Chapter 19. Theory of Consumer Behavior

Chapter 19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.19-1Theory of Consumer Behavior Chapter ObjectivesMarginal utilityThe law of diminishing returnsTotal utilityMaximizing utilityThe water-diamond paradoxConsumer surplus19-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.UtilityWhat is utility?Utility is NOT usefulness!Utility means only that you think enough of something to buy itUtility is measured by how much you are willing to pay for something19-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Hypothetical Demand Schedule for HamburgersPrice Purchased$2.75 1Units 19-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Hypothetical Demand Schedule for HamburgersPrice Purchased$2.75 1 2.00 2Units19-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Hypothetical Demand Schedule for HamburgersPrice Purchased$2.75 1 2.00 2 1.00 3 Units19-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Hypothetical Demand Schedule for HamburgersPrice Purchased$2.75 1 2.00 2 1.00 3 .25 4Units19-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price Purchased MU$2.75 1 $2.75 2.00 2 2.00 1.00 3 1.00 .25 4 .25Marginal Utility is the additional utility derived from consuming one more unit of a good or serviceUnits19-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price Purchased MU$2.75 1 $2.75 2.00 2 2.00 1.00 3 1.00 .25 4 .25Marginal Utility is the additional utility derived from consuming one more unit of a good or serviceNote: Marginal Utility is the same as the price.19-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price Purchased MU$2.75 1 $2.75 2.00 2 2.00 1.00 3 1.00 .25 4 .25Law of Diminishing Marginal Utility: As we consume more and more of a good or service,we like it less and lessUnits19-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 1.00 3 1.00 .25 4 .25Total Utility is the utility derived from consuming a certain number of units of a good or serviceUnits19-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 .25 4 .25Total Utility is the utility derived from consuming a certain number of units of a good or serviceUnits19-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25Total Utility is the utility derived from consuming a certain number of units of a good or serviceUnits19-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00Total Utility is the utility derived from consuming a certain number of units of a good or serviceUnits19-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00 Total Utility is the utility derived from consuming a certain number of units of a good or serviceTo get total utility, just add up the marginal utilities of the units purchased Units19-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Maximizing UtilityHow much we buy of any good or service depends onIts priceOur marginal utility schedulePrice Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00UnitsIn real life there is usually only ONE price!19-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Maximizing UtilityWe try to spend our money on what will give us the most utility!As we consume more of a good or service, its utility declines!This means that we will keep buying more of a good or service until our marginal utility falls to the level of the price. At this point marginal utility is the same as the price.19-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Maximizing UtilityWe try to spend our money on what will give us the most utility!As we consume more of a good or service, its utility declines!This means that we will keep buying more of a good or service until our marginal utility falls to the level of the price. At this point marginal utility is the same as the price.19-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Marginal UtilityPrice= 1Maximizing UtilityWe try to spend our money on what will give us the most utility!Remember, as we consume more of a good or service, its utility declines!This means that we will keep buying more of a good or service until our MU falls to the level of the pricePrice Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00UnitsThe price is $1.00. How many units would you buy?19-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The answer is 3Maximizing Utility We try to spend our money on what will give us the most utility!Remember, as we consume more of a good or service, its utility declines!This means that we will keep buying more of a good or service until our MU falls to the level of the pricePrice Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00UnitsThe MU of the last unit purchased will always equal its price19-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The answer is 3Maximizing Utility We try to spend our money on what will give us the most utility!Remember, as we consume more of a good or service, its utility declines!This means that we will keep buying more of a good or service until our MU falls to the level of the pricePrice Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00UnitsThe price is $2. How many units will you buy?19-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The answer is 2Maximizing UtilityWe try to spend our money on what will give us the most utility!Remember, as we consume more of a good or service, its utility declines!This means that we will keep buying more of a good or service until our MU falls to the level of the pricePrice Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00Units19-22Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The answer is 2The MU of the last unit purchased will always equal its priceGeneral Utility FormulaThe MU of the last unit purchased will always equal its priceMU 2.75 2.00 1.00 .25Price2.752.001.00.25=====1If this is true for hamburgers it will be true for everything elseMU1 MU2 MU3 MUnP1P2P3Pn===Remember, we will keep buying anything until its MU declines to the price level 19-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00 0 0 0 6.00If a good or service were free, you would keep consuming until the MU fell to zeroAs we consume more units, MU declines, but TU keeps risingTherefore, we maximize our total utility when our MU falls to zero19-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price QD MU Price QD MU Price OD MU$ 3.00 1 $3.00 $1.50 1 $1.50 $1.50 1 $1.50 2.00 2 2.00 1.00 2 1.00 .50 2 .50 1.00 3 1.00 .50 3 .50 Hamburgers Fries CokeHow many burgers, fries, and cokes would you consume if burgers were $3, fries were $.50 and cokes were $.50?19-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price QD MU Price QD MU Price OD MU$ 3.00 1 $3.00 $1.50 1 $1.50 $1.50 1 $1.50 2.00 2 2.00 1.00 2 1.00 .50 2 .50 1.00 3 1.00 .50 3 .50 Hamburgers Fries CokeHow many burgers, fries, and cokes would you consume if burgers were $3, fries were $.50 and cokes were $.50?One hamburger; three fries; and two cokes19-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Price QD MU Price QD MU Price OD MU$ 3.00 1 $3.00 $1.50 1 $1.50 $1.50 1 $1.50 2.00 2 2.00 1.00 2 1.00 .50 2 .50 1.00 3 1.00 .50 3 .50 Hamburgers Fries Coke19-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.How many burgers, fries, and cokes would you consume if burgers were $1, fries were $1.00 and cokes were $1.50?Price QD MU Price QD MU Price OD MU$ 3.00 1 $3.00 $1.50 1 $1.50 $1.50 1 $1.50 2.00 2 2.00 1.00 2 1.00 .50 2 .50 1.00 3 1.00 .50 3 .50 Hamburgers Fries CokeHow many burgers, fries, and cokes would you consume if burgers were $1, fries were $1.00 and cokes were $1.50?First answer: one hamburger; three fries; and two cokesSecond answer: three hamburgers; two fries; one cokeThis is consistent with the law of supply and demand19-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Water-Diamond ParadoxWater, which is essential to life is cheapWater is abundantA great deal of water is consumedTherefore the MU of the last gallon consumed is as low as its price, which is relatively lowDiamonds are not essential to life, yet they are very expensiveDiamonds are scarcePeople buy relatively few diamondsTherefore the MU of the last diamond purchased is as high as its price, which is relatively very highMuwater MUdiamondsPwaterPdiamonds==119-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Consumer SurplusConsumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00 0 5 0The price of hamburgers is $0.25HamburgerSchedule19-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Consumer SurplusConsumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00 0 5 0The price of hamburgers is $0.25HamburgerScheduleYou would buy 4 @ .25 = $1.0019-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Consumer SurplusConsumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00 0 5 0The price of hamburgers is $0.25HamburgerScheduleYou would buy 4 @ .25 = $1.00You would have been willing to pay $6.0019-32Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Consumer SurplusConsumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00 0 5 0The price of hamburgers is $0.25HamburgerScheduleYou would buy 4 @ .25 = $1.00You would have been willing to pay $6.00Your consumer surplus would be ($6.00 - $1.00) = $5.0019-33Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Consumer SurplusConsumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00 0 5 0Price of Hamburgers is $2.00HamburgerSchedule19-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Consumer SurplusConsumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00 0 5 0Price of Hamburgers is $2.00HamburgerScheduleYou would buy 2 @ 2.00 = $4.0019-35Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Consumer SurplusConsumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00 0 5 0Price of Hamburgers is $2.00HamburgerScheduleYou would buy 2 @ 2.00 = $4.00You would have been willing to pay $4.7519-36Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Consumer SurplusConsumer surplus is . . . the difference between what you pay for some good or service and what you would have been willing to pay Price Purchased MU TU $2.75 1 $2.75 $2.75 2.00 2 2.00 4.75 1.00 3 1.00 5.75 .25 4 .25 6.00 0 5 0Price of Hamburgers is $2.00HamburgerScheduleYou would buy 2 @ 2.00 = $4.00You would have been willing to pay $4.75Your consumer surplus would be ($4.75 - $4.00) = $0.7519-37Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 0 1 2 3 4 5 61.002.003.000.25If the price of hamburger is $0.25, you would have purchased 4. The consumer surplus would be the triangle area above the price lineDConsumer SurplusThe consumer surplus in this graph would be represented by the area to the left of the demand curve (what you would have been willing to pay) and above the price line19-38Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 0 1 2 3 4 5 61.002.003.000.25If the price of hamburger is $2.00, you would have purchased 2. The consumer surplus would be the triangle area above the price lineDConsumer SurplusThe consumer surplus in this graph would be represented by the area to the left of the demand curve (what you would have been willing to pay) and above the price line19-39Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.