Basic Microeconomics PDF - Theory of Consumer Behaviour

THEORY OF CONSUMER BEHAVIOUR LESSON VI BA Core Course 1- Basic Microeconomics  Utility Utility = want-satisfying power of a good/service Utility ≠ Usefulness Utility is subjective Utility is difficult to quantify (Utils)  UTILITY: A TOOL TO...

THEORY OF CONSUMER BEHAVIOUR LESSON VI BA Core Course 1- Basic Microeconomics  Utility Utility = want-satisfying power of a good/service Utility ≠ Usefulness Utility is subjective Utility is difficult to quantify (Utils)  UTILITY: A TOOL TO ANALYZE PURCHASE DECISIONS The Purpose of Utility Analysis The purpose of utility analysis = analyzing how people behave rather than how they think Theory of consumer choice = each consumer spends his or her income in a way that yields the greatest satisfaction Utility = amount of satisfaction  UTILITY: A TOOL TO ANALYZE PURCHASE DECISIONS Total versus Marginal Utility Total utility = total benefit to a consumer from all the units of a good purchased Marginal utility = extra benefit from the last unit of a good purchased. Also, the change in total utility from the purchase of 1 more unit of the good.  number of goods purchased   total utility but a  marginal utility TOTAL AND MARGINAL UTILITY Tacos Total Marginal 30 consumed Utility, Utility, Total Utility (utils) per meal Utils Utils 20 0 0 1 10 10 0 1 2 3 4 5 6 7 Units consumed per meal Marginal Utility (utils) 10 8 6 4 2 0 -2 1 2 3 4 5 6 7 Units consumed per meal TOTAL AND MARGINAL UTILITY Tacos Total Marginal 30 consumed Utility, Utility, Total Utility (utils) per meal Utils Utils 20 0 0 10 1 10 10 0 1 2 3 4 5 6 7 Units consumed per meal Marginal Utility (utils) 10 8 6 4 2 0 -2 1 2 3 4 5 6 7 Units consumed per meal TOTAL AND MARGINAL UTILITY Tacos Total Marginal 30 consumed Utility, Utility, Total Utility (utils) per meal Utils Utils 20 0 0 10 1 10 10 8 2 18 0 1 2 3 4 5 6 7 Units consumed per meal Marginal Utility (utils) 10 8 6 4 2 0 -2 1 2 3 4 5 6 7 Units consumed per meal TOTAL AND MARGINAL UTILITY Tacos Total Marginal 30 consumed Utility, Utility, Total Utility (utils) per meal Utils Utils 20 0 0 10 1 10 10 8 2 18 6 3 24 0 1 2 3 4 5 6 7 Units consumed per meal Marginal Utility (utils) 10 8 6 4 2 0 -2 1 2 3 4 5 6 7 Units consumed per meal TOTAL AND MARGINAL UTILITY Tacos Total Marginal 30 consumed Utility, Utility, Total Utility (utils) per meal Utils Utils 20 0 0 10 1 10 10 8 2 18 6 3 24 0 1 2 3 4 5 6 7 4 4 28 Units consumed per meal Marginal Utility (utils) 10 8 6 4 2 0 -2 1 2 3 4 5 6 7 Units consumed per meal TOTAL AND MARGINAL UTILITY Tacos Total Marginal consumed Utility, Utility, 30 Total Utility (utils) per meal Utils Utils 20 0 0 10 1 10 10 8 2 18 6 3 24 0 1 2 3 4 5 6 7 4 4 28 Units consumed per meal Marginal Utility (utils) 2 10 8 5 30 6 4 2 0 -2 1 2 3 4 5 6 7 Units consumed per meal TOTAL AND MARGINAL UTILITY Tacos Total Marginal 30 consumed Utility, Utility, Total Utility (utils) per meal Utils Utils 20 0 0 10 1 10 10 8 2 18 6 3 24 0 1 2 3 4 5 6 7 4 4 28 Units consumed per meal Marginal Utility (utils) 2 10 8 5 30 6 0 4 6 30 2 0 -2 1 2 3 4 5 6 7 Units consumed per meal TOTAL AND MARGINAL UTILITY Tacos Total Marginal TU 30 consumed Utility, Utility, Total Utility (utils) per meal Utils Utils 20 0 0 10 1 10 10 8 2 18 6 3 24 0 1 2 3 4 5 6 7 4 4 28 Units consumed per meal Marginal Utility (utils) 2 10 8 5 30 6 0 4 6 30 2 -2 0 7 28 -2 1 2 3 4 5 6 7 MU Units consumed per meal TOTAL AND MARGINAL UTILITY Tacos Total Marginal TU 30 consumed Utility, Utility, Total Utility (utils) per meal Utils Utils 20 0 0 Observe 10 Diminishing 1 10 10 8 2 18 Marginal 6 3 24 0 1 2 Utility 3 4 5 6 7 4 4 28 Units consumed per meal Marginal Utility (utils) 2 10 8 5 30 6 0 4 6 30 2 -2 0 7 28 -2 1 2 3 4 5 6 7 MU Units consumed per meal  Law of Diminishing Marginal Utility Law of diminishing marginal utility: Added satisfaction declines as a consumer acquires additional units of a product. e.g. Your desire for a car may be very strong? What about for a second car? A third? Additional units of a good/service are worth less and less to a consumer in money terms.  USING MARGINAL UTILITY The Optimal Purchase Rule Buy the quantity of each good at which price and marginal utility are exactly equal. If marginal utility is greater (less) than price, the consumer can improve well being by purchasing more (less).  MARGINAL UTILITY AND DEMAND ▪ From Diminishing Marginal Utility to Downward- Sloping Demand Curves Law of diminishing marginal utility  negative slope of demand curves  price   quantity demanded   marginal utility Restores equality between price and marginal utility  MARGINAL UTILITY AND DEMAND From Diminishing Marginal Utility to Downward-Sloping Demand Curves If successive units of a good yield smaller and smaller amounts of extra utility, then the consumer will buy additional units of the good only if its price falls.  THEORY OF CONSUMER BEHAVIOR Consumer Choice and Budget Constraint For simplicity, assume the following for the typical consumer: Rational Behavior – want to maximize total utility Clear-cut Preferences Budget Constraint (limited income) Every good has a price tag So, consumers must compromise!  CONSUMER CHOICE AS A TRADE-OFF: OPPORTUNITY COST Decision to purchase something  decision to forgo something else Opportunity cost of spending an extra dollar on good X = the utility from good Y the purchaser could have gotten by spending that dollar on good Y  THEORY OF CONSUMER BEHAVIOR Utility Maximizing Rule The consumer’s money income should be allocated so that the last centavos spent on each product yields the same amount of extra (marginal) utility. illustrated...  UTILITY MAXIMIZING COMBINATION Product A: Product B: $ 10 income Price = $1 Price = $2 Marginal Marginal Marginal utility per Marginal utility per Unit of utility, dollar utility, dollar product utils (MU/price) utils (MU/price) First 10 10 24 12 How should the $10 income be allocated?  UTILITY MAXIMIZING COMBINATION Product A: Product B: $ 10 income Price = $1 Price = $2 Marginal Marginal Marginal utility per Marginal utility per Unit of utility, dollar utility, dollar product utils (MU/price) utils (MU/price) First 10 10 24 12 Examine the two marginal utilities  UTILITY MAXIMIZING COMBINATION Product A: Product B: $ 10 income Price = $1 Price = $2 Marginal Marginal Marginal utility per Marginal utility per Unit of utility, dollar utility, dollar product utils (MU/price) utils (MU/price) First 10 10 24 12 Examine the two marginal utilities …per dollar  UTILITY MAXIMIZING COMBINATION Product A: Product B: $ 10 income Price = $1 Price = $2 Marginal Marginal Marginal utility per Marginal utility per Unit of utility, dollar utility, dollar product utils (MU/price) utils (MU/price) First 10 10 24 12 Decision: Buy 1 Product B for $2  UTILITY MAXIMIZING COMBINATION Product A: Product B: $ 10 income Price = $1 Price = $2 Marginal Marginal Marginal utility per Marginal utility per Unit of utility, dollar utility, dollar product utils (MU/price) utils (MU/price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth What 6 next? 6 16 8 Fifth 5 5 12 6 Sixth 4 4 6 3 Seventh 3 3 4 2  UTILITY MAXIMIZING COMBINATION Product A: Product B: $ 10 income Price = $1 Price = $2 Marginal Marginal Marginal utility per Marginal utility per Unit of utility, dollar utility, dollar product utils (MU/price) utils (MU/price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth What 6 next? 6 16 8 Fifth 5 5 12 6 Buy one of each Sixth 4 4 6 3 Seventh 3 3 4 2  UTILITY MAXIMIZING COMBINATION Product A: Product B: $ 10 income Price = $1 Price = $2 Marginal Marginal Marginal utility per Marginal utility per Unit of utility, dollar utility, dollar product utils (MU/price) utils (MU/price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 6 16 8 Fifth and 5 then... 5 12 6 Sixth 4($5 left) 4 6 3 Seventh 3 3 4 2  UTILITY MAXIMIZING COMBINATION Product A: Product B: $ 10 income Price = $1 Price = $2 Marginal Marginal Marginal utility per Marginal utility per Unit of utility, dollar utility, dollar product utils (MU/price) utils (MU/price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 6 16 8 Fifth third 5 unit 5 of12 6 Sixth product 4 4 B 6 3 Seventh 3 3 4 2  UTILITY MAXIMIZING COMBINATION Product A: Product B: $ 10 income Price = $1 Price = $2 Marginal Marginal Marginal utility per Marginal utility per Unit of utility, dollar utility, dollar product utils (MU/price) utils (MU/price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 $3 left... 6 16 8 Fifth 5 5 12 6 Sixth 4 4 6 3 Seventh 3 3 4 2  UTILITY MAXIMIZING COMBINATION Product A: Product B: $ 10 income Price = $1 Price = $2 Marginal Marginal Marginal utility per Marginal utility per Unit of utility, dollar utility, dollar product utils (MU/price) utils (MU/price) First 10 10 24 12 Second 8 8 20 10 Third 7 7 18 9 Fourth 6 $3 left... 6 16 8 Fifth 5 5 12 6 Buy Sixth both! 4 4 6 3 Seventh 3 3 4 2  UTILITY MAXIMIZING COMBINATION Product A: Product B: $ 10 income Price = $1 Price = $2 Marginal Marginal Marginal utility per Marginal utility per Unit of utility, dollar utility, dollar product utils (MU/price) utils (MU/price) First 10 10 24 12 Second 8 8 20 10 Third 7 Income is gone... 7 18 9 Fourth the 6 on 6 last dollar spent 16 8 each good gave the same Fifth 5 5 12 6 utility (8) per dollar Sixth 4 4 6 3 Seventh 3 3 4 2 UTILITY MAXIMIZING COMBINATION Algebraic Restatement of the Utility Maximization Rule MU of product A MU of product B Price of A = Price of B 8 Utils 16 Utils $1 = $2 UTILITY MAXIMIZATION AND THE DEMAND CURVE Deriving the Demand Schedule and Curve Recall our basic determinants of demand: Preferences or Tastes Money Income Prices of Other Goods  UTILITY MAXIMIZATION AND THE DEMAND CURVE Deriving the Demand Schedule and Curve Create a demand schedule from the purchase decisions as the price of the product is varied... Price per unit of B Quantity Demanded $2 4 1 6 Graphically… UTILITY MAXIMIZATION AND THE DEMAND CURVE Deriving the Demand Schedule and Curve $2 Price per unit of Good B 1 DB 0 4 6 Quantity Demanded of Good B  UTILITY MAXIMIZATION AND THE DEMAND CURVE Deriving the Demand Schedule and Curve Income $2 and Price per unit of Good B Substitution Effects 1 Revisited DB 0 4 6 Quantity Demanded of Good B  THE LAW OF DEMAND A Closer Look… The Income Effect A lower price increases real income (purchasing power) - and vice versa The Substitution Effect A lower price relative to other goods attracts new buyers - and vice versa FROM INDIVIDUAL TO MARKET DEMAND CURVES Market Demand as a Horizontal Sum Market demand curve = the horizontal sum of the individual demand curves The “Law” of Demand Negative slope for market demand curves Individual demand curves usually have negative slopes Lower price draws new customers into the market  TOTAL MARKET DEMAND VS. INDIVIDUAL CONSUMER DEMAND Alex’s Z Naomi’s M demand demand Market demand D K Price Price Price A A N N C C $10 9 6 D Z M 0 9 0 6 0 15 Quantity Demanded Quantity Demanded Quantity Demanded (a) (b) (c)  APPLICATIONS AND EXTENSIONS iPods How do they compare to portable CD players? How much would you value a second iPod? A third? How do Apple’s continued enhancements entice buyers? Cash vs. Noncash Gifts Which do you prefer? Why?  CONSUMER SURPLUS Voluntary purchase  benefit > costs Consumer surplus = net benefit to the buyer Consumer Surplus = the difference between the maximum price a consumer is (or consumers are) willing to pay for a product and the price that they actually pay Graphically, it is the area that lies below the demand curve and above the price line up to the quantity purchased.  PRODUCER SURPLUS Producer Surplus = the difference between the actual price a producer receives (or producers receive) and the minimum acceptable price. Graphically, it is the area that lies above the supply curve and below the price line up to the quantity sold. CALCULATING MARGINAL NET UTILITY (SURPLUS) GRAPHIC CALCULATION OF CONSUMER’S SURPLUS $16 $15.00 Marginal Utility and Price per Pizza 15 A Marginal utility (demand) curve 14 $13.00 B 13 $4.00 $12.50 C 12 $2.00 $11.50 D $1.50 11 $0.50 P 10 P 9 $8.00 E 8 7 6 $5.00 5 F 4 $3.00 3 G 2 1 $0 0 1 2 3 4 5 6 7 8 Number of Pizzas Purchased  RESOLVING THE DIAMOND-WATER PARADOX Diamonds are unnecessary, but scarce  high price and high marginal utility Water is necessary, but plentiful  low price and low marginal utility Given the enormous amounts of water consumed, the total utility derived from water is much greater than from diamonds. But, the relative prices relate to marginal (not total) utility. INDIFFERENCE CURVE ANALYSIS GEOMETRY OF AVAILABLE CHOICES: THE BUDGET LINE Budget line Graphical representation of all possible combinations of a household’s purchases of two goods, given their prices and a fixed amount of money to spend Properties of the Budget Line Represents the maximum amounts of the goods the consumer can afford GEOMETRY OF AVAILABLE CHOICES: THE BUDGET LINE Changes in the Budget Line  income  parallel shift in the budget line  relative prices of the goods   slope of the budget line  THE BUDGET LINE: What is Attainable Units of Units of A Price B Price Total $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A 2 9 12 6 0 12 12 4 2 0 2 4 6 8 10 12 Quantity of B THE BUDGET LINE: What is Attainable Units of Units of A Price B Price Total $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A 2 9 12 6 0 12 12 4 2 0 2 4 6 8 10 12 Quantity of B THE BUDGET LINE: What is Attainable Units of Units of A Price B Price Total $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A 2 9 12 6 0 12 12 4 2 0 2 4 6 8 10 12 Quantity of B THE BUDGET LINE: What is Attainable Units of Units of A Price B Price Total $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A 2 9 12 6 0 12 12 4 2 0 2 4 6 8 10 12 Quantity of B THE BUDGET LINE: What is Attainable Units of Units of A Price B Price Total $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A 2 9 12 6 0 12 12 4 2 0 2 4 6 8 10 12 Quantity of B THE BUDGET LINE: What is Attainable Units of Units of A Price B Price Total $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A (Unattainable) 2 9 12 6 0 12 12 4 2 (Attainable) 0 2 4 6 8 10 12 Quantity of B THE BUDGET LINE: What is Attainable Units of Units of A Price B Price Total $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A (Unattainable) 2 9 12 6 0 12 12 4 2 (Attainable) 0 2 4 6 8 10 12 Quantity of B THE BUDGET LINE: What is Attainable Units of Units of A Price B Price Total $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A (Unattainable) 2 9 12 6 0 12 12 4 2 (Attainable) 0 2 4 6 8 10 12 Quantity of B  PROPERTIES OF THE INDIFFERENCE CURVE Indifference curve = a line connecting all combinations of the goods that are equally desirable Properties of the indifference curve: higher is better never intersect negative slope bowed in (convex)  THE SLOPES OF INDIFFERENCE CURVES AND BUDGET LINES Slope of the indifference curve = marginal rate of substitution of the two goods The slope of the budget line = relative prices of the two goods  INDIFFERENCE CURVES What is Preferred Units of Units of A Price B Price Total j $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A 2 9 12 6 0 12 12 An Indifference 4 Schedule Combi- Units Units nation of A of B 2 j 12 2 0 2 4 6 8 10 12 Quantity of B  INDIFFERENCE CURVES What is Preferred Units of Units of A Price B Price Total j $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A 2 9 12 6 k 0 12 12 An Indifference 4 Schedule Combi- Units Units nation of A of B 2 j 12 2 0 k 6 4 2 4 6 8 10 12 Quantity of B  INDIFFERENCE CURVES What is Preferred Units of Units of A Price B Price Total j $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A 2 9 12 6 k 0 12 12 l An Indifference 4 Schedule Combi- Units Units nation of A of B 2 j 12 2 0 k 6 4 2 4 6 8 10 12 l 4 6 Quantity of B  INDIFFERENCE CURVES What is Preferred Units of Units of A Price B Price Total j $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A 2 9 12 6 k 0 12 12 l An Indifference 4 m Schedule Combi- Units Units nation of A of B 2 j 12 2 0 k 6 4 2 4 6 8 10 12 l 4 6 Quantity of B m 3 8  INDIFFERENCE CURVES What is Preferred Units of Units of A Price B Price Total j $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A 2 9 12 6 k 0 12 12 l An Indifference 4 m Schedule Combi- Units Units nation of A of B 2 I j 12 2 0 k 6 4 2 4 6 8 10 12 l 4 6 Quantity of B m 3 8  INDIFFERENCE CURVES What is Preferred Units of Units of A Price B Price Total j The slope $1.50 $1.00 Expenditures 12 represents 8 0 $12 10 the marginal 6 3 12 rate of substi- 4 6 12 8 Quantity of A tution, (MRS) 2 9 12 6 k 0 12 12 l An Indifference 4 m Schedule Combi- Units Units nation of A of B 2 I2 I1 j 12 2 0 k 6 4 2 4 6 8 10 12 l 4 6 Quantity of B m 3 8  INDIFFERENCE CURVES What is Preferred Units of Units of A Price B Price Total $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A 2 9 12 6 0 12 12 An Indifference 4 Schedule Combi- Units Units nation of A of B 2 I1 j 12 2 0 k 6 4 2 4 6 8 10 12 l 4 6 Quantity of B m 3 8  INDIFFERENCE CURVES What is Preferred Units of Units of A Price B Price Total $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 Quantity of A 2 9 12 6 0 12 12 An Indifference 4 I4 I3 Schedule Combi- Units Units nation of A of B 2 I2 I1 j 12 2 0 k 6 4 2 4 6 8 10 12 l 4 6 Quantity of B m 3 8  INDIFFERENCE CURVES What is Preferred Units of Units of A Price B Price Total $1.50 $1.00 Expenditures 12 8 0 $12 6 3 12 10 An 4 6 12 8 Indifference Quantity of A 2 9 12 Map 6 0 12 12 An Indifference 4 I4 I3 Schedule Combi- Units Units nation of A of B 2 I2 I1 j 12 2 0 k 6 4 2 4 6 8 10 12 l 4 6 Quantity of B m 3 8  THE SLOPES OF INDIFFERENCE CURVES AND BUDGET LINES Tangency Conditions Utility maximization point on the budget line tangent to an indifference curve Marginal rate of substitution = price ratio at that point EQUILIBRIUM AT TANGENCY Units of Units of A Price B Price Total $1.50 $1.00 Expenditures 12 8 0 $12 10 6 3 12 4 6 12 8 (Unattainable) Quantity of A 2 9 12 6 0 12 12 An Indifference 4 I4 Schedule Combi- Units Units I3 nation of A of B 2 (Attainable) I2 I1 j 12 2 0 k 6 4 2 4 6 8 10 12 l 4 6 Quantity of B m 3 8 EQUILIBRIUM AT TANGENCY Equilibrium 12 occurs when the consumer 10 selects the (Unattainable) 8 Quantity of A combination which reaches 6 the highest 4 attainable I4 I3 indifference 2 I2 (Attainable) I1 curve. 0 2 4 6 8 10 12 Quantity of B EQUILIBRIUM AT TANGENCY What happens if the price of B increases to $1.50 The budget line 12 rotates, reflecting PriceB QuantityB 10 the reduction in the quantity of B $1.00 6 8 Quantity of A units, which is 6 attainable. 4 2 I3 0 2 4 6 8 10 12 Quantity of B EQUILIBRIUM AT TANGENCY What happens if the price of B increases to $1.50 The budget line 12 rotates, reflecting PriceB QuantityB 10 the reduction in the quantity of B $1.00 6 8 Quantity of A units, which is 1.50 3 6 attainable. 4 2 I3 By recording the I2 various quantities 0 demanded at the 2 4 6 8 10 12 various prices yields Quantity of B the Demand schedule  THE SLOPES OF INDIFFERENCE CURVES AND BUDGET LINES Consequences of Income Changes: Inferior Goods Inferior goods: indifference curves located such that  income   purchases of one good  purchases of the other  THE SLOPES OF INDIFFERENCE CURVES AND BUDGET LINES Consequences of Price Changes: Deriving the Demand Curve  slope of the budget line  quantity purchased of that good  quantity of the other good DERIVING THE DEMAND CURVE What happens if the price of B increases to $1.50 Price of B Plotting the Points yields the PriceB QuantityB Demand Curve $1.00 6 $1.50 1.50 3 for Product B 1.00 By recording the various quantities DB demanded at the 0 various prices yields 2 4 6 8 10 12 the Demand schedule Quantity of B HAVE A GREAT DAY ☺