Chapter 21 – Consumer Behavior and Utility Maximization
Income and Substitution effect
Income Effect – The effect that as price declines, a consumer’s “real income” increases, their purchasing power increases and therefore the demand for the product also increases
Substitution effect - When the price of a good decreases, it becomes a relatively better buy and thus more attractive to the buyer
The combination of the Income effect and the Substition effect drives the law of demand
Law of Diminishing Marginal Utility – we already studied this – this is the law that as you buy more and more of an item, subsequent purchases are worth less and less
Utility –the want-satisfying power of a good, not necessarily the usefulness (ex Paintings), Utility of goods is much different for different people
It is difficult to quantify (b/c it is subjective) but utils are units of satisfaction
Total Utility and Marginal Utility
Total Utility is the number of utils a consumer derives from a particular number of goods (of the same kind,)
Marginal Utility – the number of extra utils a consumer receives from buying more of something
Marginal Utility, Demand and Elasticity
How does the law of diminishing marginal utility explain why the demand curve for a given product slopes downward? If the marginal utility of an object decreases, then the things are worth less and less, thus they will be willing to pay less and less for them
Consumer Choice and Budget Constraint
Rational Behavior – People try to maximize their utils of satisfaction from their income
Preferences – Consumers have preferences and know the utility they will get from successive, marginal purchases
Budget Constraint – At any time, the consumer has a limited amount of money to spend
Prices – Goods are scarce relative to the demand for them, so every good carries a price tag
Utility Maximizing rule – The consumer should allocate his or her money income so that the last dollar spent on each product yields the same amount of extra (marginal) utility
Marginal Utility per dollar –to make the amounts of extra utility derived from differently priced goods comparable marginal utilities must be put on a per dollar spent basis
Algebraic restatement: The Marginal utility per dollar spent on A is the MU of the product/price so
(MU of product A)/Price of A = (MU of Product B)/Price B = (MU of Product C)/Price C etc
Utility Maximization and the Demand Curve
Deriving the Demand Schedule and Curve – By looking at the Marginal Utility per dollar data we can find how many items a consumer will purchase at any particular price based on their utility
Income and Substitution effect revisited – Switch between products in order to satisfy the Utility maximizing rule
The Value of Time – Time has a value so when considering the price of goods/services, include the price of the persons time (hourly wage). For example it makes since for a business executive to fly somewhere rather than take a bus there because while the cost of the bus may be quite less, the cumulative cost of fare + time spent*hourly wage is much greater for the bus
People eat more at buffet meals because the marginal utility is positive and the price is zero
Budget Curves – The relative amount of two goods that a consumer can buy
Indifference Curves – All the combinations of two products that will yield the same total satisfaction or utility. They are Downsloping, Convex to the Origin – the slope measures the maginal rate of substitution
If we superimpose the budget line on an indifference map (set of indifference curves that yield different total utilities) The point of tangency between the budget line and one of the indifference curves is the equilibrium position
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