V.

Consumer Behaviour
(Chapter 6)
 In this chapter you will learn
1. The difference between marginal and total utility.

2. That utility-maximizing consumers adjust their expenditure

until the marginal utility per dollar spent is equalized across
products.
3. Explain how the income and substitution effects of a price
change determine the slope of a demand curve.

4. See that consumer surplus is the “bargain” the

consumer gets by paying less for the product
than the maximum price he or she is willing to
pay.

5. Explain the “paradox of value

 Think about…
If you were to compare the shopping carts of
almost any two consumers, you would observe
striking differences.
Why does Paula have potatoes, peaches, and
Pepsi in her cart while Sam has sugar, cookies,
and 7-up in his?
You will see how individual consumers
allocate their income among the various goods
and services available to them.
Given a certain budget, how does a consumer
decide which goods and services to buy?
 Household’s Budget

A household’s consumption choices are determined by:

■ Consumption possibilities

■ Preferences

■ Consumption Possibilities
A household’s consumption possibilities are constrained
by its budget and the prices of the goods and services it buys.

A budget line describes the limits to a household’s

consumption choices.
 Household’s Budget

■ Figure 1 shows a
budget line.
■ The household can
afford all the points
on or below the
budget line.
■ The household
cannot afford the
points beyond the
budget line.
 Household’s Budget
Relative Price
A relative price is the price of one good divided
by the price of another good.

The price of a movie is $6 and the price of pop is

$3 a six-pack.

So the relative price of a movie is $6 per movie

divided by $3 per six-pack, which equals 2 six-
packs per movie
 Household’s Budget
■ A fall in the price of
the good on the x-
axis increases the
affordable quantity of
that good and
decreases the slope of
the budget line.
■ Figure 2(a) shows the
rotation of a budget
line after a change in
the relative price of
movies.
 Household’s Budget
Real Income
A household’s real income is the household’s income
expressed as the quantity of goods that the household can
afford to buy.

Expressed in terms of pop, Lisa’s real Income is 10 six-

packs—the maximum quantity of six-packs that she can
buy.

Lisa’s real income equals her money income ($30) divided

by the price of a six-pack ($3).
 Household’s Budget
■ A change in the
household’s income
brings a parallel shift
of the budget line.
■ The slope of the budget
line doesn’t change
because the relative price
doesn’t change.
■ Figure 2(b) shows
how the budget line
shifts when income
changes.
 Preferences and Utility
■ Preferences
A household’s preferences determine the benefits or
satisfaction a person receives consuming a good or service.
The benefit or satisfaction from consuming a good or
service is called utility.

Total utility is the total benefit a person gets from the

consumption of goods. Generally, more consumption gives
more utility.
 Three characteristics of the Utility
1. “ Utility” and “usefulness” are not synonymous.
Painting by Picasso may offer great utility to art
connoisseurs but are useless functionally.

2. Utility is subjective.
The utility of a specific product may vary
widely from person to person. A Celine Dion
CD has a tremendous utility for one of her fans,
but no utility to someone who listens only U2.
3. Utility is difficult to quantify. But for purpose of
illustration, we assume that people can measure
satisfaction with units called UTILS
(units of utility).

For example, a particular consumer may get 100

utils of satisfaction from a smoothie, 10 utils of
satisfaction from a candy bar, and 1 util of
satisfaction from a stick of gum.

These imaginary units of satisfaction are

convenient for quantifying consumer behaviour.
Marginal utility is the change in total utility that results
from a one-unit increase in the quantity of a good
consumed.

Diminishing Marginal Utility

Ceteris paribus, the utility that any consumer derives from
successive units of a particular product is assumed to diminish
as total consumption of the product increases.

That is, marginal utility falls as the level of consumption rises.

 Utility Schedules and Graphs
Movies 100 • •••
•
• total

Utility
Attended Total Marginal 80 utility
per Month Utility Utility
•
60
•
0 0 •
30
1 30 40
20 •
2 50
15 20
3 65
10
4 75
5 83 0 2 4 6 8 10
6 89 Quantity of Movies
8
Marginal Utility
7 93
8 96 30
6
9 98
10 99
4 20 • marginal utility
3
2 10 •
• • •
1
0 2 4 6 8 10
Quantity of Movies
 Relationship between total utility and
marginal utility (GRAPH)

■ As more of a product is consumed, total utility

increases at a diminishing rate, reaches a
maximum and then declines.

■ Marginal utility reflects the changes in total

utility. Thus, marginal utility diminishes with
increased consumption, becomes zero when
total utility is at a maximum, and is negative
when total utility declines.
The law of diminishing marginal utility
This principle, is that added satisfaction
declines as a consumer acquires additional
units of a given product.
■ Consumer wants in general may be insatiable,
wants for a particular item can be satisfied.
■ In a specific span of time over which
consumer’s tastes remain unchanged, consumer
can get as much of a particular good or service
as they can afford.
■ But, the more of that product they obtain, the
less additional product they want.
 Example (Durable goods)
Consumer’s desires for an automobile, when
they have none may be very strong, but the
desire for a second car is less intense, and for a
third or fourth weaker and weaker.

Unless they are collectors, even the wealthiest

families rarely have more than a half-dozen
cars, although their income would allow them
to purchase a whole fleet of vehicles.
 Maximizing Utility
Consumers must decide how to adjust their expenditure to
maximize total utility.

A utility-maximizing consumer allocates expenditures so that

the utility obtained from the last dollar spent on each product is
equal.

An example? Consider a consumer whose utility from the last

dollar spent on Coke is more than from the last dollar spent on
burritos.

She could increase her total utility by switching a dollar of

expenditure from burritos to Coke...
… and continuing until the marginal utility per dollar spent on
Coke equals the marginal utility per dollar spent on burritos.

For two products, X and Y, the utility-maximizing condition is:

MUX MUY MUX pX

= or =
pX pY MUY pY

In the second equation, we see the consumer adjusting her

consumption (and thus the ratios of MUs) in response to
changes in relative prices.
 Maximizing Utility EXAMPLE

1. Call the marginal utility of movies MUM

2. Call the marginal utility of pop MUP
3. Call the price of movies PM
4. Call the price of pop PP
5. The marginal utility per $ from movies is MUM/PM
6. The marginal utility per $ from pop is MUP/PP.
 Maximizing Utility
QM MUM MUM/PM QP MUP MUP/PP

A 0 10
B 1 8
C 2 6
D 3 4
E 4 2
F 5 0
 Maximizing Utility
QM MUM MUM/PM QP MUP MUP/PP

A 0 10
B 1 50 8
C 2 38 6
D 3 33 4
E 4 29 2
F 5 25 0
 Maximizing Utility
QM MUM MUM/PM QP MUP MUP/PP

A 0 10
B 1 50 8.33 8
C 2 38 6.33 6
D 3 33 5.50 4
E 4 29 4.83 2
F 5 25 4.17 0
 Maximizing Utility
QM MUM MUM/PM QP MUP MUP/PP

A 0 10 15
B 1 50 8.33 8 17
C 2 38 6.33 6 19
D 3 33 5.50 4 28
E 4 29 4.83 2 42
F 5 25 4.17 0
 Maximizing Utility
QM MUM MUM/PM QP MUP MUP/PP

A 0 10 15 5.00
B 1 50 8.33 8 17 5.67
C 2 38 6.33 6 19 6.33
D 3 33 5.50 4 28 9.33
E 4 29 4.83 2 42 14.00
F 5 25 4.17 0
 Maximizing Utility
QM MUM MUM/PM QP MUP MUP/PP

A 0 10 15 5.00
B 1 50 8.33 8 17 5.67
C 2 38 6.33 6 19 6.33
D 3 33 5.50 4 28 9.33
E 4 29 4.83 2 42 14.00
F 5 25 4.17 0
 Maximizing Utility
■ Figure 4 illustrates the
utility-maximizing rule.
■ The two x-axis values

show affordable
combinations of movies
and pop.
■ First, plot MUM/PM
against the quantity of
movies.
■ Then plot MU /P
P P
against the quantity of
pop—from right to left.
■ If MUM/PM > MUP/PP,
then moving a dollar
from pop to movies
increases the total utility
from movies by more
than it decreases the
total utility from pop, so
total utility increases.
■ Only when MUM/PM
equals MUP/PP, is it not
possible to reallocate
the budget and increase
total utility.
 ■ Similarly, if MUP/PP >
MUM/PM, then moving a
dollar from movies to
pop increases the total
utility from pop by more
than it decreases the
total utility from movies,
so total utility increases.
■ Again, only when
MUM/PM equals MUP/PP,
it is not possible to
reallocate the budget and
increase total utility.
 Summarizing
■ The hypothesis of diminishing marginal utility
tells us that as a consumer buys less of a
product, the marginal utility rises.
■ This leads to the basic prediction of demand
theory:
 A rise in the price of a product leads each
utility-maximizing consumer to reduce the
quantity demanded of the product.
 Example
■ The consumer may buy two tacos at a price of
$1 each, but because less marginal utility is
obtained from additional tacos, the consumer
will choose not to buy more at that price.
■ The consumer would rather spend additional
dollars on products that provide more (or
equal) utility, not less utility.
■ Therefore, additional tacos with less utility are
not worth buying unless the price declines.
(when marginal utility becomes negative, the
restaurant would have to pay you to consume
another taco)
Example  Vending Machines and
Diminishing Marginal Utility
Newspaper dispensing devices and soft drink
vending machines are similar in their basic
operations.
Both allows consumers to buy a product by
inserting coins. But there is an important
difference in two device:
The newspaper dispenser opens to the full
stack of papers and seemingly “trust”,
requiring the consumer to buy one at a time.
WHY THE DIFFERENCE ?
 The idea of diminishing marginal utility is
the key to solving this puzzle
■ Most consumers take only single copies from the
newspaper box because the magazine utility of a
second newspaper is nearly zero.
■ They could grab a few extra papers and try to sell
them on the street, but the revenue obtained
would be small relative to their time and effort.
■ In selling their product newspaper publishers rely
on “zero marginal utility of a second unit” not on
“consumer honesty”. Also, newspapers are
obsolete the next day.
 In contrast,
■ Soft drink sellers do not allow buyers to make
a single payment and they take as many cans as
they want.

■ If they did, consumers would clean out the

machine because the marginal utility of
successive cans of pop diminishes slowly, so
buyers could take extra cans and consume them
later. As a result soft drink firms sell their
products on a pay-per can basis.
 In summary
■ Newspaper publishers and soft drink firms use
alternative vending techniques because of the
very different rates of decline in marginal
utility for their products.

QUESTION:
Some restaurants offer “All you can eat”
buffets at a set price. How can they afford to
make such offers?
 The Slope of the Demand Curve

The overall effect of a price change is the combination of the

income and substitution effects.

For a price increase:

- the substitution effect is to reduce quantity demanded
- the income effect could go either way

But for a normal good, the two effects work in the same
direction and so the demand curve is downward sloping.
 Income and Substitution Effects
of Price Changes

■The Substitution Effect

 The substitution effect is the change in the
quantity of a product demanded resulting from a
change in its relative price (holding real income
constant).
 The substitution effect increases the quantity
demanded of a product whose price has fallen and
reduces the quantity demanded of a product whose
price has risen.
 Income and Substitution Effects
of Price Changes

■The Income Effect

 The income effect is the change in the quantity of a product
demanded resulting from a change in real income (holding
relative prices constant).

 The income effect leads consumers to buy more of a product

whose price has fallen, provided that the product is a normal
good.

 The size of the income effect depends on the amount of income

spent on the product whose price changes and on the amount by
which the price changes.
 The Slope of the Demand Curve
 The substitution effect leads consumers to
increase their demand for all normal goods
whose prices fall.
 The income effect leads consumers to buy
more of all normal goods whose prices fall.
 Because of the combined operation of the
income and substitution effects, the demand
curve for any normal good will be negatively
sloped.
 A fall in price will increase the quantity
demanded.
 The Slope of the Demand Curve
Giffen Goods

■ Products with a positively sloped demand curve.

■ Giffen goods have two key characteristics:
 The good must be an inferior good—a reduction in
real income leads households to purchase more of
that good
 The good must take a large proportion of total
household expenditure and therefore have a large
income effect
Income and Substitution Effects of a Price
Change
 Consumer Surplus on Milk Consumption

■ Consumer
Surplus ̶ the
difference
between the
market price and
the maximum
price that the
consumer is
willing to pay to
obtain that unit.
 Consumer surplus is the difference between the
total value that consumers place on all units
consumed of a product and the payment that
they actually make to purchase that amount of
the product.
 The area under the demand curve shows the
total value a consumer places on a good.
 The market demand curve shows the valuation
that consumers place on each unit of the
product.
 For any given quantity, the area under the
demand curve and above the price line shows
the consumer surplus received from consuming
 The diamond-water paradox (Adam
Smith)
Why would water, essential to life, be priced below
diamonds, which have much less usefulness?

The paradox is resolved when we consider that water

is in great supply relative to demand and thus has a
very low price per litre.

Diamonds, in contrast, are rare and costly to mine,

cut, and polish. Because their supply is small relative
to demand, their price is very high per caret.
 The marginal utility of the last unit of
water consumed is very low.

■ The reason follows our utility-maximizing rule.

Consumer (and producers) respond to the very low
price of water by using a great deal of it for
generating electricity, irrigating crops, heating
buildings, watering lawns, quenching thirst, and so
on.
 In equilibrium
Consumption is expanded until marginal utility,
which declines as more water is consumed, equals
its low price.

Conversely, relatively few diamonds are

purchased because of their prohibitively high
price, meaning that their marginal utility remains
high.

MU of water (low) = MU of diamonds (high)

Price of water (low) Price of diamonds (high)
■ The total utility derived from the consumption
of water is larger because of the enormous
amounts of water consumed, including the
trillions of liters that have far higher marginal
utilities than the last unit consumed.

■ In contrast, the total utility derived from

diamonds is low since their high price means
that relatively few of them are bought.
 Solving the paradox
Water has much more total utility (roughly,
usefulness) than diamonds even though the
price of diamonds greatly exceeds the price of
water. These relative prices relate to marginal
utility, not total utility.
 But….
Who stands in the grocery store and computes
ratios of marginal utilities and prices?

Keep in mind, though, that utility theory is

used by economists to predict how consumers
will behave when faced with such events as
changing prices and incomes.

Economist continue to use the theory of utility

maximization because its predictions are rarely
rejected by the data.