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Objectives: At the end of the discussion the students will be able to:
study the consumption choices of people; analyze the preferences of the goods, how higher utility satisfaction is achieved and maximized given a certain level of income; know the concepts of: total utility, marginal utility, and the law of diminishing marginal utility. understand how rational consumers compare marginal utility-to-price ratios for products in purchasing combinations of products that maximize their utility.
Outline:
The Concept of Utility -Utility -Measuring Utility - Total Utility - Marginal Utility Law of Diminishing Marginal Utility Utility Maximization The paradox of value
for understanding the demand side of the market. Study consumer behavior to answer: How do consumers respond to marketing efforts the company might use?
Consumer Buying Behavior refers to the buying behavior of final consumers (individuals & households) who buy goods and services for personal consumption.
Buyer Buyer
Behavior: Culture
Most basic cause of a person's wants Most basic cause of a person's wants
Groups of people with shared Groups of people with shared value systems based on value systems based on common life experiences. common life experiences. North Indian Consumers North Indian Consumers African American Consumers African American Consumers Asian American Consumers Asian American Consumers Mature Consumers Mature Consumers
Behavior: Social
Groups Groups Membership Membership Reference Reference Family Family Husband, wife, kids Husband, wife, kids Influencer, buyer, user Influencer, buyer, user
Behavior: Personal
Personal Influences Personal Influences
Age and Family Life Cycle Age and Family Life Cycle Stage Stage Economic Situation Economic Situation Occupation Occupation Personality & Self-Concept Personality & Self-Concept
Needs and Motives Need: an imbalance between a consumers actual and desired states Motives: inner states that direct a person toward the goal of satisfying a felt need
UTILITY THEORY . . .
What
UTILITY is
Dictionary
defines UTILITY as usefulness, service, value, worth or benefit In Economics, UTILITY means the benefit or satisfaction that aperson gets from the consumption of a good or service. UTILITY is the basis of choice
The
There
is a way in Economics that will quantify or measure utility or satisfaction through the concept of UTIL UTIL is an artificial construct or arbitrary number used to measure utility or satisfaction
Cardinal Utility Approach - refers to the measurement of utility by assigning numerical values, referred to as utils, such as 1 util, 12 utils, 140 utils or -35 utils. - assumes that we can assign values for utility, (Jevons, Walras, and Marshall). E.g., derive 100 utils from eating a slice of pizza - attaches specific numbers to different levels of satisfaction
Ordinal Utility Approach - measures utility in terms of ranks, such as those indicating levels from most satisfying to least satisfying, best to worst, and highest to lowest.
-does not assign values, instead works
EXAMPLE
+
30 utils 20 utils
+
50 utils
This just shows that one can ASSIGN a number of UTILs to each GOOD. This is a subjective value because it depends on the persons level of SATISFACTION derived from CONSUMING a GOOD.
concept of utility helps us to make predictions about consumption choices. But Marginal Utility Theory is NOT as precise as the concept of Utility.
UTILITY The TOTAL satisfaction a person receives from consuming a particular quantity of a good MARGINAL UTILITY The ADDITIONAL utility a person receives from consuming an TU extra unit of a particular good. MU =
Q
TOTAL UTILITY
Depends
on the quantity of the good consumed more consumption generally gives more total utility. Total utility generally increases as the quantity consumed of a good increases.
TU, in general, increases with Q At some point, TU can start falling with Q (see Q = 6) If TU is increasing, MU > 0 From Q = 1 onwards, MU is declining principle of diminishing marginal utility As more and more of a good are consumed, the process of consumption will (at some point) yield smaller and smaller additions to utility
TU2 TU1 = MU1 (extra utils derived from consuming one more cup of coffee
CUPS OF COFFEE TOTAL UTILITY MARGINAL UTILITY
0 1 2 3 4 5
TU1 0 TU2 10 19 27 34 40
TU2 TU1 = MU1 (extra utils derived from consuming one more cup of coffee
CUPS OF COFFEE TOTAL UTILITY MARGINAL UTILITY
0 1 2 3 4 5
TU1 0 TU2 10 19 27 34 40
10 - 0= 10 19 - 10= 9 27 19 = 8 34 27 = 7 40 34 = 6
MARGINAL UTILITY
10 - 0= 10 19 - 10= 9 27 19 = 8 34 27 = 7 40 34 = 6
=The general tendency of marginal utility to decrease as the quantity of a good consumed increases.
The gains in satisfaction will decline as successive units of a given product are consume
Consumers will buy as much as pleases them, with their income. As each additional unit is purchased, the excess satisfaction gained from each purchase decreases, until it becomes irrational to continue purchasing.
For example, one slice of pizza may give you much satisfaction, as does the second slice. The third slice makes you extremely full, while the fourth slice makes you nauseous. At this point, it becomes irrational for you to purchase additional slices of pizza.
20 15 10 5 0 -5 1 2 3 4 5 6 Quantity Q
Figure 4.2
of the reasons is the LAW OF DIMINISHING MARGINAL UTILITY The inverse relationship of price and quantity demanded is partly explained by the law of diminishing marginal utility. As one consumes successive units of a specific good, the less will be the utility it can give. Therefore, since this will give lower utilities, the price of the good must decrease.
I will only buy more units of the good if you will give me a discount! Or make the good cheap so that I can buy large quantities of the good. Since the satisfaction I get from consuming extra units of good decreases, I will only buy the good at a lower price!
P1 P2
Q1
Q2
Consumer Equilibrium
So
far, we have assumed that any amount of goods and services are always available for consumption In reality, consumers face constraints (income and prices):
Limited
wants to get the most for his money or maximize total utility PREFERENCES desires certain goods Clear cut preference for goods and services. Buyers have a good idea of how much marginal utility they may have in successive units of the various products they might purchase. BUDGET CONSTRAINT - faces budget limitation because of limited money income PRICES considers the prices of goods
The
goal of a consumer is to maximize satisfaction or utility given the limited income. This is accomplished by applying the marginal utility concept. Given the limited income and the prices of goods, the consumer would want to obtain the highest utility possible.
Maximizing Rule: -The rule that leads to the greatest total utility from all the goods and services consumed. The rule is: 1. Allocate the entire available budget. 2. Make the Marginal utility per peso spent the same for all goods.
objective: to maximize his/her utility subject to income constraint 2 goods (X, Y) Prices Px, Py are fixed Consumers income (I) is given
Consumer Equilibrium
Marginal
utility per peso additional utility derived from spending the next peso on the good
MU M U p e r p e=s o P
Consumer Equilibrium
Optimizing
condition:
X
M U PX
If
M U = P Y
M X M Y U U > PX P Y
Utility theory helps us to deepen our understanding of the concept of efficiency and to see more clearly the distinction between value and price. Lets see how . . .
Utility Maximization Rule: to maximize satisfaction, a consumer should allocate his or her money income so that the last peso spent on each product yields the same amount of extra utility. Marginal Utility per peso should be equal for each product you buy!
Simple Illustration
Suppose:
Numerical Illustration
Qx 1 2 3 4 5 6 TUX 30 39 45 50 54 56 MUX 30 9 6 5 4 2 MUx Px 15 4.5 3 2.5 2 1 QY 1 2 3 4 5 6 TUY 50 105 148 178 198 213 MUY 50 55 43 30 20 15 MUy Py 5 5.5 4.3 3 2 1.5
Combination
B:
Y=5
TU
X = 5 and
Presence of 2 potential equilibrium positions suggests that we need to consider income. To do so let us examine how much each consumer spends for each combination. Expenditure per combination Total expenditure = PX X + PY Y
Combination
Scenarios:
If
consumers income = 46, then the optimum is given by combination A. .Combination B is not affordable If the consumers income = 60, then the optimum is given by Combination B.Combination A is affordable but it yields a lower level of utility
Water
is more valuable than a diamond because water is more essential to life itself. Yet water is much cheaper than a diamond. Why? Adam Smith tried to solve this paradox, but it was not until marginal utility theory had been developed that anyone give satisfactory answer.
Consumer Surplus
The paradox of value emphasizes that the recorded monetary value of a good may be a misleading indicator of the total economic value of that good. The measured economic value of the air we breathe is zero, yet airs contribution to welfare is immeasurably large. The gap between the total utility of a good and its total market value is called consumer surplus. The surplus that arises because we receive more than we pay for as a result of the law of diminishing marginal utility. We have consumer surplus basically because we pay for the same amount for each unit of a commodity that we buy, from the first to the last.
Activity:
Answer the following questions briefly: 1. Do we always have limitations in consuming goods? Defend your answer. 2. Why do people go for more expensive goods rather than cheaper goods? 3. When you get stranded in a desert for a long time, which do you think has more value, water or diamond? Discuss your answer. 4. 4. Why is it necessary for us to spend our budget wisely?