Consumer Behavior Topic 4. Utility Like elasticity, Utility is another fancy name for satisfaction or happiness Utility refers to satisfaction derived.

Consumer Behavior

Topic 4

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

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

Total Utility

Number of Ice Cream Total Utility

0 0 util

1 10 util

2 18 util

3 24 util

4 28 util

7-4

Total Utility

Ice Cream

Total Utility

0 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

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

Marginal Utility

Number of Ice Cream

Total Utility

0 0 util

1 10 util

2 18 util

3 24 util

4 28 util

Undefined

7-7

10 util

8 util

6 util

4 util

Marginal

Utility

Marginal Utility

Ice Cream

Marginal Utility

0 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

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

Utility Graphically

0

10

20

30

1086420

-2

1 2 3 4 5 6 7

1 2 3 4 5 6 7

TU

(1)Tacos

ConsumedPer Meal

(2)Total

Utility,Utils

(3)MarginalUtility,Utils

0

1

2

3

4

5

6

7

0

10

18

24

28

30

30

28

]]]]]]]

10

8

6

4

2

0

-2

TU

MU

Total Utility

Marginal Utility

Units Consumed Per Meal

Q

7-10

MU

Q

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 fixedWhen Prices (or P) are fixed

7-11


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


We need a stable preference for Pizza This preference is expressed by TU and

MU Pizza

(1)Consumed

per week

(2)TotalUtility

(3)MarginalUtility

0 0

1 56

2 88

3 112

4 130

5 142

6 150


Pizza

(1)Consumed

per week

(2)TotalUtility

(3)MarginalUtility

0 0

1 56 56

2 88 32

3 112 24

4 130 18

5 142 12

6 150 8


Similarly we need a stable Preference for Video Rental expressed by TU and MU

Video Rental

(1)Viewed

per week

(2)TotalUtility

(3)Marginal

Utility

0 0

1 40

2 68

3 88

4 100

5 108

6 114


Video Rental

(1)Viewed

per week

(2)TotalUtility

(3)Marginal

Utility

0 0

1 40 40

2 68 28

3 88 20

4 100 12

5 108 8

6 114 6


Which one would you consume first? Is it your first pizza (with 56 MU)?

Pizza Video Rental

(1)Consumed

per week

(2)TotalUtility

(3)MarginalUtility

(1)Viewed

per week

(2)TotalUtility

(3)Marginal

Utility

0 0 0 0

1 56 56 1 40 40

2 88 32 2 68 28

3 112 24 3 88 20

4 130 18 4 100 12

5 142 12 5 108 8

6 150 8 6 114 6


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)TotalUtility

(3)MarginalUtility

(1)Viewed

per week

(2)TotalUtility

(3)Marginal

Utility

0 0 0 0

1 56 56 1 40 40

2 88 32 2 68 28

3 112 24 3 88 20

4 130 18 4 100 12

5 142 12 5 108 8

6 150 8 6 114 6



(1)Consume

d per

week

(2)TotalUtility

(3)Margin

alUtility

(4)Marginal

Utility per $

MUP

(1)Viewed

per week

(2)TotalUtility

(3)Margina

lUtility

(4)Margina

lUtility per $

MUP

0 0 --- --- 0 0 --- ---

1 56 56 7 1 40 40 10

2 88 32 4 2 68 28 7

3 112 24 3 3 88 20 5

4 130 18 2.25 4 100 12 3

5 142 12 1.5 5 108 8 2

6 150 8 1 6 114 6 1.5


Comparing Per dollar MU or MUP

This consumer should consume in the following sequence:

1. First Video rental 2. First Pizza and Second

Video rental (one of each)3. Third video rental4. Second Pizza5. Third Pizza and Fourth

Video Rental (one of each)6. And no more, why?


(1)Consume

d per

week

(4)Marginal

Utility per $

MUP

(1)Viewed

per week

(4)Margina

lUtility per $

MUP

0 --- 0 ---

1 7 1 10

2 4 2 7

3 3 3 5

4 2.25 4 3

5 1.5 5 2

6 1 6 1.5


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 P

In this case, MUPizza MUVideo rental

Ppizza PVideo rental

3= =

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

=

Utility Maximizing Condition MUPizza MUVideo rental

PPizza PVideo rental =

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]


(1)Quantity of Pizza

(4)MUP

(1)Quantity of

Video Rental

(4)MUP

0 --- 0 ---

1 7 1 10

2 4 2 7

3 3 3 5

4 2.25 4 3

5 1.5 5 2

6 1 6 1.5

Utility Maximizing ConditionAmong these three combinations, which

one is really utility maximizing:A. 1 pizza and 2 video [per $ MU is 7]B. 3 pizza and 4 video [per $ MU is 3]C. 5 pizza and 6 video [per $ MU is 1.5]To know that we need think about the BudgetComb. 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)

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

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

Equilibrium Quantity

At the equilibrium combination TU is 212Equilibrium Quantity suggests that no other affordable quantity choice will yield higher TUNote, 2 pizza and 6 video also cost $40But the TU is 202


(1)Quanti

ty

(2)TU

(4)MUP

(1)Quanti

ty

(2)TU

(4)MUP

0 0 --- 0 0 ---

1 56 7 1 40 10

2 88 4 2 68 7

3 112 3 3 88 5

4 130 2.25 4 100 3

5 142 1.5 5 108 2

6 150 1 6 114 1.5

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

MUPizza MUVideo rental

PPizza PVideo rental <

>


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


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?

>

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

>

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 up!

It goes down!

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


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


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



(1)Consume

d per

week

(2)TotalUtility

(3)Margin

alUtility

(4)Marginal

Utility per $

MUP

(1)Viewed

per week

(2)TotalUtility

(3)Margina

lUtility

(4)Margina

lUtility per $

MUP

0 0 --- --- 0 0 --- ---

1 56 56 7 1 40 40 10

2 88 32 4 2 64 24 7

3 112 24 3 3 84 20 5

4 130 18 2.25 4 96 12 3

5 142 12 1.5 5 106 10 2

6 150 8 1 6 114 8 1.5


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

Where does Demand curve come from

We can plot that point (4, 4)as follows: Price

4

4 Quantity Demanded


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



(1)

Quantity

(2)

TU

(3)

MU

(4)

MUP

(1)

Quantity

(2)

TU

(3)

MU

(4)

MUP

When P=4

(5)

MUP

When P=8

0 0 --- --- 0 0 --- --- ---

1 56 56 7 1 40 40 10 5

2 88 32 4 2 64 24 6 3

3 112 24 3 3 84 20 5 2.5

4 130 18 2.25 4 96 12 3 1.5

5 142 12 1.5 5 108 8 2 1.25

6 150 8 1 6 114 6 1.5 1


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


Price

8 4

D

2 4 Quantity Demanded

Consumer Behavior Topic 4. Utility Like elasticity, Utility is another fancy name for satisfaction or happiness Utility refers to satisfaction derived.

Documents