1. 1 MANAGERIAL ECONOMICS An Analysis of Business Issues Howard Davies and Pun-Lee Lam Published by FT Prentice Hall

2. 2 Chapter 6: Consumer Behaviour Objectives: After studying the chapter, you should understand: 1. The purpose of the economic theory of consumer behaviour 2. The difference between that theory and Consumer Behaviour in Marketing 3. The main approaches to consumer behaviour in Economics

3. 3 Economic Theories of Consumer Behaviour n ARE NOT rich and highly descriptive analyses of the links between consumers’ personal, social and psychological characteristics and their purchasing behaviour –look for that in the Marketing treatment of the issue n They ARE abstract and logical analyses of what is meant by ‘rational choice behaviour’ and the implications of rational behaviour –for instance, is it necessarily true that a rational consumer will buy more of a product as its price falls? –begin by defining ‘rational choice’ and then follow through the consequences

4. 4 The Main Approaches Are: n Utility Theory n Indifference Analysis n Revealed Preference n The Characteristics Approach

5. 5 Utility Theory n Consumers seek to maximise their UTILITY, which increases as they consumer more ‘goods’ and decreases as they consumer more ‘bads’ n As a consumer has more of a ‘good’, the extra (marginal) utility they enjoy from each successive extra unit of the good declines –the principle of diminishing marginal utiity n A utility-maximising consumer will purchase a combination of goods such that the extra utility acquired per $ or cent, £ or penny, is the same for every good OR: n the ratio of the marginal utilities is equal to the ratio of the prices

6. 6 Utility Theory and Falling Prices n If a consumer has a fixed income and begins in equilibrium : –MU apples /P apples = MU pears /P pears n Then the price of apples falls n Left-hand side of the equation> Right-hand side n There is an opportunity to increase UTILITY- how to do it? n Shift spending from pears to apples - WHY DOES THIS WORK? n Because each extra penny spent on apples gives more additional utility than each extra penny spent on pears

7. 7 Indifference Analysis n UTILITY theory requires us to think in terms of a cardinally measurable unobservable concept, which is rather ‘heroic’ n INDIFFERENCE ANALYSIS explains consumer behaviour on the basis of less restrictive assumptions (tho’ the logic is very similar)

8. 8 Indifference Analysis n The following assumptions are made about ‘rational’ consumers –they know when they prefer one bundle of goods to another or are indifferent between them - their preferences are complete –Preferences are symmetric. If I prefer A to B, I cannot prefer B to A. –Preferences are transitive. If I prefer A to B and B to C I must prefer A to C. n (These are not as unproblematic as they may seem)

9. 9 Indifference Analysis n Good A Good B All combinations of A and B for which the consumer is indifferent AN INDIFFERENCE CURVE

10. 10 Indifference Analysis n Good A Good B Slopes show relative preferences for A and B An A-lover

11. 11 An Indifference Map n Good A Good B The preferred direction if A and B are both‘goods

12. 12 The Optimal Combination of A and B n Good A Good B Budget Line

13. 13 If the Price of B Falls n Good A Good B Budget Line More B is bought and (in this example only) the same amount of A

14. 14 What Can We Say In General About the Consequences of a Price Fall? n The overall move from one equilibrium to another is the PRICE EFFECT n PRICE EFFECT can be divided into SUBSTITUTION EFFECT and INCOME EFFECT n SUBSTITUTION EFFECT is the result of changing prices n INCOME EFFECT is the result of changing real incomes

15. 15 How to Find the Substitution and Income Effects? n Good A Good B Budget Line More B is bought (and in this example only) the same amount of A

16. 16 Substitution Effect n Good A Good B If the consumer was on the same I-curve as before (same real income) but prices moved to their new level, (budget line has the new slope) more B must be bought

17. 17 Income Effect n Good A Good B If relative prices don’t change but real income rises

18. 18 Income Effect n The substitution effect MUST lead more B to be bought if the relative price of B falls n The Income effect could work in either direction or be neutral –for inferior goods, income effect is negative –for normal goods it is positive n A GIFFEN good is one where the income effect is negative and powerful enough to outweigh the substitution effect –lower prices, less is bought

19. 19 Other Approaches n Indifference analysis, and its mathematical version, is the standard approach n Revealed Preference and the Characteristics Approach merit brief consideration

20. 20 Revealed Preference n Less restrictive assumptions - consumers are consistent in their choices n A budget line is constructed and the consumer’s choice observed n When price of one good falls, a new choice is made n The new choice cannot involve less of the good whose price has fallen

21. 21 Revealed Preference Apples Oranges n Why? X Z If combination X is the original choice and Z is the new choice (after the price of oranges falls), X to Z is the price effect. The broken line shows the goods which could be bought if income remained at the level requiredto buy the original basket of goods, but the new price ratio held. We don’t know exactly where the consumer would choose to be, but they cannot be to the left of X because they have already rejected superior combinations in favour of X

22. 22 The Characteristics Approach n Lancaster 1966 n Consumers do not desire ‘goods’ but bundles of ‘characteristics’ –not a computer but processing speed memory storage functions n Different brands offer different combinations of characteristics. Combining brands may allow other combinations to be achieved n Desirable mixes of characteristics might be identified

23. 23 Practical Applications of Demand Theory? n LIMITED. The purpose is to examine the meaning and consequences of rational behaviour n Forms the theoretical foundation for statistical analyses of demand n The ‘characteristics’ concept is a useful starting point in Marketing and has led to ideas like ‘hedonic price’ models. –Take many different examples or brands of a good. Regress the price on the characteristics to see how the market prices them –In Hong Kong, residential property prices are determined by net floor area, but age, a view of water, pollution and family density also had significant (but small) effects