1. Chapter 3 Consumer Behavior

2. Chapter 32©2005 Pearson Education, Inc. 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?

3. Chapter 33©2005 Pearson Education, Inc. 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

4. Chapter 34©2005 Pearson Education, Inc. Consumer Behavior - Applications 1.How would General Mills determine the price to charge for a new cereal before it went to the market? 2.To what extent did the food stamp program provide individuals with more food versus merely subsidizing food they bought anyway?

5. Chapter 35©2005 Pearson Education, Inc. 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

6. Chapter 36©2005 Pearson Education, Inc. Consumer Behavior There are three steps involved in the study of consumer behavior 1.Consumer Preferences  To describe how and why people prefer one good to another 2.Budget Constraints  People have limited incomes

7. Chapter 37©2005 Pearson Education, Inc. Consumer Behavior 3.Given preference sand limited incomes, what amount and type of goods will be purchased?  What combination of goods will consumers buy to maximize their satisfaction?

8. Chapter 38©2005 Pearson Education, Inc. 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

9. Chapter 39©2005 Pearson Education, Inc. Consumer Preferences – Basic Assumptions 1.Preferences are complete.  Consumers can rank market baskets 2.Preferences are transitive.  If prefer A to B, and B to C, the must prefer A to C 3.Consumers always prefer more of any good to less.  More is better

10. Chapter 310©2005 Pearson Education, Inc. 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

11. Chapter 311©2005 Pearson Education, Inc. Indifference Curves: An Example Market BasketUnits of FoodUnits of Clothing A2030 B1050 D4020 E3040 G1020 H1040

12. Chapter 312©2005 Pearson Education, Inc. 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

13. Chapter 313©2005 Pearson Education, Inc. The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A. Indifference Curves: An Example Food 10 20 30 40 10203040 Clothin g 50 G A EH B D

14. Chapter 314©2005 Pearson Education, Inc. 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

15. Chapter 315©2005 Pearson Education, Inc. Indifferent between B, A, & D E is preferred to U 1 U 1 is preferred to H & G Indifference Curves: An Example Food 10 20 30 40 10203040 Clothin g 50 U1U1 G D A E H B

16. Chapter 316©2005 Pearson Education, Inc. 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

17. Chapter 317©2005 Pearson Education, Inc. 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

18. Chapter 318©2005 Pearson Education, Inc. 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.

19. Chapter 319©2005 Pearson Education, Inc. U2U2 U3U3 Indifference Map Food Clothing U1U1 A B D Market basket A is preferred to B. Market basket B is preferred to D.

20. Chapter 320©2005 Pearson Education, Inc. 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.

21. Chapter 321©2005 Pearson Education, Inc. Indifference Maps Food Clothing B is preferred to D A is indifferent to B & D B must be indifferent to D but that can’t be if B is preferred to D U1U1 U1U1 U2U2 U2U2 A B D

22. Chapter 322©2005 Pearson Education, Inc. 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

23. Chapter 323©2005 Pearson Education, Inc. A B D E G -6 1 1 -4 -2 1 1 Observation: The amount of clothing given up for 1 unit of food decreases from 6 to 1 Indifference Curves Food Clothing 23451 2 4 6 8 10 12 14 16

24. Chapter 324©2005 Pearson Education, Inc. 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.

25. Chapter 325©2005 Pearson Education, Inc. Marginal Rate of Substitution Food 23451 Clothing 2 4 6 8 10 12 14 16 A B D E G -6 1 1 1 1 -4 -2 MRS = 6 MRS = 2

26. Chapter 326©2005 Pearson Education, Inc. 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

27. Chapter 327©2005 Pearson Education, Inc. 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

28. Chapter 328©2005 Pearson Education, Inc. 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

29. Chapter 329©2005 Pearson Education, Inc. 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

30. Chapter 330©2005 Pearson Education, Inc. Consumer Preferences Orange Juice (glasses) Apple Juice (glasses) 2341 1 2 3 4 0 Perfect Substitutes

31. Chapter 331©2005 Pearson Education, Inc. Consumer Preferences Perfect Complements  Two goods are perfect complements when the indifference curves for the goods are shaped as right angles.  Example: If have 1 left shoe and 1 right shoe, you are indifferent between having more left shoes only Must have one right for one left

32. Chapter 332©2005 Pearson Education, Inc. Consumer Preferences Right Shoes Left Shoes 2341 1 2 3 4 0 Perfect Complements

33. Chapter 333©2005 Pearson Education, Inc. 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

34. Chapter 334©2005 Pearson Education, Inc. Consumer Preferences How do we account for bads in our preference analysis?  We redefine the commodity Clean air Pollution reduction Asbestos removal

35. Chapter 335©2005 Pearson Education, Inc. 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

36. Chapter 336©2005 Pearson Education, Inc. 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

37. Chapter 337©2005 Pearson Education, Inc. Consumer Preferences: An Application These consumers place a greater value on performance than styling Styling Performance

38. Chapter 338©2005 Pearson Education, Inc. Consumer Preferences: An Application These consumers place a greater value on styling than performance Styling Performance

39. Chapter 339©2005 Pearson Education, Inc. 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.

40. Chapter 340©2005 Pearson Education, Inc. Consumer Preferences The theory of consumer behavior does not required assigning a numerical value to the level of satisfaction Although ranking of market baskets are good, sometimes numerical value are useful

41. Chapter 341©2005 Pearson Education, Inc. 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.

42. Chapter 342©2005 Pearson Education, Inc. Utility Utility function  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)

43. Chapter 343©2005 Pearson Education, Inc. Utility - Example Market Basket FoodClothingUtility A838 + 2(3) = 14 B646 + 2(4) = 14 C444 + 2(4) = 12 Consumer is indifferent between A & B and prefers both to C

44. Chapter 344©2005 Pearson Education, Inc. 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

45. Chapter 345©2005 Pearson Education, Inc. Utility - Example Food 10155 5 10 15 0 Clothing U 1 = 25 U 2 = 50 U 3 = 100 A B C BasketU = FC C25 = 2.5(10) A25 = 5(5) B25 = 10(2.5)

46. Chapter 346©2005 Pearson Education, Inc. 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

47. Chapter 347©2005 Pearson Education, Inc. 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.

48. Chapter 348©2005 Pearson Education, Inc. Utility The actual unit of measurement for utility is not important. An ordinal ranking is sufficient to explain how most individual decisions are made.

49. Chapter 349©2005 Pearson Education, Inc. 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.

50. Chapter 350©2005 Pearson Education, Inc. 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

51. Chapter 351©2005 Pearson Education, Inc. 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.

52. Chapter 352©2005 Pearson Education, Inc. The Budget Line The budget line then can be written: All income is allocated to food (F) and/or clothing (C)

53. Chapter 353©2005 Pearson Education, Inc. 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, P F = $1 and P C = $2

54. Chapter 354©2005 Pearson Education, Inc. Budget Constraints Market Basket Food P F = $1 Clothing P C = $2 Income I = P F F + P C C A040$80 B2030$80 D4020$80 E6010$80 G800$80

55. Chapter 355©2005 Pearson Education, Inc. The Budget Line 10 20 A B D E G ( I/P C ) = 40 Food 4060 80 = ( I/P F ) 20 10 20 30 0 Clothing

56. Chapter 356©2005 Pearson Education, Inc. 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.

57. Chapter 357©2005 Pearson Education, Inc. 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

58. Chapter 358©2005 Pearson Education, Inc. The Budget Line

59. Chapter 359©2005 Pearson Education, Inc. 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.

60. Chapter 360©2005 Pearson Education, Inc. 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

61. Chapter 361©2005 Pearson Education, Inc. 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

62. Chapter 362©2005 Pearson Education, Inc. 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

63. Chapter 363©2005 Pearson Education, Inc. The Budget Line - Changes A increase in income shifts the budget line outward Food (units per week) Clothing (units per week) 8012016040 20 40 60 80 0 ( I = $160) L2L2 ( I = $80) L1L1 L3L3 ( I = $40) A decrease in income shifts the budget line inward

64. Chapter 364©2005 Pearson Education, Inc. 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

65. Chapter 365©2005 Pearson Education, Inc. 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

66. Chapter 366©2005 Pearson Education, Inc. The Budget Line - Changes ( 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 Food (units per week) Clothing (units per week) 80 120 160 40

67. Chapter 367©2005 Pearson Education, Inc. 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

68. Chapter 368©2005 Pearson Education, Inc. 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

69. Chapter 369©2005 Pearson Education, Inc. 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.

70. Chapter 370©2005 Pearson Education, Inc. Consumer Choice The maximizing market basket must satisfy two conditions: 1.It must be located on the budget line.  They spend all their income – more is better 2.It must give the consumer the most preferred combination of goods and services.

71. Chapter 371©2005 Pearson Education, Inc. 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

72. Chapter 372©2005 Pearson Education, Inc. Consumer Choice U3U3 D U2U2 C Food (units per week) 408020 Clothing (units per week) 20 30 40 0 U1U1 A B A, B, C on budget line D highest utility but not affordable C highest affordable utility Consumer chooses C

73. Chapter 373©2005 Pearson Education, Inc. 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

74. Chapter 374©2005 Pearson Education, Inc. Consumer Choice Recall, the slope of an indifference curve is: Further, the slope of the budget line is:

75. Chapter 375©2005 Pearson Education, Inc. Consumer Choice Therefore, it can be said at consumer’s optimal consumption point,

76. Chapter 376©2005 Pearson Education, Inc. 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

77. Chapter 377©2005 Pearson Education, Inc. 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

78. Chapter 378©2005 Pearson Education, Inc. Consumer Choice If MRS ≠ P F /P C then individuals can reallocate basket to increase utility If MRS > P F /P C  Will increase food and decrease clothing until MRS = P F /P C If MRS < P F /P C  Will increase clothing and decrease food until MRS = P F /P C

79. Chapter 379©2005 Pearson Education, Inc. Consumer Choice Food (units per week) Clothing (units per week) 408020 30 40 0 Point B does not maximize satisfaction because the MRS =-10/10 = 1 is greater than the price ratio = 1/2 +10 F U1U1 -10 C B

80. Chapter 380©2005 Pearson Education, Inc. 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.

81. Chapter 381©2005 Pearson Education, Inc. 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.

82. Chapter 382©2005 Pearson Education, Inc. Consumer Choice: An Application Revisited Styling Performance $10,000 These consumers Want performance worth $7000 and styling worth $3000 $3,000 $7,000

83. Chapter 383©2005 Pearson Education, Inc. Consumer Choice: An Application Revisited These consumers want styling worth $7000 and performance worth $3000 $3,000 $7,000 Styling $10,000 Performance

84. Chapter 384©2005 Pearson Education, Inc. 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

85. Chapter 385©2005 Pearson Education, Inc. 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

86. Chapter 386©2005 Pearson Education, Inc. A Corner Solution Ice Cream (cup/month) Frozen Yogurt (cups monthly) B A U2U2 U3U3 U1U1 A corner solution exists at point B.

87. Chapter 387©2005 Pearson Education, Inc. 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

88. Chapter 388©2005 Pearson Education, Inc. 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:

89. Chapter 389©2005 Pearson Education, Inc. 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.

90. Chapter 390©2005 Pearson Education, Inc. 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

91. Chapter 391©2005 Pearson Education, Inc. 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, U 2

92. Chapter 392©2005 Pearson Education, Inc. A Corner Solution - Example P Q Education ($) Other Consumption ($) U2U2 A U1U1 B Jane better off on U 2 B is corner solution MRS ≠ P E /P OG

93. Chapter 393©2005 Pearson Education, Inc. A Corner Solution - Example P Q Education ($) Other Consumption ($) U2U2 A U1U1 B If gift is unrestricted, Jane can be at point C on U 3 Better off than with restricted gift C U3U3

94. Chapter 394©2005 Pearson Education, Inc. 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.

95. Chapter 395©2005 Pearson Education, Inc. 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) D

96. Chapter 396©2005 Pearson Education, Inc. Revealed Preferences-- Two Budget Lines l1l1 l2l2 B A 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

97. Chapter 397©2005 Pearson Education, Inc. 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

98. Chapter 398©2005 Pearson Education, Inc. 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 yellow area E B A G I 3 : E revealed preferred to A I 4 : G revealed preferred to A

99. Chapter 399©2005 Pearson Education, Inc. 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

100. Chapter 3100©2005 Pearson Education, Inc. 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

101. Chapter 3101©2005 Pearson Education, Inc. 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

102. Chapter 3102©2005 Pearson Education, Inc. 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).

103. Chapter 3103©2005 Pearson Education, Inc. 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

104. Chapter 3104©2005 Pearson Education, Inc. Marginal Utility and Consumer Choice Rearranging:

105. Chapter 3105©2005 Pearson Education, Inc. 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

106. Chapter 3106©2005 Pearson Education, Inc. Marginal Utility and Consumer Choice Rearranging, gives the equation for utility maximization:

107. Chapter 3107©2005 Pearson Education, Inc. 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.

108. Chapter 3108©2005 Pearson Education, Inc. 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

109. Chapter 3109©2005 Pearson Education, Inc. 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?

110. Chapter 3110©2005 Pearson Education, Inc. 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

111. Chapter 3111©2005 Pearson Education, Inc. 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

112. Chapter 3112©2005 Pearson Education, Inc. 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

113. Chapter 3113©2005 Pearson Education, Inc. 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

114. Chapter 3114©2005 Pearson Education, Inc. 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

115. Chapter 3115©2005 Pearson Education, Inc. 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

116. Chapter 3116©2005 Pearson Education, Inc. 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