Consumer Decision Making Frederick University 2014

Determinants of Household Demand The price of the product in question. The income available to the household. The household’s amount of accumulated wealth. The prices of related products available to the household. The household’s tastes and preferences. The household’s expectations about future income, wealth, and prices. Factors that influence the quantity of a given good or service demanded by a single household include:

Consumer Decision Making Assumptions Consumers want to derive maximum satisfaction from goods and services in consumption Consumers always prefer more satisfaction to less satisfaction Consumers are aware of their own taste and preferences Preferences are transitive

Constraints of the Consumer Choice Objective constraints: consumer’s income prices of the goods in consumption Subjective constraints: individual taste individual preferences

The Basis of Choice: Utility Utility – the satisfaction derived from a product or service in consumption Marginal Utility – the extra utility, derived from an extra unit of the good in consumption (MU) TU derived from n units of the good in consumption = MU 1 + MU 2 + … + MU n

The Law of Diminishing Marginal Utility For any good or service, the marginal utility of that good or service decreases as the quantity of the good increases

TU and MU Units of the good Marginal Utility MU Total Utility TU

TU and MU MU of wine TU of wine MU Q

The Model of Consumer Choice Assumptions The consumer consumes only two goods – wine and movies The consumer wants to derive maximum TU from the goods in consumption Wine and movies are substitutable, but not perfectly substitutable Consumption is affected by the law of diminishing marginal utility The prices of the goods and the consumer’s income are given

Budget Constraint MU reveals the ordering of consumer preferences among bundles of goods. It tells us what the consumer is willing to buy. It does not tell us what the consumer is able to buy. It does not tell us anything about the consumer’s buying power. The budget constraint shows all the combinations of goods that can be purchased with a given level of income.

The Budget Constraint Y = € 100; Pw = € 10; P m = € 10 The Budget Line wMY W M

Optimal Consumption Choice Given an income and prices, we want to choose the optimal consumption bundle (the bundle the consumer likes best) Choice must be feasible – i.e. in the budget set But: more is better – the choice must be on the budget line We choose the most-preferred point on the budget line – the one associated with the highest satisfaction (Total Utility)!

Consumer’s Equilibrium Maximum TU If prices of wine and movies are equal, MU w = Mu m If the price of wine is twice as great as the price of movies, MU w = 2 Mu m WTUMUMTUMU MU w : MU m = P w : P m Or MUw : Pm = Pw : MUm

Optimal Consumption Choice Consumer Equilibrium The Consumer is in equilibrium when MU W /P W = MU M /P M If MU W /P W > MU M /P M the consumer will be motivated to rearrange his/her purchases and buy more wine and fewer movies. The MU of the next bottle of wine, however, will be lower, while the MU of the last movie will be greater and the equation will be achieved

The Income Effect of a Price Change When the price of a product falls, a consumer has more purchasing power with the same amount of income. When the price of a product rises, a consumer has less purchasing power with the same amount of income.

The Substitution Effect of a Price Change When the price of a product falls, that product becomes more attractive relative to potential substitutes. When the price of a product rises, that product becomes less attractive relative to potential substitutes.

Income and Substitution Effects The income effect: Consumption changes because purchasing power changes. The substitution effect: Consumption changes because opportunity costs change. Price changes affect households in two ways:

Income Effect and Substitution Effect Income effect Q Substitution effect Price effect Q P Normal goods Inferior Goods regular Giffen goods Q Q Q Q Q Q Q Q Q Q = const

Consumer Surplus Any is willing to pay ₤ 5 for the first hamburger, but since she will derive less satisfaction from the second hamburger, she will be willing to pay less, say, ₤ 4.75 for it Marginal willingness to pay – the maximum amount the consumer is willing to pay for one extra unit of a good in consumption Q MWP P = ₤ 2.50 MWP - P Consumer surplus = ∑ (MWP – P) = = ₤8.25

The Diamond/Water Paradox The diamond/water paradox states that: 1. the things with the greatest value in use frequently have little or no value in exchange, and 2. the things with the greatest value in exchange frequently have little or no value in use.

The Diamond/Water Paradox Total utility of water is high, while total utility of diamonds is low People are willing to pay a lot of money for a piece of a diamond and just a little money for a drop of water, because the Marginal Utility of a diamond is very high, while the Marginal Utility of water is very low The choice is made on the basis of Marginal Utility, not total utility