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CONSUMER BEHAVIOR
1. SATISFACTION M AXIMIZATION
1.1 DECISION MAKING AT THE MARGIN
Rational consumers choose items for which they receive the best value for money. They aim to maximize their satisfaction from the consumption of goods. In other words, they make their decision at the margin by weighing the marginal benefits against the marginal costs.
1.4 THE LAW OF DIMINISHING MARGINAL UTILITY
The marginal utility of a good declines as the consumption of a good increases. Each additional unit consumed will either give more or less utility. The tendency of the marginal utility to decline is known as the law of diminishing marginal utility. At some level, utility will be at its maximum, and no extra satisfaction can be gained by the consumption of further units.
MARGINAL COST
The additional cost of consuming or producing one more unit of a good.
MARGINAL BENEFIT
The additional benefit of consuming or producing one more unit of a good.
1.2 UTILITY
Utility is the satisfaction derived from consuming a number of units of a good in a given period of time.
ASSUMPTIONS/CONDITIONS
1. Consumer must be rational 2. Consumer purchases two goods at a time
4. Consumer fully utilizes income
THE PRINCIPLES OF THE LAW OF DIMINISHING MARGINAL UTILITY
This is explained by the following example. Assuming the consumer has a disposable income of 18,
1.3 MARGINAL UTILITY
Marginal utility is the additional satisfaction gained from consuming an extra unit of a good within a certain time period.
PX = 1 PY = 3
Maximum TU occurs when MU=0 6X+4Y = 18 At QX = 6 and QY = 4, equilibrium and full use of income is achieved.
1.5 WEAKNESSES OF THE LAW OF DIMINISHING MARGINAL UTILITY
1. Utility cannot be measured in absolute terms. It is not possible to give an exact value of how much the marginal utility of one good exceeds the marginal utility of another. 2. Marginal utility is based on satisfaction. Under the influence of advertising, consumers may not obtain the satisfaction they expected to.
3. Some consumers associate status with the price of goods consumed. Habit-forming products also do not follow the law of diminishing marginal utility. The theory does not explain the demand for goods with an upward sloping demand curve.
1. If good X is a normal good, the consumer will want to buy more because of the income effect. This means that both the income and substitution effects make the consumer want to buy more. 2. However, if good X is inferior, the consumer will actually want to buy less as they can now afford to buy more luxurious goods. However, note that the substitution effect is said to outweigh the income effect, as people are more likely to prefer the lower price as compared to the more luxurious status.
2. THE BUDGET LINE
2.1 DEFINITION
A budget line shows what combination of two goods a consumer can buy at a given income and at a certain price level. For example, If Y = 100, PX = 2, and PY = 1
4. THE DOWNWARD S LOPE OF THE DEMAND CURVE ACCORDING TO THE M ARGINAL UTILITY THEORY
Consumer equilibrium in a one commodity world is at the point where . The amount a consumer is willing to spend on a good depends on the desire for the good, which is dependent on the marginal utility derived from the good. The higher the marginal utility, the more desirable the good and the higher the price one is willing to pay. As consumption increases, the marginal utility decreases and therefore only lower prices can induce a higher level of consumption. Thus, the marginal utility curve corresponds to the individual downward-sloping demand curve. The consumer will go on purchasing more of a good until its marginal utility in terms of money equals its price. Therefore, as seen in the table, as the price of the good rises, the equilibrium quantity falls.
2.2 FACTORS INFLUENCING THE BUDGET LINE
INCOME
Changes in income cause a parallel shift of the budget line. An increase causing an outward shift, and a decrease causing an inward shift.
PRICES OF X AND Y
Changes in the prices of X and Y will cause the maximum possible quantity of purchase of a good to rise or fall. Thus changes in the price of X will cause the curves point on the X-axis to shift, whilst the point on the Y-axis to remain where it is.
5. PARDOXICAL VALUES
For certain goods, the price does not reflect importance, but rather satisfaction. For example, water and diamonds.
3. THE PRICE EFFECT OR THE SUBSTITUTION AND INCOME EFFECT
If the price of a good falls, the quantity demanded will usually increase. This is due to the substitution and income effect. Think of their combined effect as the price effect, which can be thought of as the direction of the demand curve, up or down.
6. PARETO EFFICIENCY
Pareto efficiciency occurs when increasing the utility of Good Y without affecting the utility of Good X is possible.
A SUBSTITUTION EFFECT
When there is a fall in the price of good X, X becomes relatively cheaper when compared to other goods and therefore there will be a desire to buy more of good X. Consumers inevitably switch to the relatively cheaper good.
AN INCOME EFFECT
When the price of good X falls, the consumer has more real income. If he or she bought the same amount of goods as before the change in price, there would be excess money. Thus the consumer now has more purchasing power.
