Consumer Behavior· The goal of consumer behavior is utility

maximization

· Consumer choice among various alternatives is subject to constraints:· income or budget· prices of goods purchased· preferences

Models of Consumer Behavior

· Marginal Utility approach· cardinal measure of utility

· Indifference approach· ordinal utility

Cardinal Utility Approach to Consumer Behavior

· Total and Marginal utility· Law of diminishing Marginal Utility· Equimarginal rule and utility

maximization

Total utility [TU] is defined as the amount of satisfaction an individual derives from consuming a given quantity of a goodduring a specific period of time

1 2 3 4 5 6 7 Q/ut

204060

10080

120Utility

Q12

4

8

567

3

TU30557590

100105105100

. .. . . . ..TU

TU

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” muffins..or paani puri..

· It is possible for total utility to initially increase at an increasing rate..

Marginal Utility [MU] is the change in total utility [DTU] caused by a one unit change in quantity consumed[DQ] ;

MU = DTUDQ

UtilityQ12

4

8

567

3

TU30557590

100105105100

MUDQ=1 DTU=30

The first unit consumed increases TU by 30.

.30

DQ=1 DTU=25.25

DQ

The 2cd unit increases TU by 25.

25DQ=1 DTU=20

.20

.1510

.50

-5

1 2 3 4 5 6 7 Q/ut

1020

30

MU

. . .MU

1 2 3 4 5 6 7 Q/ut

204060

10080

120 TU

331

UtilityQ12

4

8

567

3

TU30557590

100105105100

MU30 DTU=30252015

50

-5

10MU

Marginal Utility· Marginal utility [MU] is the change in total

utility associated with a 1 unit change in consumption.

· Relation between TU and MU:· As total utility increases at a decreasing rate, MU

declines.· When TU is a maximum, MU is 0 [This is sometimes

called the “Satiation point” or the point of “absolute diminishing utility.”

· As total utility declines, MU is negative

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.

Qy

Qx

B > PxQx + PyQyThe budget constraint can be expressed:

The amount of good Y that can be purchasedis the budget divided by the price of good Y, B

Py

BPy

For an B = $80,and Py = $5

805 = 16 =

The amount of good Xthat can be purchasedis, B

Px

BPx

For an B = $80,and PX = $3

803 = 26.7 =

Connecting the two interceptsidentifies all combinations ofgoods X &Y that can be purchased for a budget of $80,Py = $5, and PX = $3.

Any combinationinside area 0AC can be purchased for less than $80.

0A

C

Good XUtility X

Qx

12

4

8

567

3

TUx

30557590

100105105100

20151050

-5

3025

MUx

Good YUtility Y

Qy

12

4

8

567

3

TUy

6090110120

128128120100

603020 10 8 0 - 8- 20

MUy

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, 7 units

of good X and 6 of Y.

Once the goods have a priceand there is a budget constraint, the individualwill try to maximize the utility from each additionaldollar spent.

Utility XQx

12

4

8

567

3

TUx

30557590

100105105100

20151050

-5

3025

MUx

For PX = $3, the MUX per dollar spent on good X is;

Given the budget constraint, Individuals will attempt to gain the maximum utility for each additional dollar spent,“the marginal dollar.”

MUXPX

10.8.336.675.003.331.670

For PY = $5, the MUY per dollar spent on good Y is;

Utility YQy

12

4

8

567

3

TUy

6090110120

128128120100

60302010 8 0 - 8- 20

MUy

MUYPY

126421.60

Utility XQx

12

4

8

567

3

TUx

30557590

100105105100

20151050

-5

3025

MUx

MUXPX

10.8.336.675.003.331.670

Utility YQy

12

4

8

567

3

TUy

6090110120

128128120100

60302010 8 0 - 8- 20

MUy

MUYPY

126421.60

Now the preferences of the individuals and the relative pricesof 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.

MUXPX

10.8.336.675.003.331.670

MUYPY

126421.60

Given the preferences of the individual and the relativeprices 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 $5The second expenditure is for good X, [MUX $ is greater than MUY $]Ö$3

The third & fourth expenditures are forgood X since the MU per dollar spent isgreater for X than Y.

Ö$3Ö$3

The fifth expenditure is for is for good Y.

Ö $5

Continue to maximize the MU per $ spent.

Ö$3Ö $5

Ö$3

AT THIS POINT YOU HAVE SPENT THE BUDGET OF $30.MUXPX

>MUYPY

, BUY X ! MUXPX

<MUYPY

, BUY Y !

MUXPX

>MUYPY

says that the marginal utility of an additionaldollar spent on good X is greater than that ofa dollar spent on good Y.

MUXPX

<MUYPY

indicates that the MU per dollar spent on goodY exceeds that of a dollar spent on good X.

If the amount spent on the two goods is equal to the budgetthen MUX

PX >MUY

PY

suggests that the individual should buyless of Y in order to buy more of X.

MUXPX

<MUYPY

says to purchase less X to pay for additionalamounts of Y.

= MUXPX

MUYPY

is an equilibrium condition!