Lecture 4 Consumer Behavior Recommended Text: Franks and Bernanke - Chapter 5

Consumption Decision  Consumers choose from a “menu” of items in various combinations Must be affordable, given income and prices of goods  Factors affecting the consumption decision: An individual’s taste & preferences  Microeconomists take people’s taste & preference as given How much money an individual has to spend (budget) Price of the goods in the marketplace

Consumption & Utility  Utility – a measure of the satisfaction derived from consuming a product, good, or service Since utility is derived from the inherent characteristics or qualities that make a product desirable, utility may be objective or subjective. Util - a hypothetical numerical measurement of utility (used to represent the satisfaction derived from consuming products).

Total Utility and Marginal Utility  Total Utility (TU) – total satisfaction derived from consumption of a good.  Marginal Utility (MU) – The amount of additional utility derived from the consumption of an additional unit of a good when the quantity of consumption of all other goods are held constant MU = ΔTU / ΔQ = ∂TU/∂Q MU is the utility provided by the last unit of the good consumed

Example

Example (Cont.)

Law of Diminishing Marginal Utility As additional units of a good are consumed a point is always reached where the utility derived from each additional unit declines.

Example (Cont.)

Indifference Curves  Indifference Curve (IC) - a line showing all combinations of two goods (products) that provide the same level of utility i.e., the consumer is indifferent between them  As we move along the IC, the utility level remains the same but quantities of goods consumed change as one good replaces (or substitutes) for the other. IC QyQy QxQx X1X1 X2X2 Y2Y2 Y1Y1

Characteristics of Indifference Curves  The closer to the origin, the lower the level of utility and vice versa.  Each IC represents a unique utility level - - Hence, ICs never intersect  ICs are negatively sloped and convex. The downward slope of the IC indicates that if the consumer consumes less of one good, she would consume more of the other (for utility to remain constant).  The whole set of IC is called an indifference map. IC 1 QyQy QxQx IC 2

Indifference Curves  Marginal rate of substitution (MRS) – The number of units of one good that must be given up to receive an extra unit of another good, holding the level of satisfaction constant. MRS XY =  Y /  X MRS is the slope of the indifference curve. IC QyQy QxQx Y1Y1 Y2Y2 X1X1 X2X2 YY XX

Marginal Rate of Substitution MRS XY =  Y/  X XY YY XX

Diminishing Marginal Rate of Substitution  More the consumer has of a particular good, say X, the less of another good, say Y, he would be willing to give up to obtain an additional unit of X.  That is, MRS of X for Y gets smaller as the consumer has more of X and less of Y.  This is applicable only if Y and X are imperfect substitutes. IC Y X

Budget Constraint  Budget Constraint – price & availability of goods in the market, along with the size of the budget, place a constraint on consumption.  Budget and budget constraint are represented by the budget line. X Y

Budget Line  Budget Line – a line indicating all combinations of two goods that can be purchased using all of the consumer’s budget, i.e., I = X P x + Y P y  Assume I = 30, P X = 1, & P Y = Total ExpenditureYX

Budget Line  Every combination of goods along the budget line can be purchased for the same total expenditure. The distance from the origin is an indication of the size of the budget. The closer to the origin, the lower the budget and vice versa. Only purchases on the budget line use all of the consumer’s budget. X Y

Budget Line  I = X P x + Y P y OR  Y = I/P y – (P x / Py) X  Where, I/P y is the Y-intercept, I/P X is the X-intercept and - (P x / P y ) is the slope X Y I/P Y I/P X Slope = - (Px / Py)

Changes in Budget  A budget increase (decrease) will result in a parallel shift of the budget line to the right (left)  If the price of one good changes, slope of budget line changes X Y X Y

Review of Budget Line and Indifference Curve  Budget Line: a line indicating all combinations of two goods that can be purchased using all of the consumer’s budget. Only purchases on the budget line use all of the consumer’s budget.  Indifference Curve (IC): a line showing all combinations of two goods (products) that provide the same level of utility. ICs that are higher in graphs represent greater level of satisfaction. X Y IC 1 IC 2 IC3 X Y

Consumer Choice Problem  The basic problem a consumer faces is how to allocate the budget among various goods to maximize utility (satisfaction).  That is, the consumer’s objective is to select from all combinations of goods within her means (i.e., combinations on his budget line) the one that gives him the maximum utility (i.e., the one that lies on the highest indifference curve.)

Utility Maximization Decision V W X Y S U T IC 1 IC 2 IC3

Utility Maximization Decision V W X Y S U T IC 1 IC 2 IC3 It is then clear that from all the market baskets that are within the consumer’s reach, market basket “V” would give the consumer the maximum utility. Note that the market basket V is at a point where the budget line is tangent to IC 2. Thus, the slope of the budget line should be equal to the slope of the indifference curve.

Utility Maximization Decision  Slope of the budget line = P X / P Y  Slope of the indifference curve = MRS XY =  Y /  X  Thus at the point of tangency: MRS =  Y /  X = P X / P Y  Thus, the consumer maximizes his utility where MRS is equal to the ratio of prices.

 If the consumer’s income and the price of good Y remains the same, a change in the price of X causes the consumer’s budget line to pivot around its Y- intercept A rise in the price of X causes the budget line to pivot inward A fall in the price of X causes the budget line to pivot outward Impact of Changes in Product Prices

Impact of Changes in Product Prices: Non-Giffen Goods  IF P X increases- X becomes relatively more expensive than Y The (absolute) slope of the budget line increases and the budget line rotates inward The consumer can no longer afford to remain on original indifference curve and must move to a lower indifference curve The new equilibrium will be at S. V W X Y S IC 2 IC 1

Impact of Changes in Product Prices  IF P X decreases- X becomes cheaper relative to Y The slope of the budget line decreases and the budget line rotates outward The consumer can afford to move to a higher indifference curve The new equilibrium will be at S V X Y IC 1 S IC 2

Price Consumption Curve (PCC)  The PCC connects points representing equilibrium market baskets corresponding to all possible levels of the price of good X, while price of Y and income remain the same. b X Y IC 2 c IC 3 a PCC IC 1

Deriving a Demand Curve An individual’s demand curve for a particular good is derived from the individual’s budget (budget line) & taste & preferences (indifference curve) or the PCC. The law of demand states that, ceteris paribus, the quantity of a product demanded will vary inversely to the price of that product.

V X Y IC 2 W IC 3 S IC 1 X1X1 X2X2 X3X3 Y3Y3 Y2Y2 Y1Y1 X Price of X X1X1 X2X2 X3X3 P1P1 P2P2 P3P3 Demand Curve for X PCC

Deriving a Demand Curve  Demand Curve – a line connecting all combinations of price and quantities consumed  Each point on a demand curve gives the price and quantity combination of a good that a consumer will buy, given his or her budget constraint and the prices of other goods.  Each point on the demand curve gives a quantity of the good that a consumer will buy to maximize utility. X Price of X X1X1 X2X2 X3X3 P1P1 P2P2 P3P3 Demand Curve for X

Non-Giffen and Giffen Goods  Non-Giffen Good - A good that follows the law of demand, so that when price goes up, the quantity demanded goes down  Giffen Good - A good that violates the law of demand, so that when price goes up, the quantity demanded goes up  Giffen goods are rare or nonexistent Using the theory of indifference curves indicates exception to the law of demand

Non-Giffen Goods and Giffen Goods

Impact of Changes in Income  A change in income results in a parallel shift of the budget line (slope stays unaffected as long as the prices remain constant) An increase in income shifts the budget line to the right (outward) A decrease in income shifts the budget line to the left (inward)  Normal Good – a good that you consume more (less) as your income rises (falls)  Inferior good – a good that you consume less (more) as your income rises (falls)

Normal and Inferior Goods

Changes in Income and Changes in the Optimum Point  Assume that both goods X and Y are normal goods – the consumer consumes more of X and Y as her income rises With rising income, the consumer’s utility maximizing market baskets change from “u” to “v” to “w.” If we connect all of the points representing utility maximizing market baskets (u, v, and w) corresponding to all possible levels of income, the resulting curve is called the Income Consumption Curve. W X Y IC 3 IC 2 IC 1 ICC U V w

Deriving an Engel Curve The ICC can be used to derive an Engel Curve, which are important for studies of family expenditure patterns. For fixed prices, the Engel Curve describes the relationship between a consumer’s income and his expenditure on a specific good.

X Y IC 3 IC 2 IC 1 ICC U V w X I X1 X2 X3 I3 I2 I1 Engel Curve

Deriving an Engel Curve  Engel Curve – a line connecting all combinations of income and quantities consumed  Each point on an Engel curve gives the income and quantity combination of a good that a consumer will buy, given the prices of all goods.  As the income increases (decreases), the quantity demanded of that product increases (decreases). This is true only for normal goods.  The shape of the Engel curve for a particular good will depend on the nature of the good, the nature of the consumer’s taste, and the level at which the commodity prices are held constant. X I X1 X3 I3 I2 I1 Engel Curve X2