1. Chapter 3
Consumer Behavior

2. Introduction How are consumer preferences used to determine demand?
How do consumers allocate income to the purchase of different goods?
How do consumers with limited income decide what to buy?
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3. Introduction
How can we determine the nature of consumer preferences for observations of consumer behavior?
How can cost of living indexes measure well-being of consumers
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4. Consumer Behavior - Applications
How would General Mills determine the price to charge for a new cereal before it went to the market?
To what extent did the food stamp program provide individuals with more food versus merely subsidizing food they bought anyway?
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5. Consumer Behavior
The theory of consumer behavior can be used to help answer these and many more questions
Theory of consumer behavior
The explanation of how consumers allocate income to the purchase of different goods and services
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6. Consumer Behavior
There are three steps involved in the study of consumer behavior
Consumer Preferences
To describe how and why people prefer one good to another
Budget Constraints
People have limited incomes
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7. Consumer Behavior
Given preferences and limited incomes, what amount and type of goods will be purchased?
What combination of goods will consumers buy to maximize their satisfaction?
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8. Consumer Preferences
How might a consumer compare different groups of items available for purchase?
A market basket is a collection of one or more commodities.
Individuals can choose between market baskets containing different goods
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9. Consumer Preferences – Basic Assumptions
Preferences are complete.
Consumers can rank market baskets
Preferences are transitive.
If prefer A to B, and B to C, the must prefer A to C
Consumers always prefer more of any good to less.
More is better
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10. Consumer Preferences
Consumer preferences can be represented graphically using indifference curves
Indifference curves represent all combinations of market baskets that the person is indifferent to
A person will be equally satisfied with either choice
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11. Indifference Curves: An Example
Market Basket
Units of Food
Units of Clothing A 20 30 B 10 50 D 40 E G H
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12. Indifference Curves: An Example
Graph the points with one good on the x-axis and one good on the y-axis
Plotting the points we can make some immediate observations about preferences
More is better
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13. Indifference Curves: An Example
Food 10 20 30 40
Clothing 50
The consumer prefers
A to all combinations
in the yellow box, while
all those in the pink
box are preferred to A. G A E H B D
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14. Indifference Curves: An Example
Points such as B & D have more of one good but less of another compared to A
Need more information about consumer ranking
Consumer may decide they are indifference between B, A and D
We can then connect those points with an indifference curve
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15. Indifference Curves: An Example
Indifferent between B, A, & D
E is preferred to U1
U1 is preferred to H & G
Food 10 20 30 40
Clothing 50 G D A E H B
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16. Indifference Curves
Any market basket lying northeast of an indifference curve is preferred to any market basket that lies on the indifference curve.
Points on the curve are preferred to points southwest of the curve
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17. Indifference Curves Indifference curves slope downward to the right.
If it sloped upward it would violate the assumption that more is preferred to less.
Some points that had more of both goods would be indifferent to a basket with less of both goods
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18. Indifference Curves
To describe preferences for all combinations of goods/services, we have a set of indifference curves – an indifference map
Each indifference curve in the map shows the market baskets among which the person is indifferent.
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19. Indifference Map D B A U3 U2 U1 Clothing Market basket A
Food
Clothing U3 U2
Market basket A
is preferred to B.
Market basket B is
preferred to D. U1 D B A
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20. Indifference Maps
Indifference maps give more information about shapes of indifference curves
Indifference curves can not cross
Violates assumption that more is better
Why? What if we assume they can cross.
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21. Indifference Maps U1 U2 A B D B is preferred to D Clothing
A is indifferent to B & D
B must be indifferent to D but that can’t be if B is preferred to D
Food
Clothing A B D
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22. Indifference Curves
The shapes of indifference curves describes how a consumer is willing to substitute one good for another
A to B, give up 6 clothing to get 1 food
D to E, give up 2 clothing to get 1 food
The more clothing and less food a person has, the more clothing they will give up to get more food
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23. Indifference Curves A B D E G 2 3 4 5 1 6 8 10 12 14 16 Clothing-1 -6 1 -4 -2
Food
Clothing 2 3 4 5 1 6 8 10 12 14 16
Observation: The amount
of clothing given up for
1 unit of food decreases
from 6 to 1
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24. Indifference Curves
We measure how a person trades one good for another using the marginal rate of substitution (MRS)
It 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.
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25. Marginal Rate of Substitution
Food 2 3 4 5 1
Clothing 6 8 10 12 14 16 A B D E G -6 1 -4 -2 -1
MRS = 6
MRS = 2
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26. Marginal Rate of Substitution
Indifference curves are convex
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 generally prefer a balanced market basket
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27. Marginal Rate of Substitution
The MRS decreases as we move down the indifference curve
Along an indifference curve there is a diminishing marginal rate of substitution.
The MRS went from 6 to 4 to 1
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28. Marginal Rate of Substitution
Indifference curves with different shapes imply a different willingness to substitute
Two polar cases are of interest
Perfect substitutes
Perfect complements
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29. Marginal Rate of Substitution
Perfect Substitutes
Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant.
Example: a person might consider apple juice and orange juice perfect substitutes
They would always trade 1 glass of OJ for 1 glass of Apple Juice
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30. Consumer Preferences Perfect Substitutes 2 3 4 1 Apple Juice
Orange Juice
(glasses)
Apple
Juice 2 3 4 1
Perfect
Substitutes
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31. Consumer Preferences Perfect Complements
Two goods are perfect complements when the indifference curves for the goods are shaped as right angles.
Example: If you have 1 left shoe and 1 right shoe, you are indifferent between having more left shoes only
Must have one right for one left
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32. Consumer Preferences Perfect Complements 2 3 4 1 Left Shoes
Right Shoes
Left
Shoes 2 3 4 1
Perfect
Complements
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33. Consumer Preferences We have assumed all our commodities are “goods”
There are commodities we don’t want more of - bads
Things for which less is preferred to more
Examples
Air pollution
Asbestos
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34. Consumer Preferences
How do we account for bads in our preference analysis?
We redefine the commodity
Clean air
Pollution reduction
Asbestos removal
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35. Consumer Preferences: An Application
In designing new cars, automobile executives must determine how much time and money to invest in restyling versus increased performance
Higher demand for car with better styling and performance
Both cost more to improve
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36. Consumer Preferences: An Application
An analysis of consumer preferences would help to determine where to spend more on change: performance or styling
Some consumers will prefer better styling and some will prefer better performance
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37. Consumer Preferences: An Application
Styling
Performance
These consumers place a greater value on performance than styling
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38. Consumer Preferences: An Application
Styling
Performance
These consumers place a greater value on styling than performance
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39. Consumer Preferences: An Application
Knowing which groups dominates the market will help decide where redesigning dollars should go
A recent study in the US shows that over the past two decades most consumers have preferred styling over performance.
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40. Consumer Preferences
The theory of consumer behavior does not require assigning a numerical value to the level of satisfaction
Although ranking of market baskets are good, sometimes numerical value are useful
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41. Consumer Preferences Utility
A numerical score representing the satisfaction that a consumer gets from a given market basket.
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.
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42. Utility Utility function U(F,C) = F + 2C 14 = 8 + 2(3)
Formula that assigns a level of utility to individual market baskets
If the utility function is
U(F,C) = F + 2C
A market basket with 8 units of food and 3 units of clothing gives a utility of
14 = 8 + 2(3)
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43. Utility - Example Market Basket Food Clothing Utility A 8 3
8 + 2(3) = 14 B 6 4
6 + 2(4) = 14 C
4 + 2(4) = 12
Consumer is indifferent between A & B and prefers both to C
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44. Utility - Example
Baskets for each level of utility can be plotted to get an indifference curve
To find the indifference curve for a utility of 14, we can change the combinations of food and clothing that give us a utility of 14
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45. Utility - Example Basket U = FC C 25 = 2.5(10) A 25 = 5(5)
Food 10 15 5
Clothing
Basket U = FC
C 25 = 2.5(10)
A 25 = 5(5)
B 25 = 10(2.5)
U2 = 50
U1 = 25
U3 = 100 A B C
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46. Utility
Although we numerically rank baskets and indifference curves, numbers are ONLY for ranking
A utility of 4 is not necessarily twice as good as utility of 2
There are two types of ranking
Ordinal ranking
Cardinal ranking
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47. Utility Ordinal Utility Function Cardinal 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 describes the extent to which one market basket is preferred to another.
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48. Utility The actual unit of measurement for utility is not important.
An ordinal ranking is sufficient to explain how most individual decisions are made.
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49. 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.
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50. Budget Constraints The Budget Line
Indicates all combinations of two commodities for which total money spent equals total income.
We assume only 2 goods are consumed, so we do not consider savings
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51. 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.
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52. The Budget Line The budget line then can be written:
All income is allocated to food (F) and/or clothing (C)
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53. The Budget Line
Different choices of food and clothing can be calculated that use all income
These choices can be graphed as the budget line
Example:
Assume income of $80/week, PF = $1 and PC = $2
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54. Budget Constraints Market Basket Food PF = $1 Clothing PC = $2 Income
I = PFF + PCC A 40
$80 B 20 30 D E 60 10 G 80
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55. The Budget Line A (I/PC) = 40 B 30 10 D 20 E 10 G Food 40 60
80 = (I/PF) 20 10 30
Clothing A B D E G 10 20
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56. 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.
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57. The Budget Line
The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent.
We can rearrange the budget line equation to make this more clear
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58. The Budget Line
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59. 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.
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60. The Budget Line As we know, income and prices can change
As incomes and prices change, there are changes in budget lines
We can show the effects of these changes on budget lines and consumer choices
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61. The Budget Line - Changes
The Effects of Changes in Income
An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant).
Can buy more of both goods with more income
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62. The Budget Line - Changes
The Effects of Changes in Income
A decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant).
Can buy less of both goods with less income
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63. The Budget Line - Changes
Food
(units per week)
Clothing
(units
per week) 80
120
160 40 20 60
A increase in
income shifts
the budget line
outward
(I = $160) L2
A decrease in
income shifts
the budget line
inward
(I = $80) L1 L3
(I =
$40)
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64. The Budget Line - Changes
The Effects of Changes in Prices
If the price of one good increases, the budget line shifts inward, pivoting from the other good’s intercept.
If price of food increases and you buy only food (x-intercept), then can’t buy as much food. The point shifts in
If buy only clothing (y-intercept), can buy the same amount. No change
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65. The Budget Line - Changes
The Effects of Changes in Prices
If the price of one good decreases, the budget line shifts outward, pivoting from the other good’s intercept.
If price of food decreases and you buy only food (x-intercept), then can buy more food. The point shifts out.
If buy only clothing (y-intercept), can buy the same amount. No change
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66. The Budget Line - Changes40
Food
(units per week)
Clothing
(units
per week) 80
120
160
A decrease in the
price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.
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) L1
(PF = 1/2) L2
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67. The Budget Line - Changes
The Effects of Changes in Prices
If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change.
However, the budget line will shift inward to a point parallel to the original budget line
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68. The Budget Line - Changes
The Effects of Changes in Prices
If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change.
However, the budget line will shift outward to a point parallel to the original budget line
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69. Consumer Choice
Given preferences and budget constraints, how do consumers choose what to buy?
Consumers choose a combination of goods that will maximize their satisfaction, given the limited budget available to them.
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70. Consumer Choice
The maximizing market basket must satisfy two conditions:
It must be located on the budget line.
They spend all their income – more is better
It must give the consumer the most preferred combination of goods and services.
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71. Consumer Choice
Graphically we can see different indifference curves of a consumer choosing between clothing and food
Remember that U3 > U2 > U1 for our indifference curves
Consumer wants to choose highest utility within their budget
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72. Consumer Choice 40 A 30 D 20 C U3 U2 U1 B A, B, C on budget line
Clothing
(units per
week) 20 30 40 U3 D
A, B, C on budget line
D highest utility but not affordable
C highest affordable utility
Consumer chooses C U2 C U1 A B
Food (units per week) 40 80 20
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73. Consumer Choice
Consumer will choose highest indifference curve on budget line
In previous graph, point C is where the indifference curve is just tangent to the budget line
Slope of the budget line equals the slope of the indifference curve at this point
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74. Consumer Choice Recall, the slope of an indifference curve is:
Further, the slope of the budget line is:
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75. Consumer Choice
Therefore, it can be said at consumer’s optimal consumption point,
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76. 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).
Note this is ONLY true at the optimal consumption point
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77. Consumer Choice
Optimal consumption point is where marginal benefits equal marginal costs
MB = MRS = benefit associated with consumption of 1 more unit of food
MC = cost of additional unit of food
1 unit food = ½ unit clothing
PF/PC
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78. Consumer Choice
If MRS ≠ PF/PC then individuals can reallocate basket to increase utility
If MRS > PF/PC
Will increase food and decrease clothing until MRS = PF/PC
If MRS < PF/PC
Will increase clothing and decrease food until MRS = PF/PC
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79. maximize satisfaction
Consumer Choice
Food (units per week)
Clothing
(units per
week) 40 80 20 30
Point B does not
maximize satisfaction
because the
MRS =-10/10 = 1
is greater than the
price ratio = 1/2 U1 B
-10C
+10F
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80. Consumer Choice: An Application Revisited
Consider two groups of consumers, each wishing to spend $10,000 on the styling and performance of a car.
Each group has different preferences.
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81. Consumer Choice: An Application Revisited
By finding the point of tangency between a group’s indifference curve and the budget constraint auto companies can see how much consumers value each attribute.
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82. Consumer Choice: An Application Revisited
Styling
Performance
$10,000
These consumers
Want performance worth $7000 and styling worth $3000
$3,000
$7,000
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83. Consumer Choice: An Application Revisited
Styling
$10,000
Performance
These consumers want styling worth $7000 and performance worth $3000
$3,000
$7,000
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84. Consumer Choice: An Application Revisited
Once know preferences, can design a production and marketing plan
Company can then make a sensible strategic business decision on how to allocate performance and styling on new cars
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85. Consumer Choice
A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another.
MRS is not necessarily equal to PA/PB
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86. A Corner Solution A U2 U3 U1 A corner solution exists at point B. B
Ice Cream (cup/month)
Frozen
Yogurt
(cups
monthly) B A
A corner solution
exists at point B. U2 U3 U1
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87. A Corner Solution
At point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line.
f 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
Opposite is true if corner solution was at point A
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88. 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:
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89. 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.
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90. A Corner Solution - Example
Suppose Jane Doe’s parents set up a trust fund for her college education.
The money must be used only for education.
Although a welcome gift, an unrestricted gift might be better
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91. A Corner Solution - Example
Original budget line, PQ, with a market basket, A, of education and other goods
Trust fund shifts out the budget line as long as trust fund, PB, spent on education
Jane increases satisfaction moving to higher indifference curve, U2
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92. A Corner Solution - Example
Education ($)
Other
Consumption
($)
Jane better off on U2
B is corner solution
MRS ≠ PE/POG U2 P Q A U1 B
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93. A Corner Solution - Example
Education ($)
Other
Consumption
($)
If gift is unrestricted, Jane can be at point C on U3
Better off than with restricted gift U2 C U3 P Q A U1 B
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94. Revealed Preferences
If we know the choices a consumer has made, we can determine what their preferences are if we have information about a sufficient number of choices that are made when prices and incomes vary.
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95. Revealed Preferences – Two Budget Lines
Food (units per month)
Clothing
(units per
month) l1
I1: Chose A over B
A is revealed preferred to B
l2: Choose B over D
B is revealed preferred to D l2 A B D
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96. Revealed Preferences-- Two Budget Lines
Food (units per month)
Clothing
(units per
month) D
All market baskets
in the pink
shaded area are
preferred to A.
B is preferred to
all market baskets
in the yellow area
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97. Revealed Preference
As you continue to change the budget line, individuals can tell you which basket they prefer to others.
More the individual reveals, the more you can discern about their preferences
Eventually you can map out an indifference curve
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98. Revealed Preferences – Four Budget Lines
A: preferred to all
market baskets in
the yellow 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)
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99. Marginal Utility and Consumer Choice
Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.
How much happier is the individual from consuming one more unit of food
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100. Marginal Utility - 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 as consumption increases
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101. Marginal Utility
The principle of diminishing marginal utility states that as more of a good is consumed, the additional utility the consumer gains will be smaller and smaller.
Note that total utility will continue to increase since consumer makes choices that make them happier
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102. Marginal Utility and Indifference Curves
As consumption moves along an indifference curve:
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).
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103. Marginal Utility and Consumer Choice
Formally:
No change in total utility along an indifference curve.
Trade off of one good to the other leaves the consumer just as well off
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104. Marginal Utility and Consumer Choice
Rearranging:
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105. Marginal Utility and Consumer Choice
When consumers maximize satisfaction:
Since the MRS is also equal to the ratio of the marginal utility of consuming F and C
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106. Marginal Utility and Consumer Choice
Rearranging, gives the equation for utility maximization:
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107. 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.
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108. Cost-of-Living Indexes
Social security payments are given to qualifying individuals
Each year the benefit increases equal to the rate of increase of the Consumer Price Index (CPI)
Ratio of the present cost of typical bundle of goods/services in comparison to the cost during a base period
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109. Cost-of-Living Indexes
Does the CPI give a good measure of inflation and therefore a measure of the cost of living changes?
Should the CPI be used to measure how much cost of living has increased determining increases in government payment programs?
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110. Cost-of-Living Indexes
The ideal cost of living index represents the cost of attaining a given level of utility at current prices relative to the cost of attaining the same utility at base prices
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111. Cost-of-Living Indexes
To obtain the ideal cost of living index would require too much information such as consumer preferences as well as prices and expenditures
Actual price indexes are based on consumer purchases, not preferences
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112. Cost-of-Living Indexes
Laspeyres price index
Amount of money at current year prices that an individual requires to purchase a bundle of goods/services chosen in a base year divided by the cost of purchasing the same bundle at base-year prices
Ex: CPI
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113. Cost-of-Living Indexes
The Laspeyres price index assumes that consumers do not alter their consumption patterns as prices change
Tend to overstate the true cost of living index
Using the CPI to adjust retirement benefits will tend to overcompensate most recipients requiring greater government expenditure
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114. Cost-of-Living Indexes
Paasche index
Focuses on the cost of buying the current year’s bundle
Amount of money at current –year prices that an individual requires to purchase a current bundle of goods/services divided by the cost of purchasing the same bundle in a base year
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115. Cost-of-Living Indexes
Comparison of indexes
Both are fixed weight indexes
Quantities of various goods and services in each index remain unchanged
Laspeyres index keeps quantities at base year levels
Paasche index keeps unchanged quantities at current year levels
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116. Cost-of-Living Indexes
Chain-Weighted Indexes
Cost-of-living index that accounts for changes in quantities of goods and services
Introduced to overcome problems that arose when long-term comparisons were make using fixed weight price indexes
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