Consumer Decision Making

1
Consumer Decision Making

• Frederick University
• 2014

2
Determinants of Household Demand
Factors that influence the quantity of a given
good or service demanded by a single household
include

• The price of the product in question.
• The income available to the household.
• The households amount of accumulated wealth.
• The prices of related products available to the
  household.
• The households tastes and preferences.
• The households expectations about future income,
  wealth, and prices.

3
Consumer Decision Making

• Assumptions
• Consumers want to derive maximum satisfaction
  from goods and services in consumption
• Consumers always prefer more satisfaction to less
  satisfaction
• Consumers are aware of their own taste and
  preferences
• Preferences are transitive

4
Constraints of the Consumer Choice

• Objective constraints
• consumers income
• prices of the goods in consumption
• Subjective constraints
• individual taste
• individual preferences

5
The Basis of Choice Utility

• Utility the satisfaction derived from a
  product or service in consumption
• Marginal Utility the extra utility, derived
  from an extra unit of the good in consumption
  (MU)
• TU derived from n units of the good in
  consumption MU1 MU2 MUn

6
The Law of Diminishing Marginal Utility

• For any good or service, the marginal utility of
  that good or service decreases as the quantity of
  the good increases

7
TU and MU
Units of the good


4
1
2
3
Marginal Utility MU
6
4
3
5
Total Utility TU
11
15
18
6
8
TU and MU

• TU of wine

• MU of wine

MU
6
5
1
2
Q
9
The Model of Consumer Choice

• Assumptions
• The consumer consumes only two goods wine and
  movies
• The consumer wants to derive maximum TU from the
  goods in consumption
• Wine and movies are substitutable, but not
  perfectly substitutable
• Consumption is affected by the law of diminishing
  marginal utility
• The prices of the goods and the consumers income
  are given

10
Budget Constraint

• MU reveals the ordering of consumer preferences
  among bundles of goods. It tells us what the
  consumer is willing to buy.
• It does not tell us what the consumer is able to
  buy. It does not tell us anything about the
  consumers buying power.
• The budget constraint shows all the combinations
  of goods that can be purchased with a given level
  of income.

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The Budget Constraint

• Y 100 Pw 10 P m 10

• The Budget Line

W
w M Y
10 0 100
9 1 100
8 2 100
7 3 100
6 4 100
5 5 100
4 6 100
M
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Optimal Consumption Choice

• Given an income and prices, we want to choose the
  optimal consumption bundle (the bundle the
  consumer likes best)
• Choice must be feasible i.e. in the budget set
• But more is better the choice must be on the
  budget line
• We choose the most-preferred point on the budget
  line the one associated with the highest
  satisfaction (Total Utility)!

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Consumers Equilibrium
W TU MU M TU MU
1 60 60 1 100 100
2 110 50 2 180 80
3 150 40 3 240 60
4 180 30 4 280 40
5 200 20 5 300 20
6 210 10 6 310 10

• Maximum TU
• If prices of wine and movies are equal,
• MUw Mum
• If the price of wine is twice as great as the
  price of movies,
• MUw 2 Mum

MUw MUm Pw Pm
Or MUw Pm Pw MUm
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Optimal Consumption ChoiceConsumer Equilibrium

• The Consumer is in equilibrium when
• MUW/PW MUM/PM
• If MUW/PW gt MUM/PM the consumer will be motivated
  to rearrange his/her purchases and buy more wine
  and fewer movies. The MU of the next bottle of
  wine, however, will be lower, while the MU of the
  last movie will be greater and the equation will
  be achieved

15
The Income Effect of a Price Change

• When the price of a product falls, a consumer has
  more purchasing power with the same amount of
  income.
• When the price of a product rises, a consumer has
  less purchasing power with the same amount of
  income.

16
The Substitution Effect of a Price Change

• When the price of a product falls, that product
  becomes more attractive relative to potential
  substitutes.
• When the price of a product rises, that product
  becomes less attractive relative to potential
  substitutes.

17
Income and Substitution Effects
Price changes affect households in two ways

• The income effect Consumption changes because
  purchasing power changes.
• The substitution effect Consumption changes
  because opportunity costs change.

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Income Effect and Substitution Effect
Inferior Goods
P
Normal goods
Giffen goods
regular
Income effect


Q
Q
Q
Q
Substitution effect
Q
Q
Q
Q
Price effect
Q
Q const
Q
Q

19
Consumer Surplus

• Any is willing to pay 5 for the first hamburger,
  but since she will derive less satisfaction from
  the second hamburger, she will be willing to pay
  less, say, 4.75 for it
• Marginal willingness to pay the maximum amount
  the consumer is willing to pay for one extra unit
  of a good in consumption

Q


7
8
9
1
2
3
4
5
6
MWP
4.50
3.50
2.50
5
4.75
4
1.50
0.25
0
MWP - P
2.50
1
-1
2.25
2
1.50
0
P 2.50
Consumer surplus ? (MWP P) 2.50 2.25 2
1.50 1 8.25
20
The Diamond/Water Paradox

• The diamond/water paradox states that
• the things with the greatest value in use
  frequently have little or no value in exchange,
  and
• the things with the greatest value in exchange
  frequently have little or no value in use.

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The Diamond/Water Paradox

• Total utility of water is high, while total
  utility of diamonds is low
• People are willing to pay a lot of money for a
  piece of a diamond and just a little money for a
  drop of water, because the Marginal Utility of a
  diamond is very high, while the Marginal Utility
  of water is very low
• The choice is made on the basis of Marginal
  Utility, not total utility