Chapter 21 The Theory of Consumer Behavior

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In This Lecture
The Diamond-Water
Paradox
The Law of Diminishing
Marginal Utility
Consumer Equilibrium
Marginal Utility Analysis
and the Law of Demand
Behavioral Economics
To select a topic, click on its link above
2014 Cengage Learning. All Rights Reserved. May not be copied, scanned,
Diamond-Water Paradox
The paradox: Water is cheap and diamonds are

expensive!
The observation that things that have the greatest value
in use sometimes have little value in exchange and things
that have little value in use sometimes have the greatest
value in exchange.
How can this be explained???
Utility theory provides a solution!
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2014 Cengage Learning. All Rights Reserved. May not be copied, scanned,
or duplicated, in whole or in part, except for use as permitted in a license to In this
distributed with certain product , service, or otherwise on password-protected Lesson
Utility Theory
Utility is a measure of the satisfaction,

happiness, or benefit that results from the
consumption of a good.
A util is an artificial construct used to measure
utility.
Total utility is the total satisfaction a person
receives from consuming a particular quantity of
a good.
Marginal utility is the additional utility a person
receives from consuming an additional unit of a
particular good.
2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, Click to return
website for classroom use Lesson
Law of Diminishing
Marginal Utility
The marginal utility gained by consuming equal

successive units of a good will decline as the
amount consumed increases.
The total utility of something can be rising as the
marginal utility of that something is falling.
Total Utility, Marginal Utility, and the Law of
Diminishing Marginal Utility
Both total utility and marginal utility are

expressed in utils.
Marginal utility is the change in total
utility divided by the change in the
quantity consumed of the good, MU =
TU/Q.
Total Utility, Marginal Utility, and the Law of
Diminishing Marginal Utility
Law of Diminishing Marginal Utility
Application
The law of diminishing marginal utility is based

on the idea that if a good has a variety of uses
but only 1 unit of the good is available, then the
consumer will use the first unit to satisfy his or
her most urgent want.
If 2 units are available, the consumer will use the
second unit to satisfy a less urgent want.
Interpersonal Utility
Comparison
Comparing the utility one person receives from a good,
service, or activity with the utility another person receives
from the same good, service, or activity.
No Interpersonal Utility
Comparison
Caution: The utility obtained by one person cannot be
scientifically or objectively compared with the utility
obtained from the same thing by another person
because utility is subjective.
Diamond-Water Paradox Resolved
The total utility of water is high because water is extremely useful.

The total utility of diamonds is low in comparison because diamonds
are not as useful as water.
The marginal utility of water is low because water is so plentiful that
people end up consuming it at low marginal utility.
The marginal utility of diamonds is high because diamonds are so
scarce that people end up consuming them at high marginal utility.
Do prices reflect total or marginal utility? Marginal utility.
Self-test
1. State and solve the diamond-water paradox.
The paradox is that water, which is essential to life, is cheap, and
diamonds, which are not essential to life, are expensive. The solution to
the paradox depends on knowing the difference between total and
marginal utility and the law of diminishing marginal utility. By saying that
water is essential to life and that diamonds are not essential to life, we
signify that water gives us high total utility relative to diamonds. But
then, if water gives us greater total utility than diamonds do, why isnt
the price of water greater than that of diamonds.
(continued)
Self-test
Price isnt a reflection of total utility; it is a reflection of marginal utility.
The marginal utility of water is less than that of diamonds. This answer
raises another question: How can the total utility of water be greater
than that of diamonds, but the marginal utility of water be less than that
of diamonds? The answer is based on the fact that water is plentiful
and diamonds are not and on the law of diminishing marginal utility.
There is so much more water than diamonds that the next (additional)
unit of water gives us less utility (lower marginal utility) than the next
unit of diamonds.
Self-test
2. If total utility is falling, what does this imply for
marginal utility? Give an arithmetical example
to illustrate your answer.
If total utility declines, marginal utility must be negative. For example, if
total utility is 30 utils when Lydia consumes 3 apples and 25 utils when
she consumes 4 apples, it must be because the fourth apple had a
marginal utility of 5 utils. Chapter 1 explains that something that takes
utility away from us (or gives us disutility) is called a bad. For Lydia, the
fourth apple is a bad, not a good.
Self-test
3. When would the total utility of a good and the
marginal utility of a good be the same?
The total utility and the marginal utility of a good are the same for the
first unit of the good consumed. For example, before Tomas eats his first
apple, he receives no utility or disutility from apples. Eating the first
apple, he receives 15 utils. So the total utility (TU) for 1 apple is 15 utils,
and the marginal utility (MU) for the first apple is 15 utils.
Consumer Equilibrium
The analysis is based on the assumption that

individuals seek to maximize utility.
Occurs when the consumer has spent all income
and the marginal utilities per dollar spent on
each good purchased are equal:
where the letters AZ represent all the goods a

person buys. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned, Click to return
Marginal Utility Analysis and the Law of
Demand
Marginal utility analysis can be used to illustrate the law
of demand, which states that price and quantity
demanded are inversely related, ceteris paribus.
Starting from consumer equilibrium in a world containing
only two goods, A and B, a fall in the price of A will cause
MUA /PA to be greater than MUB /PB.
As a result, the consumer will purchase more of good A
to restore herself to equilibrium.
Self-test
1. Alesandro purchases two goods, X and Y, and
the utility gained for the last unit purchased of
each is 16 utils and 23 utils, respectively. The
prices of X and Y are $1 and $1.75,
respectively. Is Alesandro in consumer
equilibrium? Explain your answer.
Alesandro is not in consumer equilibrium because the marginal utility
per dollar of X is 16 utils, and the marginal utility per dollar of Y is
13.14 utils. To be in equilibrium, a consumer has to receive the same
marginal utility per dollar for each good consumed.
Self-test
2. In a two-good world, in which the goods are A
and B, what does it mean to be in consumer
disequilibrium?
The marginal utility-to-price ratio for one of the goods is higher than the
ratio for the other good.
Behavioral Economics I
Behavioral economists argue that

some human behavior does not fit
neatlyat a minimum, easilyinto
the traditional economic
framework.
Behavioral economists believe
they have identified human
behaviors that are inconsistent
with the model of men and women
as rational, self-interested, and
consistent. 2014 Cengage Learning. All Rights Reserved. May not be copied, scanned,
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to In this
Behavioral Economics II
These behaviors include the following:

(1) Individuals are willing to spend some money to lower the
incomes of others even if it means their incomes will be
lowered.
(2) Individuals dont always treat $1 as $1;some dollars seem
to be treated differently from other dollars.
(3) Individuals sometimes value a good more if it is theirs
than if it isnt theirs and they are seeking to acquire it
(endowment effect).
Self-test
1. Brandons grandmother is very cautious about spending

money. Yesterday, she gave Brandon a gift of $100 for his
birthday. Brandon also received a gift of $100 from his father,
who isnt nearly as cautious about spending money as
Brandons grandmother is. Brandon believes that it would
somehow be wrong to spend his grandmothers gift on
frivolous things, but it wouldnt be wrong to spend his
fathers gift on such things. Is Brandon compartmentalizing?
Explain your answer.
Yes, Brandon is compartmentalizing. He is treating $100 that
comes from his grandmother differently from $100 that comes from
his father.
Self-test
2. Summarize David Friedmans explanation of
the endowment effect.
The endowment effect relates to individuals valuing X more highly
when they possess it than when they dont have it but are thinking of
acquiring it. Friedman argues that if we go back in time to a hunter-
gatherer society when there were no well established property rights
(no rules as to what is mine and thine), if some individuals would
fight hard to keep what they possessed but wouldnt fight as hard to
acquire what they did not possess, they would have a higher
probability of surviving than individuals who would fight hard at both
times. Thus, those who would fight hard only to keep what they
possessed would have a higher probability of reproductive success.
The characteristic of holding on to what you have has been passed
down from generation to generation, and, although it may not be as
important today as it was in a hunter-gatherer society, it still
influences behavior.
Wall Street Journal
The Wall Street Journal is a is a rich source of

information which provides real life examples of micro-
and macro economic activities. Check todays issue to
see the most current news.
http://www.wsj.com

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2014 Cengage Learning. All Rights Reserved.

May not be copied, scanned,

The paradox: Water is cheap and diamonds are

Utility is a measure of the satisfaction,

The marginal utility gained by consuming equal

Both total utility and marginal utility are

The law of diminishing marginal utility is based

The total utility of water is high because water is extremely useful.

The analysis is based on the assumption that

where the letters AZ represent all the goods a

Behavioral economists argue that

These behaviors include the following:

1. Brandons grandmother is very cautious about spending

The Wall Street Journal is a is a rich source of

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