Professors Farhoud Kafi

Consumer Preference and Behavior What are the consumer opportunity?  Array of goods and services they can afford. What are the consumer preference?  Bundles which they actually buy Can we develop a model that shows how they buy these bundles?  Yes, we can develop a utility/attribute function What would be the ultimate goal?  Maximizing Utility, subject to Budgetary (Income) constraint.

How the Objective is Achieved Given the choices among the bundles, consumers will pick each bundle based on the value he/she assigns to that bundle while considering; budget, price, and all other attributes important to his/her choice.

How to model the consumer choice We assume consumer is rational decision maker We assume the bundles ranked higher by consumer are superior We assume additional bundles, inevitably will lead to diminishing marginal satisfaction (DMU) Based on information received from the consumer, we can map and develop the consumer utility function Given the constraint, we can then identify the best possible bundle

Use of indifference map in modeling consumer behavior We assume consumer has only two bundles to choose We assume consumer assigns budget to acquire these bundles We assume money left over provides no marginal benefit to consumer We assume consumer can express preference We assume more is preferred to less We assume substitution has DMR We assume consumer is constraint by the budget and prices are exogenous to the model

Consumer preferences can be described with indifference curves.

The Properties of Indifference Curves Do not intersect More is always better Negatively sloped throughout Slope: MRS = “Marginal rate of substitution” Here MRS =  CD /  Pizza

The Consumer’s Budget Constraint Income = 100, P pizza = $5.00, P CDs = $10.00 Slope = - P pizza / P CDs Pizza's CDs

Consumer in Equilibrium at E MRS = P pizza /P CDs

Consumer in disequilibrium at B

Difference in Preferences

Different Preferences lead to Different Choices

Assignment Question 1 1. Alex’s preferences for bagels and wine can be isolated and examined. Assume that Alex’s budget is $200. Bagels cost $2.00 each and wine costs $10.00 per liter. Assume that Alex spends all of his income on bagels and wine in order to maximize his total utility. a) Write the equation for his budget line. What is the slope of the budget line and what does it mean? Draw the budget line. Use the X-axis for bagels and the Y-axis for wine.

Budget Equation P B Q B + P W Q W = I P B = 2 P W = 10 I = 200 2Q B + 10Q W = 200

Graph of the Budget Line QBQB QWQW

Bagels and Wine (continued) c) Draw Alex’s preferences map and superimpose the budget line. Label Alex’s utility- maximizing combination of bagels and wine as point “A.” What is meant by the “utility- maximizing combination of bagels and wine?”

Alex’s Preference Map QBQB QWQW U1 U2 U3 U4

Rational Consumer (Alex) Choice QBQB QWQW U1 U2 U3 U4 A

Utility-Maximizing Combination of Bagels and Wine Slope of Indifference Curve = MRS MRS = - (  Wine/  Bagels) MRS = - (  Q W /  Q B ) Slope of Budget Line = Relative Price Ratio = – (P B /P W ) Utility-maximizing combination is where the slope of the indifference curve is equal to the slope of the budget line.

Utility-Maximizing Combination of Bagels and Wine MRS = (P B /P W ) This is also the point where the highest possible indifference curve is just tangent to the budget line.

Bagels and Wine (continued) c) Sally is currently spending her entire budget on bagels. She purchases no wine. Draw Sally’s indifference curves and explain her consumption choices in term of marginal utility.

Sally’s Indifference Curves and Budget Line QBQB QWQW U1U2U3

Marginal Utility MU =  U/  Q Sally’s Marginal Utility for Wine MU W =  U/  Q W = 0 MRS = - (  Q W /  Q B ) MRS = - (  U/  Q B )/(  U/  Q W ) MRS = - MU B /MU W = Undefined Sally will not give up any bagels to gain any wine

Bagels and Wine (continued) d) Consider alternative strategies wine manufacturers could use to target Sally and consumers like her (i.e. lowering price of wine, advertising, free samples).