Consumer Behavior and Utility Maximization

A closer look at the law of demand

The law of demand is based on common sense.
A high price discourages consumers from
buying; a low price encourages them to buy. We
mentioned two explanations of the downward-
sloping demand curve-income and substitution
effects and the law of diminishing marginal
utility--that backed up everyday observation.
We now want to say more about these
explanations in the context of consumer
behavior.
 Income and substitution effect
(Concluding Remark)
• The income and substitution effects combine
to increase a consumer’s ability and
willingness to buy more of a specific good
when its price falls.
Law of Diminishing Marginal Utility
• A second explanation of the downward-sloping
demand curve is that, although consumer
wants in general may be insatiable, wants for
particular commodities can be satisfied. In a
specific span of time over which consumers’
tastes remain unchanged, consumers can get
as much of a particular good or service as they
can afford. But the more of that product they
obtain, the less they want still more of it.
Law of Diminishing Marginal Utility (Cont’d)

• Consider durable goods, for example. A

consumer’s desire for an automobile, when he
or she has none, may be strong. But the desire
for a second car is less intense; and for a third
or fourth, weaker and weaker.
Total marginal Utility:
 Terminology
• Evidence indicates that consumers can fulfill
specific wants with succeeding units of a
commodity but that each added unit provides
less utility than the last unit purchased. Recall
that a product has utility if it can satisfy a want:
Utility is want-satisfying power. The utility of a
good or service is the satisfaction or pleasure
one gets from consuming it. Three characteristics
of this concept must be emphasized:
 Terminology (Cont’d)
• “Utility” and “usefulness” are not synonymous.
Paintings by Picasso may offer great utility to art
connoisseurs but are useless functionally (other
than for hiding a crack on a wall).
• Implied in the first characteristics is the fact that
utility is subjective. The utility of a specific product
may vary widely from person to person. Eyeglasses
have tremendous utility to someone who has poor
eyesight but no utility at all to a person with 20-20
vision.
 Terminology (Cont’d)
• Because utility is subjective, it is difficult to
quantify. But for purposes of illustration we
assume that people can measure satisfaction
with units called utils (units of utility).
 Total Utility and Marginal Utility
• We must distinguish carefully between total utility
and marginal utility. Total utility is the amount of
satisfaction or pleasure a person derives from
consuming some specific quantity-for example, 10
units-of a good or service. Marginal utility is the
extra satisfaction a consumer realizes from an
additional unit of that product-for example, from the
eleventh unit. Alternatively, we can say that marginal
utility is the change in total utility that results from
the consumption of 1 more unit of a product.
Table & graphic presentation of
Total utility and Marginal utility.
 Consumer Surplus
• Consumer surplus is the gain people receive when they can buy
things for less than what they were willing to pay.
• The easiest way to understand consumer surplus is by looking at the
gap between the total utility of a good and its total market value.
The surplus arises because we “receive more than we pay for” as a
result of the law of diminishing marginal utility.
• We have consumer surplus basically because we pay the same
amount for each unit of a commodity that we buy , from the first to
the last. We pay the same price for each egg or glass of water. Thus
we pay for each unit what the last unit is worth. But by our
fundamental law of diminishing marginal utility, the earlier units are
worth more to us than the last. Thus we enjoy a surplus of utility on
each of these earlier units.
 Consumer Surplus (Cont’d)
• Figure on the right illustrates the
concept of consumer surplus in the
case where money provides a firm
measuring rod for utility. Here, an
individual consumes water, which has
a price of $1 per gallon. This is shown
by the horizontal rust line at $1 in the
Figure . The consumers considers
how many gallon jugs to buy at that
price. The first gallon is highly
valuable, slaking extreme thirst, and
the consumer is willing to pay $9 for
it. But this first gallon costs only the
market price of $1, so the consumer
has gained a surplus of $8.
 Consumer Surplus (Cont’d)
• Consider the second gallon.
This is worth $8 to the
consumer, but again costs
only $1, so the surplus is $7.
And so on down to the ninth
gallon, which is worth only
50 cents to the consumer,
and so it is not bought. The
consumer equilibrium
comes at point E, where 8
gallons of water are bought
at a price of $1 each.
 Consumer Surplus (Cont’d)
• But here we make an • Because of diminishing MU,
consumers satisfaction exceeds what
important discovery: Even is paid.
though the consumer has
paid only $8, the total
value of the water is $44.
This is obtained by adding
up each of the marginal
utility columns (=$9+$8+
…..+2). Thus the consumer
has gained a surplus of
$36 over the amount paid.
Because of diminishing MU, consumers satisfaction exceeds what is paid.

• The downward-sloping demand for water reflects the

diminishing marginal utility of water. Note, how much
excess or surplus satisfaction occurs from the earlier
units.
• Adding up all the grey surpluses ($8 of surplus on unit 1 +
$7 of surplus on unit 2+ . . . + $1 of surplus on unit 8),we
obtain the total consumer surplus of $36 on water
purchases.
• In the simplified case here, the area between the demand
curve and the price line is the total consumer surplus.
 Consumer surplus for a Market
• The figure above examines the case of a
single consumer purchasing water. We
can also apply the concept of consumer
surplus to a market as a whole.
• The market demand curve in figure
place in the right here, is the horizontal
summation of the individual demand
curve. The logic of the individual
consumer surplus carries over to the
market as a whole. The area of the
market demand curve above the price
line , shown as NER in the figure,
represents the total consumer surplus.
• The total area under the demand curve
OREM shows the total utility attached
to the consumption of water. We obtain
consumer surplus from the area NER.