Ch04 -Theory of Consumer Behavior

8/8/2019 Ch04 -Theory of Consumer Behavior

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Chapter 4 Chapter 4 Theory ofTheory of

ConsumerConsumerBehaviorBehaviorEconomics 11 UPLBEconomics 11 UPLB

Prepared by T.B. Paris, Jr.Prepared by T.B. Paris, Jr.

December 11, 2007December 11, 2007


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Theory of ConsumerTheory of Consumer

BehaviorBehavior Useful for understanding the demandUseful for understanding the demand

side of the market.side of the market. UtilityUtility- amount of satisfaction derived- amount of satisfaction derived

from the consumption of a commodityfrom the consumption of a commodity

.measurement units.measurement units utilsutils Utility conceptsUtility concepts

cardinal utility -cardinal utility - assumes that we can assignassumes that we can assignvalues for utility, (Jevons, Walras, andvalues for utility, (Jevons, Walras, andMarshall). E.g., derive 100 utils from eatingMarshall). E.g., derive 100 utils from eating

a slice of pizzaa slice of pizza ordinal utility approachordinal utility approach - does not assign- does not assign

values, instead works with a ranking ofvalues, instead works with a ranking ofpreferences. (Pareto, Hicks, Slutsky)preferences. (Pareto, Hicks, Slutsky)


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Total utility and marginalTotal utility and marginal

utilityutility Total utilityTotal utility(TU) - the overall(TU) - the overall

level of satisfaction derived fromlevel of satisfaction derived from

consuming a good or serviceconsuming a good or service

Marginal utilityMarginal utility(MU)(MU) additionaladditionalsatisfactionsatisfaction that an individualthat an individual

derives from consuming anderives from consuming an

additional unitadditional unitof a good orof a good orservice.service.

TUMU

Q

=


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Q TU MU

0 0 ---

1 20 20

2 27 7

3 32 5

4 35 3

5 35 0

6 34 -1

7 36 -4

Example (Table4.1):

Total utility and marginalTotal utility and marginal

utilityutility TU, in general, increases with QTU, in general, increases with Q

At some point, TU can startAt some point, TU can startfalling with Q (see Q = 6)falling with Q (see Q = 6)

If TU is increasing, MU > 0If TU is increasing, MU > 0

From Q = 1 onwards, MU isFrom Q = 1 onwards, MU isdecliningdeclining principle ofprinciple ofdiminishing marginal utilitydiminishing marginal utility AsAsmore and more of a good aremore and more of a good areconsumed, the process ofconsumed, the process ofconsumption will (at some point)consumption will (at some point)yield smaller and smalleryield smaller and smalleradditions to utilityadditions to utility

Q TU MU

0 0 ---

1 20 20

2 27 7

3 32 5

4 35 3

5 35 0

6 34 -1

7 30 -4

Example (Table4.1):


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Total Utility CurveTotal Utility Curve

510

15

20

25

30

35

0 1 2 3 4 5 6

Quantity

T

otal

utility(inuti

ls)

Q

TU

Figure 4.1


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-5

0

5

10

15

20

1 2 3 4 5 6

Quantity

Mar

gi n

alutility(

i nutils

)

Q

MU

Figure 4.2

Marginal Utility CurveMarginal Utility Curve


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Consumer EquilibriumConsumer Equilibrium

So far, we have assumed that anySo far, we have assumed that any

amount of goods and servicesamount of goods and services

are always available forare always available for

consumptionconsumption In reality, consumers faceIn reality, consumers face

constraints (income and prices):constraints (income and prices): Limited consumers income orLimited consumers income or

budgetbudget

Goods can be obtained at a priceGoods can be obtained at a price


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Some simplifyingSome simplifying

assumptionsassumptions Consumers objective: toConsumers objective: to

maximize his/her utility subjectmaximize his/her utility subject

to income constraintto income constraint

2 goods (X, Y)2 goods (X, Y)

Prices Px, Py are fixedPrices Px, Py are fixed

Consumers income (I) is givenConsumers income (I) is given


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Marginal utility per pesoMarginal utility per pesoadditional utility derived fromadditional utility derived from

spending the next peso on thespending the next peso on the

goodgood

MU per pesoMU

P

=


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Optimizing condition:Optimizing condition:

IfIf

spend more on good X and less of Yspend more on good X and less of YX Y

X Y

MU MU

P P>

X Y

X Y

MU MU

P P

=


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Simple IllustrationSimple Illustration

Suppose:Suppose: X = fishballX = fishball

Y = siomaiY = siomai

Assume: PAssume: PXX= 2= 2

PPYY= 10= 10


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Numerical IllustrationNumerical Illustration

Qx

TUX

MUX

MUxPx

QY

TUY

MUY

MUyPy

1 30 30 15 1 50 50 5

2 39 9 4.5 2 105 55 5.5

3 45 6 3 3 148 43 4.3

4 50 5 2.5 4 178 30 3

5 54 4 2 5 198 20 2

6 56 2 1 6 213 15 1.5


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2 potential optimum positions2 potential optimum positions

Combination A:Combination A: X = 3 and YX = 3 and Y

= 4= 4 TU = TUTU = TU

XX+ TU+ TU

YY= 45 + 178 = 223= 45 + 178 = 223

Combination B:Combination B: X = 5 andX = 5 and

Y = 5Y = 5 TU = TUTU = TU

XX+ TU+ TU

YY= 54 + 198 = 252= 54 + 198 = 252


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Presence of 2 potential equilibriumPresence of 2 potential equilibrium

positions suggests that we need topositions suggests that we need to

consider income. To do so let usconsider income. To do so let us

examine how much each consumerexamine how much each consumerspends for each combination.spends for each combination.

Expenditure per combinationExpenditure per combination

Total expenditure = PTotal expenditure = PXX X + PX + PYY YY Combination A: 3(2) + 4(10) = 46Combination A: 3(2) + 4(10) = 46

Combination B: 5(2) + 5(10) = 60Combination B: 5(2) + 5(10) = 60


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Scenarios:Scenarios: If consumers income = 46, then theIf consumers income = 46, then the

optimum is given by combination A.optimum is given by combination A.

.Combination B is not affordable.Combination B is not affordable If the consumers income = 60, thenIf the consumers income = 60, then

the optimum is given bythe optimum is given by

Combination B.Combination A isCombination B.Combination A isaffordable but it yields a lower levelaffordable but it yields a lower level

of utilityof utility


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endend

Ch04 -Theory of Consumer Behavior

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