Understanding Consumer Behavior: Utility Theory, Competition, and Monopoly
Utility Theory
Utility theory attempts to explain consumer behavior. From this perspective, utility is the ability of an asset to satisfy needs. A good is more useful to the extent that it better meets a need. This utility is qualitative (real or apparent qualities of the goods), spatial (the object must be within reach of the individual), and temporal (referring to when the need is satisfied).
This theory is based on several assumptions:
- Consumer income per unit of time is limited.
- The characteristics of a good determine its usefulness and therefore affect consumer decisions.
- The consumer seeks to maximize total satisfaction (total utility) and therefore spends all their income.
- The consumer has perfect information; that is, they know the good’s features and prices.
- The consumer is rational, meaning they seek to achieve their objectives, in this case, the greatest possible satisfaction. This implies that the consumer can determine their preferences and be consistent in their choices. Thus, if the consumer prefers good A over good B and good B over good C, then they prefer good A over good C (transitivity).
The economic theory of consumer behavior faces a major problem (the central problem of consumer theory): the inability to quantify the degree of satisfaction or utility that the consumer gets from goods. There is no objective measure of drive satisfaction. This problem has been addressed through two approaches:
Cardinal Approach: Assumes that it is possible to measure utility, so there is a unit of measure for satisfaction.
Ordinal Approach: This approach does not measure consumer utility but provides combinations of goods that the consumer prefers or is indifferent to compared to other combinations.
Cardinal Approach
From the above assumptions and concepts, we define two concepts of utility or satisfaction:
Total Utility: The total satisfaction from consuming a certain amount of a good.
Marginal Utility: The extra satisfaction from consuming one additional unit.
How Does a Consumer Achieve Optimum Satisfaction?
To answer that, more information is needed:
- Consumer income.
- The utility obtained from other alternative assets.
How Much of Each Good Should the Consumer Buy to Maximize Total Satisfaction?
To answer this, we need to calculate the marginal utility for each good and the marginal utility per dollar spent (marginal utility divided by the price of the good):
Equilibrium (max and min price)
Taxes: Tributes are required depending on the economic capacity of the parties responsible for payment (affecting income).
Grant: Public health care provision is economic and time-bound (the subsidy increases income).
Perfect Competition
Perfect competition occurs when there are many buyers and many sellers (atomicity) without any single one having significant influence on the price.
Features:
- Atomization: There is a large number of buyers and sellers.
- Price Taking: Every buyer and seller accepts the market price.
- Homogeneous Product: Products are similar.
- Perfect Information: Consumers have full information about prices and products (homo economicus), informing their behavior before buying.
- Market Mobility: Freedom of entry and exit.
Perfect Competition Curve
For profit maximization, the curve must represent income.
- The average variable cost curve increases with increasing production due to diminishing marginal product.
- Profit maximization occurs where marginal revenue equals marginal cost.
Efficient Scale: The point at which the company achieves the lowest cost; the amount of production that minimizes average total cost.
- If the marginal cost is less than the average total cost, the average total cost is decreasing.
- Marginal cost increases with scale.
- This helps determine if a company is profitable.
- Profit is always the difference between total revenue and total cost.
- The total cost curve intersects the marginal cost curve at its lowest point.
When No Value Is Lost or Shutdown Decision
The decision to produce anything during a given period depends on the market situation.
Output Decision: Leaving the market (saving all costs).
Monopoly
A monopoly is a single company selling a product with no close substitutes. This type of market has certain characteristics:
- It has a single vendor (the company is the entire industry).
- The goods produced have no close substitutes.
- There may be imperfect information.
- It is a form of price setting: the monopolist faces the market’s downward-sloping demand curve.
- The price may fall if the monopolist wants to sell more. If the monopolist increases the price, the quantity sold will decrease.
- The monopolist may choose to increase the price or quantity sold, but not both.
Causes of Monopolies
Resource monopolies, government-created monopolies, and natural monopolies.
Natural Monopoly
Arises when a single company can provide a good or service to an entire market at a lower cost than two or more companies due to economies of scale (barriers to competition increase costs). The size of the market determines the size of the monopoly.
Marginal Revenue
- Both have the same source because the price of the unit produced equals the revenue from that unit.
- Marginal revenue can be negative when the price effect on revenue is greater than the quantity effect on production.
- Marginal revenue decreases as the monopolist faces a downward-sloping demand curve.
- Marginal revenue for a monopolist differs from that of a perfectly competitive company because when the monopolist increases the quantity sold, it produces two effects: a production effect (selling more increases revenue) and a price effect (selling more decreases the price).
- A monopoly maximizes profit where marginal revenue equals marginal cost, and sets a price higher than marginal cost.
How Does Monopoly Compare with Competition?
Competition
- Large number of buyers and sellers.
- Homogeneous (identical) products.
- Perfect information.
- Firms are price takers.
- No barriers to entry or exit.
Monopoly
- Single vendor.
- Goods produced have no close substitutes.
- Imperfect information may exist.
- The company is a price setter.
- Legal or natural barriers to entry exist.
How Is a Monopoly Regulated?
- Setting prices (prices are set at the company’s marginal cost).
- State grants to companies to overcome losses at marginal cost pricing.