Household and Consumer Behavior
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This document discusses the law of diminishing marginal utility. It explains that as consumption of a good increases, the marginal utility obtained from each additional unit decreases. This law explains the downward sloping demand curve. The document also covers total utility, marginal utility, consumer equilibrium, deriving the demand curve, and applications like income and substitution effects. Prospect theory and how people judge gains and losses is also summarized.
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Household and Consumer Behavior
- 1. Household and Consumer Behavior 9 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Prepared by: Prof. Seyed Ali Fallahchay
- 2. Law of Diminishing Marginal Utility • Utility is the satisfaction one gets from consuming a good or service •Not the same as usefulness •Subjective •Difficult to quantify LO1
- 3. Law of Diminishing Marginal Utility • Util is one unit of satisfaction or pleasure • Total utility is the total amount of satisfaction • Marginal utility is the extra satisfaction from an additional unit of the good MU = ΔTU/ΔQ LO1
- 4. Law of Diminishing Marginal Utility • As consumption of a good or service increases, the marginal utility obtained from each additional unit of the good or service decreases • Explains downward sloping demand LO1
- 5. Total Utility and Marginal Utility LO1 0 10 20 30 10 8 6 4 2 0 -2 1 2 3 4 5 6 7 1 2 3 4 5 6 7 TotalUtility(Utils)MarginalUtility(Utils) (2) Total Utility, Utils (3) Marginal Utility, Utils 0 1 2 3 4 5 6 7 0 10 18 24 28 30 30 28 10 8 6 4 2 0 -2 Total Utility TU(1) Tacos Consumed Per Meal MU ] ] ] ] ] ] ]
- 6. Theory of Consumer Behavior • Rational behavior • Preferences • Budget constraint • Prices LO2
- 7. Utility Maximizing Rule • Consumer allocates his or her income so that the last dollar spent on each product yields the same amount of extra (marginal) utility • Algebraically MU of product A MU of product B Price of A Price of B LO2 =
- 8. Numerical Example LO2 The Utility Maximizing Combination of Apples and Oranges Obtainable with an Income of $10 (2) Apple (Product A): Price = $1 (3) Oranges (Product B): Price = $2 (1) Unit of Product (a) Marginal Utility, Utils (b) Marginal Utility per dollar (MU/Price) (a) Marginal Utility, Utils (b) Marginal Utility per dollar (MU/Price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 6 16 8 Fifth 5 5 12 6 Sixth 4 4 6 3 Seventh 3 3 4 2
- 9. Decision-Making Process LO2 Sequence of Purchases to Achieve Consumer Equilibrium, Given the data in Table 6.1 Choice Number Potential Choices Marginal Utility per Dollar Purchase Decision Income Remaining 1 First Apple First Orange 10 12 First orange for $2 $8 = $10 - $2 2 First Apple Second Orange 10 10 First apple for $1 and Second orange for $2 $5 = $8 -$3 3 Second Apple Third Orange 8 9 Third orange for $2 $3 = $5 - $2 4 Second Apple Fourth Orange 8 8 Second apple for $1 and Fourth orange for $2 $0 = $3 - $3
- 10. Deriving the Demand Curve LO3 PriceofOrange 0 $1 $2 4 6 Quantity Demanded of Oranges $2 1 4 6 Quantity Demanded Price Per Orange DO
- 11. Income and Substitution Effects • Income effect •The impact that a price change has on a consumer’s real income • Substitution effect •The impact that a change in a product’s price has on it’s relative expensiveness LO4
- 12. Applications and Extensions • New products •iPod • Diamond-water paradox • Opportunity cost and time • Medical care purchases • Cash and noncash gifts LO5
- 13. Prospect Theory • How people actually deal with life’s up and downs • People judge things relative to the status quo • People experience: • Diminishing marginal utility for gains • Diminishing marginal disutility for losses • People are loss adverse LO5
- 14. Losses and Shrinking Packages • Consumers see any price increase as a loss relative to the status quo • Producers are reducing package size instead of raising prices LO5
- 15. Framing Effects and Advertising • Consumers evaluate events in a particular mental frame • New information alters the frame in which the consumer defines whether situations are gains or losses LO5
- 16. Anchoring and Credit Card Bills • Estimates of value are influenced by recent information no matter how irrelevant • Can lead to people altering valuations unconsciously LO5
- 17. Mental Accounting and Warranties • Separate purchases into “mental accounts” rather than looking at the big picture • Mental accounting exaggerates any potential loss LO5
- 18. The Endowment Effect • Market transactions may be affected by the endowment effect because: •The seller has a tendency to demand a higher price •The buyer has a tendency to offer a lower price LO5
- 19. Nudging People • Using behavioral economics to change people’s behavior • Subtle manipulations are used to generate socially better outcomes • Unaware of being manipulated LO5
Editor's Notes
- In this chapter, the law of diminishing marginal utility is developed, which leads into a detailed discussion of the theory of consumer choice. The numerical illustrations of the utility maximizing rule should be viewed as a pedagogical technique, rather than an attempt to portray the actual choice making process of consumers. When this illustration is explained by “order of purchase,” the brief algebraic summary of consumer equilibrium should pose no great difficulties for most students. The discussion of the diamond-water paradox helps students look beyond what may be their first conclusions about the importance and value of products.
- Utility is a subjective notion in economics, referring to the amount of satisfaction a person gets from consumption of a certain item. Utility and usefulness are not the same thing. Items that are essentially useless can provide a lot of utility.
- Utility is measured in utils. Total utility is the total amount of satisfaction one gets from the consumption of a single product or a combination of products. Total utility can be derived by adding up the utils of successive units consumed. Marginal utility refers to the extra utility a consumer gets from one additional unit of a specific product. In a short period of time, the marginal utility derived from successive units of a given product will decline. This is known as diminishing marginal utility.
- Although consumers’ wants, in general, are insatiable, wants for specific commodities can be fulfilled. The more of a specific product that consumers obtain, the less they will desire more units of that product. Theory of consumer behavior uses the law of diminishing marginal utility to explain how consumers allocate their income.
- Curves TU and MU are graphed from the data in the table. As more of a product is consumed, total utility increases at a diminishing rate, reaches a maximum, and then declines. Marginal utility, by definition, reflects the changes in total utility. Thus, marginal utility diminishes with increased consumption, becomes zero when total utility is at a maximum, and is negative when total utility declines. As shown by the shaded rectangles, marginal utility is the change in total utility associated with each additional taco. Or, alternatively, each new level of total utility is found by adding marginal utility to the preceding level of total utility.
- Rational behavior – The consumer tries to use his or her money income to derive the greatest satisfaction from it. Preferences – Each consumer has clear cut preferences for certain goods and services available in the market. Budget constraint – At any point in time the consumer has a limited, fixed amount of money to spend. Prices – Every good has a price and prices are unaffected by amounts purchased by the consumer. Goods and services have prices and are scarce relative to the demand for them.
- A consumer is in equilibrium when utility is “balanced (per dollar) at the margin.” When this is true, there is no incentive to alter the expenditure pattern unless tastes, income, or prices change. When using the utility maximizing rule, it is important to express the marginal utility of the good as marginal utility per dollar spent since the two goods probably have different prices. Therefore, we can’t just compare utilities because it’s like comparing apples to oranges. So, we have to find the marginal utility per dollar by dividing the marginal utility of the good by the price.
- It is assumed in this table that the amount of marginal utility received from additional units of each of the two products is independent of the quantity of the other product. For example, the marginal utility schedule for apples is independent of the number of oranges obtained by the consumer. When determining whether to buy the apples or oranges, we will compare the marginal utility per dollar.
- This illustration shows how consumers must choose among alternative goods with their limited money incomes. As long as one good provides more utility per dollar than another, the consumer will buy more of the first good; as more of the first product is bought, its marginal utility diminishes until the amount of marginal utility per dollar just equals that of the other product. This table summarizes the step-by-step decision making process the rational consumer will pursue to reach the utility maximizing combination. The algebraic statement of this utility-maximizing state is that the consumer will allocate income in such a way that: MU of apples/price of apples = MU of oranges/price oranges
- At a price of $2 the consumer represented by the data in the table maximizes utility by purchasing 4 oranges. The decline in the price of oranges to $1 disrupts the consumer’s initial utility-maximizing equilibrium. The consumer restores equilibrium by purchasing 6 rather than 4 oranges. Thus, a simple price-quantity schedule emerges, which creates two points on a downsloping demand curve.
- The substitution effect and income effect work simultaneously. Income effect is the impact that a price change has on a consumer’s real income and, consequently, on the quantity demanded of the good. If the price of a good falls, income is freed up and can be used to buy more of both, or either, good under consideration. The income effect is shown by the fact that a decline in price expands the consumer’s real income and the consumer can purchase more of this and other products until equilibrium is once again attained for the new level of real income. Substitution effect is the impact that a change in a product’s price has on its relative expensiveness and on the quantity demanded. If the price of a product falls, this decreases its relative expensiveness and thus the consumer will now substitute more of this good for the other. When the price of an item declines, the consumer will no longer be in equilibrium until more of the item is purchased and the marginal utility of the item declines to match the decline in price. More of this item is purchased rather than another relatively more expensive substitute.
- iPods were a new product perceived by consumers as having a greater marginal utility to price ratio than the older portable CD players and other similar products, and thus resulted in a major shift in demand for the new product as consumers attempted to restore their consumer equilibrium. Why do some goods that are essential to life have low prices and goods that are not essential to life have high prices? The marginal utility of the last unit of water consumed is small because we consume a lot of water. The marginal utility of the last diamond is large because we consume few diamonds. Time also has a value, so this must be considered in decision making and utility maximization. When time is considered, consumer behavior appears to be much more rational. Highly skilled people, like doctors, earn high wages and therefore incur a higher opportunity cost whenever they use their time in some other way. They are more likely to buy goods over the internet and pay higher prices for things that will save them time. Unskilled workers or retirees have low opportunity costs for their time and therefore will use time to search out ways to save money. They are more likely to search for bargains and take longer trips if it saves them money. Foreigners observe that Americans waste material goods but conserve time. This could be because American’s high productivity makes their time more valuable than many of the goods they waste. With medical care purchases Americans with health insurance pay an upfront fixed charge each month and this charge is not affected by the amount we consume. The additional marginal benefit is higher than the marginal cost of additional use. This explains why Americans use so much more than if they had to pay full price. Noncash gifts result in a loss of utility and we then take action to maximize our utility, such as taking it back and exchanging it, etc. Noncash gifts may yield less utility to the receiver than a cash gift of equal monetary value because the noncash gift may not match the receiver’s preferences. Individuals know their own preferences better than the gift giver.
- Daniel Kahnemman was awarded the Nobel Prize in economics for this work. People judge good things and bad things relative to the status quo or the situations they are used to. People are loss adverse meaning we feel losses of some amount much more acutely than gains of the same amount.
- Producers have to be careful about increasing prices because consumers are aware of the price changes and view higher prices as a loss. When producers faced sharply higher input costs a few years ago, instead of increasing prices, they responded by decreasing the package size. Some industries who have varied the size of their packages are cereal, soap, candy, and paper towels.
- An example of framing would be labeling, such as “20% fat,” or “80% lean” meat, which are actually describing the same thing. However, one describes a loss (20% fat) and the other description is a gain (80% lean). If a new frame is introduced it can alter the consumer’s valuation of marginal utility and it will affect the consumption decision.
- An example of anchoring is when credit card companies print out small minimum due payments. The small minimum payments serve as an anchor. This results in people making smaller payments over a longer period of time than they would otherwise.
- Mental accounting explains the suboptimal tendency of people to view consumption purchases in isolation rather than all of their consumption options simultaneously. When making a TV purchase, the price of the new television is in the purchaser’s mind rather than their future income streams and their ability to pay in the case of the low probability of a television breaking down. People then buy an overpriced warranty on the TV (or some other electronics) even though new TVs (electronics) rarely break down past the expiration of the regular warranty.
- People have a tendency to put a higher economic value on things that they currently possess rather than identical items that they might purchase. The loss adverse effect on the seller will be stronger than the gain effect on the buyer. Sellers put higher valuations on things they own and buyers put lower valuations on things they do not own.
- Examples: By changing the default option on retirement plans to automatically enroll instead of not enroll, the number of people enrolled rose dramatically. An electric company used smiley faces on bills with below average usage and frowney faces on bills with above average usage to encourage people to conserve more energy.