Chapter Twenty One: Consumer Behavior and Utility Maximization

I. A Closer Look at the Law of Demand A. Review: there are two main reasons why the law of demand works: 1. Income and Substitution Eects a. Income eect: The impact that a change in price has on a consumers purchasing power. b. Substitution eect: The impact that a change in price has on the relative expensiveness of said product. 2. Law of Diminishing Marginal Utility a. As quantity procured increases, the marginal utility received from each unit lowers. i. Terminology: a. Utility: want satisfying power i. Utility and usefulness are not synonymous. ii. Utility is subjective. iii. Because utility is subjective, it is hard to quantify. b. Total Utility and Marginal Utility i. Total utility (TU): The total amount of satisfaction or pleasure a person derives from consuming some specic quantity of a good or service. ii. Marginal utility (MU): The extra satisfaction received from an additional unit of said product. iii. The relationship between TU and MU demonstrates the law of diminishing marginal utility. c. Marginal Utility, Demand, and Elasticity i. If marginal utility falls sharply as consumption increases, demand is inelastic. ii. If marginal utility declines slowly as consumption increases, demand is elastic. B. Theory of Consumer Behavior 1. Consumer Choice and Budget Constraint a. A typical consumer situation has the following dimensions: i. Rational behavior : Consumers try to derive the greatest amount of utility. ii. Preferences: Each consumer has clear-cut preferences for certain goods available. iii. Budget constraint: At any point in time, the consumer has a xed and limited income. iv. Prices: Goods are scarce relative to demand, so every good carries a price tag. b. As a result, the consumer must conpromise by nding the most satisfying mix of goods/services. 2. Utility-maximizing rule: consumers should allocate their money income so that the last dollar spent on each product yields the same amount of marginal utility. a. To make the amounts of marginal utility derives from dierently priced goods comparable, marginal utilities must be put on a per-dollar-spent basis.
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M U of product A P rice of A

M U of product B P rice of B

C. Utility Maximization and the Demand Curve 1. Deriving the Demand Schedule and Curve a. We can derive a downward-sloping demand curve by changing the price of one product in the consumer-behavior model and noting the change in the utility-maximizing quantity of that product demanded. D. Applications and Extensions 1. DVDs and DVD players 2. The Diamond-Water Paradox 3. The Value of Time 4. Medical Care Purchases 5. Cash and Noncash Gifts