Consumer Behavior &

Utility Maximization

ECO 2023Chapter 7Fall 2007

Created by: M. Mari

Terminology

• Utility – the satisfaction or enjoyment that you receive from a choice or consumption of a good– subjective

• Total utility – total amount of satisfaction or pleasure from consuming some specific quantity of a good

• Marginal utility – the extra utility from consuming one more unit of the good

Utility Analysis

• Utility– Satisfaction or enjoyment from an

action– Subjective– Depends on tastes– Economists assumes simply that

tastes are given and are relatively stable

Law of Diminishing Marginal Utility

The law states: that as a consumer consumes more units of product, the marginal or additional utility that he or she will receive from the product declines

GraphicallyUtility increases as consumption increases until it reaches a maximum and begins to drop.

Total

Utility

Units consumed

Law of Diminishing Marginal Utility

• Explains why the demand curve for a given product slopes downward.

• If successive units of a good yield smaller and smaller amounts of marginal, or extra, utility, then the consumer will buy additional units of a product only if its price falls.

Theory of Consumer Behavior

• The law of diminishing marginal utility explains how consumers allocate their money incomes among the many goods and services available for purchase.

Consumer Choice and Budget Constraint

– A typical consumer’s situation has the following dimensions

• Rational behavior• Preferences – clear cut preferences for

certain of the goods and services that are available in the market

• Budget constraint – consumer has a fixed or limited amount of money income

• Prices

– Different individuals will choose different mixes of goods and services that most satisfy him or her

Utility Maximizing Rule:

• To maximize satisfaction, the consumer should allocate his or her money income so that the last dollar spent on each product yield the same amount of extra utility

Example

• Product A: Price = $1• Product B: Price = $2

Units Marginal Utility (units)

MU/P Marginal Utility

MU/P

1 10 10 24 12

2 8 8 20 10

3 7 7 18 9

4 6 6 16 8

5 5 5 12 6

6 4 4 6 3

7 3 3 4 2

Income and Substitution Effects

• Income Effect: is the impact that a change in the price of a product has on a consumer’s real income and consequently on the quantity demanded of the good

• Substitution Effect: is the impact that a change in a product’s price has on its relative expensiveness and consequently on the quantity of the good demanded.

• The income and substitution effect combine to increase a consumer’s ability and willingness to buy more a specific good when price falls.