Lecture 8: The Theory of Consumer Behavior
Outline:
1. How do neoclassical economists model consumer behavior?
i. Theory of Utility maximization
ii. Assumptions of the theory
iii. Budget constraint
iv. Total utility and marginal utility
v. Total willingness to pay and marginal willingness to pay
vi. Deriving the downward sloping demand curve.
2. Criticisms of the theory of utility maximization
i. Is more always better?
ii. The role of marketing and advertising?
iii. Conspicuous consumption
3. An individual's demand curve and the market demand curve.
4. Consumer surplus
i. For an individual
ii. For all consumers in a market
5. Folbre 10.3
6. Dollars and Sense articles # 11, 12.
1. Neoclassical Theory of Consumer Behavior:
i. Utility Maximization :
Neoclassical economists assume that consumers make choices among commodities that maximize their satisfaction/happiness/utility subject to the constraint imposed by the prices of the goods and their income.
ii. Assumptions of the Theory of Utility Maximization:
1. People get happiness from consuming commodities. For simplicity, only material goods are assumed to make people happy.
2. More (of most commodities) is preferred to less. Consumers are happier and happier the more and more of a given commodity they can consume.
3. People's preferences or tastes are given exogenously. This implies that tastes are not affected by the actions of firms (advertising) or by prices (expensive goods are not desired just because they are expensive).
iii. Maximizing utility subject to a budget constraint:
An example:
* Consumers want as much of both commodities - margaritas and tacos - as they can have.
* They are limited by their income and the prices of the goods.
Budget constraint:
Pm*m + Pt*t = I
Where: Pm is the price of a margarita
Pt is the price of a taco
m is the number of margaritas bought
t is the number of tacos bought
I is the person's income
* The budget constraint tells us all of the possible combinations of tacos and margaritas that a person can afford to buy, given their income and the prices of the goods.
GRAPH of the budget line - shifts of the budget line
iv. Utility:
Definition:
Total utility refers to the total satisfaction a person gets from consuming some quantity of a commodity.
Definition:
Marginal utility refers to the extra satisfaction a person gets from consuming an extra unit of a commodity.
Increasing Total Utility:
A person's total satisfaction increases with each unit of a commodity that s/he consumes.
Diminishing Marginal Utility (DMU):
A person gets less and less extra satisfaction from consuming successive units of a commodity.
* EXAMPLE
* GRAPHS
v. Willingess to pay:
Definition:
Total willingness to pay refers to the total $ value that a person is willing to pay for some quantity of a commodity.
Definition:
Marginal willingness to pay refers to the $ value that a person is willing to pay for an extra unit of a commodity.
Increasing total willingness to pay:
A person will be willing to pay more for a larger quantity of a commodity.
Diminishing marginal willingness to pay (DMWTP):
A person will be willing to pay less for each successive unit of a commodity that s/he purchases.
Deriving the downward sloping demand curve:
Question: What is the relationship between DMU and DMWTP?
Question: What will the MWTP curve look like?
Question: What is the relationship between the MWTP curve
and the demand curve?
2. Criticisms of the theory of utility maximization
i. Criticisms of the "more is better" assumption:
1. Studies show that people are not necessarily happier in rich countries than in poor countries - the U.S. and Cuba rate about the same on a happiness scale.
2. The ability to buy more commodities in recent times has meant that people need to earn more income and that has required working more - the opportunity cost is TIME spent with family, friends, in community service, in leisure.
3. Commodity production like that in the industrialized countries has large environmental effects - pollution, rapid rate of use of natural resources - and these could not be sustained if the entire planet consumed at the same rate as consumers in the industrialized countries.
Dollars and Sense reading 11 "Enough is enough" elaborates on this.
ii. Criticism of the assumption that marketing and advertising do not affect consumer preferences:
1. "Persuasive" advertising is much more prevalent than advertising that seeks purely to inform.
2. Presumably firms would spend billions of dollars on persuasive advertising if it did not affect consumer preferences.
Dollars and Sense article 12 "Marketing Power" elaborates on this.
iii. Criticizing the assumption that price does not affect consumer preferences:
1. Veblen, an institutional economist wrote about "conspicuous consumption" in his book The Theory of the Leisure Class. Conspicuous consumption refers to a phenomenon whereby people buy more of a good the higher the price of the good in order to show off their wealth to others.
2. Examples of conspicuous consumption goods include diamonds, expensive cars, furs, yachts, etc.
3. The demand curve for a conspicuous consumption good will be upward sloping rather than downward sloping.
3. The Market Demand Curve:
Question: How do we go from an individual's demand curve to the market demand curve?
Definition:
The market demand curve is the horizontal sum of all the individual demand curves for a particular commodity.
4. Consumer surplus:
Definition:
Consumer surplus is the difference between what a consumer or consumers is willing to pay for a good and what they have to pay.
Consumer surplus and an individual's demand curve:
What consumers are willing to pay for each unit of a commodity is subtracted from what they have to pay for each unity of the commodity (its price) and the resulting amount is the consumer's surplus or gain.
* GRAPH - a step diagram
Question: Why is consumer surplus described as a gain?
Consumer surplus and the market demand curve:
What all consumers in the market are willing to pay for each unit of a commodity subtracted from what they have to pay for each unit (its price) and the resulting amount is the consumers' surplus or gain.
* GRAPH
Note: We can approximate the area of consumer surplus with the area of the triangle below the demand curve and above the price.