The Consumer and Consumer Behavior Managerial Economics Lecture 4: The Consumer and Consumer Behavior

Overview Consumer Behavior Constraints Consumer Equilibrium Standard economic model Total and Marginal Utility Consumer Preference Indifference Curve Constraints The Budget Constraint Changes in Income Changes in Prices Consumer Equilibrium

At this very moment………… Your heart is pumping blood throughout your body. Your lungs are providing oxygen and expelling carbon dioxide Your eyes are scanning through this slide while your brain processes the information on it. The human brain can do what even supercomputers and sophisticated “artificial intelligence” technology are incapable of doing. Despite the complexities of human thought processes, managers need a model that explains how individuals behave in the marketplace and in the work environment.

Who is a consumer? What is behavior? What is consumer behavior?

Consumer behavior Consumer is an individual who purchases goods and services from firms for consumption. Behavior deals with the action or reaction of a person/organism under normal or specified situation. Consumer behavior addresses how consumers respond or react to alternative choices that confront them. As a manager you should not be only interested in the consumer but also the purchaser.

Consumer Behavior Standard Economic Model When you walk into a shop, you are invariably confronted with wide range of goods. Most people have limited financial resources and cannot buy everything they want. Therefore, how are purchasing choices made? One assumption might be that, you consider the constraint that is your income, the prices of the various goods being offered for sale and the value they represent. Value is the worth of an individual of owning an item represented by the satisfaction derived from its consumption

Consumer Behavior Standard Economic Model They are some key assumptions of the standard economic model which is important to keep in mind. These assumptions are: Buyers (or economic agents) are rational More is preferred to less Buyers seek to maximize their utility Utility is the satisfaction derived from consumption. Consumers act in self-interest and do not consider the utility of others.

Consumer Behavior Total and Marginal Utility Given the assumption that, consumers prefer more to less, intuition might tell us that total utility increases as consumption increases. However, this may be true up to a point. For instance: You have walked for 15 hours. You are hot, sweaty and very thirsty. After some few minutes, you came across ‘an ice water seller’ and decided to buy some. If you were asked to rate the satisfaction derived from consuming the 1st sachet out of 10 (utils) at that time you might rate it at 10.

Consumer Behavior Total and Marginal Utility You order a 2nd sachet as you are still thirsty; the 2nd sachet still brings some satisfaction, but if asked to rate it you might give it 8 Total utility now is 18 utils – the second sachet has increased total utility However, you did not rate the 2nd sachet quite as high as the 1st because some of your thirst has been quenched Marginal utility measures the addition to total utility as a result of the consumption of an extra unit. The marginal utility of the 1st sachet was 10 but for the 2nd sachet marginal utility was 8.

1 2 3 10 18 24 10 8 6 TOTAL AND MARGINAL UTILITY Sachet consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 2 3 10 18 24 Total Utility (utils) 10 8 6 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) 1 2 3 4 5 6 7 Units consumed per meal

1 2 3 4 5 6 10 18 24 28 30 10 8 6 4 2 TOTAL AND MARGINAL UTILITY Sachet consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 2 3 4 5 6 10 18 24 28 30 Total Utility (utils) 10 8 6 4 2 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) 1 2 3 4 5 6 7 Units consumed per meal

1 2 3 4 5 6 7 10 18 24 28 30 10 8 6 4 2 -2 TOTAL AND MARGINAL UTILITY TU Sachet consumed per meal Total Utility, Utils Marginal Utility, Utils 30 20 10 1 2 3 4 5 6 7 10 18 24 28 30 Total Utility (utils) 10 8 6 4 2 -2 0 1 2 3 4 5 6 7 Units consumed per meal 10 8 6 4 2 -2 Marginal Utility (utils) MU 1 2 3 4 5 6 7 Units consumed per meal

Which of these will you buy? UTILITY MAXIMIZING COMBINATION Product A: Price = $1 Product B: Price = $2 $ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First 10 10 24 12 How should the $10 income be allocated? Which of these will you buy?

Decision: Buy 1 Product B for $2 UTILITY MAXIMIZING COMBINATION Product A: Price = $1 Product B: Price = $2 $ 10 income Marginal utility per dollar (MU/price) Marginal utility per dollar (MU/price) Marginal utility, utils Marginal utility, utils Unit of product First 10 10 24 12 Decision: Buy 1 Product B for $2

Consumer Behavior There are two important but distinct factors to consider in the area of consumer behavior Consumer Opportunities The possible goods and services consumers can afford to consume. Consumer Preferences The goods and services consumers actually consume.

Assumptions Let assume that there are two goods in this world Good Y and Good X Assume a consumer is able to order his or her preferences for alternative combinations or bundles of good from best to worst. Given the choice between 2 bundles of goods a consumer either: Prefers bundle A to bundle B: A  B. Prefers bundle B to bundle A: A  B. Is indifferent between the two: A  B.

Indifference Curve Analysis A curve that defines the combinations of 2 or more goods that give a consumer the same level of satisfaction. Because consumers prefer more consumption to less, higher indifference curves are preferred to lower ones The idea that buyers can rank preferences from best to worst (or vice versa) is captured by expected utility theory Any point on III is preferred to any points on I and II . I. II. III. Good Y Good X

Consumer Preference Ordering Properties The preference ordering is assumed to satisfy four fundamental properties. Completeness More is Better Diminishing Marginal Rate of Substitution Transitivity

Complete Preferences Completeness Property Consumer is capable of expressing preferences (or indifference) between all possible bundles. (“I don’t know” is NOT an option!) If the only bundles available to a consumer are A, B, and C, then the consumer is indifferent between A and C (they are on the same indifference curve). will prefer B to A. will prefer B to C. I. II. III. Good Y Good X A C B

More Is Better! More Is Better Property Good Y III. II. I. Good X Bundles that have at least as much of every good and more of some good are preferred to other bundles. Bundle B is preferred to A since B contains at least as much of good Y and strictly more of good X. Bundle B is also preferred to C since B contains at least as much of good X and strictly more of good Y. More generally, all bundles on ICIII are preferred to bundles on ICII or ICI. And all bundles on ICII are preferred to ICI. I. II. III. Good Y Good X A C B 1 33.33 100 3

Diminishing MRS MRS Good Y The amount of good Y the consumer is willing to give up for X to maintain the same satisfaction. The rate at which a consumer is willing to substitute one good for another and maintain the same satisfaction level. To go from consumption bundle A to B the consumer must give up 50 units of Y to get one additional unit of X. To go from consumption bundle B to C the consumer must give up 16.67 units of Y to get one additional unit of X. To go from consumption bundle C to D the consumer must give up only 8.33 units of Y to get one additional unit of X. This explains why IC curves are convex from the origin 100 50 33.33 25 I. II. III. Good Y Good X 1 3 4 2 A B C D

Consistent Bundle Orderings Transitivity Property For the three bundles A, B, and C, the transitivity property implies that if C  B and B  A, then C  A. Transitive preferences along with the more-is-better property imply that indifference curves will not intersect. the consumer will not get caught in a perpetual cycle of indecision. 2 I. II. III. Good Y Good X 1 100 5 50 7 75 A B C

Constraints

Constraints In making decisions, individuals face constraints. Legal constraints Time constraints Physical constraints Childrearing constraints Budget constraints

Budget constraint If a consumer has only Ȼ30.00 in his or her pocket, upon reaching a supermarket, the total value of goods he or she presents to the cashier cannot exceed Ȼ30.00. Why?

Budget constraint Because the consumer is restricted by his budget. Thus budget constraint restricts consumer behavior by forcing the consumer to select a bundle of goods that is affordable. Let M = Consumer’s income Px = Price of good X Py = Price of good Y

The Budget Constraint Budget Line Market Rate of Substitution Opportunity Set (Budget set) The set of consumption bundles that are affordable. PxX + PyY  M. Budget Line The bundles of goods that exhaust a consumers income. PxX + PyY = M. Market Rate of Substitution The slope of the budget line -Px / Py. Y X Opportunity Set Budget Line Y = M/PY – (PX/PY)X M/PY M/PX B Px Py H Unaffordable Affordable

Market rate of substitution This figure represents a budget line for a consumer who has Ȼ 10 in income and faces the following: Price of good Y is Ȼ2 Price of good X is Ȼ1 The slope of the budget line will be -1/2. Why? The reason the budget line represents substitution between two goods is as follows: At bundle A 3 units of Y 4 units of X At bundle B 4 units of Y 2 units of X Y 5 B 4 A 3 2 4 10 X

Changes in Income and Price Consumer’s opportunity set depends on two factors Market price Consumer’s income

Changes in the Budget Line M0/PY M0/PX Y New Budget Line for a price decrease. X M2/PY M2/PX M1/PY M1/PX M0/PX0 M0/PX1 Changes in Income Increases lead to a parallel, outward shift in the budget line (M1 > M0). Decreases lead to a parallel, downward shift (M2 < M0). Changes in Price A decrease in the price of good X rotates the budget line counter-clockwise (PX0 > PX1). An increase in the price rotates the budget line clockwise (not shown).

Problem A consumer has initial income of Ȼ100 and faces prices of Px = Ȼ1 and Py = Ȼ5. Graph the budget line, compute the slope of the budget line and show how it changes when the price of good X increases to Px = Ȼ5

Consumer Equilibrium The equilibrium consumption bundle is the affordable bundle that yields the highest level of satisfaction. Consumer equilibrium occurs at a point where MRS = PX / PY. Equivalently, the slope of the indifference curve equals the budget line. I. II. III. C A B D X Y Consumer Equilibrium M/PY M/PX

Price changes and Consumer equilibrium

Price Changes and Consumer Equilibrium Substitute Goods An increase (decrease) in the price of good X leads to an increase (decrease) in the consumption of good Y. Examples: Coke and Pepsi. Delay Mackerel and Geisha. Complementary Goods An increase (decrease) in the price of good X leads to a decrease (increase) in the consumption of good Y. Herb Afrik and Lime. Computer CPUs and monitors.

Substitute Goods When the price of good Coke (X) falls and the consumption of Pepsi (Y) falls, then X and Y are substitute goods. (PX1 > PX2) Pepsi (Y) I M/PY1 II M/PX2 A Y1 B X1 Y2 X2 M/PX1 Coke (X)

Complementary Goods When the price of Phones (X) falls and the consumption of Credit (Y) rises, then Phones and Credit are complementary goods. (PX1 > PX2) Credit (Y) M/PY1 II M/PX2 I B Y2 X2 A Y1 X1 M/PX1 Phones (X)

Income changes and consumer equilibrium

Income Changes and Consumer Equilibrium Normal Goods Good X is a normal good if an increase (decrease) in income leads to an increase (decrease) in its consumption. Inferior Goods Good X is an inferior good if an increase (decrease) in income leads to a decrease (increase) in its consumption.

Normal Goods Y An increase in income increases the consumption of normal goods. (M0 < M1). M1/Y M1/X II B I Y1 X1 M0/Y M0/X A Y0 X0 X

Inferior Goods II Y If we assume that good X is an inferior good. An increase in income decreases the consumption of good X (inferior good). (M0 < M1). M1/Y M1/X Y1 X1 B I M0/Y M0/X A Y0 X0 X

Application Choices of workers and managers

Model of Income-leisure Leisure and income are considered substitute goods To induce workers to give up leisure, firms must compensate them. Suppose a firm offers to pay a worker Ȼ100 for each hour of leisure, what do you think will happen? .

Demand curves

Individual Demand Curve X Y $ D II I An individual’s demand curve is derived from each new equilibrium point found on the indifference curve as the price of good X is varied. P0 P1 X0 X1

Market Demand The market demand curve is the horizontal summation of individual demand curves. It indicates the total quantity all consumers would purchase at each price point. $ Individual Demand Curves $ Market Demand Curve 50 40 D1 D2 DM 1 2 Q 1 2 3 Q

L = U(X,Y) + λ [M – PxX – PyY] Utility Maximization Given prices of Px and Py and a level of income M, the consumer attempts to maximize utility subject to the budget constraint. Formally, this problem can be solved by forming the Lagrangian: If you are given U=U(X,Y) and M= PxX+PyY Then L = U(X,Y) + λ [M – PxX – PyY]

Problem Suppose that a consumer’s utility function is If Px = 5, Py = 10, and the consumer’s money income is M = 1,000, what are the optimal values of X and Y? Derive the consumer’s demand equations for goods X and Y.

Conclusion Indifference curve properties reveal information about consumers’ preferences between bundles of goods. Completeness. More is better. Diminishing marginal rate of substitution. Transitivity. Indifference curves along with price changes determine individuals’ demand curves. Market demand is the horizontal summation of individuals’ demands.