Chapter 3 Consumer Behavior 1

Topics to be Discussed Consumer Preferences Budget Constraints Consumer Choice Revealed Preferences Chapter 3: Consumer Behavior 2

Topics to be Discussed Marginal Utility and Consumer Choices Cost-of-Living Indexes Chapter 3: Consumer Behavior 3

Consumer Behavior Two applications that illustrate the importance of the economic theory of consumer behavior are: Apple-Cinnamon Cheerios The Food Stamp Program. Chapter 3: Consumer Behavior 4

Consumer Behavior General Mills had to determine how high a price to charge for Apple- Cinnamon Cheerios before it went to the market. Chapter 3: Consumer Behavior 5

Consumer Behavior When the food stamp program was established in the early 1960s, the designers had to determine to what extent the food stamps would provide people with more food and not just simply subsidize the food they would have bought anyway. Chapter 3: Consumer Behavior 6

Consumer Behavior These two problems require an understanding of the economic theory of consumer behavior. Chapter 3: Consumer Behavior 7

Consumer Behavior 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. Chapter 3: Consumer Behavior 8

Consumer Behavior There are three steps involved in the study of consumer behavior. 2) Then we will turn to budget constraints. People have limited incomes. Chapter 3: Consumer Behavior 8

Consumer Behavior 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? Chapter 3: Consumer Behavior 9

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. Chapter 3: Consumer Behavior 10

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

Consumer Preferences A 20 30 B 10 50 D 40 20 E 30 40 G 10 20 H 10 40 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 Chapter 3: Consumer Behavior 12

Consumer Preferences Indifference Curves Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person. Chapter 3: Consumer Behavior 13

Consumer Preferences 50 G A E H B D 40 30 20 10 10 20 30 40 Clothing (units per week) 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 Chapter 3: Consumer Behavior 15

Consumer Preferences 50 B H 40 E A 30 D 20 U1 G 10 Clothing (units per week) U1 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 Chapter 3: Consumer Behavior 17

Consumer Preferences Indifference Curves Indifference curves slope downward to the right. If it sloped upward it would violate the assumption that more of any commodity is preferred to less. Chapter 3: Consumer Behavior 18

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. Chapter 3: Consumer Behavior 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. Chapter 3: Consumer Behavior 20

Consumer Preferences Indifference Curves Finally, indifference curves cannot cross. This would violate the assumption that more is preferred to less. Chapter 3: Consumer Behavior 21

Consumer Preferences D B A U3 U2 U1 Clothing (units per week) Market basket A is preferred to B. Market basket B is preferred to D. U3 U2 U1 Food (units per week) Chapter 3: Consumer Behavior 24

Consumer Preferences Indifference Curves Cannot Cross U1 U2 A B D 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) Chapter 3: Consumer Behavior 26

Consumer Preferences A B D E G 16 14 12 10 8 6 4 2 1 2 3 4 5 -1 -6 1 -4 -2 Observation: 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 Question: Does this relation hold for giving up food to get clothing? 8 6 4 2 Food (units per week) 1 2 3 4 5 Chapter 3: Consumer Behavior 32

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. Chapter 3: Consumer Behavior 29

Consumer Preferences A 16 14 MRS = 6 12 10 B 8 D MRS = 2 6 E 4 G 2 1 2 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 Chapter 3: Consumer Behavior 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. Chapter 3: Consumer Behavior 33

Marginal Rate of Substitution Consumer Preferences Marginal Rate of Substitution Question What are the first three assumptions? Chapter 3: Consumer Behavior 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 Chapter 3: Consumer Behavior 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. Chapter 3: Consumer Behavior 35

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. Chapter 3: Consumer Behavior 36

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

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

Consumer Preferences BADS Examples Things for which less is preferred to more Examples Air pollution Asbestos Chapter 3: Consumer Behavior

Consumer Preferences What Do You Think? How can we account for Bads in the analysis of consumer preferences? Chapter 3: Consumer Behavior

Designing New Automobiles (I) Consumer Preferences Designing New Automobiles (I) Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling. Chapter 3: Consumer Behavior 41

Designing New Automobiles (I) Consumer Preferences Designing New Automobiles (I) An analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars. Chapter 3: Consumer Behavior 41

styling for additional Consumer Preferences Consumer Preference A: High MRS Styling These consumers are willing to give up considerable styling for additional performance Performance Chapter 3: Consumer Behavior 43

Consumer Preferences Consumer Preference B: Low MRS Styling These consumers are willing to give up considerable performance for additional styling Performance Chapter 3: Consumer Behavior 44

Designing New Automobiles (I) Consumer Preferences Designing New Automobiles (I) What Do You Think? How can we determine the consumers preference? Chapter 3: Consumer Behavior 41

Designing New Automobiles (I) Consumer Preferences Designing New Automobiles (I) A recent study of automobile demand in the United States shows that over the past two decades most consumers have preferred styling over performance. Chapter 3: Consumer Behavior 45

Designing New Automobiles (I) Consumer Preferences Designing New Automobiles (I) Growth of Japanese Imports 1970’s and 1980’s 15% of domestic cars underwent a style change each year This compares to 23% for imports Chapter 3: Consumer Behavior 45

Consumer Preferences Utility Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket. Chapter 3: Consumer Behavior 103

Consumer Preferences 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. Chapter 3: Consumer Behavior 104

Consumer Preferences Utility Functions Assume: The utility function for food (F) and clothing (C) U(F,C) = F + 2C Market Baskets: F units C units U(F,C) = F + 2C A 8 3 8 + 2(3) = 14 B 6 4 6 + 2(4) = 14 C 4 4 4 + 2(4) = 12 The consumer is indifferent to A & B The consumer prefers A & B to C Chapter 3: Consumer Behavior 104

Utility Functions & Indifference Curves Consumer Preferences Utility Functions & Indifference Curves Clothing (units per week) A B C Assume: U = FC Market Basket U = FC C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5) U1 = 25 U2 = 50 (Preferred to U1) U3 = 100 (Preferred to U2) 15 10 5 Food (units per week) 5 10 15 Chapter 3: Consumer Behavior 42 54

Consumer Preferences Ordinal Versus Cardinal Utility Ordinal Utility Function: places market baskets in the order of most preferred to least preferred, but it does not indicate how much one market basket is preferred to another. Cardinal Utility Function: utility function describing the extent to which one market basket is preferred to another. Chapter 3: Consumer Behavior 27

Consumer Preferences 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. Chapter 3: Consumer Behavior 28

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. Chapter 3: Consumer Behavior 42 46

Budget Constraints The Budget Line The budget line indicates all combinations of two commodities for which total money spent equals total income. Chapter 3: Consumer Behavior 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. Chapter 3: Consumer Behavior 42 48

Budget Constraints The budget line then can be written: Chapter 3: Consumer Behavior 42 49

Budget Constraints A 0 40 $80 B 20 30 $80 D 40 20 $80 E 60 10 $80 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 Chapter 3: Consumer Behavior 12 50

Budget Constraints A (I/PC) = 40 B 30 10 D 20 20 E 10 G Clothing (units per week) Pc = $2 Pf = $1 I = $80 A B D E G Budget Line F + 2C = $80 (I/PC) = 40 10 20 30 20 10 Food (units per week) 20 40 60 80 = (I/PF) Chapter 3: Consumer Behavior 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. Chapter 3: Consumer Behavior 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. Chapter 3: Consumer Behavior 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. Chapter 3: Consumer Behavior 42 57

Budget Constraints The Effects of Changes in Income and Prices Income Changes An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant). Chapter 3: Consumer Behavior 42 58

Budget Constraints The Effects of Changes in Income and Prices Income Changes A decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant). Chapter 3: Consumer Behavior 42 58

Budget Constraints 80 60 40 20 Clothing (units per week) A increase in income shifts the budget line outward (I = $160) L2 80 60 L3 (I = $40) A decrease in income shifts the budget line inward 40 (I = $80) L1 20 Food (units per week) 40 80 120 160 Chapter 3: Consumer Behavior 42 61

Budget Constraints The Effects of Changes in Income and Prices Price Changes If the price of one good increases, the budget line shifts inward, pivoting from the other good’s intercept. Chapter 3: Consumer Behavior 42 62

Budget Constraints The Effects of Changes in Income and Prices Price Changes If the price of one good decreases, the budget line shifts outward, pivoting from the other good’s intercept. Chapter 3: Consumer Behavior 42 62

Budget Constraints L3 L2 L1 (PF = 2) (PF = 1/2) 40 (PF = 1) 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 Chapter 3: Consumer Behavior 42 65

Budget Constraints The Effects of Changes in Income and Prices Price Changes If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change. Chapter 3: Consumer Behavior 42 66

Budget Constraints The Effects of Changes in Income and Prices Price Changes However, the budget line will shift inward to a point parallel to the original budget line. Chapter 3: Consumer Behavior 42 66

Budget Constraints The Effects of Changes in Income and Prices Price Changes If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change. Chapter 3: Consumer Behavior 42 67

Budget Constraints The Effects of Changes in Income and Prices Price Changes However, the budget line will shift outward to a point parallel to the original budget line. Chapter 3: Consumer Behavior 42 67

Consumer Choice Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them. Chapter 3: Consumer Behavior 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. Chapter 3: Consumer Behavior 69

Consumer Choice Recall, the slope of an indifference curve is: Further, the slope of the budget line is: Chapter 3: Consumer Behavior 70

Consumer Choice Therefore, it can be said that satisfaction is maximized where: Chapter 3: Consumer Behavior 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). Chapter 3: Consumer Behavior 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) Chapter 3: Consumer Behavior 76

Consumer Choice 40 D 30 20 U3 Pc = $2 Pf = $1 I = $80 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) Chapter 3: Consumer Behavior 77

indifference curve are Consumer Choice Pc = $2 Pf = $1 I = $80 Clothing (units per week) 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) Chapter 3: Consumer Behavior 78

Designing New Automobiles (II) Consumer Choice Designing New Automobiles (II) Consider two groups of consumers, each wishing to spend $10,000 on the styling and performance of cars. Each group has different preferences. Chapter 3: Consumer Behavior 79

Designing New Automobiles (II) Consumer Choice Designing New Automobiles (II) By finding the point of tangency between a group’s indifference curve and the budget constraint auto companies can design a production and marketing plan. Chapter 3: Consumer Behavior 79

Designing New Automobiles (II) Styling These consumers are willing to trade off a considerable amount of styling for some additional performance $10,000 $3,000 $7,000 $10,000 Performance Chapter 3: Consumer Behavior 81

Designing New Automobiles (II) Styling $3,000 These consumers are willing to trade off a considerable amount of performance for some additional styling $7,000 $10,000 $10,000 Performance Chapter 3: Consumer Behavior 81

Decision Making & Public Policy Consumer Choice Decision Making & Public Policy Choosing between a non-matching and matching grant to fund police expenditures Chapter 3: Consumer Behavior

Consumer Choice Non-matching Grant Private Expenditures ($) U1 A R S P Before Grant Budget line: PQ A: Preference maximizing market basket Expenditure OR: Private OS: Police R S P Q Police Expenditures ($) O Chapter 3: Consumer Behavior

Consumer Choice Non-matching Grant Private Expenditures ($) V T B U Z After Grant Budget line: TV B: Preference maximizing market basket Expenditure OU: Private OZ: Police B U Z U1 U3 P A R Police Expenditures ($) O S Q Chapter 3: Consumer Behavior

Consumer Choice Matching Grant Private Expenditures ($) C X W T U1 P R Before Grant Budget line: PQ A: Preference maximizing market basket After Grant C: Preference maximizing Expenditures OW: Private OX: Police C X W T U1 P R U2 A R O S Q Police ($) Chapter 3: Consumer Behavior

Consumer Choice Matching Grant Private Expenditures ($) T U1 U3 P B U Nonmatching Grant Point B OU: Private expenditure OZ: Police expenditure Matching Grant Point C OW: Private expenditure OX: Police expenditure U3 P B U Z W A C U2 O X Q R Police ($) Chapter 3: Consumer Behavior

Consumer Choice A Corner Solution A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another. This exists where the indifference curves are tangent to the horizontal and vertical axis. MRS is not equal to PA/PB Chapter 3: Consumer Behavior 83

A Corner Solution A U2 U3 U1 A corner solution exists at point B. B Frozen Yogurt (cups monthly) A U2 U3 U1 A corner solution exists at point B. B Ice Cream (cup/month) Chapter 3: Consumer Behavior 84

Consumer Choice A Corner Solution At point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line. This suggests that if the consumer could give up more frozen yogurt for ice cream he would do so. However, there is no more frozen yogurt to give up! Chapter 3: Consumer Behavior 85

Consumer Choice A Corner Solution When a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio. In this instance it can be said that: Chapter 3: Consumer Behavior 86

Consumer Choice A Corner Solution If the MRS is, in fact, significantly greater than the price ratio, then a small decrease in the price of frozen yogurt will not alter the consumer’s market basket. Chapter 3: Consumer Behavior 87

Consumer Choice A College Trust Fund Suppose Jane Doe’s parents set up a trust fund for her college education. Originally, the money must be used for education. Chapter 3: Consumer Behavior 88

Consumer Choice A College Trust Fund If part of the money could be used for the purchase of other goods, her consumption preferences change. Chapter 3: Consumer Behavior 88

Consumer Choice A College Trust Fund A U1 U2 B C U3 Other Consumption ($) The trust fund shifts the budget line A U1 A: Consumption before the trust fund U2 B B: Requirement that the trust fund must be spent on education C U3 C: If the trust could be spent on other goods P Q Education ($) Chapter 3: Consumer Behavior 92

Revealed Preferences If we know the choices a consumer has made, we can determine what her preferences are if we have information about a sufficient number of choices that are made when prices and incomes vary. Chapter 3: Consumer Behavior 93

Revealed Preferences-- Two Budget Lines I1: Chose A over B A is revealed preferred to B l2: Choose B over D B is revealed preferred to D Clothing (units per month) l1 l2 B A D Food (units per month) Chapter 3: Consumer Behavior 97

Revealed Preferences-- Two Budget Lines All market baskets in the pink shaded area are preferred to A. Clothing (units per month) l2 B l1 D A B is preferred to all market baskets in the green area Food (units per month) Chapter 3: Consumer Behavior 97

Revealed Preferences-- Four Budget Lines A: preferred to all market baskets in the green area E B A G I3: E revealed preferred to A I4: G revealed preferred to A Clothing (units per month) l3 All market baskets in the pink area preferred to A l1 l4 l2 Food (units per month) Chapter 3: Consumer Behavior 102

Revealed Preferences for Recreation Scenario Roberta’s recreation budget = $100/wk Price of exercise = $4/hr/week Exercises 10 hrs/wk at A given U1 & I1 Other Recreational Activities ($) l1 C 100 U1 A 80 l2 U2 B The rate changes to $1/hr + $30/wk New budget line I2 & combination B Reveal preference of B to A 60 40 Would the Club’s profits increase? 20 Amount of Exercise (hours) 25 50 75 Chapter 3: Consumer Behavior 102

Marginal Utility and Consumer Choice Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good. Chapter 3: Consumer Behavior 107

Marginal Utility and Consumer Choice Example The marginal utility derived from increasing from 0 to 1 units of food might be 9 Increasing from 1 to 2 might be 7 Increasing from 2 to 3 might be 5 Observation: Marginal utility is diminishing Chapter 3: Consumer Behavior 108

Marginal Utility and 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. Chapter 3: Consumer Behavior 109

Marginal Utility and 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). Chapter 3: Consumer Behavior 110

Marginal Utility and Consumer Choice Formally: Chapter 3: Consumer Behavior 111

Marginal Utility and Consumer Choice Rearranging: Chapter 3: Consumer Behavior 112

Marginal Utility and Consumer Choice Because: Chapter 3: Consumer Behavior 113

Marginal Utility and 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: Chapter 3: Consumer Behavior 115

Marginal Utility and Consumer Choice Which gives the equation for utility maximization: Chapter 3: Consumer Behavior 116

Marginal Utility and 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. Chapter 3: Consumer Behavior 117

Marginal Utility and Consumer Choice Gasoline Rationing In 1974 and again in 1979, the government imposed price controls on gasoline. This resulted in shortages and gasoline was rationed. Chapter 3: Consumer Behavior 118

Marginal Utility and Consumer Choice Gasoline Rationing Nonprice rationing is an alternative to market rationing. Under one form everyone has an equal chance to purchase a rationed good. Gasoline is rationed by long lines at the gas pumps. Chapter 3: Consumer Behavior 118

Marginal Utility and 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. Chapter 3: Consumer Behavior 119

Marginal Utility and Consumer Choice The horizontal axis shows her annual consumption of gasoline at $1/gallon. The vertical axis shows her remaining income after purchasing gasoline. Chapter 3: Consumer Behavior 120

Marginal Utility and Consumer Choice Spending on other goods ($) 5,000 U1 C 15,000 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 B 20,000 A 20,000 Gasoline (gallons per year) Chapter 3: Consumer Behavior 123

Cost-of-Living Indexes The CPI is calculated each year as the ratio of the cost of a typical bundle of consumer goods and services today in comparison to the cost during a base period. Chapter 3: Consumer Behavior 124

Cost-of-Living Indexes What Do You Think? Does the CPI accurately reflect the cost of living for retirees? Is it appropriate to use the CPI as a cost- of-living index for other government programs, for private union pensions, and for other private wage agreements? Chapter 3: Consumer Behavior 125

Cost-of-Living Indexes Example Two sisters, Rachel and Sarah, have identical preferences. Sarah began college in 1987 with a $500 discretionary budget. In 1997, Rachel started college and her parents promised her a budget that was equivalent in purchasing power. Chapter 3: Consumer Behavior 126

Cost-of-Living Indexes 1987 (Sarah) 1997 (Rachel) Price of books $20/book $100/book Number of books 15 6 Price of food $2.00/lb. $2.20/lb Pounds of food 100 300 Expenditure $500 $1,260 Chapter 3: Consumer Behavior 127

Cost-of-Living Indexes Sarah’ Expenditure $500 = 100 lbs. of food x $2.00/lb. + 15 books x $20/book Rachel’ Expenditure for Equal Utility $1,260 = 300 lbs. of food x $2.20/lb. + 6 books x $100/book Chapter 3: Consumer Behavior 128

Cost-of-Living Indexes The ideal cost-of-living adjustment for Rachel is $760. The ideal cost-of-living index is $1,260/$500 = 2.52 or 252. This implies a 152% increase in the cost of living. Chapter 3: Consumer Behavior 129

Cost-of-Living Indexes Books (per quarter) For Rachel to achieve the same level of utility as Sarah, with the higher prices, her budget must be sufficient to allow her to consume the bundle shown by point B. l2 B U1 A 25 l1 20 15 10 5 Food (lb./quarter) 50 100 200 250 300 350 400 450 500 550 600 Chapter 3: Consumer Behavior 131

Cost-of-Living Indexes The ideal cost of living index represents the cost of attaining a given level of utility at current (1997) prices relative to the cost of attaining the same utility at base (1987) prices. Chapter 3: Consumer Behavior 132

Cost-of-Living Indexes To do this on an economy-wide basis would entail large amounts of information. Price indexes, like the CPI, use a fixed consumption bundle in the base period. Called a Laspeyres price index Chapter 3: Consumer Behavior 133

Cost-of-Living Indexes Laspeyres Index The Laspeyres index tells us: The amount of money at current year prices that an individual requires to purchase the bundle of goods and services that was chosen in the base year divided by the cost of purchasing the same bundle at base year prices. Chapter 3: Consumer Behavior 134

Cost-of-Living Indexes Calculating Rachel’s Laspeyres cost of living index Setting the quantities of goods in 1997 equal to what were bought by her sister, but setting their prices at their 1997 levels result in an expenditure of $1,720 (100 x 2.20 + 15 x $100) Chapter 3: Consumer Behavior 135

Cost-of-Living Indexes Her cost of living adjustment would now be $1,220. The Laspeyres index is: $1,720/$500 = 344. This overstates the true cost-of-living increase. Chapter 3: Consumer Behavior 136

Cost-of-Living Indexes Books (per quarter) Using the Laspeyres index results in the budget line shifting up from I2 to I3. l3 B U1 A 25 l1 20 15 10 5 l2 Food (lb./quarter) 50 100 200 250 300 350 400 450 500 550 600 Chapter 3: Consumer Behavior 131

Cost-of-Living Indexes What Do You Think? Does the Laspeyres index always overstate the true cost-of-living index? Chapter 3: Consumer Behavior 138

Cost-of-Living Indexes Yes! The Laspeyres index assumes that consumers do not alter their consumption patterns as prices change. Chapter 3: Consumer Behavior 139

Cost-of-Living Indexes Yes! By increasing purchases of those items that have become relatively cheaper, and decreasing purchases of the relatively more expensive items consumers can achieve the same level of utility without having to consume the same bundle of goods. Chapter 3: Consumer Behavior 139

Cost-of-Living Indexes The Paasche Index Calculates the amount of money at current-year prices that an individual requires to purchase a current bundle of goods and services divided by the cost of purchasing the same bundle in the base year. Chapter 3: Consumer Behavior 140

Cost-of-Living Indexes Comparing the Two Indexes Both indexes involve ratios that involve today’s current year prices, PFt and PCt. However, the Laspeyres index relies on base year consumption, Fb and Cb. Whereas, the Paasche index relies on today’s current consumption, Ft and Ct . Chapter 3: Consumer Behavior 141

Cost-of-Living Indexes Then a comparison of the Laspeyres and Paasche indexes gives the following equations: Chapter 3: Consumer Behavior 142

Cost-of-Living Indexes Comparing the Two Indexes Suppose: Two goods: Food (F) and Clothing (C) Chapter 3: Consumer Behavior 141

Cost-of-Living Indexes Comparing the Two Indexes Let: PFt & PCt be current year prices PFb & PCb be base year prices Ft & Ct be current year quantities Fb & Cb be base year quantities Chapter 3: Consumer Behavior 141

Cost-of-Living Indexes Comparing the Two Indexes Sarah (1990) Cost of base-year bundle at current prices equals $1,720 (100 lbs x $2.20/lb + 15 books x $100/book) Cost of same bundle at base year prices is $500 (100 lbs x $2.00/lb + 15 books x $20/book) Chapter 3: Consumer Behavior 141

Cost-of-Living Indexes Comparing the Two Indexes Sarah (1990) Chapter 3: Consumer Behavior 141

Cost-of-Living Indexes Comparing the Two Indexes Sarah (1990) Cost of buying current year bundle at current year prices is $1,260 (300 lbs x $2.20/lb + 6 books x $100/book) Cost of the same bundle at base year prices is $720 (300 lbs x $2/lb + 6 books x $20/book) Chapter 3: Consumer Behavior 141

Cost-of-Living Indexes Comparing the Two Indexes Sarah (1990) Chapter 3: Consumer Behavior 141

Cost-of-Living Indexes The Paasche Index The Paasche index will understate the cost of living because it assumes that the individual will buy the current year bundle in the base year. Chapter 3: Consumer Behavior 143

Cost-of-Living Indexes In 1995, the government adopted the chain-weighted price index to deflate its measure of real GDP. Developed to overcome problems that arose when long-term comparisons of GDP were made using fixed-weight price indexes and prices were rapidly changing. Chapter 3: Consumer Behavior 144

Cost-of-Living Indexes The Bias of the CPI What Do You Think? What is the impact on the Federal budget of using the CPI (a Laspeyres index) to adjust social security and other programs for changes in the cost of living? Chapter 3: Consumer Behavior 144

Summary People behave rationally in an attempt to maximize satisfaction from a particular combination of goods and services. Consumer choice has two related parts: the consumer’s preferences and the budget line. Chapter 3: Consumer Behavior 145

Summary Consumers make choices by comparing market baskets or bundles of commodities. Indifference curves are downward sloping and cannot intersect one another. Consumer preferences can be completely described by an indifference map. Chapter 3: Consumer Behavior 145

Summary The marginal rate of substitution of F for C is the maximum amount of C that a person is willing to give up to obtain one additional unit of F. Budget lines represent all combinations of goods for which consumers expend all their income. Chapter 3: Consumer Behavior 146

Summary Consumers maximize satisfaction subject to budget constraints. The theory of revealed preference shows how the choices that individuals make when prices and income vary can be used to determine their preferences. Chapter 3: Consumer Behavior 148

End of Chapter 3 Consumer Behavior 1