1. Chapter 3 Consumer Behavior

2. Chapter 3: Consumer BehaviorSlide 2 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.

3. Chapter 3: Consumer BehaviorSlide 3 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.

4. Chapter 3: Consumer BehaviorSlide 4 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?

5. Chapter 3: Consumer BehaviorSlide 5 Consumer Preferences 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. Market Baskets

6. Chapter 3: Consumer BehaviorSlide 6 Consumer Preferences Three Basic Assumptions 1) Preferences are complete. 2) Preferences are transitive. 3) Consumers always prefer more of any good to less.

7. Chapter 3: Consumer BehaviorSlide 7 Consumer Preferences A2030 B1050 D4020 E3040 G1020 H1040 Market BasketUnits of Food Units of Clothing

8. Chapter 3: Consumer BehaviorSlide 8 Consumer Preferences Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person. Indifference Curves

9. Chapter 3: Consumer BehaviorSlide 9 The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A. Consumer Preferences Food (units per week) 10 20 30 40 10203040 Clothing (units per week) 50 G A EH B D

10. Chapter 3: Consumer BehaviorSlide 10 U1U1 Combination B,A, & D yield the same satisfaction E is preferred to U 1 U 1 is preferred to H & G Consumer Preferences Food (units per week) 10 20 30 40 10203040 Clothing (units per week) 50 G D A E H B

11. Chapter 3: Consumer BehaviorSlide 11 U2U2 U3U3 Consumer Preferences Food (units per week) Clothing (units per week) U1U1 A B D Market basket A is preferred to B. Market basket B is preferred to D.

12. Chapter 3: Consumer BehaviorSlide 12 U1U1 U2U2 Consumer Preferences Food (units per week) Clothing (units per week) A D B The consumer should be indifferent between A, B and D. However, B contains more of both goods than D. Indifference Curves Cannot Cross

13. Chapter 3: Consumer BehaviorSlide 13 A B D E G -6 1 1 -4 -2 1 1 Observation: The amount of clothing given up for a unit of food decreases from 6 to 1 Consumer Preferences Food (units per week) Clothing (units per week) 23451 2 4 6 8 10 12 14 16 Question: Does this relation hold for giving up food to get clothing?

14. Chapter 3: Consumer BehaviorSlide 14 Consumer Preferences 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. Marginal Rate of Substitution

15. Chapter 3: Consumer BehaviorSlide 15 Consumer Preferences Food (units per week) Clothing (units per week) 23451 2 4 6 8 10 12 14 16 A B D E G -6 1 1 1 1 -4 -2 MRS = 6 MRS = 2

16. Chapter 3: Consumer BehaviorSlide 16 Consumer Preferences 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 Marginal Rate of Substitution

17. Chapter 3: Consumer BehaviorSlide 17 Consumer Preferences Perfect Substitutes and Perfect Complements Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant. Marginal Rate of Substitution

18. Chapter 3: Consumer BehaviorSlide 18 Consumer Preferences Orange Juice (glasses) Apple Juice (glasses) 2341 1 2 3 4 0 Perfect Substitutes Perfect Substitutes

19. Chapter 3: Consumer BehaviorSlide 19 Consumer Preferences Perfect Substitutes and Perfect Complements Two goods are perfect complements when the indifference curves for the goods are shaped as right angles. Marginal Rate of Substitution

20. Chapter 3: Consumer BehaviorSlide 20 Consumer Preferences Right Shoes Left Shoes 2341 1 2 3 4 0 Perfect Complements Perfect Complements

21. Chapter 3: Consumer BehaviorSlide 21 Consumer Preferences BADS Things for which less is preferred to more Examples Air pollution Asbestos

22. Chapter 3: Consumer BehaviorSlide 22 Consumer Preferences What Do You Think? How can we account for Bads in the analysis of consumer preferences?

23. Chapter 3: Consumer BehaviorSlide 23 Consumer Preferences Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling. Designing New Automobiles (I)

24. Chapter 3: Consumer BehaviorSlide 24 Consumer Preferences These consumers are willing to give up considerable styling for additional performance Styling Performance Consumer Preference A: High MRS Consumer Preference A: High MRS

25. Chapter 3: Consumer BehaviorSlide 25 Consumer Preferences These consumers are willing to give up considerable performance for additional styling Styling Performance Consumer Preference B: Low MRS Consumer Preference B: Low MRS

26. Chapter 3: Consumer BehaviorSlide 26 Consumer Preferences What Do You Think? How can we determine the consumers preference? Designing New Automobiles (I)

27. Chapter 3: Consumer BehaviorSlide 27 Consumer Preferences A recent study of automobile demand in the United States shows that over the past two decades most consumers have preferred styling over performance. Designing New Automobiles (I)

28. Chapter 3: Consumer BehaviorSlide 28 Consumer Preferences Utility Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket.

29. Chapter 3: Consumer BehaviorSlide 29 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 8 3 8 + 2(3) = 14 B 6 4 6 + 2(4) = 14 C 4 4 4 + 2(4) = 12 The consumer is indifferent to A & B The consumer prefers A & B to C

30. Chapter 3: Consumer BehaviorSlide 30 Consumer Preferences Food (units per week) 10155 5 10 15 0 Clothing (units per week ) U 1 = 25 U 2 = 50 (Preferred to U 1 ) U 3 = 100 (Preferred to U 2 ) A B C Assume: U = FC Market Basket U = FC C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5) Utility Functions & Indifference Curves

31. Chapter 3: Consumer BehaviorSlide 31 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.

32. Chapter 3: Consumer BehaviorSlide 32 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.

33. Chapter 3: Consumer BehaviorSlide 33 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.

34. Chapter 3: Consumer BehaviorSlide 34 Budget Constraints The Budget Line The budget line indicates all combinations of two commodities for which total money spent equals total income.

35. Chapter 3: Consumer BehaviorSlide 35 Budget Constraints The budget line then can be written:

36. Chapter 3: Consumer BehaviorSlide 36 Budget Constraints A040$80 B2030$80 D4020$80 E6010$80 G800$80 Market BasketFood (F) Clothing (C)Total Spending P f = ($1)P c = ($2)P f F + P c C = I

37. Chapter 3: Consumer BehaviorSlide 37 Budget Line F + 2C = $80 10 20 (I/P C ) = 40 Budget Constraints Food (units per week) 406080 = (I/P F )20 10 20 30 0 A B D E G Clothing (units per week ) Pc = $2 P f = $1 I = $80

38. Chapter 3: Consumer BehaviorSlide 38 Budget Constraints Food (units per week) Clothing (units per week) 8012016040 20 40 60 80 0 A increase in income shifts the budget line outward (I = $160) L2L2 (I = $80) L1L1 L3L3 (I = $40) A decrease in income shifts the budget line inward

39. Chapter 3: Consumer BehaviorSlide 39 Budget Constraints Food (units per week) Clothing (units per week) 8012016040 (P F = 1) L1L1 An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward. L3L3 (P F = 2) (P F = 1/2) L2L2 A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward.

40. Chapter 3: Consumer BehaviorSlide 40 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.

41. Chapter 3: Consumer BehaviorSlide 41 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.

42. Chapter 3: Consumer BehaviorSlide 42 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.

43. Chapter 3: Consumer BehaviorSlide 43 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.

44. Chapter 3: Consumer BehaviorSlide 44 Consumer Choice Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.

45. Chapter 3: Consumer BehaviorSlide 45 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.

46. Chapter 3: Consumer BehaviorSlide 46 Recall, the slope of an indifference curve is: Consumer Choice Further, the slope of the budget line is:

47. Chapter 3: Consumer BehaviorSlide 47 Consumer Choice Therefore, it can be said that satisfaction is maximized where:

48. Chapter 3: Consumer BehaviorSlide 48 Consumer Choice Food (units per week) Clothing (units per week) 408020 30 40 0 U1U1 B Budget Line Pc = $2 P f = $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

49. Chapter 3: Consumer BehaviorSlide 49 Consumer Choice Budget Line U3U3 D Market basket D cannot be attained given the current budget constraint. Pc = $2 P f = $1 I = $80 Food (units per week) Clothing (units per week) 408020 30 40 0

50. Chapter 3: Consumer BehaviorSlide 50 U2U2 Consumer Choice Pc = $2 P f = $1 I = $80 Budget Line 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 =P f /P c =.5 Food (units per week) Clothing (units per week) 408020 30 40 0

51. Chapter 3: Consumer BehaviorSlide 51 Consumer Choice Choosing between a non-matching and matching grant to fund police expenditures Decision Making & Public Policy

52. Chapter 3: Consumer BehaviorSlide 52 Consumer Choice Non-matching Grant Police Expenditures ($) Private Expenditures ($) O P Q U1U1 A Before Grant Budget line: PQ A: Preference maximizing market basket Expenditure OR: Private OS: Police R S

53. Chapter 3: Consumer BehaviorSlide 53 V T U3U3 U1U1 After Grant Budget line: TV B: Preference maximizing market basket Expenditure OU: Private OZ: Police B U Z R Consumer Choice Non-matching Grant P Police Expenditures ($) Private Expenditures ($) OSQ A

54. Chapter 3: Consumer BehaviorSlide 54 P R U2U2 T U1U1 Consumer Choice Matching Grant Police ($) Private Expenditures ($) OQS R Before Grant Budget line: PQ A: Preference maximizing market basket After Grant C: Preference maximizing market basket Expenditures OW: Private OX: Police C X W A

55. Chapter 3: Consumer BehaviorSlide 55 T U3U3 U1U1 Nonmatching Grant Point B OU: Private expenditure OZ: Police expenditure Matching Grant Point C OW: Private expenditure OX: Police expenditure W X Consumer Choice Non-Matching Grant P Police ($) Private Expenditures ($) OQ A U2U2 C R B U Z

56. Chapter 3: Consumer BehaviorSlide 56 Consumer Choice 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/or vertical axis. MRS is not equal to P A /P B at the chosen bundle. A Corner Solution

57. Chapter 3: Consumer BehaviorSlide 57 A Corner Solution Ice Cream (cup/month) Frozen Yogurt (cups monthly) B A U2U2 U3U3 U1U1 A corner solution exists at point B.

58. Chapter 3: Consumer BehaviorSlide 58 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:

59. Chapter 3: Consumer BehaviorSlide 59 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.

60. Chapter 3: Consumer BehaviorSlide 60 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 income vary.

61. Chapter 3: Consumer BehaviorSlide 61 D Revealed Preferences-- Two Budget Lines l1l1 l2l2 B A I 1 : Chose A over B A is revealed preferred to B l 2 : Choose B over D B is revealed preferred to D Food (units per month) Clothing (units per month)

62. Chapter 3: Consumer BehaviorSlide 62 Revealed Preferences-- Two Budget Lines l2l2 B l1l1 D A All market baskets in the pink shaded area are preferred to A. Food (units per month) Clothing (units per month) B is preferred to all market baskets in the green area

63. Chapter 3: Consumer BehaviorSlide 63 All market baskets in the pink area preferred to A Food (units per month) Revealed Preferences-- Four Budget Lines Clothing (units per month) l1l1 l2l2 l3l3 l4l4 A: preferred to all market baskets in the green area E B A G I 3 : E revealed preferred to A I 4 : G revealed preferred to A

64. Chapter 3: Consumer BehaviorSlide 64 Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good. Marginal Utility and Consumer Choice Marginal Utility

65. Chapter 3: Consumer BehaviorSlide 65 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. Diminishing Marginal Utility Marginal Utility and Consumer Choice

66. Chapter 3: Consumer BehaviorSlide 66 Marginal Utility and the Indifference Curve If consumption moves along an indifference curve, the additional utility derived from an increase in the consumption of one good, food (F), must balance the loss of utility from the decrease in the consumption in the other good, clothing (C). Marginal Utility and Consumer Choice

67. Chapter 3: Consumer BehaviorSlide 67 The equation for utility maximization: Marginal Utility and Consumer Choice

68. Chapter 3: Consumer BehaviorSlide 68 In 1974 and again in 1979, the government imposed price controls on gasoline. This resulted in shortages and gasoline was rationed. Gasoline Rationing Marginal Utility and Consumer Choice

69. Chapter 3: Consumer BehaviorSlide 69 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. Gasoline Rationing Marginal Utility and Consumer Choice

70. Chapter 3: Consumer BehaviorSlide 70 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. Marginal Utility and Consumer Choice

71. Chapter 3: Consumer BehaviorSlide 71 The horizontal axis shows her annual consumption of gasoline at $1/gallon. The vertical axis shows her remaining income after purchasing gasoline. Marginal Utility and Consumer Choice

72. Chapter 3: Consumer BehaviorSlide 72 B 20,000 A Gasoline (gallons per year) Spending on other goods ($) 20,000 5,000 U1U1 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 U2U2 Marginal Utility and Consumer Choice