Theory of Consumer Behavior

Chapter 4 – Theory of Consumer Behavior Economics 11 – UPLB Prepared by T. B. Paris, Jr. December 11, 2007 Theory of Consumer Behavior ? ? ? Useful for understanding the demand side of the market. Utility – amount of satisfaction derived from the consumption of a commodity †¦. measurement units ? utils Utility concepts ? ? cardinal utility – assumes that we can assign values for utility, (Jevons, Walras, and Marshall). E. g. , derive 100 utils from eating a slice of pizza ordinal utility approach – does not assign values, instead works with a ranking of preferences. Pareto, Hicks, Slutsky) Total utility and marginal utility ? ? Total utility (TU) – the overall level of satisfaction derived from consuming a good or service Marginal utility (MU) additional satisfaction that an individual derives from consuming an additional unit of a good or service. ? TU MU = ? Q Total utility and marginal utility Example (Table 4. 1): Q 0 1 2 3 4 5 6 7 T U 0 20 27 32 35 35 34 30 36 MU –20 7 5 3 0 -1 -4 ? ? ? ? TU, in general, increases with Q At some point, TU can start falling with Q see Q = 6) If TU is increasing, MU > 0 From Q = 1 onwards, MU is declining ? principle of diminishing marginal utility ? As more and more of a good are consumed, the process of consumption will (at some point) yield smaller and smaller additions to utility Total Utility Curve TU 35 Total utility(in utils) 30 25 20 15 10 5 0 1 2 3 4 5 Quantity 6 Q Figure 4. 1 Marginal Utility Curve MU Marginal utility (in utils) 20 15 10 5 0 -5 Figure 4. 2 1 2 3 4 5 6 Quantity Q Consumer Equilibrium ? ?So far, we have assumed that any amount of goods and services are always available for consumption In reality, consumers face constraints (income and prices): Limited consumers income or budget ? Goods can be obtained at a price ? Some simplifying assumptions ? ? ? ? Consumer’s objective: to maximize his/her utility subject to income constraint 2 goods (X, Y ) Prices Px, Py are fixed Consumer’s income (I) is given Consumer Equilibrium ? Marginal utility per peso ? additional utility derived from spending the next peso on the good MU MU per peso = PConsumer Equilibrium ? Optimizing condition: MU X MU Y = PX PY ? If MU X MU Y > PX PY ? spend more on good X and less of Y Simple Illustration ? Suppose: X = fishball Y = siomai ? Assume: PX = 2 PY = 10 Numerical Illustration Qx 1 2 3 4 5 6 TUX 30 39 45 50 54 56 MUX 30 9 6 5 4 2 MUx Px 15 4. 5 3 2. 5 2 1 QY 1 2 3 4 5 6 TUY 50 105 148 178 198 213 MUY 50 55 43 30 20 15 MUy Py 5 5. 5 4. 3 3 2 1. 5 ? ? 2 potential optimum positions Combination A: ? X = 3 and Y = 4 ? TU = TUX + TUY = 45 + 178 = 223 ? Combination B: ? ? X = 5 and Y = 5 TU = TUX + TUY = 54 + 198 = 252 ? Presence of 2 potential equilibrium positions suggests that we need to consider income. To do so let us examine how much each consumer spends for each combination. Expenditure per combination ? ? Total expenditure = PX X + PY Y Combination A: 3(2) + 4(10) = 46 ? Combination B: 5(2) + 5(10) = 60 ? Scenarios: If consumer’s income = 46, then the optimum is given by combination A. .†¦Combination B is not affordable ? If the consumer’s income = 60, then the optimum is given by Combination B†¦. Combination A is affordable but it yields a lower level of utility ? end