What will you learn in this chapter?
• How revealed preferences relate to utility.
• How budget constraints affect utility maximization.
• How income affects consumption choices.
• How prices affect consumption choices and how to distinguish between income and substitution effects.
• How utility is influenced by outside perceptions, and how people get utility from altruism and reciprocity.
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1© 2014 by McGraw‐Hill Education 1
Chapter 7
Consumer Behavior
© 2014 by McGraw‐Hill Education 2
What will you learn in this chapter?
• How revealed preferences relate to utility.
• How budget constraints affect utility
maximization.
• How income affects consumption choices.
• How prices affect consumption choices and how
to distinguish between income and substitution
effects.
• How utility is influenced by outside perceptions,
and how people get utility from altruism and
reciprocity.
© 2014 by McGraw‐Hill Education 3
• Utility is a measure of the amount of
satisfaction a person derives from something.
– Incorporates emotions and sensations.
– Universal measure (or yardstick) that allows
individuals to compare choices.
– Not typically comparable across individuals.
• Rational individuals maximize utility when
making choices.
– For example, if playing soccer for the next hour
yields more utility than playing baseball, rational
individuals will play soccer.
Utility basics
2© 2014 by McGraw‐Hill Education 4
• Utility is hard to measure.
• How can anything meaningful be said about
the utility people experience?
– Observe what people actually do.
• The principle of revealed preference is that
people’s preferences can be determined by
observing their choices and behavior.
• Unique to a specific choice of a particular
person at one date.
Revealed preferences
© 2014 by McGraw‐Hill Education 5
• The principle of revealed preferences isn’t feasible
for analyzing how people make choices.
• Instead, a more formal method is required.
• Utility functions aid in systematically analyzing
choices.
– A utility function is a formula for calculating the total
utility that a particular person derives from consuming
a combination of goods and services.
• A bundle is a unique combination of goods and
services that a person could choose to consume.
Utility functions
© 2014 by McGraw‐Hill Education 6
• Utility functions quantify preferences.
• Utility measurements are relative, not
absolute.
• For example, suppose Sarah receives a utility
of 3 for each serving of mac‐n‐cheese she eats,
2 for broccoli, and 8 for ice cream.
• If she eats 1 serving of mac‐n‐cheese, 2
servings of broccoli, and 2 of ice cream, then:
total utility = (3 x 1) + (2 x 2) + (8 x 2) = 23
Utility functions
3© 2014 by McGraw‐Hill Education 7
• When individuals continue to engage in an activity
or consume more of one good or service, the
utility from the next unit is not as great as the last
unit.
– Marginal utility is the change in total utility from
consuming an additional unit of a good or service.
– The principle of diminishing marginal utility is that the
additional utility gained from consuming successive
units of a good or service tends to be smaller than the
utility gained from the previous unit or service.
• Sometimes, marginal utility becomes negative.
Marginal utility
© 2014 by McGraw‐Hill Education 8
Diminishing marginal utility
Scoops of ice cream-1
0
1
2
3
4
5
6
7
1 2 3 4 5 6 7 8
Marginal utility per scoop
A
Scoops of ice cream
80
5
10
15
20
25
1 2 3 4 5 6 7
Total utility
A
The utility function and the marginal utility can be plotted. An individual
maximizes utility when total utility is greatest or marginal utility is zero.
Marginal utility measures the per
unit utility from each scoop of ice
cream.
Total utility increases with each scoop of
ice cream until point A, the seventh
scoop, at which total utility is maximized.
© 2014 by McGraw‐Hill Education 9
• People have many wants and are constrained
by the time and money available to them.
• Rational individuals maximize utility within
those constraints by spending their resources
on the bundle that yields the highest possible
total utility.
• A budget constraint provides all possible
combinations of goods and services a
consumer can buy for a given income.
Maximizing utility with constraints
4© 2014 by McGraw‐Hill Education 10
The budget constraint
1
2
3
4
5
6
7
8
9
0 1 2 3 4 5
Movie tickets
Concert tickets
A
C
B
Cody can buy 8 movie
tickets for $120
or 4 movie tickets and
2 concert tickets
or 4 concert
tickets.
The budget constraint for two goods is displayed using a movie ticket
price of $15, a concert ticket price of $30, and an income of $120.
• Point A: All income
spent on movies (8
movie tickets).
• Point B: Income spent
on both goods (4 movie
and 2 concert tickets).
• Point C: All income
spent on concerts (4
concert tickets).
• Represents all feasible
bundles.
© 2014 by McGraw‐Hill Education 11
Active Learning: The budget constraint
1
2
3
4
5
6
7
8
9
0 1 2 3 4 5
Movie tickets
Concert tickets
A
C
B
H
I
F
G
D
J
E
K
Which bundle(s) are not within the following budget constraint?
© 2014 by McGraw‐Hill Education 12
Active Learning: The budget constraint
• Find all feasible bundles using a movie ticket price of $15, a
concert ticket price of $30, and an income of $120.
• Is the bundle of 4 concert tickets and 1 movie ticket feasible?
Bundle
Concert
tickets
Movie
tickets
Total
cost
5© 2014 by McGraw‐Hill Education 13
Maximizing total utility
Utility from movie tickets
Number of
tickets Marginal utility Total utility
1 95
2 190
3 285
4 365
5 430
6 465
7 475
8 465
Utility from concert tickets
Number of
tickets
Marginal utility Total utility
1 100
2 185
3 210
4 210
95
95
95
80
65
35
10
‐10
110
85
25
0
Below are the associated utilities from consuming a specific
number of concerts and movie tickets.
Utility increases with each concert ticket
until 3 tickets, at which total utility is
maximized.
Utility increases with each movie ticket
until 7 tickets, at which total utility is
maximized.
© 2014 by McGraw‐Hill Education 14
Maximizing total utility
Bundle
Concert
tickets
Movie
tickets
Utility from
movie tickets
Total
utility
A 0 8
B 1 6
C 2 4
D 3 2
E 4
0
100
185
210
210 0
465
465
365
190
0
465
565
400
210
Utility from
concert tickets
550
To maximize total utility, the total utility of each feasible bundle is
identified and then compared to each other.
• Bundle C with 2 concert tickets and 4 movie tickets has the highest total
utility and is the preferred bundle.
• Given this budget, a rational consumer spends all income on the
combination of movie and concert tickets that maximizes utility.
© 2014 by McGraw‐Hill Education 15
Maximizing total utility
1
2
3
4
5
6
7
8
9
0 1 2 3 4 5
Concert tickets
A
Budget constraint
At point A, utility from
concert tickets is 0 and
utility from movie tickets is
465. Total utility is 465.
B
C
D
E
At point B, utility from
concert tickets is 100 and
utility from movie tickets is
465. Total utility is 565.
At point D, utility from
concert tickets is 210 and
utility from movie tickets is
190. Total utility is 400.
At point C, utility from
concert tickets is 185 and
utility from movie tickets is
365. Total utility is 550.
At point E, utility from
concert tickets is 210 and
utility from movie tickets is
0. Total utility is 210.
Movie tickets
Each bundle on the budget constraint has a corresponding utility.
• Utility falls as one moves away from the preferred bundle, C.
6© 2014 by McGraw‐Hill Education 16
• When a person’s income increases, more
bundles of goods and services become
affordable.
• When income decreases, fewer bundles are
affordable, and consumers will probably have
to cut consumption of some things.
• A change in income is represented by shifting
the entire budget line outward.
Responding to changes in income
© 2014 by McGraw‐Hill Education 17
The effect of an increase in income
• An increase in income
allows individuals to
afford more goods.
• The entire budget line
shifts outward.
2
4
6
8
10
12
14
0 1 2 3 4 5 6
Movie tickets
Concert tickets
1. An increase in
income shifts the
budget curve out.
New budget constraint
2. Cody can now afford as
many as 12 movie tickets
or 6 concert tickets.
Suppose a person’s income increases from $120 to $180.
© 2014 by McGraw‐Hill Education 18
Active Learning: Effect of a decrease in
income
Suppose a mother decides to reduce her child’s movie and concert
allowance. Graphically demonstrate the effect.
2
4
6
8
10
12
14
0 1 2 3 4 5 6
Movie tickets
Concert tickets
7© 2014 by McGraw‐Hill Education 19
Active Learning: Effect of a decrease in
income
Suppose a mother decides to reduce her child’s movie and concert
allowance. Graphically demonstrate the effect.
2
4
6
8
10
12
14
0 1 2 3 4 5 6
Movie tickets
Concert tickets
1. A decrease in
income shifts the
budget curve in.
New budget constraint
© 2014 by McGraw‐Hill Education 20
• When prices change, an individual’s budget
constraint is affected in two ways:
– An income effect occurs as consumption changes from
increased effective wealth due to a lower price.
– The substitution effect is the change in consumption
that results from a change in the relative price of
goods.
• The opportunity cost of consuming a good changes as prices
change.
• A price change causes the budget line to rotate.
Responding to changes in prices
© 2014 by McGraw‐Hill Education 21
The effect of a price change
• When the price of one
good changes, the budget
constraint rotates
outward.
• The new budget line
demonstrates the new
feasible bundles that are
now available.
• The change in the slope
of the budget line reflects
the change in the relative
prices of the two goods.
2
4
6
8
10
12
14
0 1 2 3 4 5 6
Movie tickets
Concert tickets
A change in the price
of one good rotates
the budget curve.
12 movie tickets
are now
affordable.
New budget constraint
Suppose the price of a movie ticket decreases from $15 to $10.
8© 2014 by McGraw‐Hill Education 22
Active Learning: The effect of a price change
• Suppose that the price of a movie ticket increases from
$15 to $30, while the price of a concert ticket and the
consumer’s income stay the same at $30 and $120
respectively.
• Find all feasible bundles of movie tickets and concert
tickets.
Bundle
Concert
tickets
Movie
tickets
Total
cost
© 2014 by McGraw‐Hill Education 23
• People gain utility from a variety of sources.
– Outside perception:
• What others think of your purchases.
• How much others have.
– Inward preferences:
• How you prefer to spend your money.
• Both outside perception and inward
preferences contribute to decision making.
Utility and society
© 2014 by McGraw‐Hill Education 24
• Utility maximization encompasses individuals
giving to others.
– Altruism is a motive for action in which a person’s
utility increases simply because someone else’s utility
increases.
– Altruistic and selfish or image‐conscious motivations
can coexist perfectly well.
• Utility maximization suggests people gain utility by
punishing bad behavior and rewarding good
behavior.
– Reciprocity is responding to another’s action with a
similar action.
Utility, altruism, and reciprocity
9© 2014 by McGraw‐Hill Education 25
Summary
• Economists assume that individuals seek to
maximizes their utility within the limits of their
available resources.
• Individuals are constrained by their income and
the prices of goods they desire to purchase.
• A budget constraint shows all possible feasible
consumption bundles available to an individual
given a fixed budget.
– An increase in income shifts the budget constraint
outward.
– An increase in price causes the budget constraint to
rotate inward.
© 2014 by McGraw‐Hill Education 26
Summary
• Economists generally assume that individuals’
preferences are demonstrated through the
choices that they make, a concept known as
revealed preference.
• Individuals gain utility from a variety of sources.
– Outside perception.
– Inward preferences.
• Utility maximization:
– Individuals giving to others.
– People gain utility by punishing bad behavior and
rewarding good behavior.