Department ofEconomics, Management and Humanities Czech Technical University in Prague
ECONOMICS SLlO~ S LECTURE NoA
CONSUMER BEHAVIOR AND UTILITY MAXIMIZA TI ON Handout
Doc. Ing. Helena Fialová, CSc. Ing. Jan Jandera
Prague
2000/2001
Lecture 4 CONSUMER BEHA VIOR and UTILITY MAXIMIZA TI ON THE LAW OF DEMAND: 2 EXPLANATIONS 1. Income and substitution effects * The ineome effeet A decline in priee of respeetive produet inereases the eonsumer's real income (purehasing power). * The substitution effeet Consumers will substitute the eheaper produet for other produets.
The income and substitution effect combine to make a consumer able and willing to buy more of a specific good at a low price than at a high price. 2. Law of DIMINISHING MARGINAL UTILITY Utility is the benefit or satisfaction a person receivesfrom consuming a good or service. Utility is a subjective notion (usefulness is different). We can measure utility with units called "utils".
TOTAL AND MARGINAL UTILITY (Fig. 4.1) Total utility is the total amount of satisfaction or pleasure a person derives from consuming some specificquantity of a good or service. Marginal utility is the extra satisfaction a consumer realizes from an additional unit of that product. The law oj diminishing marginal utility indicates that the gains in satisfaction will decline as successive units of a given product are consumed. TYPICAL CONSUMER'S SITUATION * Rational behavior * Preferenees * Budget restraint * Priees
1
UTILITY MAXIMIZING RULE (Fig. 4.2) The last dollar spent on each product purchased yields the same amount of marginal utility. MUA PA
MUB - -------
=
PB
MUo Po
INDIFFERENCE CURVE ANALYSIS BUDGET LINE (Fig. 4.3) A budget line shows various combinations of two products which can be purchased with a given money income.
A budget line is influenced by * income changes (Fig. 4.4 a) * price changes (Fig. 4.4 b) Budget line reflects "objective market data" (combinations of goods which are attainable, given money income and prices).
INDIFFERENCE CURVES An indifference curve shows all combinations of products A and B which will yield the same totallevel of satisfaction or utility to the consumer. Indifference curves embody "subjective" information about consumer preferences for A and B. (Fig. 4.5) Indifference curves are downsloping and convex to origin (the slope becomes flatter or diminishes ).
The slope of the indifference curve measures the MARGINAL RATE OF SUBSTITUTION (MRS). MRS is the rate, at the margin, at which the consumer will substitute one good for the other to remain equally satisfied.
INDIFFERENCE MAP (Fig. 4.6) A map consisting of a number of indifference curves which show different level of total utility.
2
THE CONSUMER'S EQUILIBRIUM POSITION Tbe point wbere tbe budget line is tangent to tbe bigbest attainable indifference cUl"Ve.(Fig. 4.7) Tbe slope of tbe bigbest attainable indifference cUl"Ve(wbicb reflects MRS) equals tbe slope of tbe budget line (PsIP A). PH MRS=PA
DERlVING THE DEMAND CURVE (Fig. 4.8) The Diamond- Water Paradox
3
Fig.4.1 Total and Man!inal Utilitv
Total Utility
10
Marginal Utility
u
5
5
MU
Q o
12
3 4 5
Q O 1:
2
3 4 5
o
12345
TU MU O ---4 4 7 3 9 2 ---10~1 1O
O
Fig.4.2 The Utilitv-Maximizine: Combination of Products A and B Obtainable with aD IDcome of $10*
"
( )
"'"
,,',
a"."
,',
Fourth
Fifth
Sixth Seventh'
;.,.""
"
utility
per dollar uti Is (MUjprice)
Second, Third
,e
. utility,
'utils
10 8 7 6 5 4 3
(b)
Margi~~1
Marginal utility
10 8 7 6 5 4 3
'
, Marginal
Marginal utility,
F irst
"
24 20 18 16 12 6 4
,
'
,
per dollar (MU/price) 12 10 9 8 6 3 2
*It i~ ?ssume~ir\ this table that the amount of, m?rginal utility received fr~m addlhonal unltsof each of the two produds IS mdepend~nr of the quanhty of the other product. For example, the marginal utility schedule for produd A- is independent '"of the amount of B obtained by ..the consumer. ,
Fig. 4.3 A Budget Line
7
I A
6 Q) Cf) Q) Q)
..c U 4-
o
8G 4
Cf) "O
C
::J o
3
o....
2 1
o
1
2
3 5 6 7 Boxes of Rubber Bands
Fig. 4.4
a) The Eeeect oe Income Changes on the Budget Line 9'U 8
7 a.>
CI) a.> a.>
Ineome = $18
61A
.!:: U 4-
5
o
CI)
-a c
:J
Ineome = $12
4
o a.. 3
Ineome = $9
2 1
I 1
I
O
N "'E
I 2
3
4
I '"
I
5
7
6
8
Boxes of Rubber Bands
b) The Eeeect oe Price Changes on the Budget Line
7
I
ID
6-A
u
5
CI)
4
CI) ID a.> .!::
4o
-a c :J o a..
Rubber band priee = $3 Rubber band priee = $1.50
3 2 1
---
O
1
2
3
5
6
7
Boxes of Rubber Bands
8
H
Fig. 4.5 A Consumer's Indifference Curve
12
«o
->.
.--
c:
10 8
6
('ti ::s C 4
2 O
2
4
6 8 10 Quantity of B
12
Every point on indifference curve I represents some combination of products A and B, and all those combinations are equally satisfactory to the consumer. That is, each combination of A and B on the curve yields the same total utility.
-
-
----
Fig. 4.6 AD IDdiffereDce Map
-o
--
8i
6
c ro 4 ::J O 2
o
2
4
6 8 10 Quantity of B
12
An indifference map is a set of indifference curves. Curves farther from the origin indicate higher levels of total utility. Thus any combination of products A and B represented by a point on 14has greater total utility than a combination of A and B represented by a point on h,12 and h.
Fig.4.7 The Consumer's
EQuilibrium Position
12 10
---
8 6
I:: n3 ::J O 4
2 O
2
4
6 8 10 Quantity of B
12
The consumer's equilibrium position is represented by point X, where the dark budget line is tangent to indifference curve l;. The consumer buys 4 units of A at $1.50 per unit and 6 of B at $1.00 per unit with a $12 money income. Points Z and Y represent attainable combinations of A and B but yield less total utility, as is evidenced by the fact that they are on lower indifference curves. Point W would entail more utility than X, but it requires a greater income than the $12 represented by the budget line.
Fig. 4.8 Derivin2: The Demand Curve 12 10
-«
8
o >+'" :;:; 6 c:: CtI :J O 4
2
o
2
I
4
6 8 Quantity of B I
10
12
(a) Two equilibrium positions
-
aJ $1.50 o Q)
o
lo-
1.00
n.
.50 DB
o-~
1
2" 3
4
5 6 7 8 9 10 11 12 Quantity of B
(b) The demand curve for product B (a) When the price of B is increased from $1.00 to $1.50, the equiIibrium position moves from X to X', decreasing the quantity of B demanded from 6 to 3 units. (b) The demand curve for B is determined by plotting the $1.006-unit and the $1.50 - 3-unit price-quantity combinations for B.
Department of Economics, Management and Humanities
Czech Technical University in Prague
ECONOMICS
EXERCISES No. 4
CONSUMER BEHAVIOR Handout
Doc. Ing. Helena Fialová, CSc. Ing. Jan Jandera Ing. Michal Táborský
Prague
2003
101.
~ a
-o
~ ........-
r::: ro
:::s O
d o
Quantity of N The budgetline ,
shift frOll1ab to cd in the above figure is consistent with:
a) decreases in the prices of bOUlM and N . b) an increase in Uleprice of M and a decrease in Uleprice of N . c) a decrease in money income. d) an increase in money income. Answer:
.
104.
YIB
B
x
o
The movement of Ulebudgetline from BB to bb in Uleabove figure suggests that income has:
a) increasedand Uleprice ofX has decreased.
.
b) fallen and U1eprice af Y has increased. c) fallen and the price ofX ha$ decreased. d) decreased but Ulerehave been no price changes. Answer:
f
118. An indifference curve shows all: a) possible equilibriwn positions on an indiiTerencemap. b) equilibriwn combinations or two products which/are obtainable with a given money income. c) combinations ortwo products yielding the same total utility to a consumer. d) possible combinations or two products which a consumer can purchase, given her income and tbe prices ot tbe products. Answer:
.
119. An indifference curve: a)
may be either upsloping or downsloping, depending on whetber U1etwo products are complements or substitules.
b) is downsloping and convex to the origin. c) is upsloping and has a constant slope. d) is downsloping and concave to tbeorigin. Answer: 'f
120.
An indiiTerence map implies U1at: a)
money income is constant, but U1eprices or U1etwo 'products vary direclly wiili U1equantities purchased.
c)
a conswner is better off to be at some point "high" on a given curve as opposed to a point IIlowllon ilie same curve.
d) curves rurther from U1eorigin yield higher levels ortotal utility. Answer:
,
-121. The.marginal rate or substitution measures the: 'a) magnitude or the substitution effect. b) total utility received by a consumer when equilibriwnis achieved. c) extra ulility wluch a conswner derives from successive units or a product. d) consumer's willingness to subslilutc one product for anoU1er so U1atlotal ulility will remain constant. Answer:
8
122. The marginal rale
