Chapter 7:  Consumer Behavior

This chapter explains the law of demand in terms of (1) the income and substitution effects of a price change and (2) diminishing marginal utility.  The latter leads us into a detailed discussion of the theory of consumer choice.

Income and Substitution Effects:   The income and substitution effects of a price change explain the inverse relationship between price and quantity demanded.  The income effect is the impact of a change in the price of a good on the purchasing power of consumers' incomes (real income).  An increase in price decreases real income, and a decrease in real income means consumers will purchase less of all normal goods including the good in question.  The substitution effect is the impact of a change in a product's price on its cost relative to other substitute products. A higher price for good A with no change in prices of substitute goods means that good A has become relatively more expensive compared to the substitutes.  In order to maximize satisfaction within the limits of one's income, the consumer will tend to substitute away from those goods that are relatively more expensive to those substitute goods that are relatively less expensive.  Ergo, when the price of Good A increases, consumers will buy less of it.

Diminishing Marginal Utility:    The law of diminishing marginal utility is a second explanation of the downward sloping demand curve.  As a consumer purchases additional units of a good, the extra or marginal benefit declines.

   Utility is a subjective notion in economics, referring to the amount of satisfaction one gets from consumption of a certain item. Utility has nothing to do with usefulness!  We use the "util" as a unit of measurement in order to understand the concept, although there is no way to measure units of satisfaction or utility.

   The relationship between total utility and marginal utility is a critical point.  As one consumes additional units of a good, total utility increases (up to a point), but at a decreasing rate.  The rate of change in total utility is marginal utility.  Spend some time with Figure 7.1 and observe that:

   (a)    When MU is positive and declining, TU is increasing at a decreasing rate.

   (b)    When MU is zero, TU is at its maximum.

   (c)    When MU is negative, TU is declining.

   The law of diminishing marginal utility is related to demand and price elasticity of demand.

   (a)     Successive units of a product yield smaller and smaller amounts of marginal utility, so the consumer will only buy more if the price falls.

   (b)    If marginal utility falls sharply as successive units are consumed, demand will be more price inelastic.  In other words, demand must fall by a relatively large amount before consumers will buy more.

Theory of Consumer Behavior:

    This section attempts to explain how consumers allocate their scarce income in order to maximize their total utility or satisfaction.  The theory assumes that consumers act rationally, that they have preferences, that they have limited incomes, and that goods vary by price.

    The utility maximizing rule states that the consumer should allocate her scarce income in such a way that the marginal utility per dollar spent on all goods is equal. Algebraically, the consumer will allocate  income such that

    MU_A/P_A =  MU_B/P_B = MU_C/P_C = ^{....................}MU_N/P_N

We will work through the example on pages 129-130. 

You should read and be familiar with the applications on pages 132-134.

Applications: 

I.    Complete Key Questions #3 and #4 at the end of Chapter 7

II.    Why does a newspaper dispenser open to a stack of newspapers and essentially "trusts" a consumer to take only one copy whereas a soft drink vending machine does not "trust" the same consumer and only dispenses one can for each purchase?

III.    A person has a basic choice between eating meals at home and eating meals at a restaurant.   The cost of the food that is eaten at   home is $10 per meal .  The cost of a restaurant meal is $20.  It takes two hours to eat a meal at home (including preparation time and cleanup).  It takes one hour to eat a restaurant meal.  The marginal utilities of the two meals are the same.  The person works at a job that pays $12 per hour.  What does the theory of consumer behavior suggest the rational consumer will decide to do: eat at home or in a restaurant?  Answer first by excluding the value of time from the decision.  Then include the value of time.