1. Business Economics (ECO 341) Fall Semester, 2012
Khurrum S. Mughal 1 1

2. Theme of the Lecture Consumer Preferences Budget Constraints
Consumer Choice
Marginal Utility and Consumer Choice 2

3. Consumer Behaviour
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. 8

4. Consumer Behaviour
There are three steps involved in the study of consumer behavior.
2) Then we will turn to budget constraints.
People have limited incomes. 8

5. Consumer Behaviour
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? 9

6. Basic Concepts
Total Utility
Marginal Utility 9

7. Basic Concepts 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.
104

8. Basic Concepts Ordinal Versus Cardinal Utility
Ordinal Utility Function: places market baskets in the order of most preferred to least preferred.
Cardinal Utility Function: utility function describing the extent to which one market basket is preferred to another, giving numerical values to the utility. 27

9. Basic Concepts Ordinal Versus Cardinal Rankings
The actual unit of measurement for utility is not important.
Therefore, an ordinal ranking is sufficient to explain how most individual decisions are made. 28

10. Basic Concepts BADS Examples
Things for which less is preferred to more
Examples
Air pollution
Asbestos

11. Theme of the Lecture Consumer Preferences Budget Constraints
Consumer Choice
Marginal Utility and Consumer Choice 2

12. Consumer Preferences Market Baskets
A market basket is a collection of one or more commodities.
One market basket may be preferred over another market basket containing a different combination of goods. 10

13. Consumer Preferences Market Baskets Three Basic Assumptions
1) Preferences are complete.
2) Preferences are transitive.
3) Non-satiation Consumers always prefer more of any good to less. 11

14. Consumer Preferences Indifference Curves
Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person. 13

15. Consumer Preferences B 10 50 D 40 20 E 30 40 G 10 20 H 10 40 A 20 30
Market Basket Units of Food Units of Clothing
A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40 12

16. Consumer Preferences Clothing (units per week) 50 G A E H B D 40 30 20
The consumer prefers
A to all combinations
in the blue box, while
all those in the pink
box are preferred to A. 50 G A E H B D 40 30 20 10
Food
(units per week) 10 20 30 40 15

17. Consumer Preferences Clothing (units per week) U1 50 G D A E H B 40 30
Combination B,A, & D
yield the same satisfaction
E is preferred to U1
U1 is preferred to H & G 50 G D A E H B 40 30 20 10
Food
(units per week) 10 20 30 40 17

18. 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. 19

19. Consumer Preferences Indifference Maps
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. 20

20. Consumer Preferences Clothing (units per week) Market basket AD
Market basket A
is preferred to B.
Market basket B is
preferred to D. U3 U2 U1
Food
(units per week) 24

21. Consumer Preferences Indifference Curves
Finally, indifference curves cannot cross.
This would violate the assumption that more is preferred to less. 21

22. Consumer Preferences Indifference Curves Cannot Cross Clothing
(units per week) U1 U2 A D B
The consumer should
be indifferent between
A, B and D. However,
B contains more of
both goods than D.
Food
(units per week) 26

23. Marginal Rate of Substitution
Consumer Preferences
Marginal Rate of Substitution
The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good.
It is measured by the slope of the indifference curve. 29

24. Consumer Preferences -1 -6 1 -4 -2
The amount of clothing given up for a unit of food decreases
from 6 to 1 A B D E G
Clothing
(units
per week) 16 14 12 10 8 6 4 2
Food
(units per week) 1 2 3 4 5 32

25. Consumer Preferences A Clothing (units per week) 16 14 MRS = 6 12 -610 B 1 8 -4 D
MRS = 2 6 1 E -2 4 G 1 -1 1 2
Food
(units per week) 1 2 3 4 5 32

26. Marginal Rate of Substitution
Consumer Preferences
Marginal Rate of Substitution
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. 33

27. Marginal Rate of Substitution
Consumer Preferences
Marginal Rate of Substitution
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 34

28. Marginal Rate of Substitution
Consumer Preferences
Marginal Rate of Substitution
Perfect Substitutes and Perfect Complements
Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant. 35

29. Consumer Preferences Perfect Substitutes Apple Juice (glasses) 4 3 2 1
Orange Juice
(glasses) 1 2 3 4 38

30. Marginal Rate of Substitution
Consumer Preferences
Marginal Rate of Substitution
Perfect Substitutes and Perfect Complements
Two goods are perfect complements when the indifference curves for the goods are shaped as right angles. 36

31. Consumer Preferences Perfect Complements Left Shoes 4 3 2 1 1 2 3 41 2 3 4
Right Shoes 40

32. Consumer Preferences Utility
Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket.
103

33. Theme of the Lecture Consumer Preferences Budget Constraints
Consumer Choice
Marginal Utility and Consumer Choice 2

34. 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. 42 46

35. Budget Constraints The Budget Line
The budget line indicates all combinations of two commodities for which total money spent equals total income. 42 47

36. Budget Constraints The Budget Line
Let F equal the amount of food purchased, and C is the amount of clothing.
Price of food = Pf and price of clothing = Pc
Then Pf F is the amount of money spent on food, and Pc C is the amount of money spent on clothing. 42 48

37. Budget Constraints
The budget line then can be written: 42 49

38. Budget Constraints
Market Basket Food (F) Clothing (C) Total Spending
Pf = ($1) Pc = ($2) PfF + PcC = I
A 0 40 $80 B $80 D $80 E $80 G 80 0 $80 12 50

39. Budget Constraints Clothing (units per week) Pc = $2 Pf = $1 I = $80 A
Budget Line F + 2C = $80
(I/PC) = 40 30 20 10
Food
(units per week) 20 40 60
80 = (I/PF) 42 54

40. 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. 42 55

41. 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. 42 56

42. Budget Constraints The Budget Line
The vertical intercept (I/PC), illustrates the maximum amount of C that can be purchased with income I.
The horizontal intercept (I/PF), illustrates the maximum amount of F that can be purchased with income I. 42 57

43. Budget Constraints Clothing (units per week) A increase in
income shifts
the budget line
outward
(I = $160) L2 80 60 L3
A decrease in
income shifts
the budget line
inward 40
(I = $80) L1 20
Food
(units per week) 40 80
120
160 42 61

44. Budget Constraints L3 L2 L1 Clothing (units per week)
An increase in the
price of food to
$2.00 changes
the slope of the
budget line and
rotates it inward. L3
(PF = 2)
(PF = 1/2) L2
A decrease in the
price of food to
$.50 changes
the slope of the
budget line and
rotates it outward. 40
(PF = 1) L1
Food
(units per week) 40 80
120
160 42 65

45. Theme of the Lecture Consumer Preferences Budget Constraints
Consumer Choice
Marginal Utility and Consumer Choice 2

46. Consumer Choice
Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them. 68

47. 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. 69

48. Further, the slope of the budget line is:
Consumer Choice
Recall, the slope of an indifference curve is:
Further, the slope of the budget line is: 70

49. Consumer Choice
Therefore, it can be said that satisfaction is maximized where: 71

50. 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). 72

51. maximize satisfaction
Consumer Choice
Clothing
(units per
week)
Budget Line
Pc = $2 Pf = $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 U1 40 B 30 20 20 40 80
Food (units per week) 76

52. Consumer Choice Pc = $2 Pf = $1 I = $80 U3 D Market basket D
Clothing
(units per
week)
Pc = $2 Pf = $1 I = $80 U3 D
Market basket D
cannot be attained
given the current
budget constraint. 40
Budget Line 30 20 20 40 80
Food (units per week) 77

53. indifference curve are
Consumer Choice
Clothing
(units per
week)
Pc = $2 Pf = $1 I = $80 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 =Pf/Pc = .5 40 U2
Budget Line 30 20 20 40 80
Food (units per week) 78

54. Theme of the Lecture Consumer Preferences Budget Constraints
Consumer Choice
Marginal Utility and Consumer Choice 2

55. Diminishing Marginal Utility
Marginal Utility & Consumer Choice
Diminishing Marginal Utility
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.
109

56. Marginal Utility & Consumer Choice
Marginal Utility and the Indifference Curve
If consumption moves along an indifference curve, the additional utility derived from an increase in the consumption one good, food (F), must balance the loss of utility from the decrease in the consumption in the other good, clothing (C).
110

57. Marginal Utility & Consumer Choice
112

58. Marginal Utility & Consumer Choice
Because:
113

59. Marginal Utility & Consumer Choice
When consumers maximize satisfaction the:
Since the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it follows that:
115

60. Marginal Utility & Consumer Choice
Which gives the equation for utility maximization:
116

61. Marginal Utility & Consumer Choice
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.
117

62. Marginal Utility & Consumer Choice
Gasoline Rationing
In 1974 and again in 1979, the US government imposed price controls on gasoline.
This resulted in shortages and gasoline was rationed.
118

63. Marginal Utility & Consumer Choice
Rationing hurts some by limiting the amount of gasoline they can buy.
This can be seen in the following model.
It applies to a woman with an annual income of $20,000.
119

64. Marginal Utility & Consumer Choice
The horizontal axis shows her annual consumption of gasoline at $1/gallon.
The vertical axis shows her remaining income after purchasing gasoline.
120

65. (lower level of utility).
Marginal Utility & Consumer Choice
Spending
on other
goods ($)
5,000 U1 C
15,000 B
20,000 A
2,000 D
With a limit of
2,000 gallons,
the consumer moves
to a lower
indifference curve
(lower level of utility).
18,000 U2
20,000
Gasoline
(gallons per year)
123