BackChapter 6 - Consumer Behaviour: Marginal Utility, Income and Substitution Effects, and Consumer Surplus
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Chapter 6: Consumer Behaviour
6.1 Marginal Utility and Consumer Choice
Consumer behaviour in microeconomics is driven by the motivation to maximize utility, which is the satisfaction derived from consuming goods and services. This section introduces the concepts of total and marginal utility, and explains how consumers make choices to maximize their satisfaction.
Utility: The total satisfaction a consumer receives from consuming goods and services.
Total Utility: The overall satisfaction from consuming a certain quantity of a product.
Marginal Utility: The additional satisfaction gained from consuming one more unit of a product.
Diminishing Marginal Utility: As a consumer consumes more units of a product, the marginal utility from each additional unit decreases (ceteris paribus). For example, the first litre of water consumed per week provides much more satisfaction than the second or third.
Consumers must be able to know and compare the utility from different actions to make rational choices.
Utility Schedules & Graphs
Utility schedules list the total and marginal utility for each unit consumed. Graphs typically show total utility increasing at a decreasing rate, while marginal utility declines as quantity increases.
Bottles | Alison's Total Utility | Alison's Marginal Utility |
|---|---|---|
1 | 30 | 30 |
2 | 50 | 20 |
3 | 65 | 15 |
4 | 75 | 10 |
5 | 80 | 5 |
6 | 82 | 2 |
7 | 83 | 1 |
8 | 83 | 0 |
9 | 82 | -1 |
10 | 80 | -2 |
Graphical Representation: Total utility curves slope upward but flatten, while marginal utility curves slope downward.
Total Utility, Marginal Utility, and the Demand Curve
The shape of the marginal utility curve mirrors the shape of the demand curve.
Marginal utility is the slope of the total utility function.
Market Demand Curves
The market demand curve is the horizontal sum of individual demand curves, and is typically negatively sloped, reflecting diminishing marginal utility and the law of demand.
Maximizing Utility
Consumers allocate their budget to maximize total utility. For two goods, X and Y, the consumer chooses quantities such that the utility per dollar spent is equalized across goods.
Utility Maximization Condition:
Where and are the marginal utilities of goods X and Y, and and are their prices.
Example: If a consumer derives more utility per dollar from juice than from burritos, she should spend more on juice and less on burritos until the marginal utility per dollar is equal for both goods.
Burritos | MU Burritos | TU Burritos | Juice | MU Juice | TU Juice |
|---|---|---|---|---|---|
0 | 0 | 0 | 0 | 0 | 0 |
1 | 30 | 30 | 1 | 30 | 30 |
2 | 25 | 55 | 2 | 25 | 55 |
3 | 20 | 75 | 3 | 20 | 75 |
4 | 15 | 90 | 4 | 15 | 90 |
5 | 10 | 100 | 5 | 10 | 100 |
6 | 5 | 105 | 6 | 5 | 105 |
Optimal allocation occurs where the total utility is maximized, and the marginal utility per dollar spent is equalized.
Alternatively, the condition can be rearranged as:
The Consumer's Demand Curve
When the price of a good changes, the consumer adjusts consumption to restore the utility-maximizing condition. If the price of juice rises, the consumer buys less juice, increasing its marginal utility until equilibrium is restored.
Exercises: Utility Maximization
Case | Price of X | Mg U of X | Price of Y | Mg U of Y |
|---|---|---|---|---|
A | 10 | 2 | 5 | 3 |
B | 12 | 4 | 2 | 2 |
C | 3 | 1 | 6 | 2 |
D | 4 | 2 | 4 | 2 |
E | 8 | 4 | 4 | 3 |
Students are asked to determine whether expenditure on each product should rise or fall to maximize utility.
6.2 Income and Substitution Effects of Price Changes
Substitution Effect
The substitution effect occurs when a change in the relative price of a good causes consumers to substitute away from goods that have become relatively more expensive towards those that are relatively cheaper.
When the price of a good falls, its quantity demanded increases due to substitution.
When the price rises, quantity demanded decreases.
Income Effect
The income effect reflects the change in a consumer's real income due to a price change.
For a normal good, a price decrease increases real income, leading to higher quantity demanded.
For an inferior good, a price decrease may lead to lower quantity demanded as consumers switch to superior goods.
The size of the income effect depends on the proportion of income spent on the good and the magnitude of the price change.
The Slope of the Demand Curve
The overall effect of a price change is the sum of the income and substitution effects. For normal goods, both effects work in the same direction, resulting in a downward-sloping demand curve.
For a price increase:
Substitution effect: quantity demanded decreases
Income effect: may increase or decrease quantity demanded
Graphical Illustration
Type of Good | Effect on Quantity Demanded |
|---|---|
Normal Good | Both income and substitution effects increase quantity demanded when price falls |
Inferior Good | Substitution effect increases quantity demanded, income effect decreases it |
Giffen Good | Income effect outweighs substitution effect, quantity demanded decreases as price falls |
Conspicuous Consumption Goods
Some goods are purchased for their "snob appeal"—the high price itself confers status. However, even for these goods, the market demand curve is unlikely to be positively sloped, as consumers would still prefer to buy more at lower prices if status is maintained.
6.3 Consumer Surplus
The Concept of Consumer Surplus
Consumer surplus is the difference between the maximum amount a consumer is willing to pay for a good and the amount they actually pay. It represents the net benefit to consumers from market transactions.
Litres of Milk Consumed/Week | Amount Willing to Pay ($) | Consumer Surplus if Price is ) |
|---|---|---|
First | 6.00 | 5.00 |
Second | 3.00 | 2.00 |
Third | 2.00 | 1.00 |
Fourth | 1.50 | 0.50 |
Fifth | 1.20 | 0.20 |
Sixth | 1.00 | 0.00 |
Seventh | 0.80 | - |
Eighth | 0.60 | - |
Ninth | 0.50 | - |
Tenth | 0.40 | - |
Graphically, consumer surplus is the area between the demand curve and the market price, up to the quantity purchased.
Marginal Value vs. Total Value
Marginal value: The value placed on each additional unit consumed.
Total value: The sum of the values placed on all units consumed.
Exercises: Calculating Consumer Surplus
Pizza | Rupert's Willingness to Pay ($) |
|---|---|
First | 18 |
Second | 16 |
Third | 13 |
Fourth | 9 |
Fifth | 4 |
Sixth | 0 |
Total value on five weekly pizzas: $18 + $16 + $13 + $9 + $4 = $60
If market price is $10, Rupert will buy up to the fourth pizza (since willingness to pay for the fifth is less than price).
Weekly consumer surplus: ($18-$10) + ($16-$10) + ($13-$10) + ($9-$10) = $8 + $6 + $3 + (-$1) = $16 (only positive surplus counted)
The Paradox of Value
Early economists noted the paradox of value: essential goods like water are cheap, while non-essential goods like diamonds are expensive. The resolution lies in distinguishing between total value (area under the demand curve) and marginal value (height of the curve).
Market price is determined by marginal value, not total value.
Water has high total value but low marginal value due to abundance; diamonds have low total value but high marginal value due to scarcity.
Graphical Resolution: The market price reflects the marginal value, explaining why some essential goods are inexpensive.
Example: Consumer surplus for the market is the area between the demand curve and the market price, up to the quantity consumed.
Additional info: The notes also reference recent research in social sciences on measuring happiness and utility, suggesting that utility, while not directly measurable, can be approximated through surveys and behavioral studies.
