ECONOMY Lecture Consumer Behavior

Consumer Behavior andUtility Maximization

ECONOMYHenry Prudente

THE LAW OF DEMANDA Closer Look…

The Income Effect A lower price frees income for additional purchases - and vice versa

The Substitution Effect A lower price relative to other goods attracts new buyers - and vice versa

LAW OF DIMINISHINGMARGINAL UTILITY

• Utility Defined•Want satisfying power

• Subjective Nature• Difficult to QuantifyTotal Utility- total satisfaction

Marginal Utility-extra satisfaction

graphically examined...

TOTAL AND MARGINAL UTILITYTacos

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TotalUtility,Utils

MarginalUtility,Utils

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TOTAL AND MARGINAL UTILITYTacos

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MarginalUtility,Utils

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ObserveDiminishing

MarginalUtility

THEORY OF CONSUMER BEHAVIOR

Consumer Choice and Budget Constraint

• Rational Behavior•Maximize utility

• Clear-Cut Preferences• Subject to a Budget

Constraint• Responds to Price

Changes

THEORY OF CONSUMER BEHAVIOR

Utility Maximizing Rule

The consumer’s money income should be allocated so that the last dollar spent on each product yields the same amount of extra (marginal) utility.

Algebraic Restatement of theUtility Maximization Rule

MU of product A

Price of A

MU of product B

Price of B=

UTILITY MAXIMIZING COMBINATION

APPLICATIONS AND EXTENSIONS

DVDs and DVD PlayersDVDs have greater utility than video cassettes

The Diamond-Water ParadoxWater has greater total utility than diamonds even if the price of diamonds is greater

The Value of TimeAmericans are “wasteful” of goods while economical with time, with the opposite occurring in developing nations

APPLICATIONS AND EXTENSIONS

Cash and Noncash GiftsMost people prefer cash gifts to noncash gifts because they have more choice

income effectsubstitution effectutilitytotal utilitymarginal utilitylaw of diminishing marginal utilityrational behaviorbudget constraintutility-maximizing rule