Consumer Behavior How People Choose

Preferences: Origin Where they come from “The economist is not concerned with ends as such. He is concerned with the way in which the attainment of ends is limited. The ends may be noble or they may be base. They may be “material” or” immaterial” –if ends can be so described. But if the attainment of one set of ends involves the sacrifice of others, then it has an economic aspect” (Robbins, 1932, p. 25). Consumer is faced to choices: between one good or another how much of two goods Decisions are made from an individual’s ordering observed as one structure of preferences

Preferences: Assumptions Baskets: A, B, C, … Completeness A  B B  A A  B Reflexivity If A  B then B  A More is better than less Example: B  H Transitivity If A  B and B  C then A  C Example: E  A and A  G then E  G Continuity If A  B, Then there exists a C such that A  C Food Clothing A B H DG E

Structure of Preferences and Indifference Curves Food Clothing A B H DG E Indifference Curves: The same level of satisfaction

Preferences: Indifference Curves and Indifference Maps U1U1 U2U2 U3U3 > > U1U1 U2U2 U3U3

Preferences: The Marginal Rate of Substitution Food Clothing U = U(C,F) U’U’   C UU   F + U(4,3) The total variation of U at (4,3) is = the variation with respect to C of U plus the variation with respect to F

Preferences: The Marginal Rate of Substitution Food Clothing U ’ = 0 U(4,3) The Marginal Rate of Substitution of C U’U’   C UU   F + = = 0 one is the quantity of clothes the actor is willing to give up for one unit of food MRS C MRS C (4,3) = -2 MRS F (4,3) = -½

Preferences: The Marginal Rate of Substitution Food Clothing U(4,3) MRS C (4,3) = -2 MRS F (4,3) = -½

Preferences (Substitutes) Substitutes X Y MRS Y = -1 X Y MRS Y = - ½

Preferences (Substitutes) Complements X Y X Y

Budget Example: The market price per unit of clothes is P c = 2€ The market price per unit of food is P f = 1€ How many units of clothes or food can be acquired with a Budget of 10€? 10 = P c *X C = 2*X C Food Clothing = 2*X C 22 X C = 5 10 = P f *X f = 1*X f 10 = 1*X f X f = 10 How can be used the budget to acquire goods? Consider the extremes

Budget Line Xf Xc B = pcpc XcXc +p f X f 10 = 2 * X c + 1 * X f 10 = 2X c + X f XcXc : slope y = ax + b x y y=b 1 a Slope: = B pcpc - pfpf pcpc XfXf pfpf pcpc Cross with the vertical axis: B pcpc

Budget Line and Changes on Prices Xf Xc = 2X c + X f Let consider the price of clothes decreased to Pc = 1,25€ 10 = P c *X C = 1,25*X C 10 = 1,25*X C X C = 8 1,25

Consumer Choice 10 = 2X c + X f U = U(X c,X f ) Xf Xc How does she choose? She spends all her budget (No savings) She tries to maximize her satisfaction  The choice has to be on the line  The choice has to reach the highest possible level of satisfaction

Consumer Choice 10 = 2X c + X f U = U(X c,X f ) Xf Xc How does she choose? She spends all her budget (No savings)  The choice has to be on the line B

Consumer Choice 10 = 2X c + X f U = U(X c,X f ) Xf Xc How does she choose? She tries to maximize her satisfaction  The choice has to reach the highest possible level of satisfaction BC

Consumer Choice B = p c X c + p f X f U = U(X c,X f ) Xf Xc How does she choose? Graphically, the solution takes place where the line touches tangentially the indifference curve. The solution takes place where the slope of the line equals the tangent of the utility function Mathematically: (X c, X f ) ** pfpf pcpc = MRS C

Corner Solutions Food Clothing pfpf pcpc  MRS C

Marginal Utility and Choice U(food) Food x U(x) x+1 U(x+1) U(x+2) x+2 The Marginal Utility measures the additional satisfaction obtained from consuming one additional unit of a good. decreasing The Marginal Utility is decreasing: as the consumption grows more and more, the additional satisfaction obtained is less and less