I.

Introduction
A. Kenyans spend billions of shillings 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 21-1 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.
a.Successive units of a product yield smaller
and smaller amounts of marginal utility, so
the consumer will buy more only if the
price falls. Otherwise, it is not worth it to
buy more.
b.If marginal utility falls sharply as
successive units are consumed, demand
is predicted to be inelastic. That is, price
must fall a relatively large amount before
consumers will buy more of an item.
III.The theory of consumer behavior uses the law of
diminishing marginal utility to explain how
consumers allocate their income.
A. Consumer choice and the budget constraint.
1. Consumers are assumed to be rational, i.e. they are
trying to get the most value for their money.
2. Consumers have clear‑cut preferences for various goods
and services and can judge the utility they receive from
successive units of various purchases.
3. Consumers’ incomes are limited because their individual
resources are limited. Thus, consumers face a budget
constraint.
4. Goods and services have prices and are scarce relative
to the demand for them. Consumers must choose
among alternative goods with their limited money
incomes.
B. The utility maximizing rule explains how consumers decide to
allocate their money incomes so that the last dollar spent on each
product purchased yields the same amount of extra (marginal) utility.
1. A consumer is in equilibrium when utility is “balanced (per dollar) at
the margin.” When this is true, there is no incentive to alter the
expenditure pattern unless tastes, income, or prices change.
2. Table 21-1 provides a numerical example of this for an individual
named Holly with $10 to spend. Follow the reasoning process to see
why 2 units of A and 4 of B will maximize Holly’s utility, given the $10
spending limit.
3. It is marginal utility per dollar spent that is equalized; that is,
consumers compare the extra utility from each product with its cost.
4. As long as one good provides more utility per dollar than another,
the consumer will buy more of the first good; as more of the first
product is bought, its marginal utility diminishes until the amount of
utility per dollar just equals that of the other product.
5. Table 21-2 summarizes the step-by-step decision‑making process
the rational consumer will pursue to reach the utility‑maximizing
combination of goods and services attainable.
6. The algebraic statement of this utility-maximizing state is that the
consumer will allocate income in such a way that.
• MU of product A/price of A = MU of product B/price of B = etc.
IV. Utility Maximization and the Demand Curve
A. Determinants of an individual’s demand curve are tastes, income,
and prices of other goods.

B. Deriving the demand curve can be illustrated using item B in Table

21-1 and considering alternative prices at which B might be sold. At
lower prices, using the utility‑maximizing rule, we see that more will
be purchased as the price falls.

C. The utility‑maximizing rule helps to explain the substitution effect

and the income effect.

1. When the price of an item declines, the consumer will no longer be

in equilibrium until more of the item is purchased and the marginal
utility of the item declines to match the decline in price. More of this
item is purchased rather than another relatively more expensive
substitute.

2. The income effect is shown by the fact that a decline in price

expands the consumer’s real income and the consumer must
purchase more of this and other products until equilibrium is once
again attained for the new level of real income.
The diamond-water paradox.

1. Before marginal analysis, economists were puzzled by

the fact that some essential goods like water had lower
prices than luxuries like diamonds.
2. The paradox is resolved when we look at the abundance
of water relative to diamonds.
3. Theory tells us that consumers should purchase any
good until the ratio of its marginal utility to price is the
same as that ratio for all other goods.
a. The marginal utility of an extra unit of water may be low
as is its price, but the total utility derived from water is
very large.
b. The total utility of all water consumed is much larger than
the total utility of all diamonds purchased.
c. However, society prefers an additional diamond to an
additional drop of water, because of the abundant stock
of water available.
C. Time also has a value, so this must be
considered in decision making and utility
maximization. The total price of an item must
include the value of the time spent in
consuming the product, i.e., the wage value of
an hour of time. When time is considered,
consumer behavior appears to be much
more rational.
• Highly paid doctors may not spend
hours hunting for bargains because their ime
is more valuable than the money to be
saved from finding the best buy.