1. Lecture 3: Consumer BehaviorSlide 1 Topics to be Discussed Consumer Preferences Budget Constraints Consumer Choice

2. Lecture 3: Consumer BehaviorSlide 2 Consumer Behavior Example 1: General Mills had to determine how high a price to charge for Apple-Cinnamon Cheerios before it went to the market. Example 2: 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.

3. Lecture 3: Consumer BehaviorSlide 3 Consumer Behavior Three steps involved in the study of consumer behavior. 1) Consumer preferences: how and why people prefer one good to another. 2) Budget constraints: people have limited incomes. 3) Combine the two to determine consumer choices.

4. Lecture 3: Consumer BehaviorSlide 4 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

5. Lecture 3: Consumer BehaviorSlide 5 Consumer Preferences Three Basic Assumptions 1) Preferences are complete. 2) Preferences are transitive. 3) Consumers always prefer more of any good to less. Market Baskets

6. Lecture 3: Consumer BehaviorSlide 6 Consumer Preferences A2030 B1050 D4020 E3040 G1020 H1040 Market BasketUnits of Food Units of Clothing

7. Lecture 3: Consumer BehaviorSlide 7 Consumer Preferences Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person. Indifference Curves

8. Lecture 3: Consumer BehaviorSlide 8 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

9. Lecture 3: Consumer BehaviorSlide 9 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

10. Lecture 3: Consumer BehaviorSlide 10 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. Indifference curves cannot cross.This would violate the assumption that more is preferred to less.

11. Lecture 3: Consumer BehaviorSlide 11 Consumer Preferences 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. Indifference Maps

12. Lecture 3: Consumer BehaviorSlide 12 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.

13. Lecture 3: Consumer BehaviorSlide 13 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

14. Lecture 3: Consumer BehaviorSlide 14 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

15. Lecture 3: Consumer BehaviorSlide 15 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

16. Lecture 3: Consumer BehaviorSlide 16 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

17. Lecture 3: Consumer BehaviorSlide 17 Consumer Preferences 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. Marginal Rate of Substitution

18. Lecture 3: Consumer BehaviorSlide 18 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

19. Lecture 3: Consumer BehaviorSlide 19 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

20. Lecture 3: Consumer BehaviorSlide 20 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

21. Lecture 3: Consumer BehaviorSlide 21 Consumer Preferences Orange Juice (glasses) Apple Juice (glasses) 2341 1 2 3 4 0 Perfect Substitutes Perfect Substitutes

22. Lecture 3: Consumer BehaviorSlide 22 Consumer Preferences Right Shoes Left Shoes 2341 1 2 3 4 0 Perfect Complements Perfect Complements

23. Lecture 3: Consumer BehaviorSlide 23 Consumer Preferences Utility Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket.

24. Lecture 3: Consumer BehaviorSlide 24 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

25. Lecture 3: Consumer BehaviorSlide 25 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

26. Lecture 3: Consumer BehaviorSlide 26 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.

27. Lecture 3: Consumer BehaviorSlide 27 Budget Constraints Preferences do not explain all of consumer behavior. Budget constraints limit an individual’s ability to consume in light of the prices they must pay. The budget line indicates all combinations of commodities for which total money spent equals total income.

28. Lecture 3: Consumer BehaviorSlide 28 Budget Constraints The Budget Line Let F equal the amount of food purchased, and C is the amount of clothing. Price of food = P f and price of clothing = P c Then P f F is the amount of money spent on food, and P c C is the amount of money spent on clothing.

29. Lecture 3: Consumer BehaviorSlide 29 Budget Constraints The budget line then can be written:

30. Lecture 3: Consumer BehaviorSlide 30 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

31. Lecture 3: Consumer BehaviorSlide 31 Budget Constraints The slope is the negative of the ratio of the prices: it indicates the rate at which the two goods can be substituted without changing the amount of money spent. The vertical intercept (I/P C ), illustrates the maximum amount of C that can be purchased with income I.

32. Lecture 3: Consumer BehaviorSlide 32 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).

33. Lecture 3: Consumer BehaviorSlide 33 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). Price Changes. If the price of one good increases, the budget line shifts inward, pivoting from the other good’s intercept.

34. Lecture 3: Consumer BehaviorSlide 34 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

35. Lecture 3: Consumer BehaviorSlide 35 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.

36. Lecture 3: Consumer BehaviorSlide 36 Consumer Choice Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.

37. Lecture 3: Consumer BehaviorSlide 37 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.

38. Lecture 3: Consumer BehaviorSlide 38 Recall, the slope of an indifference curve is: Consumer Choice Further, the slope of the budget line is:

39. Lecture 3: Consumer BehaviorSlide 39 Consumer Choice Therefore, it can be said that satisfaction is maximized where:

40. Lecture 3: Consumer BehaviorSlide 40 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

41. Lecture 3: Consumer BehaviorSlide 41 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

42. Lecture 3: Consumer BehaviorSlide 42 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

43. Lecture 3: Consumer BehaviorSlide 43 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 vertical axis. MRS is not equal to P A /P B A Corner Solution

44. Lecture 3: Consumer BehaviorSlide 44 A Corner Solution Ice Cream (cup/month) Frozen Yogurt (cups monthly) B A U2U2 U3U3 U1U1 A corner solution exists at point B.

45. Lecture 3: Consumer BehaviorSlide 45 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:

46. Lecture 3: Consumer BehaviorSlide 46 When consumers maximize satisfaction the: Marginal Utility and Consumer Choice Since the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it follows that:

47. Lecture 3: Consumer BehaviorSlide 47 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. Marginal Utility and Consumer Choice

48. Lecture 3: Consumer BehaviorSlide 48 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.

49. Lecture 3: Consumer BehaviorSlide 49 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.

50. Lecture 3: Consumer BehaviorSlide 50 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. Consumers maximize satisfaction subject to budget constraints.