Business Economics (ECO 341) Fall Semester, 2012 Khurrum S. Mughal 1 1

Theme of the Lecture Consumer Preferences Budget Constraints Consumer Choice Marginal Utility and Consumer Choice 2

Consumer Behaviour There are three steps involved in the study of consumer behavior. 1) We will study consumer preferences. To describe how and why people prefer one good to another. 8

Consumer Behaviour There are three steps involved in the study of consumer behavior. 2) Then we will turn to budget constraints. People have limited incomes. 8

Consumer Behaviour There are three steps involved in the study of consumer behavior. 3) Finally, we will combine consumer preferences and budget constraints to determine consumer choices. What combination of goods will consumers buy to maximize their satisfaction? 9

Basic Concepts Total Utility Marginal Utility 9

Basic Concepts Utility If buying 3 copies of Microeconomics makes you happier than buying one shirt, then we say that the books give you more utility than the shirt. 104

Basic Concepts Ordinal Versus Cardinal Utility Ordinal Utility Function: places market baskets in the order of most preferred to least preferred. Cardinal Utility Function: utility function describing the extent to which one market basket is preferred to another, giving numerical values to the utility. 27

Basic Concepts Ordinal Versus Cardinal Rankings The actual unit of measurement for utility is not important. Therefore, an ordinal ranking is sufficient to explain how most individual decisions are made. 28

Basic Concepts BADS Examples Things for which less is preferred to more Examples Air pollution Asbestos

Theme of the Lecture Consumer Preferences Budget Constraints Consumer Choice Marginal Utility and Consumer Choice 2

Consumer Preferences Market Baskets A market basket is a collection of one or more commodities. One market basket may be preferred over another market basket containing a different combination of goods. 10

Consumer Preferences Market Baskets Three Basic Assumptions 1) Preferences are complete. 2) Preferences are transitive. 3) Non-satiation Consumers always prefer more of any good to less. 11

Consumer Preferences Indifference Curves Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person. 13

Consumer Preferences B 10 50 D 40 20 E 30 40 G 10 20 H 10 40 A 20 30 Market Basket Units of Food Units of Clothing A 20 30 B 10 50 D 40 20 E 30 40 G 10 20 H 10 40 12

Consumer Preferences Clothing (units per week) 50 G A E H B D 40 30 20 The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A. 50 G A E H B D 40 30 20 10 Food (units per week) 10 20 30 40 15

Consumer Preferences Clothing (units per week) U1 50 G D A E H B 40 30 Combination B,A, & D yield the same satisfaction E is preferred to U1 U1 is preferred to H & G 50 G D A E H B 40 30 20 10 Food (units per week) 10 20 30 40 17

Consumer Preferences Indifference Curves Any market basket lying above and to the right of an indifference curve is preferred to any market basket that lies on the indifference curve. 19

Consumer Preferences Indifference Maps An indifference map is a set of indifference curves that describes a person’s preferences for all combinations of two commodities. Each indifference curve in the map shows the market baskets among which the person is indifferent. 20

Consumer Preferences Clothing (units per week) Market basket A D Market basket A is preferred to B. Market basket B is preferred to D. U3 U2 U1 Food (units per week) 24

Consumer Preferences Indifference Curves Finally, indifference curves cannot cross. This would violate the assumption that more is preferred to less. 21

Consumer Preferences Indifference Curves Cannot Cross Clothing (units per week) U1 U2 A D B The consumer should be indifferent between A, B and D. However, B contains more of both goods than D. Food (units per week) 26

Marginal Rate of Substitution Consumer Preferences Marginal Rate of Substitution The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good. It is measured by the slope of the indifference curve. 29

Consumer Preferences -1 -6 1 -4 -2 The amount of clothing given up for a unit of food decreases from 6 to 1 A B D E G Clothing (units per week) 16 14 12 10 8 6 4 2 Food (units per week) 1 2 3 4 5 32

Consumer Preferences A Clothing (units per week) 16 14 MRS = 6 12 -6 10 B 1 8 -4 D MRS = 2 6 1 E -2 4 G 1 -1 1 2 Food (units per week) 1 2 3 4 5 32

Marginal Rate of Substitution Consumer Preferences Marginal Rate of Substitution We will now add a fourth assumption regarding consumer preference: Along an indifference curve there is a diminishing marginal rate of substitution. Note the MRS for AB was 6, while that for DE was 2. 33

Marginal Rate of Substitution Consumer Preferences Marginal Rate of Substitution Indifference curves are convex because as more of one good is consumed, a consumer would prefer to give up fewer units of a second good to get additional units of the first one. Consumers prefer a balanced market basket 34

Marginal Rate of Substitution Consumer Preferences Marginal Rate of Substitution Perfect Substitutes and Perfect Complements Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant. 35

Consumer Preferences Perfect Substitutes Apple Juice (glasses) 4 3 2 1 Orange Juice (glasses) 1 2 3 4 38

Marginal Rate of Substitution Consumer Preferences Marginal Rate of Substitution Perfect Substitutes and Perfect Complements Two goods are perfect complements when the indifference curves for the goods are shaped as right angles. 36

Consumer Preferences Perfect Complements Left Shoes 4 3 2 1 1 2 3 4 1 2 3 4 Right Shoes 40

Consumer Preferences Utility Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket. 103

Theme of the Lecture Consumer Preferences Budget Constraints Consumer Choice Marginal Utility and Consumer Choice 2

Budget Constraints Preferences do not explain all of consumer behavior. Budget constraints also limit an individual’s ability to consume in light of the prices they must pay for various goods and services. 42 46

Budget Constraints The Budget Line The budget line indicates all combinations of two commodities for which total money spent equals total income. 42 47

Budget Constraints The Budget Line Let F equal the amount of food purchased, and C is the amount of clothing. Price of food = Pf and price of clothing = Pc Then Pf F is the amount of money spent on food, and Pc C is the amount of money spent on clothing. 42 48

Budget Constraints The budget line then can be written: 42 49

Budget Constraints Market Basket Food (F) Clothing (C) Total Spending Pf = ($1) Pc = ($2) PfF + PcC = I A 0 40 $80 B 20 30 $80 D 40 20 $80 E 60 10 $80 G 80 0 $80 12 50

Budget Constraints Clothing (units per week) Pc = $2 Pf = $1 I = $80 A Budget Line F + 2C = $80 (I/PC) = 40 30 20 10 Food (units per week) 20 40 60 80 = (I/PF) 42 54

Budget Constraints The Budget Line As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other. The slope of the line measures the relative cost of food and clothing. The slope is the negative of the ratio of the prices of the two goods. 42 55

Budget Constraints The Budget Line The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent. 42 56

Budget Constraints The Budget Line The vertical intercept (I/PC), illustrates the maximum amount of C that can be purchased with income I. The horizontal intercept (I/PF), illustrates the maximum amount of F that can be purchased with income I. 42 57

Budget Constraints Clothing (units per week) A increase in income shifts the budget line outward (I = $160) L2 80 60 L3 A decrease in income shifts the budget line inward 40 (I = $80) L1 20 Food (units per week) 40 80 120 160 42 61

Budget Constraints L3 L2 L1 Clothing (units per week) An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward. L3 (PF = 2) (PF = 1/2) L2 A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward. 40 (PF = 1) L1 Food (units per week) 40 80 120 160 42 65

Theme of the Lecture Consumer Preferences Budget Constraints Consumer Choice Marginal Utility and Consumer Choice 2

Consumer Choice Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them. 68

Consumer Choice The maximizing market basket must satisfy two conditions: 1) It must be located on the budget line. 2) Must give the consumer the most preferred combination of goods and services. 69

Further, the slope of the budget line is: Consumer Choice Recall, the slope of an indifference curve is: Further, the slope of the budget line is: 70

Consumer Choice Therefore, it can be said that satisfaction is maximized where: 71

Consumer Choice It can be said that satisfaction is maximized when marginal rate of substitution (of F and C) is equal to the ratio of the prices (of F and C). 72

maximize satisfaction Consumer Choice Clothing (units per week) Budget Line Pc = $2 Pf = $1 I = $80 Point B does not maximize satisfaction because the MRS (-(-10/10) = 1 is greater than the price ratio (1/2). -10C +10F U1 40 B 30 20 20 40 80 Food (units per week) 76

Consumer Choice Pc = $2 Pf = $1 I = $80 U3 D Market basket D Clothing (units per week) Pc = $2 Pf = $1 I = $80 U3 D Market basket D cannot be attained given the current budget constraint. 40 Budget Line 30 20 20 40 80 Food (units per week) 77

indifference curve are Consumer Choice Clothing (units per week) Pc = $2 Pf = $1 I = $80 A At market basket A the budget line and the indifference curve are tangent and no higher level of satisfaction can be attained. At A: MRS =Pf/Pc = .5 40 U2 Budget Line 30 20 20 40 80 Food (units per week) 78

Theme of the Lecture Consumer Preferences Budget Constraints Consumer Choice Marginal Utility and Consumer Choice 2

Diminishing Marginal Utility Marginal Utility & Consumer Choice Diminishing Marginal Utility The principle of diminishing marginal utility states that as more and more of a good is consumed, consuming additional amounts will yield smaller and smaller additions to utility. 109

Marginal Utility & Consumer Choice Marginal Utility and the Indifference Curve If consumption moves along an indifference curve, the additional utility derived from an increase in the consumption one good, food (F), must balance the loss of utility from the decrease in the consumption in the other good, clothing (C). 110

Marginal Utility & Consumer Choice 112

Marginal Utility & Consumer Choice Because: 113

Marginal Utility & Consumer Choice When consumers maximize satisfaction the: Since the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it follows that: 115

Marginal Utility & Consumer Choice Which gives the equation for utility maximization: 116

Marginal Utility & Consumer Choice Total utility is maximized when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good. This is referred to as the equal marginal principle. 117

Marginal Utility & Consumer Choice Gasoline Rationing In 1974 and again in 1979, the US government imposed price controls on gasoline. This resulted in shortages and gasoline was rationed. 118

Marginal Utility & Consumer Choice Rationing hurts some by limiting the amount of gasoline they can buy. This can be seen in the following model. It applies to a woman with an annual income of $20,000. 119

Marginal Utility & Consumer Choice The horizontal axis shows her annual consumption of gasoline at $1/gallon. The vertical axis shows her remaining income after purchasing gasoline. 120

(lower level of utility). Marginal Utility & Consumer Choice Spending on other goods ($) 5,000 U1 C 15,000 B 20,000 A 2,000 D With a limit of 2,000 gallons, the consumer moves to a lower indifference curve (lower level of utility). 18,000 U2 20,000 Gasoline (gallons per year) 123