1. Principles of Economics
Session 3

2. Topics To Be Discussed Consumer Preferences Budget Constraints
Consumer Choice
Marginal Utility
Substitution and Income Effect 2

3. Topics to be Discussed Market Demand Consumer Surplus
Recognizing Lock-In 3

4. Steps of Studying Consumer Behavior
Study consumer preferences
How and why do people prefer one good to another?
Study budget constraint
How are consumers constrained by their limited incomes?
Combine consumer preferences and budget constraints to determine consumer choices
What combination of goods will consumers buy to maximize their satisfaction? 8

5. Market Basket
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

6. Three Basic Assumptions
Preferences are complete.
Preferences are transitive.
Consumers always prefer more of any good to less. 11

7. Consumer Preferences Market Basket Units of Food Units of Clothing A20 30 B 10 50 D 40 E G H 12

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

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

10. 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 15

11. Indifference Map
An indifference map is a set of indifference curves that describes a person’s preferences for all combinations of two commodities. 20

12. Indifference Map Market basket A is preferred to B.
Clothing
(units per week) U3
Market basket A is preferred to B.
Market basket B is preferred to D. U2 U1 A B D
Food
(units per week) 24

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

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

15. 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

16. Diminishing MRS A 16 14 MRS = 6 12 10 B 8 D MRS = 2 6 E 4 G 2 1 2 3 4
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 32

17. Perfect Substitutes and Perfect Complements
Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant.
Two goods are perfect complements when the indifference curves for the goods are shaped as right angles. 35

18. Perfect Substitutes 4 3 2 1 1 2 3 4 Apple Juice (glasses) Orange Juice1 2 3 4 38

19. Perfect Complements
Left
Shoes 4 3 2 1 1 2 3 4
Right Shoes 40

20. Application of Consumer Preferences
Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling.
An analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars. 41

21. Consumers are willing to give up styling for additional
Consumer Preferences
Styling
Consumers are willing to give up
considerable
styling for additional
performance
MRS＞1
Performance 43

22. Consumer Preferences MRS＜1 Consumers are willing to give up
Styling
Consumers are
willing to give up
considerable
performance for
additional styling
MRS＜1
Performance 44

23. Utility
Utility refers to numerical score representing the satisfaction that a consumer gets from a given market basket.
103

24. Utility Function U=f(X1 , X2 , X3 , … Xn)
Assume the utility function for food (F) and clothing (C) U=f(F, C) = F + 2C
Market Baskets
F Units
C Units
Utils A 8 3
8 + 2(3) = 14 B 6 4
6 + 2(4) = 14 C
4 + 2(4) = 12
The consumer is indifferent to A & B
The consumer prefers A & B to C
104

25. Utility Functions & Indifference Curves
Clothing
(units
per week)
Assume: 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 A B C 10 5
Food
(units per week) 5 10 15 42 54

26. Ordinal vs. 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. 27

27. Budget Constraints
Budget constraints limit an individual’s ability to consume in light of the prices they must pay for various goods and services. 42 46

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

29. Budget Line
Let F = amount of food purchased C = amount of clothing purchased Pf = Price of food Pc = price of clothing M = money income
Then 42 48

30. Total Spending PfF+PcC=M
Budget Line
Market Basket
Food (F) Pf=$1
Clothing (C) Pc=$2
Total Spending PfF+PcC=M A 40
$80 B 20 30 D E 60 10 G 80 12 50

31. Budget Line Pc = $2 Pf = $1 M = $80 Budget Line F + 2C = $80 A
Clothing
(units
per week)
Pc = $ Pf = $ M = $80 A B D E G
(M/PC) = 40
Budget Line F + 2C = $80 30 20 10
Food
(units per week) 20 40 60
80 = (M/PF) 42 54

32. 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. 42 55

33. Budget Line
The slope is the negative of the ratio of the prices of the two goods.
The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent. 42 56

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

35. Effect of Income Change
Clothing
(units
per week)
A increase in income shifts the budget line outward
(M = $160) L2 80 60 L3
A decrease in income shifts the budget line inward
(M=
$40) 40
(M = $80) L1 20
Food
(units per week) 40 80
120
160 42 61

36. Effect of Price Change 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

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

38. Conditions to Maximize Utility
The choice must be located on the budget line.
The choice must give the consumer the most preferred combination of goods and services. 69

39. Consumer Choice The MRS of an indifference curve is:
The slope of the budget line is:
Therefore, satisfaction is maximized where: 70

40. Satisfaction Maximization
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

41. Consumer Choice Pc = $2 Pf = $1 M = $80
Clothing
(units per
week)
Budget Line
Pc = $ Pf = $ M = $80
Point B does not maximize satisfaction because the MRS (-10/10) = 1 is greater than the price ratio (1/2). U1 40
-10C
+10F B 30 20 20 40 80
Food (units per week) 76

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

43. Consumer Choice Pc = $2 Pf = $1 M = $80 At A: MRS =Pf /Pc = .5
Clothing
(units per
week)
Budget Line
Pc = $ Pf = $ M = $80
At market basket A the budget line and the indifference curve are tangent and no higher level of satisfaction can be attained. 40 U2 30 A
At A: MRS =Pf /Pc = .5 20 20 40 80
Food (units per week) 78

44. A offers less satisfaction than B.
Consumer Choice
Clothing
(units per
week)
Pc = $ Pf = $ M = $80 U3 D U2 A B U1  40
D is not available.
A offers less satisfaction than B.
B is the optimum choice. 30 20
Budget Line 20 40 80
Food (units per week) 77

45. Marginal Utility and Consumer Choice
Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.
107

46. Diminishing Marginal Utility
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
108

47. Principle of Diminishing MU
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

48. Marginal Utility and 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

49. Marginal Utility and Consumer Choice
112

50. Equation for Utility Maximization
116

51. Equal Marginal Principle
The equal marginal principle states that total utility is maximized when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good.
117

52. Equal Marginal Principle
Constraint=$20 Hot dog price=$2.5 Coke price=$2
Units per game
MU of hot dogs (MUH )
MUH /PH
MU of Cokes (MUc )
MUc /Pc 1 20 8 60 30 2 15 6 40 3
12.5 5 10 4 16
7.5
117

53. Equal Marginal Principle
116

54. Equal Marginal Principle
Budget=$2,000 TV ad price=$400 Radio ad price=$300
Increase in units sold
Number of ads
MBTV
MBRadio 1
400
360 2
300
270 3
280
240 4
260
225 5
150 6
200
120
116

55. Equal Marginal Principle
Budget=$2,000 TV ad price=$400 Radio ad price=$300
Increase in units sold
Number of ads
MBTV
MBRadio 1
400/400=1.00
360/300=1.20 2
300/400=0.75
270/300=0.90 3
280/400=0.70
240/300=0.80 4
260/400=0.65
225/300=0.75 5
240/400=0.60
150/300=0.50 6
200/400=0.50
120/300=0.40
116

56. Effect of a Price Change
Clothing
(units per
month)
M = $20
PC= $2
PF =$2, $1, $0.5 3 7 A U1 10 20 U2 B 8 6 5 U3 D 40
Three separate
indifference curves
are tangent to
each budget line.
Food (units
per month) 4

57. Effect of a Price Change
Clothing
(units per
month)
The price-consumption curve traces out the utility maximizing market basket for the various prices for food. 3 7 A U1 10 20 U2 B 8 6 5 U3 D 40
Price-consumption curve
Food (units
per month) 4

58. Demand Curve 10 7 6 5 3 8 10 20 40 3 $2.00 8 $1.00 Demand curve 20
Clothing
(units per
month) 10 7 A B 6 D U1 5 U2 U3 3 8 10 20 40
Food (units per month)
Price
of Food 3
$2.00 8
$1.00
Demand curve 20
$0.50
Food (units per month) 4

59. Effects of Income Changes
Pf = $1
Pc = $2
M = $10, $20, $30 D 7 16 U3 30 15
Clothing
(units per
month) B U2 20 10
Income-consumption curve 3 4 A U1 5 10
Food (units
per month)

60. Effects of Income Changes
Price of
food
An increase in income,
from $10 to $20 to $30,
with the prices fixed,
shifts the consumer’s
demand curve to the right. 16 D3 H 10 D2 G 4 D1 E
$1.00
Food (units
per month)

61. Effects of Income Changes
An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve.
Simultaneously, the increase in income shifts the demand curve to the right. 4

62. Normal Good vs. Inferior Good
The income-consumption curve has a positive slope.
The quantity demanded increases with income.
The income elasticity of demand is positive. 4

63. Normal Good vs. Inferior Good
The income-consumption curve has a negative slope.
The quantity demanded decreases with income.
The income elasticity of demand is negative. 4

64. An Inferior Good Income-Consumption Curve 15 30 Steak (units per
month)
Income-Consumption Curve
…but hamburger becomes an inferior good when the income consumption curve bends backward between B and C. U2 10 5 20 A U1 B
Both hamburger and steak behave as a normal good, between A and B...
Hamburger
(units per month)

65. Income and Substitution Effects
Substitution Effect Consumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is now relatively more expensive.
Income Effect Consumers experience an increase in real purchasing power when the price of one good falls.

66. Income and Substitution Effects
Clothing
(units per
month)
Normal Good
M=$60, Pf = $3, Pc = $3 A U1 20
Decreased Pf = $2 30
Total Effect = 18.5 17 4 16 D
Income Effect = 4.5 U2 B
Substitution Effect = 14 5
22.5 18
Substitution
Effect
Food (units
per month)
Income Effect O
25.5
Total Effect

67. Income and Substitution Effects
M=$60, Pf = $3, Pc = $3
Clothing
(units per
month)
Inferior Good
Decreased Pf = $2 A U1 20 U2 B 30
Total Effect = 6.5 17
Substitution Effect = 14 4 16 D
Income Effect = - 7.5 13
10.5
Substitution Effect ＞ Income Effect. 18 5
Substitution
Effect
Food (units
per month)
Income Effect O
25.5
Total Effect

68. Income and Substitution Effects
Clothing
(units per
month)
Giffen Good F2 T B U2 R F1 S A U1
The income effect may theoretically be large enough to cause the demand curve for a good to slope upward. This is of little practical interest E D
Total Effect
Food (units
per month) O
Substitution
Effect
Income Effect

69. Market Demand
Price Individual A Individual B Individual C Market
($) (units) (units) (units) (units)

70. summing the consumer’s
Market Demand Curve
Price 5 DC DB
Market Demand
The market demand
curve is obtained by
summing the consumer’s
demand curves 4 DA 3 2 1
Quantity 5 10 15 20 25 30

71. Consumer Surplus
Willingness to pay is the maximum price that a buyer is willing and able to pay for a good.
It measures how much the buyer values the good or service. 9 6

72. Consumer Surplus
Consumer surplus is the amount a buyer is willing to pay for a good minus the amount the buyer actually pays for it. 10 9

73. Four Possible Buyers’ Willingness to Pay11 10

74. Consumer Surplus
The market demand curve depicts the various quantities that buyers would be willing and able to purchase at different prices. 6 8

75. Four Possible Buyers’ Willingness to Pay11 11

76. Measuring Consumer Surplus with the Demand Curve
Price of
Album
John’s willingness to pay
$100
Paul’s willingness to pay 80
George’s willingness to pay 70
Ringo’s willingness to pay 50
Demand
Quantity of
Albums 1 2 3 4 13 13

77. Measuring Consumer Surplus with the Demand Curve
Price of
Album
Price = $80
$100
John’s consumer surplus ($20) 80 70 50
Demand
Quantity of
Albums 1 2 3 4 13 13

78. Measuring Consumer Surplus with the Demand Curve...
Price of
Album
Price = $70
$100
John’s consumer surplus ($30) 80
Paul’s consumer surplus ($10) 70
Total consumer surplus ($40) 50
Demand
Quantity of
Albums 1 2 3 4 13 13

79. Measuring Consumer Surplus with the Demand Curve
The area below the demand curve and above the price measures the consumer surplus in the market. 13 13

80. How the Price Affects Consumer SurplusB C A
Initial
consumer
surplus
Consumer surplus to new consumers Q1 P1 D E F
Additional consumer surplus to initial consumers Q2 P2
Demand
Quantity 17 21

81. Paradox of Value
Nothing is more useful than water; but it will scare purchase anything. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it
－The Wealth of Nations, Adam Smith 5 5

82. Price and Usefulness of Diamond
Consumer Surplus
Demand P Q
Quantity 17 21

83. Price and Usefulness of Water
Consumer Surplus
Demand P Q
Quantity 17 21

84. Consumer Surplus and Economic Well-Being
Consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it. 5 5

85. Consumer Surplus and Importation
Price
Domestic
supply
Price before trade
World Price
Price after trade
Domestic
quantity
supplied
Domestic
quantity
demanded
Imports
Domestic demand
Quantity 21

86. Consumer Surplus and Importation
Price
Domestic
supply A
Consumer surplus
before trade
Price before trade
World Price
Price after trade
Domestic demand
Quantity 21

87. Consumer Surplus and Importation
Price
Domestic
supply A
Consumer surplus
after trade B D
Price before trade
World Price
Price after trade
Imports
Domestic demand
Quantity 21

88. Recognizing Lock-In

89. Recognizing Lock-In
Cost of switching
Compare
Ford v. GM
Mac v. PC

90. What’s the Difference? Durable investments in complementary assets
Hardware
Software
Wetware
Supplier wants to lock-in customer
Customer wants to avoid lock-in
Basic principle: Look ahead and reason back
Kierkegaaard: “it is perfectly true, as philosophers say, that life must be understood backwards. But they forget the other proposition, that it must be lived forwards.”

91. Small Switching Costs Matter
Phone number portability
addresses
Hotmail (advertising, portability)
ACM, CalTech
Look at lockin costs on a per customer basis

92. Classification of Lock-In
Contractual commitments: damages
Durable purchases and replacement: declines with time
Brand-specific training: rises with time
Information and data: rises with time
Specialized suppliers: may rise
Search costs: learn about alternatives
Loyalty programs: rebuild cumulative usage

93. Contractual Commitments
“Requirements contract”: Purchase supplies from one supplier
Beware of “evergreen contracts”

94. Follow the Lock-in cycle
Brand Selection
Lock-In
Sampling
Selects brand: comparison
Sampling phase: try the product
Entrenchment: makes the durable investments
Lock-in: costly to change
Entrenchment

95. Assignment
Review Chapter 5
Answer questions on P94
Preview Chapter 6

96. Thanks