6.1 Chapter 7 – The Theory of Consumer Behavior  The Theory of Consumer behavior provides the theoretical basis for buyer decision- making and the foundation for demand.  In essence, we will assume that the consumer’s goal is to maximize utility subject to a budget constraint.  Thus, this theory is an application of the logic of constrained maximization.

6.2 Assumptions of the Theory of Consumer Behavior  Consumers have complete information –Know goods available and utility provided –Price of each good is known –Income is known  Consumers can rank order their preferences –Given choices A and B, can determine A  B or B  A or A  B –Rationality – transitive preferences, if A  B and B  C then A  C –More is preferred to less

6.3 Consumer Preferences and Utility  Utility is a measure of the benefits received from the goods consumed.  The utility function is an equation the relationship between total utility and the different combinations(bundles) of goods.  U=f(X,Y,Z), where U is utility and X,Y, and Z are quantities of three goods.  The utility measurement is only important to the extent that it accurately represents preferences.

6.4 Indifference Curves  An indifference curve is a locus of points indicating different combinations of 2 goods each of which yields the same level of satisfaction.  Note 2 goods are assumed since we desire to present model graphically.

6.5 Characteristics of Indifference Curves  Negative slope – tradeoffs, if more of X then less of Y if utility is held constant  Convex to the origin – diminishing MRS, the more of X you have relative to Y the more willing you are to trade X for Y and vice-versa.  Indifference curves cannot intersect – violation of transitivity assumption

6.6 Marginal Rate of Substitution  The MRS is the (negative of the) slope of the indifference curve. Therefore it reflects It is a measure of the number of units of Y that must be given up if X is increased by a single unit, holding utility constant. Note it will diminish as we move down an indifference curve.

6.7 Indifference Curves Y X a b c a  c b  c a  b??? No b  a

6.8 Concept of an Indifference Map  Graph of several indifference curves each representing different levels of utility.  The higher (further from the origin) an indifference curve, the greater the level of utility.

6.9 Marginal Utility and MRS  Marginal utility of a good is the change in total utility in response to consuming an additional unit.  The change in total utility is given by the following equation

6.10 Marginal Utility and MRS Along an indifference curve the change in utility is equal to zero and

6.11 The Budget Constraint  Suppose you have $100 to spend on two goods, X & Y, and the prices of each are $10 and $20 respectively. Determine the equation relating Y to X reflecting your budget constraint.  100 = 10X+20Y or  Y=5-0.5X  In general, budget constraint is  Y = M/P Y -(P X /P Y )X  Note linear and slope is ratio of prices

6.12 Changes in the Budget  What happens to the budget line if income, M, changes?  What happens to budget line if one of the prices change?  Y = M/P Y -(P X /P Y )X

6.13 Change in Income Y X 10 5 Budget line I – M=100, P X =10, P Y =20 Budget Line II – M=140, Prices same I 14 7

6.14 Change in Price Y X 10 5 Budget line I – M=100, P X =10, P Y =20 Budget Line II – M=100, P X =20, P Y =20 I II

6.15 Utility Maximization  In graphical model consumer is trying to obtain the highest level of utility subject to the budget constraint which limits his/her choices.  The budget line shows what combinations of X and Y that the consumer is able to purchase.  The indifference map shows the consumer’s preferences for X and Y.

6.16 Utility Maximization  The Optimal Solution, where the consumer maximizes utility subject to the budget constraint, is found where the budget line is tangent to an indifference curve. Since indifference curves cannot intersect this will be the highest possible level of utility given the constraint.  See Figure 6.7 page 211

6.17 Utility Maximization  At any tangency point the slopes of the two relationships must be equal.  Slope of Indifference curve is the MRS – the rate the consumer is willing to substitute Y for X, holding utility constant.  Slope of budget line is the ratio of prices, which reflects the rate the consumer is able to substitute Y for X

6.18 Utility Maximization Rate willing to sub = Rate able to sub

6.19 Utility Maximization  Recall the Marginal Utility interpretation of the MRS or slope of the indifference curve.

6.20 An Individual Consumer’s Demand Curve  If you change the price of say Good X and observe the optimal amount purchased of Good X, you have the required information to plot the demand curve, ie. Price versus Quantity Demanded

6.21 Income And Substitution Effects  If the price of Good X is decreased, we expect the quantity demanded of Good X to increase. This is due to two effects: –Substitution effect – more of X because it is now relatively cheaper(compared to Y) –Income effect(for Normal Good) – more of Good X because the consumer’s real income(purchasing power) has risen due to lower price of X and constant income and price of Y.  Note income effect can differ from example if Good X is an inferior good

6.22 Income And Substitution Effects  Income and substitution effects reinforce each other if the good is normal and demand curves must be negatively sloped.  However, if the good is an inferior good the income and substitution effects of a price change are in opposite directions and whether demand curve is negatively sloped depends on which effect is the larger.

6.23 Giffen Goods  A Giffen Good is an inferior good for which the income effect is larger than the substitution effect and the demand curve would be upward-sloping.  Generally ignore Giffen Goods since –they are rare –Even if possible for an individual, no evidence it could happen for the demand of group of individuals

6.24 Market Demand Curves  Nothing more than the horizontal aggregation of the individual demand curves of all consumers in the market.  See Table 6.2 and Figure 6.13

6.25 Imperfect Information About Price and Quantity  Since consumers do not have perfect information about prices and products (quality and characteristics), there is often an incentive to gather additional information through search.  Since there are expected benefits associated with search as well as expected costs – the optimal amount of search to conduct is to point where MB = MC.  Note the full price for the consumer is the money (product) price plus the per unit search costs.

6.26 Imperfect Information and Advertising  Since consumers do not possess perfect information, firms expend resources to advertise their products. This takes two basic forms: –Purely informative advertising –Image advertising