficult to measure 9/21/2018

Total Utility & Marginal Utility Total Utility- Total amount of satisfaction a person derives from consuming some specific quantity (I.e. 10 units) Marginal Utility- The extra satisfaction a consumer realizes from an additional unit of that product. (I.e. going from the 10th unit to the 11th the difference between the two). 9/21/2018

Key Graph Tacos Consumed Total Utility Marginal --- 1 10 2 18 8 3 24 6 --- 1 10 2 18 8 3 24 6 4 28 5 30 7 -2 9/21/2018

Law of Diminishing Marginal Utility Consumers fulfill specific wants with succeeding units of a commodity Each added unit provides less utility (satisfaction) than the last unit purchased. 9/21/2018

Theory of Consumer Behavior The typical consumers situation has the following dimensions: Rational behavior Get most out of their $ Preferences Clear-cut preferences for goods/services Budget constraint Fixed amount to spend Prices Every good carries a price tag The consumer is a rational person who tries to use his or her money to derive the greatest amount of utility Each consumer has clear-cut preferences for certain goods & services that are available in the market. At any point in time, the consumer has a fixed, limited amount of money. Goods are scarce relative to the demand for them. 9/21/2018

Utility-Maximizing Rule To maximize satisfaction, the consumer should allocate his or her income so that the last dollar spent on each product yields the same amount of marginal utility. Marginal Utility per Dollar- Before applying the utility maximizing rule to these data, we must put the MU information on a per-dollar-spent basis 2. Person has $10, how can they maximize their utility and get the most out of their $10? 9/21/2018

Utility-Maximizing Table (Income = $10 to spend) Units Marginal Utility (Product A) Price = $1 MU Per Dollar (MU/Price) Utility (Product B) Price = $2 MU Per Dollar 1 10 24 2 8 20 3 7 18 4 6 16 5 12 9/21/2018

Budget Line Schedule or curve that shows various combinations of two products a consumer can buy with a specific money income. Characteristics Income changes Increase in money income shifts the budget line to the right; decrease to the left. Price changes Decline in prices of both products shifts the curve to the right. Increase in prices of both shifts the curve to the left. Figure 1 (p 151) consumer’s budget line Figure 2 (p152) consumer’s indifference curve 2. Increase in money income shifts the budget line to the right; decrease to the left. 3. Decline in prices of both products shifts the curve to the right. Increase in prices of both shifts the curve to the left. 9/21/2018

Total Expense (Price * Units) Add A & B Together Budget Schedule Units of A Price = $1.50 Units of B Price = $1 Total Expense (Price * Units) Add A & B Together 8 12 (12+0) 6 3 12 (9+3) 4 12 (6+6) 2 9 12 (3+9) 12 12 (0+12) 9/21/2018

Indifference Curves Shows all combinations of two products that will yield the same utility to the consumer 9/21/2018

Indifference Schedule Combination Units of A Units of B J 12 2 K 6 4 L M 3 8 9/21/2018

Indifference Map Series of indifference curves Each curve reflects a different level of total utility 9/21/2018

Consumers Equilibrium Position Budget Line – Combinations of products a customer can afford Of these combinations, the consumer would prefer the combination that provides the greatest utility The equilibrium position is the point that is on the budget line but on the furthest indifference curve 9/21/2018