Consumer Behavior

Consumer Behavior • The goal of consumer behavior is utility maximization • Consumer choice among various alternatives is subject to constraints: • income or budget • prices of goods purchased • preferences

Models of Consumer Behavior • Marginal Utility approach • cardinal measure of utility • Indifference approach • ordinal utility

Cardinal Utility Approach to Consumer Behavior • Total and Marginal utility • Law of diminishing Marginal Utility • Equimarginal rule and utility maximization

120 Q 100 1 30 55 2 80 75 3 60 4 90 40 5 100 20 6 105 7 105 1 2 3 4 5 6 7 Q/ut 8 100 Total utility [TU] is defined as the amount of satisfactionan individual derives from consuming a given quantity of a goodduring a specific period of time TU Utility . . . . . TU TU . . .

Nature of Total Utility • When more and more units of a good are consumed in a specific time period, the utility derived tends to increase at a decreasing rate • Eventually, some maximum utility is derived and additional units cause total utility to diminish. As an example, think of eating “free” muffins..or paanipuri.. • It is possible for total utility to initially increase at an increasing rate..

DTU MU = DQ Utility MU Q TU MU 30 DQ=1 DTU=30 1 25 30 20 DQ=1 DTU=25 55 2 10 DQ=1 DTU=20 75 3 4 90 1 2 3 4 5 6 7 Q/ut DQ 5 100 6 105 5 7 105 0 8 -5 100 Marginal Utility [MU] is the change in total utility [DTU] caused by a one unit change in quantity consumed[DQ] ; The first unit consumed increases TU by 30. . . The 2cd unit increases TU by 25. . . 30 . . . 25 . MU 20 15 10

331 Utility Q TU MU 120 1 30 100 55 2 80 75 3 60 4 90 40 5 100 20 6 105 5 7 105 0 1 2 3 4 5 6 7 Q/ut 8 -5 100 TU 30 DTU=30 25 20 15 10 MU

Marginal Utility • Marginal utility [MU] is the change in total utility associated with a 1 unit change in consumption. • Relation between TU and MU: • As total utility increases at a decreasing rate, MU declines. • When TU is a maximum, MU is 0 [This is sometimes called the “Satiation point” or the point of “absolute diminishing utility.” • As total utility declines, MU is negative

Diminishing Marginal Utility • Initially, it may be possible for TU to increase at an increasing rate. In which case MU will increase [MU is the slope of TU which is increasing]. • Eventually, as more and more of a good are consumed in a given time period, TU continues to increase but at a decreasing rate; MU decreases.

B Py B Qy Px C B 80 = 16 = Py 5 A Qx B 80 0 = 26.7 = Px 3 B > PxQx + PyQy The budget constraint can be expressed: The amount of good Y that can be purchasedis the budget divided by the price of good Y, The amount of good X that can be purchased is, For an B = $80,and Py = $5 For an B = $80,and PX = $3 Any combinationinside area 0AC can be purchased for less than $80. Connecting the two intercepts identifies all combinations of goods X &Y that can be purchased for a budget of $80, Py = $5, and PX = $3.

Utility X Utility Y MUx TUx MUy Qy Qx TUy 1 1 30 60 60 30 55 90 30 2 2 25 75 20 110 20 3 3 4 4 15 90 120 10 10 5 5 100 128 8 6 6 5 105 128 0 0 7 7 105 120 - 8 -5 8 8 100 100 - 20 Consider an individual’s utility preference for 2 goods, X & Y; If the two goods were “free,”[ or no budget constraint],the individual would consume each good until the MU ofthat good was 0, Good Y Good X 7 unitsof good X and 6 of Y. Once the goods have a price and there is a budget constraint, the individual will try to maximize the utility from each additional dollar spent.

MUX MUY Utility X Utility Y PX PY MUx TUx MUy Qy Qx TUy 1 1 30 60 60 30 10. 12 55 90 30 8.33 2 2 25 6 75 20 110 20 3 3 6.67 4 4 4 15 5.00 90 120 10 2 10 1.6 5 5 3.33 100 128 8 6 6 5 1.67 105 128 0 0 0 0 7 7 105 120 - 8 -5 8 8 100 100 - 20 Given the budget constraint, Individuals will attempt to gain the maximum utility for each additional dollar spent, “the marginal dollar.” For PX = $3, the MUX per dollar spent on good X is; For PY = $5, the MUY per dollar spent on good Y is;

MUX MUY Utility X Utility Y PX PY MUx TUx MUy Qy Qx TUy 1 1 30 60 60 30 10. 12 55 90 30 8.33 2 2 25 6 75 20 110 20 3 3 6.67 4 4 4 15 5.00 90 120 10 2 10 1.6 5 5 3.33 100 128 8 6 6 5 1.67 105 128 0 0 0 0 7 7 105 120 - 8 -5 8 8 100 100 - 20 Now the preferences of the individuals and the relative prices of the two goods are displayed in the tables. If the objective isto maximize utilitygiven prices, preferences, andbudget, spend eachadditional $ on thegood that yieldsthe greater utility for that expenditure.

MUX MUY PX PY The second expenditure is for good X, [MUX $ is greater than MUY $] 10. 12 8.33 6 6.67 4 5.00 2 1.6 3.33 1.67 0 0 < > MUY MUX MUY MUX PY PX PY PX Given the preferences of the individual and the relative prices of the goods [PX = $3, PY = $5], the MU’s for each dollar spent are: To maximize TU given a budget of $30,the first expenditure would logically be for good Y since the MUY for each dollar is 12. Ö $5 $3 Ö $3 Ö Ö $5 The third & fourth expenditures are forgood X since the MU per dollar spent isgreater for X than Y. Ö $3 $5 Ö $3 Ö The fifth expenditure is for is for good Y. $3 Ö Continue to maximize the MU per $ spent. AT THIS POINT YOU HAVE SPENT THE BUDGET OF $30. , BUY X ! , BUY Y !

> MUY MUX PY PX < MUY MUX PY PX If the amount spent on the two goods is equal to the budget then > MUY MUX suggests that the individual should buy less of Y in order to buy more of X. PY PX < MUY MUX PY PX MUX MUY = PX PY says that the marginal utility of an additional dollar spent on good X is greater than that of a dollar spent on good Y. indicates that the MU per dollar spent on goodY exceeds that of a dollar spent on good X. says to purchase less X to pay for additionalamounts of Y. is an equilibrium condition!

Consumer Behavior