Consumer Behavior - Utility Theory

1 Consumer Behavior - Utility Theory At this point we want to start examining the economic decision-making of individual entities in the economy. That is, individual consumers, households, firms, and industries. This is really the start of Microeconomics. Although it takes both D & S to make a market and to determine a price level, it is often felt that it is consumers, those entities whose decisions are reflected by demand, who are the major driving force in the market. This belief tends to have some validity since if you consider it for a moment you'll realize that we tend to focus more on consumption at various stages in our lives than we do on production.

2 When you are very young and very old you are more of a Consumer than a producer. It is during that middle part of your life that you are, in general, the most productive. Therefore we'll start by looking at the demand side of the market. We will examine Consumer Behavior and develop a model that shows:1.) How consumers make consumption decisions; that is, how they determine what portion of their income to spend on various ) Why the demand for some G/Ss is more elastic than the demand for other , we will be developing a model of Behavior that explains DEMAND and the rationale behind the downward sloping D curve.

3 This is termed Utility is a somewhat abstract concept. What you buy/consume depends partly upon your preferences/tastes (and also on resource constraints).You want what a G/S provides - the satisfaction of some want - not the actual G/S is simply a method of ranking/ordering your preferences. Preferences are themselves anintangible concept, but in general wouldn't you agree that your preference for a certain good is linked in a positive way to the amount of satisfaction that you derive from the consumption of that good?

4 Earlier we used the term Utility to denote the satisfaction of wants. Additionally, we made the assumption that: "man is a rational self-interested Utility maximizer".Basically then, what we are going to do is examine how you expend your resources so that your Utility is maximized. This discussion assumes that you can't affect prices!And, since earlier we noted that because of scarcity consumers can't have everything that they want we'll have to maximize Utility subject to constraints. These constraints are our budget and prices.

5 This model then is going to take into consideration 3 things:Income, Prices and Consumer preferences ( given by Utility comparisons).Most discussions of Utility at this level use a numerical measure of Utility . This is fine as a pedagogical tool but there are a lot of caveats that should be ) Utility CANNOT BE MEASURED IN AN ABSOLUTE SENSE! That is, you cannot measure it quantitatively/numerically. How much satisfaction/benefit do you get from the consumption of some good such as your favorite beverage? Can you give me some numerical magnitude that has meaning?

6 I can't. You can indicate the order of your preference, you can state that goodx P goody. You can measure it in an ordinal sense such as 1st., 2nd. etc. So why do we express Utility quantitatively? Because it facilitates the explanation of the concept of MU. But remember that any numbers used here are essentially plucked out of the air. They are only ) Utility IS SUBJECTIVE AND CAN CHANGE OVER TIME. What gives one person a lot of satisfaction may not give another person the same satisfaction. And you may not get the same amount of satisfaction in the future as you do now.

7 EXAMPLE: CLOTHES; They go in and out of are 2 measures of Utility that we need to define and Utility (TU) - The total amount of satisfaction received from all units consumed of a Utility (MU) - The change in total Utility from consuming one more unit of a is used here in the same sense as TU Q TU= MULet's take an example:Assume that you are given:# of diet Coke Consumed Utility of each then you have TU & MU 0 - 0 - 1 10 10 10 2 15 25 15 3 8 33 8 Clearly you would not consume the 2nd.

8 Diet coke which has 15 units of satisfaction after the first which only has 10 units thus the order of consumption is relevant or the ranking of the additional Utility of another unit consumed, be it the 2nd., 3rd., 4th., or whatever, have to be >, <, or the same as the Utility of the previous unit?Normally, if a good can be used to satisfy more than 1 want, you would use the first unit to satisfy the greatest want first and any successive units to satisfy lesser wants. For example: You are stranded in the desert, you are filthy and you are dying of thirst.

9 A rescuer arrives and gives you water. Would you drink or wash first? You would probably drink the first few units until you were no longer thirsty and then if there were any remaining units you would then wash! The implication is that succeeding units satisfy lesser wants or that you get lesser Utility from succeeding gives us the: LAW OF DIMINISHING MARGINAL Utility - the MU gained by consuming equal and successive units of a G will eventually decline as the amount of a G consumed increases - all other things held things to note about MU and TU:1.

10 As long as MU > 0, then TU is increasing;2.) when MU < 0, then TU is decreasing. Does it make sense to stop consuming then when MU = 0 unless you are constrained prior to this point? YES!!One of our goals here is to determine how we maximize Utility subject to our income and price constraints and in the process see if we can determine a general rule for this that will also tell us how much of a particular good a Consumer will develop this let's again take an example: Assume that there are only two goods to which we allocate our budget.