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This is a PowerPoint presentation on consumer behavior and demand.

This is a PowerPoint presentation on consumer behavior and demand. A left mouse click or the enter key will add and element to a slide or move you to the next slide. The back space key will take you back an element or slide. If you wish to

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  1. This is a PowerPoint presentation on consumer behavior and demand. A left mouse click or the enter key will add and element to a slide or move you to the next slide. The back space key will take you back an element or slide. If you wish to exit the presentation, the escape key will do it! R. Larry Reynoldsã 1997

  2. Consumer Objectives • In the Neoclassical economics, the goal of consumer behavior is utility maximization [this is consistent with maximization of Net benefits] • Consumer choice among various alternatives is subject to constraints: • income or budget • prices of goods purchased • preferences Principles of Microeconomics

  3. Models of Consumer Behavior • Marginal Utility approach • cardinal measure of utility • problem of related goods • Indifference approach • ordinal utility • related goods • observable behavior Principles of Microeconomics

  4. Utility Approach to Consumer Behavior • Need for cardinal measure of utility • analysis is useful for explaining behavior • Total and Marginal utility • “law of diminishing Marginal Utility” • Equimarginal rule and utility maximization Principles of Microeconomics

  5. 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 utility an individual derives from consuming a given quantity of a goodduring a specific period of time. TU = f(Q, preferences, . . .) TU Utility . . . . . TU TU . . . Principles of Microeconomics

  6. 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” hot cakes. • It is possible for total utility to initially increase at an increasing rate. Principles of Microeconomics

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

  8. 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 [DQ] ; The first unit consumed increases TU by 30. . . The 2cd unit increases TU by 25. . . 30 . . . 25 . MU 20 15 10 Remember that the MU is associated with the midpoint between the units as each additional unit is added. Principles of Microeconomics

  9. 120 100 max TU 80 60 DQ 30 DTU 40 MU = = DQ 1 20 DTU DTU The slope of TU is = 30, DQ 1 2 3 4 5 6 7 Q/ut MU 30 20 10 1 2 3 4 5 6 7 Q/ut TU The first unit consumed, DQ increases TU by 30, DTU. The MU is the slope of TU or the rate of change in TU associated with a one unit change in quantity. [Using calculus, MU is the change in TU as change in quantity approaches 0.] . . . . TU . . . between the 2cd and 3rd units DTU = 20 or the slope of TU is 20. For the first unit: . . MU is the slope of the TU. The second unit changes TU [ DTU] by 25, The slope of TU between the 1 and second unit is 25. . . . . . . MU Where MU = 0, TU is a maximum. . Principles of Microeconomics

  10. Consumer Preferences • Both MU and TU are determined by the “preferences” or utility function of the individual and the quantity consumed. • Utility cannot be measured directly but individual choices reveal information about the individual’s preferences • Surrogate variables [age, gender, ethnic background, religion, etc.] may be correlated with preferences. • There is a tendency for TU to increase at a decreasing rate [MU declines] as more of a good is consumed in a given time period: i.e. “diminishing marginal utility” Principles of Microeconomics

  11. 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. • This is called the point of “diminishing marginal utility.” Principles of Microeconomics

  12. Consumer Choices • If there were no costs associated with choices, the individual will consume a good until MU = 0 [this maximizes TU or the total benefits, TB] • Typically, individuals are constrained by a budget [or income] and the prices they pay for the goods they consume. • Net benefits are maximized where MB = MC; as long as the MU or MB of the next unit of good purchased exceeds the Price or MC, it will increase net benefits Principles of Microeconomics

  13. Society and Individual • The individual will purchase more of a good so long as their perceived or anticipated MB exceeds the price they must pay for the good: Buy so long as MB > P, optimum where, P = MB • From a social perspective that good should only be produced and sold if the price is greater than or equal to the MC: Sell so long as P > MC, optimum where P = MC • Social optimum when MB = P = MC Principles of Microeconomics

  14. Constrained Optimization • Individual choices then become a function of the price of the good, income [budget], prices of related goods and preferences. • QX = f (PX , Y, PY, Preferences, . . . ) • Where: • PX = price of good X • Y = income • PY = prices of related goods • “preferences” is the individual’s utility function Principles of Microeconomics

  15. Utility and Demand • Individual choice is influenced by: • QX = f (PX , Y, PY, Preferences, . . . ) • These are the same variables in the demand function • The forces that shape the demand function can be analyzed with utility analysis Principles of Microeconomics

  16. 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. Principles of Microeconomics

  17. 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. Principles of Microeconomics

  18. 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; Principles of Microeconomics

  19. 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. Principles of Microeconomics

  20. 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 ! Principles of Microeconomics

  21. > 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! Principles of Microeconomics

  22. MUX MUY = PX PY MUX MUY MUZ = = = . . . = MUN PX PZ PY PN subject to the constraint: PX X + PY Y = B insures the individual has maximized their total utility andhas not spent more on the two goods than their budget. This model can be expanded to include as many goods asnecessary: subject to; PX X + PY Y + Pz Z + . . . + PN N = B From this information a demand for the goods can beconstructed. Principles of Microeconomics

  23. 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 preference functions for goods X and Y, and the prices of the two goods: PX = $3, PY = $5. the MU of derived from each dollar of expenditure can be calculated. If the individual ismaximizing utility, their choices, constrained by their preferences, the prices and their budget can be shown: Principles of Microeconomics

  24. MUX MUY PX PY 12 10. PX 6 8.33 5 6.67 4 4 2 5.00 PX = 3 1.6 3.33 2 0 1.67 1 0 1 2 3 4 5 6 7 QX/ut 5 prices [PX = $3, PY = $5] and budget [$30], the individual’s choices were: Given preferences, Five units of X and 3 units of Y were purchased These choices can be shown in the context of a demand model: Ö $5 $3 Ö $3 Ö Ö $5 . Ö $3 $5 Ö $3 Ö This point lies on thedemand for good X. $3 Ö At PX = $3, given budget, Py and preferences, 5 units of X are purchased. Principles of Microeconomics

  25. MUX MUY MUX MUX PX PY PX PX [$3] [$5] [$5] 12 10. 6 6 PX 6 8.33 5 5 5 Demand 6.67 4 4 4 4 2 5.00 3 3 3 1.6 3.33 2 2 2 0 1.67 1 1 1 MUX MUY 0 0 0 = PX PY 1 2 3 4 5 6 7 QX/ut Given the individual’s preferences, the price of Y [PY] and the budget [B = $30], the individual purchased 5 units of X when the price of X [PX ] was $3. Raise the price of X [PX ] to $5 and the MUX per $ spent is reduced. . Choices about spending the $30 are now: Ö $5 Ö The $30 is now spent. $5 Ö Ö $5 $5 . Ö That portion of demand between $3 and $5 is mapped! Ö $5 $5 At PX = $5,ceteris paribus,3 units of X arepurchased. Principles of Microeconomics

  26. Demand • By continuing to change the price of good X [and holding all other variables, PY , budget or income and preferences constant,] the rest of the demand for good X can be mapped. • All price and quantity combinations on the demand for X are equilibrium points for the consumer [They are maximizing utility; holding all other variables, PY , budget or income and preferences constant] Principles of Microeconomics

  27. PX 5 4 3 Demand 2 1 1 2 3 4 5 6 7 QX/ut By changing the price of the good [in this case, good X] andholding all other variables [PY , budget or income and preferences] constant, the demand for the good can be mapped. The demand function is a schedule of the quantities that individuals are willing and able to buy at a schedule of prices during a specific period of time, ceteris paribus. Principles of Microeconomics

  28. PX 5 4 3 Demand 2 1 1 2 3 4 5 6 7 QX/ut The demand function has a negative slope because of the income and substitution effects. Income effect: As the price of a good that you buy increasesand money income is held constant, your real income decreasesand you can not affordto buy as much as youcould before. Substitution effect: As the price of one good risesrelative to the prices ofother goods, you will tendto substitute the goodthat is relatively cheaperfor the good that is relatively more expensive. Principles of Microeconomics

  29. Income effects • As the price of a good that you buy increases, you will have less real income. • This is the basis of price indices that measure changes in real income as prices rise or fall. • The consumer price index is one of the indices that is used [currently there is a debate about how it is calculated]. Principles of Microeconomics

  30. Substitution Effects • As the price of a good increases [decreases] while the prices of other goods is constant, it becomes relatively more [less] expensive. • Individuals would substitute relatively less expensive goods for relatively more expensive ones even if their real income were constant. Principles of Microeconomics

  31. PX Supply 7 6.80 6 5 consumer surplus 4 3 Demand 2 1 1 2 3 4 5 6 7 QX/ut CONSUMER SURPLUS Notice that someone is willing and able to pay $6.80 for the first unit. If the market price [established by S and D]were $3, the buyer would purchase at $3 even though they were willing to pay $6.80 for the first unit. They receive utilitythat they did not haveto pay for [6.80-3.00].This is called consumersurplus. . At market equilibrium, Consumer surplus will bethe area above the marketprice and below the demandfunction. Principles of Microeconomics

  32. Demand • Demand functions can be derived from utility [cardinal measures] or indifference functions [ordinal measures] • Normally, demand functions show and inverse relationship between price and quantity • a change in price “causes” a change in “quantity demanded” • a change in any other variable [income, prices of related goods, population, preferences, . . .] will “cause a change in demand” or shift of demand Principles of Microeconomics

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