1. Topic 4
Consumer Behavior

2. Utility
Like elasticity, Utility is another fancy name for satisfaction or happiness
Utility refers to satisfaction derived from consumption of goods and services.
To understand consumer behavior, we must know the difference between Total Utility and Marginal Utility
7-2

3. Total Utility
Cumulative satisfaction derived from consumption of a specific quantity of goods or services.
Example:
Lets look at Bob’s satisfaction schedule from ice cream consumption.
7-3

4. Total Utility Number of Ice Cream Total Utility 0 util 1 10 util 2
0 util 1
10 util 2
18 util 3
24 util 4
28 util
7-4

5. Total Utility Ice Cream Total Utility 0 util 1 10 util 2 18 util 3
0 util 1
10 util 2
18 util 3
24 util 4
28 util
Note:
No consumption provides no utility.
Higher consumption implies higher utility.
Total utility is always rising.
7-5

6. Marginal Utility Marginal utility
Extra satisfaction from the consumption one additional unit.
It is not the total cumulative satisfaction from consumption of all previous units.
It is rather the satisfaction of just one (the last) unit consumed.
Lets look at Bob’s marginal utility.
7-6

7. Marginal Utility Number of Ice Cream Total Utility 0 util 1 10 util 2
0 util 1
10 util 2
18 util 3
24 util 4
28 util
Marginal
Utility
Undefined
10 util
8 util
6 util
4 util
7-7

8. Marginal Utility Ice Cream Marginal Utility Undefined 1 10 util 2
Undefined 1
10 util 2
8 util 3
6 util 4
4 util
Note:
Needs two units to compare marginal utility.
Marginal utility falls with consumption.
Can be even negative.
When MU is negative, TU must fall from previous TU
7-8

9. Law of Diminishing Marginal Utility
Bob’s marginal utility is falling with higher unit consumed.
This is not an accident.
This is in fact a behavioral assumption that economists make and call it:
The Law of Diminishing
Marginal Utility
7-9

10. Utility Graphically ] Total Utility 1 2 3 4 5 6 7 10 18 24 28 30 10 810 20 30 8 6 4 2 -2 1 3 5 7 TU
Total Utility
(1)
Tacos
Consumed
Per Meal
(2)
Total
Utility,
Utils
(3)
Marginal
Utility,
Utils TU 1 2 3 4 5 6 7 10 18 24 28 30 ] 10 8 6 4 2 -2 Q MU
Marginal Utility Q MU
Units Consumed Per Meal
7-10

11. Theory of Consumer Behavior
This theory tells us how consumers maximize utility.
It tells us how much of each goods or services consumer should buy to maximize total utility.
It finds utility maximizing:
Quantities (or Q*)
When Income (or M) is fixed
When Prices (or P) are fixed
7-11

12. Theory of Consumer Behavior
Assume that
A consumer’s income M=40
Wants to purchase pizza and Video rental, where
Price of Pizza, Pp =$8
Price of Video Rental, Pv =$4
TU and MU for good Pizza and Video rental are known
This theory tells us how much of Pizza and video rental this consumer should purchase

13. Theory of Consumer Behavior
We need a stable preference for Pizza
This preference is expressed by TU and MU
Pizza
(1)
Consumed
per
week
(2)
Total
Utility
(3)
Marginal 1 56 2 88 3
112 4
130 5
142 6
150

14. Theory of Consumer Behavior
Pizza
(1)
Consumed
per
week
(2)
Total
Utility
(3)
Marginal 1 56 2 88 32 3
112 24 4
130 18 5
142 12 6
150 8

15. Theory of Consumer Behavior
Similarly we need a stable Preference for Video Rental expressed by TU and MU
Video Rental
(1)
Viewed
per
week
(2)
Total
Utility
(3)
Marginal 1 40 2 68 3 88 4
100 5
108 6
114

16. Theory of Consumer Behavior
Video Rental
(1)
Viewed
per
week
(2)
Total
Utility
(3)
Marginal 1 40 2 68 28 3 88 20 4
100 12 5
108 8 6
114

17. Theory of Consumer Behavior
Which one would you consume first?
Is it your first pizza (with 56 MU)?
Pizza
Video Rental
(1)
Consumed
per
week
(2)
Total
Utility
(3)
Marginal
Viewed 1 56 40 2 88 32 68 28 3
112 24 20 4
130 18
100 12 5
142
108 8 6
150
114

18. Theory of Consumer Behavior
We can’t say that yet because pizza provides higher MU, but it is more expensive
We need to take price into account, some how
Pizza (PP=$8)
Video Rental (PV=$4)
(1)
Consumed
per
week
(2)
Total
Utility
(3)
Marginal
Viewed 1 56 40 2 88 32 68 28 3
112 24 20 4
130 18
100 12 5
142
108 8 6
150
114

19. Theory of Consumer Behavior
Pizza (PP=$8)
Video Rental (PV=$4)
(1)
Consumed
per
week
(2)
Total
Utility
(3)
Marginal
(4)
per $ MU P
Viewed
--- 1 56 7 40 10 2 88 32 4 68 28 3
112 24 20 5
130 18
2.25
100 12
142
1.5
108 8 6
150
114

20. Theory of Consumer Behavior
Comparing Per dollar MU or MU P
This consumer should consume in the following sequence:
First Video rental
First Pizza and Second Video rental (one of each)
Third video rental
Second Pizza
Third Pizza and Fourth Video Rental (one of each)
And no more, why?
Pizza (PP=$8)
Video Rental (PV=$4)
(1)
Consumed
per
week
(4)
Marginal
Utility
per $ MU P
Viewed
--- 1 7 10 2 4 3 5
2.25
1.5 6

21. Theory of Consumer Behavior
This consumption sequence indicates that
to maximize utility you must consume in a way that
MU for the last pizza consumed P
is exactly equal to
MU for the last video rentals
In this case, MUPizza MUVideo rental
Ppizza PVideo rental = = 3

22. Utility Maximizing Condition
MUPizza MUVideo rental
PPizza PVideo rental
This condition simply means that the last dollar spent on each good must provide the same marginal utility
This constitutes the condition for utility maximization =

23. Utility Maximizing Condition
MUPizza MUVideo rental
PPizza PVideo rental =
Pizza (PP=$8)
Video Rental (PV=$4)
(1)
Quantity of Pizza
(4) MU P
Quantity of Video Rental
--- 1 7 10 2 4 3 5
2.25
1.5 6
However note that the above condition is fulfilled at three quantity combinations:
1 pizza and 2 video
[per $ MU is 7]
3 pizza and 4 video
[per $ MU is 3]
5 pizza and 6 video
[per $ MU is 1.5]

24. Utility Maximizing Condition
Among these three combinations, which one is really utility maximizing:
1 pizza and 2 video [per $ MU is 7]
3 pizza and 4 video [per $ MU is 3]
5 pizza and 6 video [per $ MU is 1.5]
To know that we need think about the Budget
Comb. A cost [1x$8 + 2x$4] $16 (Money left)
Comb. B cost [3x$8 + 4x$4] $40 (Exactly)
Comb. C cost [5x$8 + 6x$4] $64 (Unaffordable)

25. Equilibrium Quantity
When the last dollar spent on each good yields the same marginal utility, there is no way to increase utility by reallocating the budget to buy some other quantity combination
This is why quantity choice at which the utility maximized is also called Equilibrium quantity

26. Equilibrium Quantity
How do we check that equilibrium quantity indeed provided highest level of utility possible
To see that we need to go back to the total utility table
Let’s compare another bundle that also costs $4o in the utility table

27. Equilibrium Quantity
Pizza (PP=$8)
Video Rental (PV=$4)
(1)
Quantity
(2) TU
(4) MU P
--- 1 56 7 40 10 2 88 4 68 3
112 5
130
2.25
100
142
1.5
108 6
150
114
At the equilibrium combination TU is 212 Equilibrium Quantity suggests that no other affordable quantity choice will yield higher TU Note, 2 pizza and 6 video also cost $40 But the TU is 202

28. Violation of Utility Max. Condition
The utility maximizing condition is violated when at the current quantity choice one of the following happens:
MUPizza MUVideo rental
PPizza PVideo rental
>
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29. Violation of Utility Max. Condition
When Utility maximization condition is violated:
Clearly the consumer is not maximizing satisfaction
Therefore, not consuming equilibrium quantities
Which means, by reallocating budget across pizza and video or buying a different combination consumer can increase satisfaction

30. Violation of Utility Max. Condition
Assume that at the current level of pizza and video consumption, we have
MUP MUV
PP PV
What specifically would you suggest this consumer to increase satisfaction?
>

31. Utility-Maximizing Conditions
Note, this situation implies that per $ MU for pizza is higher
MUP MUV
PP PV
Which means, pizza has a bigger bang for the buck
Therefore, this consumer should buy more pizza and less video
>

32. Utility-Maximizing Conditions
MUP MUV
PP PV
How does buying more pizza and less video restore utility maximizing condition
What happens to MUP when more pizza is consumed?
What happens to MUV when less video is consumed?
Therefore, by reallocating this way consumer will reach equilibrium
>
It goes down!
It goes up!

33. Where does Demand Curve Come From
Recall, demand is a relationship between:
Price and
Quantity demanded at that price
Keeping all else constant
The law of demand says that this relationship is inverse or negative
Which means:
Quantity demanded is lower at higher price and
Quantity demanded is higher at lower price
Utility theory explains why that is so

34. Where does Demand Curve Come From
Utility Theory or Consumer Behavior says that higher quantity demanded at lower price is an equilibrium choice
The law of demand comes from consumers’ utility maximizing behavior
In other words, what we will observe in few slides that when price changes MU per $ changes as well
When that happens consumers’ utility maximizing bundles changes

35. Where does Demand Curve Come From
The utility maximizing bundle changes in such a way that price and quantity choice becomes negatively related
Let’s see that using an example that we already are familiar with

36. Theory of Consumer Behavior
Pizza (PP=$8)
Video Rental (PV=$4)
(1)
Consumed
per
week
(2)
Total
Utility
(3)
Marginal
(4)
per $ MU P
Viewed
--- 1 56 7 40 10 2 88 32 4 64 24 3
112 84 20 5
130 18
2.25 96 12
142
1.5
106 6
150 8
114

37. Where does Demand Curve Come From
Based on this table, from our previous analysis we know that this consumer will choose 3 pizza and 4 video rental
This is because that choice is utility maximizing equilibrium quantity choice
Now, if I want to draw the demand curve for video rental for this consumer, I will have one point of his demand curve
That is PV=4 and Q*V=4

38. Where does Demand curve come from
We can plot that point (4, 4)as follows:
Price 4
Quantity Demanded

39. Where does Demand curve come from
However one point is not enough even for a linear demand curve. We need at least another point
To get that point, let’s increase the price of video rental from $4 to $8
If we do so, we need to update our MU table. Especially the MU/p column

40. Theory of Consumer Behavior
Pizza (PP=$8)
Video Rental (PV=$4)
(1)
Quantity
(2) TU
(3) MU
(4) P
When
P=4
(5)
P=8
--- 1 56 7 40 10 5 2 88 32 4 64 24 6 3
112 84 20
2.5
130 18
2.25 96 12
1.5
142
108 8
1.25
150
114

41. Where does Demand curve come from
Consumer utility maximization rule tells us that this consumer will choose a different quantity combination under new price
Specifically, based on his preference table (TU and MU) the consumer will choose
3 pizza and 2 video rental
This gives us another point on the demand curve for video rental of this consumer
Which is PV=8 and Q*V=2

42. Where does Demand curve come from
Price 8 4 D
Quantity Demanded