Chapter 3 Consumer Behavior

Chapter 3: Consumer BehaviorSlide 2 Topics to be Discussed Consumer Preferences Budget Constraints Consumer Choice Revealed Preferences Marginal Utility and Consumer Choice Cost-of-Living Index

Chapter 3: Consumer BehaviorSlide 3 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 BehaviorSlide 4 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 BehaviorSlide 5 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 BehaviorSlide 6 Consumer Preferences A market basket is a collection of one or more commodities. One market basket may be preferred to another market basket containing a different combination of goods. Market Baskets

Chapter 3: Consumer BehaviorSlide 7 Consumer Preferences Three Basic Assumptions 1) Preferences are complete. 2) Preferences are transitive. 3) Consumers always prefer more of any good to less. Market Baskets

Chapter 3: Consumer BehaviorSlide 8 Consumer Preferences A2030 B1050 D4020 E3040 G1020 H1040 Market BasketUnits of Food Units of Clothing

Chapter 3: Consumer BehaviorSlide 9 Consumer Preferences Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person. Indifference Curves

Chapter 3: Consumer BehaviorSlide 10 The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A. Consumer Preferences Food (units per week) Clothing (units per week) 50 G A EH B D

Chapter 3: Consumer BehaviorSlide 11 U1U1 Combination B,A, & D yield the same satisfaction E is preferred to U 1 U 1 is preferred to H & G Consumer Preferences Food (units per week) Clothing (units per week) 50 G D A E H B

Chapter 3: Consumer BehaviorSlide 12 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 BehaviorSlide 13 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 BehaviorSlide 14 Consumer Preferences 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. Indifference Maps

Chapter 3: Consumer BehaviorSlide 15 Consumer Preferences Indifference Curves Finally, indifference curves cannot cross.  This would violate the assumption that more is preferred to less.

Chapter 3: Consumer BehaviorSlide 16 U2U2 U3U3 Consumer Preferences Food (units per week) Clothing (units per week) U1U1 A B D Market basket A is preferred to B. Market basket B is preferred to D.

Chapter 3: Consumer BehaviorSlide 17 U1U1 U2U2 Consumer Preferences Food (units per week) Clothing (units per week) A D B The consumer should be indifferent between A, B and D. However, B contains more of both goods than D. Indifference Curves Cannot Cross

Chapter 3: Consumer BehaviorSlide 18 Consumer Preferences The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain an additional unit of another good, given the same level of satisfaction. It is measured by the slope of the indifference curve. Marginal Rate of Substitution

Chapter 3: Consumer BehaviorSlide 19 Consumer Preferences Food (units per week) Clothing (units per week) A B D E G MRS = 6 MRS = 2

Chapter 3: Consumer BehaviorSlide 20 Consumer Preferences 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. Marginal Rate of Substitution

Chapter 3: Consumer BehaviorSlide 21 Consumer Preferences 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 Marginal Rate of Substitution

Chapter 3: Consumer BehaviorSlide 22 Consumer Preferences Perfect Substitutes and Perfect Complements Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant. Marginal Rate of Substitution

Chapter 3: Consumer BehaviorSlide 23 Consumer Preferences Perfect Substitutes and Perfect Complements Two goods are perfect complements when the indifference curves for the goods are shaped as right angles. Marginal Rate of Substitution

Chapter 3: Consumer BehaviorSlide 24 Consumer Preferences Orange Juice (glasses) Apple Juice (glasses) Perfect Substitutes Perfect Substitutes

Chapter 3: Consumer BehaviorSlide 25 Consumer Preferences Right Shoes Left Shoes Perfect Complements Perfect Complements

Chapter 3: Consumer BehaviorSlide 26 Consumer Preferences Utility Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket.

Chapter 3: Consumer BehaviorSlide 27 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. Utility function: formula that assigns a level of utility to individual market baskets.

Chapter 3: Consumer BehaviorSlide 28 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 (3) = 14 B (4) = 14 C (4) = 12 The consumer is indifferent to A & B The consumer prefers A & B to C

Chapter 3: Consumer BehaviorSlide 29 Consumer Preferences Food (units per week) Clothing (units per week ) U 1 = 25 U 2 = 50 (Preferred to U 1 ) U 3 = 100 (Preferred to U 2 ) A B C Assume: U = FC Market Basket U = FC C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5) Utility Functions & Indifference Curves

Chapter 3: Consumer BehaviorSlide 30 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 BehaviorSlide 31 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 BehaviorSlide 32 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 BehaviorSlide 33 Budget Constraints The Budget Line Let F equal the amount of food purchased, and C is the amount of clothing. Price of food = P f and price of clothing = P c Then P f F is the amount of money spent on food, and P c C is the amount of money spent on clothing.

Chapter 3: Consumer BehaviorSlide 34 Budget Constraints The budget line then can be written:

Chapter 3: Consumer BehaviorSlide 35 Budget Constraints A040$80 B2030$80 D4020$80 E6010$80 G800$80 Market BasketFood (F) Clothing (C)Total Spending P f = ($1)P c = ($2)P f F + P c C = I

Chapter 3: Consumer BehaviorSlide 36 Budget Line F + 2C = $ (I/P C ) = 40 Budget Constraints Food (units per week) = (I/P F ) A B D E G Clothing (units per week ) Pc = $2 P f = $1 I = $80

Chapter 3: Consumer BehaviorSlide 37 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 BehaviorSlide 38 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 BehaviorSlide 39 Budget Constraints The Budget Line The vertical intercept (I/P C ), illustrates the maximum amount of C that can be purchased with income I. The horizontal intercept (I/P F ), illustrates the maximum amount of F that can be purchased with income I.

Chapter 3: Consumer BehaviorSlide 40 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 BehaviorSlide 41 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 BehaviorSlide 42 Budget Constraints Food (units per week) Clothing (units per week) A increase in income shifts the budget line outward (I = $160) L2L2 (I = $80) L1L1 L3L3 (I = $40) A decrease in income shifts the budget line inward

Chapter 3: Consumer BehaviorSlide 43 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 BehaviorSlide 44 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 BehaviorSlide 45 Budget Constraints Food (units per week) Clothing (units per week) (P F = 1) L1L1 An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward. L3L3 (P F = 2) (P F = 1/2) L2L2 A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward.

Chapter 3: Consumer BehaviorSlide 46 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 BehaviorSlide 47 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 BehaviorSlide 48 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 BehaviorSlide 49 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 BehaviorSlide 50 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 BehaviorSlide 51 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 BehaviorSlide 52 Recall, the slope of an indifference curve is: Consumer Choice Further, the slope of the budget line is:

Chapter 3: Consumer BehaviorSlide 53 Consumer Choice Therefore, it can be said that satisfaction is maximized where:

Chapter 3: Consumer BehaviorSlide 54 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 BehaviorSlide 55 Consumer Choice Food (units per week) Clothing (units per week) U1U1 B Budget Line Pc = $2 P f = $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

Chapter 3: Consumer BehaviorSlide 56 Consumer Choice Budget Line U3U3 D Market basket D cannot be attained given the current budget constraint. Pc = $2 P f = $1 I = $80 Food (units per week) Clothing (units per week)

Chapter 3: Consumer BehaviorSlide 57 U2U2 Consumer Choice Pc = $2 P f = $1 I = $80 Budget Line 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 =P f /P c =.5 Food (units per week) Clothing (units per week)

Chapter 3: Consumer BehaviorSlide 58 Consumer Choice 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 at the horizontal and vertical axis. MRS is not equal to P A /P B A Corner Solution

Chapter 3: Consumer BehaviorSlide 59 A Corner Solution Ice Cream (cup/month) Frozen Yogurt (cups monthly) B A U2U2 U3U3 U1U1 A corner solution exists at point B.

Chapter 3: Consumer BehaviorSlide 60 Consumer Choice A Corner Solution When a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio.

Chapter 3: Consumer BehaviorSlide 61 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 BehaviorSlide 62 D Revealed Preferences-- Two Budget Lines l1l1 l2l2 B A I 1 : Chose A over B A is revealed preferred to B l 2 : Choose B over D B is revealed preferred to D Food (units per month) Clothing (units per month)

Chapter 3: Consumer BehaviorSlide 63 A is preferred to all market baskets in the green area Revealed Preferences-- Two Budget Lines l2l2 B l1l1 D A All market baskets in the pink shaded area are preferred to A. Food (units per month) Clothing (units per month)

Chapter 3: Consumer BehaviorSlide 64 Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good. Marginal Utility and Consumer Choice Marginal Utility

Chapter 3: Consumer BehaviorSlide 65 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 Marginal Utility Marginal Utility and Consumer Choice

Chapter 3: Consumer BehaviorSlide 66 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. Diminishing Marginal Utility Marginal Utility and Consumer Choice

Chapter 3: Consumer BehaviorSlide 67 Marginal Utility and the Indifference Curve If consumption moves along an indifference curve, the additional utility derived from an increase in the consumption of one good, food (F), must balance the loss of utility from the decrease in the consumption in the other good, clothing (C). Marginal Utility and Consumer Choice

Chapter 3: Consumer BehaviorSlide 68 Formally: Marginal Utility and Consumer Choice

Chapter 3: Consumer BehaviorSlide 69 Rearranging: Marginal Utility and Consumer Choice

Chapter 3: Consumer BehaviorSlide 70 Because: Marginal Utility and Consumer Choice

Chapter 3: Consumer BehaviorSlide 71 When consumers maximize satisfaction the: Marginal Utility and Consumer Choice Since the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it follows that:

Chapter 3: Consumer BehaviorSlide 72 Which gives the equation for utility maximization: Marginal Utility and Consumer Choice

Chapter 3: Consumer BehaviorSlide 73 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. Marginal Utility and Consumer Choice

Chapter 3: Consumer BehaviorSlide 74 Cost-of-Living Index 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 BehaviorSlide 75 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 BehaviorSlide 76 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 BehaviorSlide 77 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 BehaviorSlide 78 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.

End of Chapter 3