Module 4 Consumer behavior.pdf

MODULE 4: CONSUMER BEHAVIOR UNIT LEARNING OUTCOME At the end of the unit, you are expected to: 1. Evaluate the rational perception of consumers which is based on their desire to maximize their level of satisfaction. 2. Distinguish the difference between total utility and marginal utility. 3. Exp...

MODULE 4: CONSUMER BEHAVIOR UNIT LEARNING OUTCOME At the end of the unit, you are expected to: 1. Evaluate the rational perception of consumers which is based on their desire to maximize their level of satisfaction. 2. Distinguish the difference between total utility and marginal utility. 3. Explain the theory behind a downward sloping demand curve 4. Illuminate the different price schedules sellers offer to different consumers for the same goods. BIG PICTURE IN FOCUS The most successful businesses are those that understand their customers. They have the “feel” of the market. Fortunately the key to understand consumer behaviour is not contained in a black box. It is the maximization of their satisfaction. Consumers wanted value for their money. All marketing strategies such as buy-one-take-one, sales, price discounting have the bottom line of maximizing the consumer level of satisfaction. In fact the consumer right has its origins in the concept of consumer behaviour. Thus a long and lasting business has to understand consumer behaviour. METALANGUAGE The Law of diminishing marginal utility states that as the consumer adds an additional unit of a good, the satisfaction derived from each unit decreases. Marginal utility is the additional satisfaction consumer derived from an additional unit consumed Total utility is the sum of all satisfaction consumers derived from a number of units of goods The utility is the characteristics of a good or service to provide consumers a certain degree of satisfaction Budget constraints are one of the limitations that limit consumer from maximizing their desired level of satisfaction  The indifference curve depicts the combination of goods that the consumer is indifferent. ESSENTIAL KNOWLEDGE Total utility and Marginal utility Economist takes a closer look in the budget and total utility of consumer to understand the combination of goods that households prefer. The budget line is one of the constraints that prevent consumers from maximizing their desired level of satisfaction. Consumers prefer a particular good or service due to its characteristics to satisfy their needs and wants, called utility. Let us inspect Table 1 below, which illustrates the ice cream consumption of a consumer. Table 4.1 Total utility and Marginal utility of consumer A B C D E F Number of cones of ice cream 1 2 3 4 5 6 Marginal utility (MU) 25 23 19 13 5 -5 Total Utility (TU) 25 48 67 80 85 80 The unit assigned to utility is called utils. In the first cone of ice cream gave the consumer the highest level of satisfaction 25 utils, the second cone of ice cream was lower at 23 utils. But the two cones of ice cream gave the consumer 48 utils. As the consumer consumes more and more cones of ice cream, the total level of satisfaction increased. However, there was a point in the consumption schedule that instead of satisfaction, a cone of ice cream provided negative util. This is the fifth cone of ice cream; at this point, the consumer will decide not to add another unit. The marginal utility (MU) is the satisfaction consumer derived for each unit of goods or services. In contrast, the total utility is the total satisfaction consumer derived from consumer units of goods and services. Shown in Figure 4.1 is the graph for the TU and MU. The TU will continue to increase as the consumer increases the number of units consumed. However, the increase is at a decreasing rate. This is called the Law of diminishing marginal utility, which shows that the satisfaction consumer derived from an additional unit of good decreases. The marginal utility (MU) is expressed mathematically as the quotient between the difference between the total utility (TU) and the difference in the units consumed (Q) For example, the MU from 3 to 4 units is 13 which can be computed as  Total Utility and Marginal Utility 90 80 70 60 50 TU/MU 40 Marginal utlity 30 Total Utility 20 10 0 -10 0 2 4 6 8 Number of cones Figure 1. Total utility and Marginal utility of consumer Pattern of Consumption For instance, the consumer with a P20 budget went to a store selling only ice cream and fries. The price of ice cream is P5 and fires at P2. Below is the MU per price for the units of ice cream and fries consumers intend to buy. There are two questions that the table below can answer. What will be the consumer pattern of consumption? How many units of ice cream and fries will the consumer buy? The consumer first buy the first unit of fries since it has the highest MU/P (9), the second buy is the second unit of fries with 7.5, the third buy is the first unit of ice cream with 5, and the fourth buy is the second unit of ice cream, the consumer will still buy the third unit of fries. However, the consumer cannot afford to buy the third unit of ice cream and will not buy the fourth unit of fries with a zero MU/P. Therefore the consumer will buy two units of ice cream and three units of fries. Table 4.2 MU of consumer for ice cream and fries Ice MU MU/P Fries MU MU/P cream 1 25 5 1 18 9 2 23 4.6 2 15 7.5 3 19 3.8 3 9 4.5 4 13 2.6 4 0 0 5 5 1 5 -12 -6  SELF-HELP If you wanted to have a deeper and broader understanding of the Total Utility and Marginal Utility, please visit these web sites: 6.Consumption choices. Principles of economics. Retrieved from https://opentextbc.ca/principlesofeconomics/chapter/6-1-consumption-choices/ Theory of consumer choice. Boundless economics. Lumen. Retrieved from https://courses.lumenlearning.com/boundless-economics/chapter/theory-of-consumer-choice/ LET’S CHECK Below is the schedule of consumption. A B C D E Fries 1 2 3 4 5 Marginal Utility 30 26 18 -10 Total Utility 30 74 80 1. Complete the table above. 2. How many units of fries will give the consumer the highest level of satisfaction? 3. At what unit, will the consumer experience dissatisfaction? 4. Graph the schedule above showing the TU and MU. ESSENTIAL KNOWLEDGE Indifference Curve By now, you are already acquitted with the basic rational behavior of a consumer. Now, it is time to understand the consumer behavior model that assists us in understanding how a consumer will react to the different market stimuli that faced them. An individual who buys goods and services from sellers to satisfy their needs or wants is a consumer. For instance, a toddler consumes goods, but it is the parent that decides the goods to buy. An individual working in a milk company that produces infant formula must understand the purchase behavior of the parent. There are two essential factors to characterize the parent purchase decision: consumer opportunities and consumer preferences. The possible goods parent can afford to represent consumer opportunities and to decide which of the goods to consume is consumer preference. Practically, there are thousands of possible combinations of goods and services any consumer can buy. It is dizzying even to think about these combinations. However, to better understand consumer behavior easily, we will assume that only two goods exist in the economy: corn and beans. The possible combination of corn and beans are represented in the table and depicted in the figure below. Shown in Table 4.3 is the indifference schedule. Noticeably at combination A, consumers preferred 1 ton of corn and 10 tons of beans, moving to combination B, consumers prefer two tons of corn and seven tons of beans, as we move along in the schedule to increase the number of corns, the number of beans decreases. However, from combination A to B, to gain an additional unit of corn from one to two tons, consumers are willing to give up three tons of beans. Also, moving from combination B to C with the same additional one unit of corn, the consumers were only willing to give up two tons of beans. Markedly as we move along the schedule, constantly increasing the tons of corn, the number of beans given up is increasing but at a decreasing rate. Why? More on the explanation later, suffice to say that consumers are willing to give up less and less of beans in addition to the same rate of increase in corn. Table 4.3 Indifference Curve for Corn and Beans Points A B C D E F G H corn (tons) 1 2 3 4 5 6 7 8 beans (tons) 10 7 5 4 3.5 3.2 3 2.9 Depicted in Figure 4.2 is the possible combination of goods X and Y, in this case, it is corn and beans that provide consumers an equal level of satisfaction. In other words, the consumer is indifferent in between any combination of corns and beans along the curve. If you ask the consumer which combination of goods you prefer A or G, the consumer will reply, “I don’t care,” because all combination of goods along the indifference curve has the same level of satisfaction. The shape of the indifference curve is concave to the point of origin. It is attributed to the marginal rate of substitutions (MRS), which represent the absolute value of the slope of the indifference curve. The MRS is the willingness of the consumer to give up units of X in exchange for an increase in units of Y or to put it simply the number of units of X consumer is willing to substitute for the number of units of Y and maintain the level of satisfaction. In computing the MRS is to get the quotient in the change for consumption for goods Y and X. It is expressed in the formula below: Thus, the MRS from combination C to D can be computed as Thus MRS is equal to -1.  Indifference Curve 12 10 8 Beans (tons) 6 4 2 0 0 2 4 6 8 10 Corns (tons) Figure 4.2 Consumer indifference curve for corn and beans There are several points we need to remember that explained the rational behavior of a consumer. First, if the consumer prefers combination X to Y and Y over Z, therefore the consumer prefers X over Z. It pertains to the characteristics of a consumer called transitivity. Thus the indifference curve cannot intersect. Second, the consumer prefers to consume more than less. Expressed in Figure 4-2, the consumer prefers combination K over N and O since K has more units of X and Y compared to N and P Indifference Curves 25 20 K Beans (tons) 15 10 O N 5 0 0 2 4 6 8 10 Corn (tons) Figure 4.3 Three indifference curve for corn and beans Third, the consumer is willing to give up less of Y in exchange for more X. The principle is called diminishing marginal rate of substitution. Finally, the principle of completeness means that consumers knew what their preferences are.  SELF-HELP If you want to have a better appreciation of the discussion on indifference curve you may refer to these web sites: Gera, I. (18, November 2019). Mapping success: Whether economists will be in vogue or not, economics. Financial Express. Retrieved from https://www.financialexpress.com/lifestyle/science/mapping-success-whether-economists-will-be-in- vogue-or-not-economics-would-certainly-be/1767281/ Agarwal, P. (02, April 2018). The marginal rate of substitution. Retrieved from https://www.intelligenteconomist.com/marginal-rate-of- substitution/#:~:text=Marginal%20Rate%20of%20Substitution%20Formula,slope%20of%20the%20indiff erence%20curve). LET’S CHECK Below is a hypothetical indifference curve with a combination of two commodities beef and chicken. Draw the indifference curve (use EXCEL) Points A B C D E F y-axis Beef 100 70 50 40 35 32 (kilos) x-axis Chicken 100 200 300 400 500 600 (kilos) 1. At combination A, how many kilos of beef consumers are willing to give up for an additional 100 kilos of chicken? 2. If the consumer moves from point D to C, how many kilos of the chicken consumer is willing to give up for 10 kilos of beef? 3. How much is the MRS if the consumer moves from D to E?  ESSENTIAL KNOWLEDGE Budget Constraints “I am out of budget” is the common expressions we hear from people who face constraints in purchasing a good or service. Although besides the budget there are several obstacles for consumers such as time and physical constraints. Budget constraints limit consumer behavior in such a manner that they are compelled to choose from a combination of goods that they can afford. A buyer who went inside the grocery with a P100 cannot checkout with more than a P100 combination of items. In demonstrating the concept, let us say that M is the individual income at any amount with Px and Py as the price for commodity X and Y. Thus we can depict the budget (M) as the sum of units of X and Y, which can only be equal or less than the income (M). mathematically it can be expressed as If the individual decides to spend all income on the combination of X and Y, it is called the budget line. Shown below are the budget schedule in Table 4.4 and the budget line in Figure 4.3. For instance, an individual has a P1,000 budget and wanted to purchase a combination of commodity X and Y at combination A. The individual can buy ten units of X only since all the income was already spent no more budget left for unit Y. In combination B, the individual can buy eight units of X (P100 x 8 units = P800) with still P200 remaining can buy a unit of Y (P200 x 1 unit = P200). While moving along the budget line, the individual can buy less and less of Y and more and more of X. Table 4.4 Consumer budget schedule Point A B C D E F X (P100/unit) 10 8 6 4 2 0 Y (P200/unit) 0 1 2 3 4 5 Amount spent for X 1000 800 600 400 200 0 Amount spent for Y 0 200 400 600 800 1000 Income spent 1000 1000 1000 1000 1000 1000 At point X, the individual can buy four units of X and only two units of Y, spending only P800. Thus all points below the budget line are the attainable combination of commodities X and Y spending below the income. However, at point Z, there are eight units of X and five units of Y, in which the individual need P1,800 beyond the income of P1,000. In other words, all points above the budget line are a combination of X and Y that are beyond the individual income.  Budget Line 6 5 Z Y @ P200?unit 4 3 2 X 1 0 0 2 4 6 8 10 12 X @ P100/unit Figure 4.4 Consumer budget line Depicted in Figure 4.5 are the changes in income. If there is an increase in real income, it means that the individual can buy more units of X and Y. Therefore from the current income at M1, there is a shift to M2. However, if there is an increase in the price of X and with the same income, the individual can only buy fewer units of X with the same units of Y. hence the budget line rotates clockwise to from M1 to M3 16 14 12 10 8 6 4 M1 M2 2 M3 0 0 2 4 6 8 10 12 14 16 Figure 4.5 Changes in the price of items and income of consumers  SELF-HELP Get a better understanding of consumer constraint through budget line visit these sites: The budget line. Tutor2u. Retrieved from https://www.tutor2u.net/economics/reference/the-budget- line Jerelin R. Concept of Budget Line (With Diagram). Retrieved from https://www.economicsdiscussion.net/indifference-curves/concept-of-budget-line-with-diagram- consumers-equilibrium-economics/27539 LET’S CHECK There are three hypothetical budget lines below in a single graph showing the three budget lines. Point A B C D E F X1 100 80 60 40 20 0 Y1 0 10 20 30 40 50 X2 50 40 30 20 10 0 Y2 0 10 20 30 40 50 X3 150 120 90 60 30 0 Y3 0 30 60 90 120 150 1. Which budget line have more combination of X and Y? 2. Which budget line has less combination of X and Y? 3. if you will decide what budget line do you want? Please explain your answer ESSENTIAL KNOWLEDGE Optimal Choice Consumers wanted to choose the combination of X and Y units that maximize their level of satisfaction. In the absence of scarcity, the more-is-better decision will guide consumers in their choice of combination of goods and services. However, in a practical sense of real-world consumers can only choose a combination of goods and services inside the budget line, beyond the budget line, the combination of goods and services are unreachable due to lack of income. In combining the theory of consumer behavior and the budget constraint, we can move closer to the selection of the optimal combination of goods and services that yield the highest level of satisfaction within the level of consumer budget. Illustrated in Figure 4.4 are points A, B, and C.  25 20 D 15 C IC (C) 10 B 5 IC (B) A IC (A) 0 0 1 2 3 4 5 6 7 Figure 4.5 Optimal combinations of goods Ideally, a consumer without any scarcity will prefer combination D with 15 units of Y and three units of X. However, with a dive budget, the consumer cannot afford the combination. There are three indifference curves, IC (A), IC (B), and IC (C). All combinations depicted in A, B, and C are attainable. In combination A, there are three units of X and five units of Y. In combination B, there are three units of X and & units of Y, and in combination, there are three units of X and 14 units of Y. Predictably the optimal combination for consumers is C combination. It is within the budget and in a higher indifference curve. SELF-HELP If you are interested to understand a more in-depth and broader rational consumer behavior please visit the following web sites. Decisions within a budget constraint. Khan Academy. Retrieved from https://www.khanacademy.org/economics-finance-domain/microeconomics/choices-opp-cost- tutorial/utility-maximization-with-indifference-curves/a/how-individuals-make-choices-based-on-their- budget-constraint-cnx Consumer Choice. Knowledge Wharton. Retrieved from https://kwhs.wharton.upenn.edu/term/consumer- choice/#:~:text=Consumer%20choice%20refers%20to%20the,purchase%20or%20consume%20over%20t ime. LET’S ANALYZE Please refer to you LMS for your quizzes and assignment on his module. IN A NUTSHELL In the consumer behavior module, the student had a grasp of understanding the rational decision of a consumer. Also, the student appreciates the different marketing strategies to entice buyers to purchase more goods. Please state three arguments on how the concept of consumer behavior is useful as a tool to help you become a better consumer. 1. 2. 3. KEY TERMS budget constraint budget line the diminishing marginal rate of substitution indifference curve the marginal rate of substitution (MRS) substitution effect transitivity