1 The Behavior of Consumers Here we study an elementary view of the economic approach to how consumers go about spending their money – you could say this is a model of how consumers confront the basic economic problem.

2 Consumers of goods and services face the incredible task of having to decide how much to buy, if any, of literally thousands of items in the marketplace. In economics we say the goal of the consumer is to maximize the utility they can get from the goods and services that are available. Utility here means the happiness or satisfaction that goods and services provide for the consumer. Let’s work with an example where there is only two goods consumers can buy – let’s pick steak and potatoes (I pick two goods to make the example relatively easy to work with, but others have studied this stuff and have shown the things I point out apply when there are tons of goods and services to choose from). Now, let’s look at something called the budget line or constraint of the consumer. Say a consumer has $10 to spend and say a pound of steak costs $1 and a pound of potatoes costs $1 (I made up the numbers to just get us started – but we usually only have a certain amount to spend and we have to pay prices for the goods and services we buy). Can the consumer buy 20 pounds of steak? Not right now. The $10 of income and the price of $1 per pound constrains the individual to only a maximum of 10 pounds of steak – and in this case no potatoes could be purchased if all is spent on steak.

3 Pounds of Steak Pounds of Potatoes Each line in this table represents a combination of steak and potatoes the consumer can buy. How did I get these numbers? Well, the amount spent on steak plus the amount spent on potatoes should add up to $10. So we really have the equation $10 = amount spent on steak + amount spent on potatoes. On the next screen let’s put the information into a graph. The graph will have the quantity of steak on the horizontal axis and the amount of potatoes on the vertical axis. Each line in the table is represented by a point in the graph. Note the amount spent on good X is the price of X times the quantity of X taken.

4 Note: From the table on the previous screen, the first row of the table is the point on the bottom right of the table. Then as we go down the table we move up the line in the graph.

5 The economic approach to consumer behavior is based on the idea that a consumer can evaluate how much they like each combination of goods. Here is a way to see which basket the consumer will choose to maximize utility given that they have $10 and each good costs $1 per unit. Start at the bottom right basket – 10 steaks and 0 potatoes (to save on typing we assume each steak and each potato is a pound.) Now, the individual is getting utility from steak only at the first point. Think about moving to point (9, 1). If the consumer moves from (10, 0) to (9,1) the consumer will lose 1 steak, but gain 1 potato. With this move there is 1) A loss in utility from the 1 steak that is given up, 2) A gain in utility from the 1 potato gained. If the gain is greater than the loss, then the consumer will make the move from (10, 0) to (9, 1). The same type of movement will be investigated between (9, 1) and (8, 2). Move to the point (8, 2) if the second potato adds more utility than the loss in utility from giving up the 9 th steak.

6 Digress: true story – my daughter JoAnn and her buddy Meg were playing one day and I heard Meg say she liked horses more than JoAnn liked horses. Have you every heard kids say this type of stuff? Well, anyway, in economics we think it is hard to compare how much two different people like certain items. BUT, we think it is very natural for a single person to compare how much they like, or how much utility they get, from different types of items like steak and potatoes. Another component to our story about consumer behavior: Notice when the consumer starts in the bottom right of the table there is a set of 10 steaks and no potatoes. We have to have a time frame in mind, so let’s say it is a week of time. If you are like me, you like steak, but does each pound give the same utility in a certain amount of time? In economics we think that the more units of an item you have in a certain amount of time the happier you probably are, but the additional units add less and less happiness for you. The marginal utility (the utility added by another unit) of each unit is said to diminish.

7 Let’s add the concept of marginal utility to the steak and potatoes example: Say you think about buying 10 steaks and 0 potatoes. Now compare this to 9 steaks and 1 potato. The 10 th steak would have relatively low utility as far as steak goes, because diminishing returns would have set in, and the first potato would have relatively high utility as far as potatoes go. So, for many of us we would take the first potato and give up the 10 th steak. But maybe not every one would. Some might just take 10 steaks and no potatoes. Now, if a person didn’t take the first potato they are done (stick a fork in them ). They have maximized utility at (10, 0). So, when the price of steak is $1 (and when the consumer has $10 and the price of potatoes is $1) the quantity demanded from some people will be 10 units. Other people will move up the line in the graph because some units of potatoes add more utility than the utility lost by having less steak. I can not predict where any one person will end up, unless I know more about that person. But we think each person knows where they will end up. (where does the vegetabletarian - a person who eats only vegetables like potatoes - end up?)

8 In steak and potatoes example I had before, the price of each good was $1 and the person had $10 to spend. Different people will have a different amount to spend, but will always follow the same basic method as presented here (remember this is the economic view.) The interesting thing is that although people have different incomes (money to spend), they can face the same prices when they shop in the same stores. When the price of each good is $1, taking 1 potato requires the person to give up 1 steak. Comparisons of the utilities involved can take place for each person and each person can maximize their own utility. So, let’s say we have three people and when the price of steak is $1 we see the demand from each of the three as Sally – 4 pounds, Sammy – 6 pounds and Billy – 7 pounds. The next thing we want to explore is what happens to the amount folks want when the price of a good changes. Let’s explore a price decline to 50 cents per pound of steak. Let’s go back to our graph, which was created with the consumer having income of $10. Plus we will say half pounds of potatoes can be purchased.

9 Note here when the price of steak fell we get a new budget line. The same maximum amount of potatoes can be bought, but now 20 steaks can be purchased if all the money is spent on steaks. When the individual gives up a steak only half a potato can be purchased. But here the same type of comparison would happen as before. In other words, the 20 th steak would be given up if the utility of the first half of potato is bigger than the utility of the 20 th steak.

10 At this point in our study I hope you can accept on faith that in economics we get the feeling that as the price of something falls people want a greater quantity of it. Before, when the price of steak is $1 we saw the demand from each of the three people as Sally – 4, Sammy – 6 and Billy – 7. So when the price is 50 cents, the demand might be Sally – 5, Sammy – 7 and Billy – 8. Know, I have asked you to accept on faith that as the price of something falls a greater quantity is demanded. Some ideas called the income effect of a price change and the substitution effect of a price change provide some of the reasoning for what I asked you to accept on faith. Let’s think about a price decline. The logic behind the income effect of a price decline is that if you buy the same amount of the good after the price decline as you did before the price decline then you will have more money left in your pocket. The price decline would make it seem like you got a raise in income – hence why I wrote an income effect. Now, in the real world we might buy more of a good if our income rises, but maybe we will buy less. It depends on the good.

11 An inferior good is one that as we get more income we want less of the good. Do you have a good like this for you? What about cassette tapes for music? Have you desired less when you have gotten more income? Or what about white bread? Have you desired more of the other kinds and less white bread the more income you have obtained? If so, these goods are inferior for you. A normal good is one where as you get more income you want more of the good. Maybe CD’s for music and rye bread are normal for you. Review something: Before I mentioned that as the price of good falls I want you to accept on faith that the amount people want will increase. Now the income effect of a price decline says the amount will increase if the good is normal but will decline if the good is inferior. What is the deal on the inferior good? Well I need to mention the substitution effect. It is thought that as the price of a good falls we will want more of it and use it as a substitute for other things. As an example of this, as the price of gas falls we will buy more gas to drive around instead of walking of riding our bike. (To walk or ride your bike you need energy that comes from food, so the gas can substitute for the food, the cheaper the gas.) So the substitution effect always says take more when the price falls.

12 Finalize our thoughts here: Inferior good  price falls would mean the income effect says take less of the good but the substitution effect says take more of the good. From experience, economists have said the substitution effect is larger than the income effect and thus when the price of a good falls people want more of it. Normal good  price falls would mean both the income and substitution effects say take more of the good. On the next screen I show a typical demand curve for one person (like Sally from before) in a graph. The curve is really the result of the individual maximizing utility and when the price of something falls a greater amount is desired due to the relationships known as the income and substitution effects.

13 $ - here measuring Price per unit of steak Quantity of steak

14 All Else Equal You may have noticed we tell stories in economics. Like I just told a story about when the price of a good falls from $1 per unit to $0.50 (fity cent) most folks demand a greater quantity of the item. As I told the story I implicitly assumed only the price changed form $1 to $0.50. All else was assumed the same. This means the person likes the good the same at either price and the consumer has the same income at either price. If a person should change how much they like a good or if their income changes then we tell another story (just not now – maybe later). Think back to the example developed here. When the person only had $10 to spend and each good costs $1 per unit we can conclude, given all else is equal, 1) The consumer was limited to buying one combination of steak and potatoes in the table, and 2) If the consumer wanted more of one good while moving along the line, then less of the other good could be obtained. These two conclusions are the result of scarcity that the consumer faces. We sketch out a method the consumer might use to make a choice.