Theory of Consumer Behavior
Lesson 7

Theory of Consumer Behavior

1. Characteristics of Consumers

1. The consumer is rational
   • Maximizes total utility
     • Utility - receive satisfaction or pleasure from consuming a product or service
     • Utility is subjective - depends on the consumer
     • Economists cannot measure utility
       • Economists use the fictional unit, utils, to describe a consumer's satisfaction level
   • "Obtains the most from his money"
   • If two products yield equal benefits, then consumer chooses the cheaper product
2. Consumer has limited income
3. A consumer's purchases do not affect the market price
   • Many consumers in the market
   • Market has pure competition on demand side
4. Knowledge and experience help consumers make decisions with imperfect information
   • The more expensive an item is, the more time consumer researches information
     • Cars
     • Homes
5. Consumers have clear-cut preferences for goods and services
   • Preferences:
     1. Can be complex
     2. Consumers have different risk levels
        • Fire, dental, and flood insurance
        • Invest in different types of stocks, bonds, certificates of deposit, etc
     3. Interest rate - consume the product now or delay consumption
     4. Influenced by advertising
        • $100 billion a year industry
        • Implies advertising is effective
          • Benefits
            • Reduces search time
            • Make more informed choices
            • Provide assurances of quality
              • e.g. brand names
              • Big Mac - identical product at McDonald's in any country around the world
          • Disadvantages
            • Advertising misleads consumers
            • Businesses cater to consumers in competitive market, so less incentive to mislead if concerned about the long run

2. Law of Diminishing Marginal Utility - consuming additional units of a good yield less and less additional utility i.e. satisfaction.

• Marginal utility - the increase in utility a consumer has from consuming one more product
• Example: Hypothetical case for pizza
  • utils are fictional units for satisfaction
• 1st slice, a person receives 100 utils, or lots of satisfaction, so he values them at $5 per slice.
• 2nd slice, a person receives 20 utils, or some gain in utility, so he values them at $3 per slice.
• 3rd slice, a person receives 5 utils, or very little gain in utility, so he values it at $1 per slice.
  • Total utility = 125 utils; total spent = $9 for 3 slices of pizza
• Book - has negative utility - consumer would never consume it if a consumer paid for product that reduced his utility, then this would be irrational

3. Consumers maximize total utility when:

MU is marginal utility while P is price. When you divide by price, you are expressing numbers as "per $1." We are removing price differences among all products, so marginal utility can be compared.

If this condition exists and the consumer still has $1, then he can maximize total utility by purchasing more pizza. As more pizza is consumed, marginal utility decreases until:

4. The good's monetary price is not the full cost to the consumer

• Consumption requires time and money
  • Time is scarce
  • Time acts like a price
• As the time to consume a good decreases, i.e. lower price, makes a product more attractive.
• Time costs depend on the individual
  • Example: If both activities gives person A the same utility and he earns $10 per hour, then the true cost of Activities A and B are below:

• Explains why consumers buy time saving products
  • Airlines vs. driving a car
  • Processed foods vs. home cooking

5. The diamonds vs. water paradox:

• Water is essential for human life, but price is very cheap
• Diamonds are not essential for life, but they have a high price
• Why:
  • People consume large amounts of water, so the marginal utility is very small for that last additional unit of water
  • People consume very little amount of diamonds, so marginal utility is very high for that last unit
• For the consumer to spend his last dollar to maximize utility, then:

P _diamonds > P _water

The last unit sold in the market sets the market price. Price of diamonds must be large while price of water must be low to cause the fractions to be equal.

A Consumer's Demand Function

• Can use marginal utility and prices to derive a demand function
• For example - price of soda is $1 and price of pizza is $10
• Let's say he drinks 7 sodas and eats 1 pizza, causing this ratio to be true
  • MU for last pizza is 20 utils
  • MU for last soda is 2 utils
• Below is his marginal utility

• The price of soda increases to $2, ceteris paribus
  • Keep everything else the same
• Now he drinks 1 soda and eats 1.5 pizzas
  • MU for last pizza is 15 utils
    • Decreases because he eats more pizza
  • MU for last soda is 3 utils
    • Increases because he drinks less soda
• Below is marginal utility

• We know two points for this consumer
  • When price of soda is $1, he drinks 7
  • When price of soda is $2, he drinks 1
• Below is his demand function

Demand Function has negative slope

• Composed of two effects.
  • Income effect - as a product's price decreases, a constant income buys more
    • Example: Monthly income is $1,000 and price of beef decreased
    • Income effect - you can buy more beef with fixed income
    • Real income increased
  • Substitution effect - as price of a product decreases, people start buying it and “substitute away” from more expensive, similar goods.
    • Price change affects consumer's behavior
    • Example: As the price decreases for Coca-Cola relative to Pepsi, people substitute Coke for Pepsi
• Law of Diminishing Marginal Utility
  • As a consumer consumes additional units of a product, each unit of consumption, yields less and less utility. Thus, he places a lower value, i.e. price, on those units
• Economists extend supply and demand analysis to many non-traditional markets
  • Example - market for crime
    • Each crime a criminal does yields a marginal benefit. The more crimes he does the less marginal benefits he gets
      • Marginal benefit is the criminal's demand for crime
    • However, each crime has a marginal cost
      • Getting caught
      • His conscience
    • The more crimes a criminal does the more likely he is to get caught
    • His market for crime is below

• If government passes stricter prison sentences for criminals, then marginal cost of crimes increases and MC shifts left
  • Price of doing a crime increases
  • Criminal does less crimes

Deriving A Demand Function - Advanced Material

A consumer maximizes his utility given his budget constraint

• From Chapter 1, a budget constraint was already shown
• Budget constraint - shows how much a consumer can purchase from two goods given his income and product prices
• Example - The easy way
  • A person's income is $1,000
  • Price of pizza is $10
  • Price of soda is $1
• Math:
  • If a consumer spends all his money on pizza, then he can buy 100 pizzas
  • If a consumer spends all his money on sodas, then he can buy 1,000 sodas
  • Budget constraint is shown below

• A person has a set of preferences for pizza and sodas
  • Indifference curves - shows how much utility a consumer gets from consuming two goods
    • The graph has three sets of preferences
      • Each indifference curve is a level of utility, and shows how much sodas and pizza yield that level of utility
    • The further right this consumer goes, then the more utility that person has from pizza and sodas
    • IC ₃ gives higher utility than IC ₂, and IC ₂ gives higher utility than IC ₁

• How do we know preferences have this shape
• Based on Law of Diminishing Marginal Utility
  • Marginal Rate of Substitution (MRS) - the consumer is willing to give up some pizza to get more soda
    • Slope of the line where it touches the indifference give in one spot
  • MRS ₁ - drawing a triangle to indicate the slope of the line
    • Person has lots of pizza but little soda
    • Notice the height of the triangle is greater than the width
    • Person is willing to give up a lot of pizza to get a little more soda
  • MRS ₂ - At this point, person has lots of soda but little pizza
    • The triangle has a small height but a large amount of soda
    • For this person to give up a little pizza, you have to get him a lot more sodas (he already has plenty).

• A consumer's budget line restricts how much goods a consumer can consume
• Looking at the graph below, the consumer wants to maximize utility
  • Assume his income is $1,000 and prices for both pizza and soda is $1
• The highest indifference curve he can attain is IC ₂
  • At that point, he consumes 50 pizzas and 400 sodas

• Demand is simple to derive
• Assume the price of soda increases from $1 to $2, then budget line shifts inward for sodas
• Consumer will try to obtain highest indifference curve, which is IC ₁
• Consumer's utility is lower, but the price of soda increased, thus he consumes less

• We can graph the demand for sodas
  • When price of soda is $1, he consumes 400 sodas
  • When price of soda is $2, he consumes 100 sodas
• His demand function for soda is shown below

Terminology