©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 1 Chapter 16 “Consumer Behavior”

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 2 Learning Objectives 1.Discuss how the income effect and substitution effect lead to a downward sloping demand curve. 2.Explain why marginal utility diminishes. 3.Practice the step by step utility- maximizing process. 4.Apply the rule of utility maximization. 1.Discuss how the income effect and substitution effect lead to a downward sloping demand curve. 2.Explain why marginal utility diminishes. 3.Practice the step by step utility- maximizing process. 4.Apply the rule of utility maximization.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 3 Learning Objectives 5.Relate utility maximization to the demand curve. 6.Summarize the influences on consumer choices. 5.Relate utility maximization to the demand curve. 6.Summarize the influences on consumer choices.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e THE LAW OF DEMAND REVISITED Demand slopes downward according to the law of demand.Demand slopes downward according to the law of demand. The law is demand is caused in part by the substitution effect.The law is demand is caused in part by the substitution effect. The substitution effect of a price change, which occurs when a lower price on a good causes a person to buy more of that good instead of alternative goods.The substitution effect of a price change, which occurs when a lower price on a good causes a person to buy more of that good instead of alternative goods. Likewise, the substitution effect of increasing the price of a good would drive consumers to buy more of the substitute good instead of the good with the increased price.Likewise, the substitution effect of increasing the price of a good would drive consumers to buy more of the substitute good instead of the good with the increased price. Demand slopes downward according to the law of demand.Demand slopes downward according to the law of demand. The law is demand is caused in part by the substitution effect.The law is demand is caused in part by the substitution effect. The substitution effect of a price change, which occurs when a lower price on a good causes a person to buy more of that good instead of alternative goods.The substitution effect of a price change, which occurs when a lower price on a good causes a person to buy more of that good instead of alternative goods. Likewise, the substitution effect of increasing the price of a good would drive consumers to buy more of the substitute good instead of the good with the increased price.Likewise, the substitution effect of increasing the price of a good would drive consumers to buy more of the substitute good instead of the good with the increased price.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 5 oFor a normal good, the income effect of a price change will also cause demand to slope down. oThe income effect occurs when the price change affects consumer purchasing power, termed real income, and thus leads to a change in quantity demanded. oA higher price reduces real income, while a lower price increases real income. oFor a normal good, the income effect of a price change will also cause demand to slope down. oThe income effect occurs when the price change affects consumer purchasing power, termed real income, and thus leads to a change in quantity demanded. oA higher price reduces real income, while a lower price increases real income. The Law of Demand Revisited

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e UTILITY AND CONSUMER SATISFACTION  Consumers buy in order to obtain utility, which is the satisfaction received from the consumption of a good.  The utility that people gain from their purchases is subjective, varying from person to person.  Utility is not measurable, since satisfaction is not measurable.  Utility does not imply that a good is useful.  Consumers buy in order to obtain utility, which is the satisfaction received from the consumption of a good.  The utility that people gain from their purchases is subjective, varying from person to person.  Utility is not measurable, since satisfaction is not measurable.  Utility does not imply that a good is useful.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 7 Total and Marginal Utility  Although utility is not measurable, it can be modeled as though it were, using the util as its unit of measure.  Total utility equals the sum of the utils a person receives from consuming a specific quantity of a good.  Marginal utility equals the increments to total utility from changes in consumption.  Although utility is not measurable, it can be modeled as though it were, using the util as its unit of measure.  Total utility equals the sum of the utils a person receives from consuming a specific quantity of a good.  Marginal utility equals the increments to total utility from changes in consumption.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 8 Total and Marginal Utility Marginal Utility = Change in total utility Change in number of units consumed units consumed

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 9 Total and Marginal Utility Utils First SliceSecond SlicePizza Marginal utility Total Utility

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 10 Diminishing Marginal Utility The law of diminishing marginal utility decrees that the first unit of a good is most satisfying, after which additional units provide progressively less and less additional utility. There is a satiation point, beyond which additional consumption actually reduces utility. The law of diminishing marginal utility decrees that the first unit of a good is most satisfying, after which additional units provide progressively less and less additional utility. There is a satiation point, beyond which additional consumption actually reduces utility.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 11  When marginal utility is negative we say that a good provides disutility, which occurs beyond the satiation point.  The total utility curve rises as long as marginal utility is a positive number.  When marginal utility equals zero, the total utility curve peaks because total utility is at its maximum value.  The total utility curve turns downward when marginal utility becomes negative.  When marginal utility is negative we say that a good provides disutility, which occurs beyond the satiation point.  The total utility curve rises as long as marginal utility is a positive number.  When marginal utility equals zero, the total utility curve peaks because total utility is at its maximum value.  The total utility curve turns downward when marginal utility becomes negative. Diminishing Marginal Utility

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 12 Total and Marginal Utility

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 13 Utility Satiation point Total Utility is maximized when marginal utility is zero. Total and Marginal Utility

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e MAXIMIZING UTILITY SUBJECT TO A BUDGET CONSTRAINT  The budget constraint, a consumer’s income, curbs the amount of total utility that can be obtained.  Consumers must choose, while striving to spend their incomes so as to obtain the greatest satisfaction from their incomes.  Consumers maximize utility subject to their budget constraint.  Utility maximization is achieved when the consumer’s choices provide the greatest amount of total utility for a specific amount of time.  The budget constraint, a consumer’s income, curbs the amount of total utility that can be obtained.  Consumers must choose, while striving to spend their incomes so as to obtain the greatest satisfaction from their incomes.  Consumers maximize utility subject to their budget constraint.  Utility maximization is achieved when the consumer’s choices provide the greatest amount of total utility for a specific amount of time.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 15 Spending at the Margin When marginal utility is divided by the prices of goods and services, the result is called marginal utility per dollar.When marginal utility is divided by the prices of goods and services, the result is called marginal utility per dollar. The rule of utility maximization is…The rule of utility maximization is… –To maximize utility, a consumer adjust spending until the marginal utility from the last dollar spent on each good is the same. When marginal utility is divided by the prices of goods and services, the result is called marginal utility per dollar.When marginal utility is divided by the prices of goods and services, the result is called marginal utility per dollar. The rule of utility maximization is…The rule of utility maximization is… –To maximize utility, a consumer adjust spending until the marginal utility from the last dollar spent on each good is the same.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 16 Algebraic Statement of the Utility Maximizing Rule Marginal Utility of X Price of X Price of X = Marginal Utility of X Price of Y, for all goods X and Y If the marginal utility per dollar of product X is greater than the marginal utility per dollar of product, consumers should purchase more of product X. Conversely, if the marginal per dollar of product Y is greater than the marginal utility of product Y, consumers should purchase more of product Y.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 17 Utility Maximizing

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 18 Utility Maximization and Demand When consumers maximize utility their individual demand curves for a good are downward sloping. In other words, the quantity demanded of a good will change in the opposite direction to a change in its price. The law of diminishing marginal utility is another explanation for the downward sloping demand curve. When consumers maximize utility their individual demand curves for a good are downward sloping. In other words, the quantity demanded of a good will change in the opposite direction to a change in its price. The law of diminishing marginal utility is another explanation for the downward sloping demand curve.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 19 Utility Maximization and Demand

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 20 $3 4 Quantity of movies $ $2 5 Utility maximization causes demand to slope downward. Denise’s demand Utility Maximization and Demand

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e EXPLORE & APPLY GOOD CHOICE, BAD CHOICE Consumers account for some 70% of total spending in the U. s. economy. Predicting consumer’s choice is difficult as since they are determined by numerous considerations. Time has utility. People try to allocate their time to attain the greatest satisfaction, taking into account time’s opportunity cost. Consumers account for some 70% of total spending in the U. s. economy. Predicting consumer’s choice is difficult as since they are determined by numerous considerations. Time has utility. People try to allocate their time to attain the greatest satisfaction, taking into account time’s opportunity cost.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 22 Good Choice, Bad Choice Information also has utility. The last dollar spent on information should have a marginal utility per dollar equal to the marginal utility per dollar of the last dollar spent on the consumer’s other purchases. Impulse buyers make purchases on the spur of the moment without consulting information sources. Advertising is intended to affect consumer’s choices, generally with the goal of getting us to buy something now. A dollar saved can provide more satisfaction than a dollar spent. Information also has utility. The last dollar spent on information should have a marginal utility per dollar equal to the marginal utility per dollar of the last dollar spent on the consumer’s other purchases. Impulse buyers make purchases on the spur of the moment without consulting information sources. Advertising is intended to affect consumer’s choices, generally with the goal of getting us to buy something now. A dollar saved can provide more satisfaction than a dollar spent.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 23 Addictive Behavior  Some people make choices that appear to be bad to others.  Binging behavior like overeating, smoking, binging on alcohol, drugs, shopping, etc., are examples.  One aspect of addiction problems is that we are unable to rationally control the things that give us utility.  A second aspect is “utility in hindsight”, where immediate gratification comes now, but the disutility comes later.  The further into the future the disutility, the more we are inclined to brush it aside.  Some people make choices that appear to be bad to others.  Binging behavior like overeating, smoking, binging on alcohol, drugs, shopping, etc., are examples.  One aspect of addiction problems is that we are unable to rationally control the things that give us utility.  A second aspect is “utility in hindsight”, where immediate gratification comes now, but the disutility comes later.  The further into the future the disutility, the more we are inclined to brush it aside.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 24 Addictive Behavior: Utility in Hindsight Utility Disutility Marginal utility perceived at the time Marginal utility perceived later Quantity of binge purchases Point where all money has been spent

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 25 Terms Along the Way substitution effect substitution effect income effect income effect utility utility util util total utility total utility marginal utility marginal utility disutility disutility substitution effect substitution effect income effect income effect utility utility util util total utility total utility marginal utility marginal utility disutility disutility law of diminishing marginal utility law of diminishing marginal utility satiation point satiation point marginal utility per dollar marginal utility per dollar law of diminishing marginal utility law of diminishing marginal utility satiation point satiation point marginal utility per dollar marginal utility per dollar

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 26 Test Yourself 1.When the price of a normal good decreases a.the income and substitute effects both prompt the consumer to purchase more of the good. b.the income and substitute effects both prompt the consumer to purchase less of the good. c.the income effect prompts the consumer to purchase less of the good, but the substitution effect prompts the consumer to purchase more. d.the income effect prompts the consumer to purchase more of the good, but the substitution effect prompts the consumer to purchase less. 1.When the price of a normal good decreases a.the income and substitute effects both prompt the consumer to purchase more of the good. b.the income and substitute effects both prompt the consumer to purchase less of the good. c.the income effect prompts the consumer to purchase less of the good, but the substitution effect prompts the consumer to purchase more. d.the income effect prompts the consumer to purchase more of the good, but the substitution effect prompts the consumer to purchase less.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 27 Test Yourself 2.Which of the following best describes the concept of utility? a.Utility is measurable. b.The utility of a good must rise the more useful it is. c.Utility is subjective. d.The utility provided by any particular good will be the same for most consumers. 2.Which of the following best describes the concept of utility? a.Utility is measurable. b.The utility of a good must rise the more useful it is. c.Utility is subjective. d.The utility provided by any particular good will be the same for most consumers.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 28 Test Yourself 3.The util is a.unrelated to the concept of utility. b.measurable with highly sensitive electronic equipment. c.used by economist to to illustrate diminishing marginal utility. d.a special kind of money used in economic experiments. 3.The util is a.unrelated to the concept of utility. b.measurable with highly sensitive electronic equipment. c.used by economist to to illustrate diminishing marginal utility. d.a special kind of money used in economic experiments.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 29 Test Yourself 4.Marginal utility will be negative when the total utility curve is a.rising. b.falling. c.at its maximum. d.in the negative range. 4.Marginal utility will be negative when the total utility curve is a.rising. b.falling. c.at its maximum. d.in the negative range.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 30 Test Yourself 5.Consumer equilibrium requires the consumer to a.maximize total utility. b.maximize marginal utility. c.purchase amounts of each good so that their marginal utilities are equal. d.ignore the price of a good in deciding how much to consume and consider only the utility of a purchase. 5.Consumer equilibrium requires the consumer to a.maximize total utility. b.maximize marginal utility. c.purchase amounts of each good so that their marginal utilities are equal. d.ignore the price of a good in deciding how much to consume and consider only the utility of a purchase.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 31 Test Yourself 6.The marginal utility per dollar of a good equals the goods marginal utility a.multiplied by $1. b.divided by $1. c.divided by the price of the good. d.multiplied by the price of the good. 6.The marginal utility per dollar of a good equals the goods marginal utility a.multiplied by $1. b.divided by $1. c.divided by the price of the good. d.multiplied by the price of the good.

©2004 Prentice Hall Publishing Ayers/Collinge, 1/e 32 The End! Next Chapter 16 Appendix