chapter 8 notes - Consumer Behavior and Utility...

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Consumer Behavior and Utility Maximization CHAPTER EIGHT CONSUMER BEHAVIOR AND UTILITY MAXIMIZATION LECTURE NOTES I. Introduction A. Americans spend trillions of dollars on goods and services each year—more than 95 percent of their after-tax incomes, yet no two consumers spend their incomes in the same way. How can this be explained? B. Why does a consumer buy a particular bundle of goods and services rather than others? Examining these issues will help us understand consumer behavior and the law of demand. II. Two Explanations of the Law of Demand A. Income and substitution effects explain the inverse relationship between price and quantity demanded. 1. The income effect is the impact of a change in price on consumers’ real incomes and consequently on the quantity of that product demanded. An increase in price means that less real income is available to buy subsequent amounts of the product. 2. The substitution effect is the impact of a change in a product’s price on its cost relative to other substitute products’ prices. A higher price for a particular product with no change in the prices of substitutes means that the item has become relatively more expensive compared to its substitutes. Therefore, consumers will buy less of this product and more of the substitutes, whose prices are relatively lower than before. B. The law of diminishing marginal utility is a second explanation of the downward sloping demand curve. Although consumer wants in general are insatiable, wants for specific commodities can be fulfilled. The more of a specific product that consumers obtain, the less they will desire more units of that product. This can be illustrated with almost any item. The text uses the automobile example, but houses, clothing, and even food items work just as well. 1. Utility is a subjective notion in economics, referring to the amount of satisfaction a person gets from consumption of a certain item. 2. Marginal utility refers to the extra utility a consumer gets from one additional unit of a specific product. In a short period of time, the marginal utility derived from successive units of a given product will decline. This is known as diminishing marginal utility. 3. Figure 8-1 and the accompanying table illustrate the relationship between total and marginal utility. a. Total utility increases as each additional taco is purchased through the first five, but utility rises at a diminishing rate since each taco adds less and less to the consumer’s satisfaction. b. At some point, marginal utility becomes zero and then even negative at the seventh unit and beyond. If more than six tacos were purchased, total utility would begin to fall. This illustrates the law of diminishing marginal utility. 4. The law of diminishing marginal utility is related to demand and elasticity.
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