Theory of Consumer    Behavior

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Theory of Consumer Behavior

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1. Chapter 4 Theory of Consumer Behavior

5. Budget Equation

6. Budget Line/Consumption Possibility Line/Budget Constraint

7. Example: If Lisa has an income of RM30 a month to spend. She buys two goods pizzas (cost RM6 each) and pepsi (RM3 for a bottle). If Lisa spends all of her income, she will reach the limits to her consumption of pizzas and pepsi as follow:

8. Factors that shifts the budget Line

10. Factors that shifts the budget Line A Change in Income An increase in the consumer’s money income shifts the budget line rightward. The slope of the budget line does not change (parallel) Example : The following new budget lines show how much Lisa can consume (while the prices of pizzas and pepsi remain constant) if her income change to a)     RM15 a month; and b)     RM60 a month

12. A household's decision about what to consume depends on two general factors : The household's budget Constrained by income and the price of the goods, which are summarized by the household's budget line. The budget constraint specifies the combination of goods the consumer can afford to buy. Preferences Economists use the concept of utility to describe preferences

13. Consumer behavior can be explained using two main approaches: Marginal Utility Theory (The Cardinalist approach) Indifference curve Analysis (The Ordinalist Approach)

14. Marginal Utility Theory (The Cardinalist approach) Alfred Marshall who introduced an imaginary unit called the util as a means of measuring utility This theory is based on the premise that the amount of satisfaction or utility obtained from the consumption of a particular product can be measured in the same way that physical units can be measured Other related issue : How we measure temperature

15. What is UTILITY The benefits or satisfaction that a persons gets from the consumption of good or service. What is TOTAL UTILITY The total benefits/satisfaction obtained from all the units of a particular product consumed. It depends on the person’s level of consumption more consumption generally give more utility What is MARGINAL UTILITY The additional utility derived from the consumption of one or more units of the product It reflect the Principle of Diminishing Marginal Utility

16. Principle of Diminishing Marginal Utility A consumer has diminishing marginal utility from a good if each unit of the good consumed adds less to total utility than the unit before. The more an individual has of a product, the less marginal utility will be from each additional unit consumed. Marginal Utility = Changes in Total Utility Changes in Quantity

19. The marginal utility decreases as the quantity of the good consumed increases - The principle of diminishing marginal utility. Lisa’s Total Utility and Marginal Utility from ice-cream

20. Maximizing Utility Consumer equilibrium is a situation in which the consumer has selected the combination of goods and services that maximize his or her total utility. In considering the consumer equilibrium, the following assumptions are made for the individual: 1.      has a limited income 2.      acts in a rational manner - aims to maximize his/her total utility subject to the income constraint Total utility is maximized when all the consumer’s income is spent and when the marginal utility per dollar spent is equal for all goods

21. The marginal utility per dollar is the marginal utility obtained from the last unit of a good consumed divided by the price of the good. The equation states that the consumer equilibrium is where the marginal utility from the last dollar spent on product x equals to the marginal utility from the last dollar spent on product y equals to the marginal utility from the last dollar spent on product n.

22. `Example : Assuming that consumer’s income = RM7, price of Good A = RM1 per unit and price of Good B = RM1 per unit

23.  Predictions of Marginal Utility Theory Marginal utility theory predicts how a change in price and income affect the amount of each good consumed Refer to the previous example, when the price of Good A falls to RM0.50, what would be the new equilibrium?

24. Criticisms of Marginal Utility Theory Measuring Utility is Impossible. Utility need not be measurable to make predictions about how people respond to changes in prices or income because utility can not be observed. “People aren’t that smart” People can’t be expected to perform the mathematical calculations assumed by marginal utility theory. Only in the “model” economy do we assume that people make the marginal utility calculations; the theory predicts that, in the real world, people’s choices are similar to those suggested by the marginal utility theory.

25. Implications of Marginal Utility Theory Consumer Surplus Consumer surplus is the difference between the value that a consumer places on a good and the price that the consumer actually pays for the item. The Paradox of Value The paradox of value asks : “Why is water, which is essential to life, cheaper than diamonds, which are not essential?”

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