Consumer Choice and Utility Maximization PDF

# CHAPTER IV ## CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION ### LEARNING OBJECTIVES After reading this chapter, you will learn about: 1. Goods and services 2. Consumer tastes and preferences 3. Maslow's hierarchy of needs 4. The economics of satisfaction 5. Consumer surplus We, as consumers are u...

# CHAPTER IV ## CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION ### LEARNING OBJECTIVES After reading this chapter, you will learn about: 1. Goods and services 2. Consumer tastes and preferences 3. Maslow's hierarchy of needs 4. The economics of satisfaction 5. Consumer surplus We, as consumers are unique in many ways. We have different needs, wants and demands. We differ in likes and dislikes, standards, reactions, lifestyles, traditions, etc. However, due to said uniqueness our behavior as consumers is hard to identify and measure. From an economic standpoint, our objective as consumers is to maximize our satisfaction given our limited budget (or income). With this in mind, economics seeks to explain why consumers behave differently and in a particular manner. In this chapter, you will learn how we, as consumers, behave in order to maximize satisfaction from the goods and services that we consume given our limited income. ## CONSUMER Who is the consumer? A consumer is one who demands goods and services. Without consumption (households), there is no need for production (firms). The consumer is king in a capitalist or free-market economy. Producers, for their own interests, have to satisfy the needs and wants of consumers in order to earn profits. In this perspective, all of us are consumers; as we live our daily lives, we demand goods and services the moment we wake up in the morning until we retire to our beds at night. Since we are the ultimate purchasers of goods and services, we have the power to determine what is produced; this is referred to as consumer sovereignty. In general terms, if we as consumers demand more of a good, then more of it will be supplied or vice versa. The producers simply obey the wishes and desires of consumers. This therefore implies that producers are 'passive agents' (Pass and Lowes 1993) in the price system, simply responding to what consumers want. However, in certain kinds of markets (notably oligopoly and monopoly), producers are so powerful vis-à-vis consumers that it is they who effectively determine the range of choice available to us consumers. This said, our freedom to satisfy our human wants is not completely unlimited. The government restricts consumer sovereignty for the good of society and its individual consumers. For example, the government prohibits the use of dangerous drugs and substances and regulates the use of products that are health hazards, like alcoholic beverages and cigarettes. It also regulates products that are destructive to the environment. ## GOODS AND SERVICES Goods refer to anything that provides satisfaction for the needs, wants, and desires of the consumer. They can be any tangible economic products (like cars, books, clothes, etc.) that contribute directly (final goods) or indirectly (intermediate goods) to the satisfaction of human needs and wants. Services, on the other hand, are any intangible economic activities (such as hairdressing, catering, insurance, banking, telecommunications, etc.), that likewise contribute directly or indirectly to the satisfaction of human wants. Tangible goods can be classified according to, but not limited to, the following: ### CONSUMER GOODS These are the goods that yield satisfaction directly to any consumer. These goods are primarily sold for consumption, and not to be used for further processing or as input/raw materials needed in producing another good. Usually, these are the goods that are easily accessible to consumers (e.g. soft drinks, bread, crackers, cellular phone loads). ### ESSENTIAL OR NECESSITY GOODS VS. LUXURY GOODS Essential or necessity goods are goods that satisfy the basic needs of man. In other words, these are goods are necessary to our daily existence. These are goods that we cannot live without such as food, water, shelter, clothing, electricity, medicine, etc. Conversely, luxury goods are those that men may do without, but are used to contribute to his comfort and well-being. Examples of luxury good/s are private jet, yacht, luxury cars, perfumes, jewelry, etc. ### ECONOMIC AND FREE GOOD An economic good is that which is both useful and scarce. It has value attached to it and a price has to be paid for its use. If a good is so abundant that there is enough of it to satisfy everyone's needs without anybody paying for it, that good is free. Water from our faucet is an economic good, because we are not utilizing it for free, we have to pay its distributor. The air that we breathe and the sunlight coming from the sun are examples of free goods. ## CONSUMER TASTES AND PREFERENCES Consumers have various tastes and preferences. Generally, tastes and preferences are determined by age, income, education, gender, occupation, customs and traditions, as well as culture. Preferences are the choices made by consumers as to which products or services to consume. The strength of our preferences will determine which products to buy, given our limited disposable income and thus, the demand of products. As well as which product to buy, we consumers also express our preferences for the particular brand of a product we purchase. Even in the choice of food, clothing, and shelter, for instance, we differ in our choices and preferences. Some prefer bread to rice, others like fish and vegetables instead of meat. In fact, we can generalize that no two consumers have exactly the same likes and dislikes. Some individuals have simple tastes and few preferences; others are sophisticated and extravagant in their preferences and tastes. Before we leave this discussion, it is also important to understand what a brand is. Simply defined, a brand is the name, term, or symbol given to a product by a supplier in order to distinguish his offering from that of similar products supplied by competitors. Brand names are used as a focal point of product differentiation between suppliers. Examples of brand names include Coca Cola for the soft drink products; Guess, Levi's, and Lacoste for RTW products, etc. Now, can you identify other brands that you usually buy or consume? ## MASLOW'S HIERARCHY OF NEEDS Maslow's hierarchy of needs identifies the basic priorities of every consumer. Maslow saw human needs in the form of a hierarchy, ascending from the lowest to the highest. He concluded that when one set of needs is satisfied, this kind of need ceases. The basic human needs placed by Maslow in an ascending order of importance (like a pyramid) are: (a) physiological needs, (b) security/safety needs, (c) social needs, (d) esteem needs, and (e) self-actualization needs. ### PHYSIOLOGICAL NEEDS These are the basic needs for sustaining human life itself, such as food, water, warmth, shelter, sex, and sleep. According to Maslow, until these needs are satisfied to the degree necessary to maintain life, other higher needs will not stimulate people. ### SAFETY NEEDS These are the needs to be free of physical danger, stimulated by the fear of losing one's work, property, food, or shelter. ### SOCIAL NEEDS These needs cover the value of the sense of belonging, love, care, acceptance (of self and by others), and understanding of family, relatives, and friends. ### ESTEEM NEEDS These needs explain the importance of self-esteem, recognition, individual status, and society's general acceptance of an individual. This kind of need produces satisfaction in the form of power, prestige, status, and self-confidence. ### SELF-ACTUALIZATION NEEDS These needs explain the worth of a person's self-development, growth, realization, and achievement. According to Maslow, this is the highest need in the hierarchy. It is the desire to become what is capable of becoming - to maximize one's potential and to accomplish something. ## THE ECONOMICS OF SATISFACTION You might be wondering by now how economics can explain the behavior of consumers in order to attain a maximum level of satisfaction of the goods and services that they generally consume. In this section, we try to explain how consumers attain maximum satisfaction level on the many goods and services available to them for consumption. However, we have to remember at this point that satisfaction is a relative term. We differ in the ways we are satisfied, as well as in the degree of our satisfaction. As we have said earlier, no two consumers have the same likes and dislikes. This section will discuss some of the theories that economists have devised to explain how consumers are able to attain maximum level of satisfaction when consuming a particular good or service. ### UTILITY THEORY Utility, in economics, refers to the satisfaction or pleasure that an individual or consumer gets from the consumption of a good or service that (s)he purchases. For purposes of economic analysis, utility is also measured by how much a consumer is willing to pay for a good/service. Table 4.1 presents a hypothetical demand schedule for siopao. You will notice in the table that the amount of money that you are willing to buy for an additional unit of siopao declines. What is the reason for this? As you might have experienced, the more siopao you eat, the more you become satiated so that you are not willing to spend more for the next siopao that you wish to consume. In other words, the satisfaction or utility that you derive in the consumption of siopao declines as you consume more and more of it. **Table 4.1 Hypothetical Demand Schedule for Siopao ** | Price (P) | Quantity Demanded (Q) | |---|---| | 15.00 | 1 | | 12.75 | 2 | | 10.50 | 3 | | 8.25 | 4 | This table shows that as you continue to buy siopao, your willingness to pay for it continuously declines because your satisfaction from the good declines as you consumer more of it. Total utility, on the other hand, is the total satisfaction that a consumer derives from the consumption of a given quantity of a good or service in a particular time period. Our total utility usually increases as we consume more and more of a good or service, but generally the increase is at a slower or declining rate. This implies that each extra unit consumed adds less marginal utility than the previous unit as we become satiated with the good or service we are consuming. Let us illustrate this using the hypothetical utility schedule presented in Table 4.2. Assume that at the end of our class, you were too hungry that you went directly to the cafeteria. In the cafeteria, you bought and consumed one siopao for your merienda. In this case, your total and marginal utilities are 40 utils. Assume further that you consumed another siopao because you were really hungry after the class. Your total utility now increases to 90 utils since the marginal utility increased by 50 utils. Let us now assume that you have consumed five siopao. Take note in that table that your total utility for the fifth unit is 350 utils. However, marginal utility is always more important, yet marginal utility has declined to 80 utils. Why is this so? This is because of the *Law of Diminishing Marginal Utility*. **Table 4.2 Hypothetical Utility Schedule for Siopao** | Unit Purchased | Total Utility | Marginal Utility | |---|---|---| | 1 | 40 | 40 | | 2 | 90 | 50 | | 3 | 170 | 80 | | 4 | 270 | 100 | | 5 | 350 | 80 | The table shows the various units purchased, the total utility for each unit purchased, and the corresponding marginal utility. The derivation of marginal utility is shown below. ### MATHEMATICAL DERIVATION OF MARGINAL UTILITY How do we derive marginal utility? Marginal utility is simply the change in total utility divided by the change in quantity. Thus, $MU = \frac{Δ TU}{Δ Q}$ Expanding our equation, we can solve for marginal utility using the following equation: $MU = \frac{TU_2 - TU_1}{Q_2 - Q_1}$ where: * $TU_2$ = the new total utility * $TU_1$ = the original utility * $Q_2$ = the new quantity consumed * $Q_1$ = the original quantity consumed Applying the formula, we can derive the marginal utility for the total utility presented in Table 4.2. Thus, if we want to determine the marginal utility from the consumption of two pieces of siopao to three pieces, we can simply apply the formulated presented above. $MU = \frac{170-90}{3-2}$ $MU = 80$ You may try the other combination of quantity and total utility and solve for the marginal utility. ## GRAPHICAL ILLUSTRATION OF TOTAL UTILITY AND MARGINAL UTILITY Figure 4.1 and 4.2 are graphical presentations of the total and marginal utility concepts. As we discussed earlier, when we consume more and more of a good or service, our total utility increases but at a decreasing rate.. This is illustrated in Figure 4.1 where we have a convex utility curve. We can see from the curve, as indicated by the dashed lines, that the initial consumption of 1 unit of Q to 2 units of Q has a larger angle than the following consumption (from 2 units to 3 units). We can therefore imply that the consumption from 1 unit of Q to 2 units of Q has a total utility of 10 utils or an incremental increase of 5 utils, while for the next consumption it only increased to 11 utils, or only an additional 1 util. **FIGURE 4.1: TOTAL UTILITY CURVE** Total utility increases with every additional consumption of a good, but it increases at a decreasing rate; consistent with the Law of Diminishing Marginal Utility. The marginal utility curve illustrated in Figure 4.2 is a concave curve. This is because marginal utility starts at a high level but declines, as consumption of the same good increases. **FIGURE 4.2: MARGINAL UTILITY CURVE** This figure illustrates the marginal utility curve. At the initial stage of consumption of a good, marginal utility is at very high level, thereafter declining as more and more of the same good is consumed at a succeeding interval. Until when do we stop consuming the same good? As consumers, we have our own unique way of maximizing our utility or satisfaction. We are given the opportunity to maximize our satisfaction by continuously consuming more units of a certain good until our satisfaction falls down zero. When our marginal utility hits zero, we can say that we have already reached the peak of our satisfaction for that good/service. Beyond this point (negative MU), we will have already exceeded our satisfaction such that we stop consuming the same good. ## CONSUMER SURPLUS We have already encountered the term surplus in our discussion of price equilibrium in the previous chapter. We have to remember that the term surplus is used in economics for several related quantities. For this section, our interest is to understand what consumer surplus is. In general, consumer surplus is a measure of the welfare we gain from the consumption of goods and services; it's a measure of the benefits that we derive from the exchange of goods. In specific terms, consumer surplus is the difference between the total amount that we are willing and able to pay for a good or service, and the total amount that we actually pay for that good or service. Let us illustrate this through an example. Suppose you are interested in buying a new pair of maong pants. With a budget of Php3,000.00, you head to the mall to look for the pants. Upon visiting a boutique, you find out that the pants that you like most only cost Php2,500.00, so you bought the pants immediately. What is your consumer surplus? Take note in our example that you are willing to pay Php3,000.00 for the pants. However, when you bought the pants your actual cost was only Php2,500.00, so therefore you have a consumer surplus of Php500.00. Why? Because consumer surplus is simply the difference between what you pay (for the pants and all other goods or services that you buy) and what you would have been willing to pay for them. **FIGURE 4.3: CONSUMER SURPLUS** This figure illustrates that concept of consumer surplus. The area between Php2,500.00 and Php3,000.00 is the consumer surplus.