1. Chapter 3
Consumer Behavior 1

2. Topics to be Discussed Consumer Preferences Budget Constraints
Consumer Choice
Revealed Preferences
Chapter 3: Consumer Behavior 2

3. Topics to be Discussed Marginal Utility and Consumer Choices
Cost-of-Living Indexes
Chapter 3: Consumer Behavior 3

4. Consumer Behavior
Two applications that illustrate the importance of the economic theory of consumer behavior are:
Apple-Cinnamon Cheerios
The Food Stamp Program.
Chapter 3: Consumer Behavior 4

5. Consumer Behavior
General Mills had to determine how high a price to charge for Apple- Cinnamon Cheerios before it went to the market.
Chapter 3: Consumer Behavior 5

6. Consumer Behavior
When the food stamp program was established in the early 1960s, the designers had to determine to what extent the food stamps would provide people with more food and not just simply subsidize the food they would have bought anyway.
Chapter 3: Consumer Behavior 6

7. Consumer Behavior
These two problems require an understanding of the economic theory of consumer behavior.
Chapter 3: Consumer Behavior 7

8. 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 Behavior 8

9. 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 Behavior 8

10. 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 Behavior 9

11. 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.
Chapter 3: Consumer Behavior 10

12. Consumer Preferences Three Basic Assumptions
Market Baskets
Three Basic Assumptions
1) Preferences are complete.
2) Preferences are transitive.
3) Consumers always prefer more of any good to less.
Chapter 3: Consumer Behavior 11

13. Consumer Preferences A 20 30 B 10 50 D 40 20 E 30 40 G 10 20 H 10 40
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
Chapter 3: Consumer Behavior 12

14. Consumer Preferences
Indifference Curves
Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person.
Chapter 3: Consumer Behavior 13

15. Consumer Preferences 50 G A E H B D 40 30 20 10 10 20 30 40 Clothing
(units per week)
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
Chapter 3: Consumer Behavior 15

16. Consumer Preferences 50 B H 40 E A 30 D 20 U1 G 10 Clothing
(units per week) U1
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
Chapter 3: Consumer Behavior 17

17. 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 Behavior 18

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.
Chapter 3: Consumer Behavior 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.
Chapter 3: Consumer Behavior 20

20. Consumer Preferences Indifference Curves
Finally, indifference curves cannot cross.
This would violate the assumption that more is preferred to less.
Chapter 3: Consumer Behavior 21

21. Consumer Preferences D B A U3 U2 U1 Clothing (units per week)
Market basket A
is preferred to B.
Market basket B is
preferred to D. U3 U2 U1
Food
(units per week)
Chapter 3: Consumer Behavior 24

22. Consumer Preferences Indifference Curves Cannot Cross U1 U2 A B D
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)
Chapter 3: Consumer Behavior 26

23. Consumer Preferences A B D E G 16 14 12 10 8 6 4 2 1 2 3 4 5-1 -6 1 -4 -2
Observation: 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
Question: Does this
relation hold for giving
up food to get clothing? 8 6 4 2
Food
(units per week) 1 2 3 4 5
Chapter 3: Consumer Behavior 32

24. 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.
Chapter 3: Consumer Behavior 29

25. Consumer Preferences A 16 14 MRS = 6 12 10 B 8 D MRS = 2 6 E 4 G 2 1 2
Clothing
(units
per week) 16 14
MRS = 6 12 -6 10 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
Chapter 3: Consumer Behavior 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.
Chapter 3: Consumer Behavior 33

27. Marginal Rate of Substitution
Consumer Preferences
Marginal Rate of Substitution
Question
What are the first three assumptions?
Chapter 3: Consumer Behavior 33

28. 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
Chapter 3: Consumer Behavior 34

29. 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.
Chapter 3: Consumer Behavior 35

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.
Chapter 3: Consumer Behavior 36

31. Consumer Preferences Perfect Substitutes 4 3 2 1 1 2 3 4 Apple Juice
(glasses) 4
Perfect
Substitutes 3 2 1
Orange Juice
(glasses) 1 2 3 4
Chapter 3: Consumer Behavior 38

32. Consumer Preferences Perfect Complements 4 3 2 1 1 2 3 4 Left Shoes1 2 3 4
Right Shoes
Chapter 3: Consumer Behavior 40

33. Consumer Preferences BADS Examples
Things for which less is preferred to more
Examples
Air pollution
Asbestos
Chapter 3: Consumer Behavior

34. Consumer Preferences What Do You Think?
How can we account for Bads in the analysis of consumer preferences?
Chapter 3: Consumer Behavior

35. Designing New Automobiles (I)
Consumer Preferences
Designing New Automobiles (I)
Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling.
Chapter 3: Consumer Behavior 41

36. Designing New Automobiles (I)
Consumer Preferences
Designing New Automobiles (I)
An analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars.
Chapter 3: Consumer Behavior 41

37. styling for additional
Consumer Preferences
Consumer
Preference A:
High MRS
Styling
These consumers are
willing to give up
considerable
styling for additional
performance
Performance
Chapter 3: Consumer Behavior 43

38. Consumer Preferences Consumer Preference B: Low MRS Styling
These consumers are
willing to give up
considerable
performance for
additional styling
Performance
Chapter 3: Consumer Behavior 44

39. Designing New Automobiles (I)
Consumer Preferences
Designing New Automobiles (I)
What Do You Think?
How can we determine the consumers preference?
Chapter 3: Consumer Behavior 41

40. Designing New Automobiles (I)
Consumer Preferences
Designing New Automobiles (I)
A recent study of automobile demand in the United States shows that over the past two decades most consumers have preferred styling over performance.
Chapter 3: Consumer Behavior 45

41. Designing New Automobiles (I)
Consumer Preferences
Designing New Automobiles (I)
Growth of Japanese Imports
1970’s and 1980’s
15% of domestic cars underwent a style change each year
This compares to 23% for imports
Chapter 3: Consumer Behavior 45

42. Consumer Preferences Utility
Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket.
Chapter 3: Consumer Behavior
103

43. 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.
Chapter 3: Consumer Behavior
104

44. 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) = B (4) = C (4) = 12 The consumer is indifferent to A & B The consumer prefers A & B to C
Chapter 3: Consumer Behavior
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45. Utility Functions & Indifference Curves
Consumer Preferences
Utility Functions & Indifference Curves
Clothing
(units
per week) A B C
Assume: U = FC
Market Basket U = FC
C = 2.5(10)
A = 5(5)
B = 10(2.5)
U1 = 25
U2 = 50 (Preferred to U1)
U3 = 100 (Preferred to U2) 15 10 5
Food
(units per week) 5 10 15
Chapter 3: Consumer Behavior 42 54

46. 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 Behavior 27

47. Consumer Preferences 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.
Chapter 3: Consumer Behavior 28

48. 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 Behavior 42 46

49. 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 Behavior 42 47

50. 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.
Chapter 3: Consumer Behavior 42 48

51. Budget Constraints The budget line then can be written:
Chapter 3: Consumer Behavior 42 49

52. Budget Constraints A 0 40 $80 B 20 30 $80 D 40 20 $80 E 60 10 $80
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
Chapter 3: Consumer Behavior 12 50

53. Budget Constraints A (I/PC) = 40 B 30 10 D 20 20 E 10 G Clothing
(units
per week)
Pc = $ Pf = $ I = $80 A B D E G
Budget Line F + 2C = $80
(I/PC) = 40 10 20 30 20 10
Food
(units per week) 20 40 60
80 = (I/PF)
Chapter 3: Consumer Behavior 42 54

54. 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 Behavior 42 55

55. 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 Behavior 42 56

56. 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.
Chapter 3: Consumer Behavior 42 57

57. 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 Behavior 42 58

58. 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 Behavior 42 58

59. Budget Constraints 80 60 40 20 Clothing (units per week) A increase in
income shifts
the budget line
outward
(I = $160) L2 80 60 L3
(I =
$40)
A decrease in
income shifts
the budget line
inward 40
(I = $80) L1 20
Food
(units per week) 40 80
120
160
Chapter 3: Consumer Behavior 42 61

60. 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 Behavior 42 62

61. 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 Behavior 42 62

62. Budget Constraints L3 L2 L1 (PF = 2) (PF = 1/2) 40 (PF = 1) 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
Chapter 3: Consumer Behavior 42 65

63. 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 Behavior 42 66

64. 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 Behavior 42 66

65. 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 Behavior 42 67

66. 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 Behavior 42 67

67. 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 Behavior 68

68. 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 Behavior 69

69. Consumer Choice Recall, the slope of an indifference curve is:
Further, the slope of the budget line is:
Chapter 3: Consumer Behavior 70

70. Consumer Choice
Therefore, it can be said that satisfaction is maximized where:
Chapter 3: Consumer Behavior 71

71. 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 Behavior 72

72. 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)
Chapter 3: Consumer Behavior 76

73. Consumer Choice 40 D 30 20 U3 Pc = $2 Pf = $1 I = $80 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)
Chapter 3: Consumer Behavior 77

74. indifference curve are
Consumer Choice
Pc = $2 Pf = $1 I = $80
Clothing
(units per
week) 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)
Chapter 3: Consumer Behavior 78

75. Designing New Automobiles (II)
Consumer Choice
Designing New Automobiles (II)
Consider two groups of consumers, each wishing to spend $10,000 on the styling and performance of cars.
Each group has different preferences.
Chapter 3: Consumer Behavior 79

76. Designing New Automobiles (II)
Consumer Choice
Designing New Automobiles (II)
By finding the point of tangency between a group’s indifference curve and the budget constraint auto companies can design a production and marketing plan.
Chapter 3: Consumer Behavior 79

77. Designing New Automobiles (II)
Styling
These consumers
are willing to trade
off a considerable
amount of styling
for some additional
performance
$10,000
$3,000
$7,000
$10,000
Performance
Chapter 3: Consumer Behavior 81

78. Designing New Automobiles (II)
Styling
$3,000
These consumers
are willing to trade
off a considerable
amount of
performance for
some additional
styling
$7,000
$10,000
$10,000
Performance
Chapter 3: Consumer Behavior 81

79. Decision Making & Public Policy
Consumer Choice
Decision Making & Public Policy
Choosing between a non-matching and matching grant to fund police expenditures
Chapter 3: Consumer Behavior

80. Consumer Choice Non-matching Grant Private Expenditures ($) U1 A R S P
Before Grant
Budget line: PQ
A: Preference maximizing
market basket
Expenditure
OR: Private
OS: Police R S P Q
Police
Expenditures ($) O
Chapter 3: Consumer Behavior

81. Consumer Choice Non-matching Grant Private Expenditures ($) V T B U Z
After Grant
Budget line: TV
B: Preference maximizing
market basket
Expenditure
OU: Private
OZ: Police B U Z U1 U3 P A R
Police
Expenditures ($) O S Q
Chapter 3: Consumer Behavior

82. Consumer Choice Matching Grant Private Expenditures ($) C X W T U1 P R
Before Grant
Budget line: PQ
A: Preference maximizing
market basket
After Grant
C: Preference maximizing
Expenditures
OW: Private
OX: Police C X W T U1 P R U2 A R O S Q
Police ($)
Chapter 3: Consumer Behavior

83. Consumer Choice Matching Grant Private Expenditures ($) T U1 U3 P B U
Nonmatching Grant
Point B
OU: Private expenditure
OZ: Police expenditure
Matching Grant
Point C
OW: Private expenditure
OX: Police expenditure U3 P B U Z W A C U2 O X Q R
Police ($)
Chapter 3: Consumer Behavior

84. Consumer Choice
A Corner Solution
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 to the horizontal and vertical axis.
MRS is not equal to PA/PB
Chapter 3: Consumer Behavior 83

85. A Corner Solution A U2 U3 U1 A corner solution exists at point B. B
Frozen
Yogurt
(cups
monthly) A U2 U3 U1
A corner solution
exists at point B. B
Ice Cream (cup/month)
Chapter 3: Consumer Behavior 84

86. Consumer Choice A Corner Solution
At point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line.
This suggests that if the consumer could give up more frozen yogurt for ice cream he would do so.
However, there is no more frozen yogurt to give up!
Chapter 3: Consumer Behavior 85

87. Consumer Choice A Corner Solution
When a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio.
In this instance it can be said that:
Chapter 3: Consumer Behavior 86

88. Consumer Choice A Corner Solution
If the MRS is, in fact, significantly greater than the price ratio, then a small decrease in the price of frozen yogurt will not alter the consumer’s market basket.
Chapter 3: Consumer Behavior 87

89. Consumer Choice
A College Trust Fund
Suppose Jane Doe’s parents set up a trust fund for her college education.
Originally, the money must be used for education.
Chapter 3: Consumer Behavior 88

90. Consumer Choice
A College Trust Fund
If part of the money could be used for the purchase of other goods, her consumption preferences change.
Chapter 3: Consumer Behavior 88

91. Consumer Choice A College Trust Fund A U1 U2 B C U3
Other
Consumption
($)
The trust fund shifts the budget line A U1
A: Consumption before the trust fund U2 B
B: Requirement that the trust fund
must be spent on education C U3
C: If the trust could be spent on
other goods P Q
Education ($)
Chapter 3: Consumer Behavior 92

92. 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 Behavior 93

93. Revealed Preferences-- Two Budget Lines
I1: Chose A over B
A is revealed preferred to B
l2: Choose B over D
B is revealed preferred to D
Clothing
(units per
month) l1 l2 B A D
Food (units per month)
Chapter 3: Consumer Behavior 97

94. Revealed Preferences-- Two Budget Lines
All market baskets
in the pink
shaded area are
preferred to A.
Clothing
(units per
month) l2 B l1 D A
B is preferred to
all market baskets
in the green area
Food (units per month)
Chapter 3: Consumer Behavior 97

95. Revealed Preferences-- Four Budget Lines
A: preferred to all
market baskets in
the green area E B A G
I3: E revealed preferred to A
I4: G revealed preferred to A
Clothing
(units per
month) l3
All market baskets in the
pink area preferred to A l1 l4 l2
Food (units per month)
Chapter 3: Consumer Behavior
102

96. Revealed Preferences for Recreation
Scenario
Roberta’s recreation budget = $100/wk
Price of exercise = $4/hr/week
Exercises 10 hrs/wk at A given U1 & I1
Other
Recreational
Activities
($) l1 C
100 U1 A 80 l2 U2 B
The rate changes to $1/hr + $30/wk
New budget line I2 & combination B
Reveal preference of B to A 60 40
Would the Club’s
profits increase? 20
Amount of Exercise
(hours) 25 50 75
Chapter 3: Consumer Behavior
102

97. Marginal Utility and Consumer Choice
Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.
Chapter 3: Consumer Behavior
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98. Marginal Utility and Consumer Choice
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
Chapter 3: Consumer Behavior
108

99. Marginal Utility and 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.
Chapter 3: Consumer Behavior
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100. Marginal Utility and 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).
Chapter 3: Consumer Behavior
110

101. Marginal Utility and Consumer Choice
Formally:
Chapter 3: Consumer Behavior
111

102. Marginal Utility and Consumer Choice
Rearranging:
Chapter 3: Consumer Behavior
112

103. Marginal Utility and Consumer Choice
Because:
Chapter 3: Consumer Behavior
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104. Marginal Utility and 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:
Chapter 3: Consumer Behavior
115

105. Marginal Utility and Consumer Choice
Which gives the equation for utility maximization:
Chapter 3: Consumer Behavior
116

106. Marginal Utility and 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.
Chapter 3: Consumer Behavior
117

107. Marginal Utility and Consumer Choice
Gasoline Rationing
In 1974 and again in 1979, the government imposed price controls on gasoline.
This resulted in shortages and gasoline was rationed.
Chapter 3: Consumer Behavior
118

108. Marginal Utility and Consumer Choice
Gasoline Rationing
Nonprice rationing is an alternative to market rationing.
Under one form everyone has an equal chance to purchase a rationed good.
Gasoline is rationed by long lines at the gas pumps.
Chapter 3: Consumer Behavior
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109. Marginal Utility and 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.
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110. Marginal Utility and Consumer Choice
The horizontal axis shows her annual consumption of gasoline at $1/gallon.
The vertical axis shows her remaining income after purchasing gasoline.
Chapter 3: Consumer Behavior
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111. Marginal Utility and Consumer Choice
Spending
on other
goods ($)
5,000 U1 C
15,000
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 B
20,000 A
20,000
Gasoline
(gallons per year)
Chapter 3: Consumer Behavior
123

112. Cost-of-Living Indexes
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 Behavior
124

113. Cost-of-Living Indexes
What Do You Think?
Does the CPI accurately reflect the cost of living for retirees?
Is it appropriate to use the CPI as a cost- of-living index for other government programs, for private union pensions, and for other private wage agreements?
Chapter 3: Consumer Behavior
125

114. Cost-of-Living Indexes
Example
Two sisters, Rachel and Sarah, have identical preferences.
Sarah began college in 1987 with a $500 discretionary budget.
In 1997, Rachel started college and her parents promised her a budget that was equivalent in purchasing power.
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126

115. Cost-of-Living Indexes
1987 (Sarah) (Rachel)
Price of books $20/book $100/book
Number of books 15 6
Price of food $2.00/lb. $2.20/lb
Pounds of food
Expenditure $500 $1,260
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127

116. Cost-of-Living Indexes
Sarah’ Expenditure
$500 = 100 lbs. of food x $2.00/lb books x $20/book
Rachel’ Expenditure for Equal Utility
$1,260 = 300 lbs. of food x $2.20/lb. + 6 books x $100/book
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128

117. Cost-of-Living Indexes
The ideal cost-of-living adjustment for Rachel is $760.
The ideal cost-of-living index is $1,260/$500 = 2.52 or 252.
This implies a 152% increase in the cost of living.
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129

118. Cost-of-Living Indexes
Books
(per quarter)
For Rachel to achieve
the same level of utility as
Sarah, with the higher
prices, her budget must
be sufficient to allow her
to consume the bundle
shown by point B. l2 B U1 A 25 l1 20 15 10 5
Food
(lb./quarter) 50
100
200
250
300
350
400
450
500
550
600
Chapter 3: Consumer Behavior
131

119. Cost-of-Living Indexes
The ideal cost of living index represents the cost of attaining a given level of utility at current (1997) prices relative to the cost of attaining the same utility at base (1987) prices.
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120. Cost-of-Living Indexes
To do this on an economy-wide basis would entail large amounts of information.
Price indexes, like the CPI, use a fixed consumption bundle in the base period.
Called a Laspeyres price index
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121. Cost-of-Living Indexes
Laspeyres Index
The Laspeyres index tells us:
The amount of money at current year prices that an individual requires to purchase the bundle of goods and services that was chosen in the base year divided by the cost of purchasing the same bundle at base year prices.
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122. Cost-of-Living Indexes
Calculating Rachel’s Laspeyres cost of living index
Setting the quantities of goods in equal to what were bought by her sister, but setting their prices at their levels result in an expenditure of $1,720 (100 x x $100)
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123. Cost-of-Living Indexes
Her cost of living adjustment would now be $1,220.
The Laspeyres index is: $1,720/$500 = 344.
This overstates the true cost-of-living increase.
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124. Cost-of-Living Indexes
Books
(per quarter)
Using the Laspeyres
index results in the
budget line shifting
up from I2 to I3. l3 B U1 A 25 l1 20 15 10 5 l2
Food
(lb./quarter) 50
100
200
250
300
350
400
450
500
550
600
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125. Cost-of-Living Indexes
What Do You Think?
Does the Laspeyres index always overstate the true cost-of-living index?
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126. Cost-of-Living Indexes
Yes!
The Laspeyres index assumes that consumers do not alter their consumption patterns as prices change.
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127. Cost-of-Living Indexes
Yes!
By increasing purchases of those items that have become relatively cheaper, and decreasing purchases of the relatively more expensive items consumers can achieve the same level of utility without having to consume the same bundle of goods.
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128. Cost-of-Living Indexes
The Paasche Index
Calculates the amount of money at current-year prices that an individual requires to purchase a current bundle of goods and services divided by the cost of purchasing the same bundle in the base year.
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129. Cost-of-Living Indexes
Comparing the Two Indexes
Both indexes involve ratios that involve today’s current year prices, PFt and PCt.
However, the Laspeyres index relies on base year consumption, Fb and Cb.
Whereas, the Paasche index relies on today’s current consumption, Ft and Ct .
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130. Cost-of-Living Indexes
Then a comparison of the Laspeyres and Paasche indexes gives the following equations:
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131. Cost-of-Living Indexes
Comparing the Two Indexes
Suppose:
Two goods: Food (F) and Clothing (C)
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132. Cost-of-Living Indexes
Comparing the Two Indexes
Let:
PFt & PCt be current year prices
PFb & PCb be base year prices
Ft & Ct be current year quantities
Fb & Cb be base year quantities
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133. Cost-of-Living Indexes
Comparing the Two Indexes
Sarah (1990)
Cost of base-year bundle at current prices equals $1,720 (100 lbs x $2.20/lb + 15 books x $100/book)
Cost of same bundle at base year prices is $500 (100 lbs x $2.00/lb + 15 books x $20/book)
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134. Cost-of-Living Indexes
Comparing the Two Indexes
Sarah (1990)
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135. Cost-of-Living Indexes
Comparing the Two Indexes
Sarah (1990)
Cost of buying current year bundle at current year prices is $1,260 (300 lbs x $2.20/lb + 6 books x $100/book)
Cost of the same bundle at base year prices is $720 (300 lbs x $2/lb + 6 books x $20/book)
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136. Cost-of-Living Indexes
Comparing the Two Indexes
Sarah (1990)
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137. Cost-of-Living Indexes
The Paasche Index
The Paasche index will understate the cost of living because it assumes that the individual will buy the current year bundle in the base year.
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138. Cost-of-Living Indexes
In 1995, the government adopted the chain-weighted price index to deflate its measure of real GDP.
Developed to overcome problems that arose when long-term comparisons of GDP were made using fixed-weight price indexes and prices were rapidly changing.
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139. Cost-of-Living Indexes
The Bias of the CPI
What Do You Think?
What is the impact on the Federal budget of using the CPI (a Laspeyres index) to adjust social security and other programs for changes in the cost of living?
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140. 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.
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141. 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.
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142. 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.
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143. 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.
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144. End of Chapter 3
Consumer Behavior 1