1. Chapter 3 Consumer Behavior

2. Chapter 3: Consumer BehaviorSlide 2 Consumer Behavior It is behavior when a person keep at the time of purchasing of any thing is called consumer behavior.

3. Chapter 3: Consumer BehaviorSlide 3 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.

4. Chapter 3: Consumer BehaviorSlide 4 Consumer Behavior 2)Then we will turn to budget constraints. People have limited incomes. 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 A2030 B1050 D4020 E3040 G1020 H1040 Market BasketUnits of Food Units of Clothing

7. Chapter 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. Chapter 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. Chapter 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. Chapter 3: Consumer BehaviorSlide 10 Consumer Preferences Indifference Curves Indifference curves slope downward to the right. Any market basket lying above and to the right of an indifference curve is preferred to any market basket that lies on the indifference curve.

11. Chapter 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. Chapter 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. 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

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 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

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. Two goods are perfect complements when the indifference curves for the goods are shaped as right angles. 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 Right Shoes Left Shoes 2341 1 2 3 4 0 Perfect Complements Perfect Complements

20. Chapter 3: Consumer BehaviorSlide 20 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. Designing New Automobiles

21. Chapter 3: Consumer BehaviorSlide 21 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

22. Chapter 3: Consumer BehaviorSlide 22 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

23. Chapter 3: Consumer BehaviorSlide 23 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)

24. Chapter 3: Consumer BehaviorSlide 24 Consumer Preferences Utility Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket. Initial Utility: satisfaction level with the utilization of first unit of any good. Marginal Utility: satisfaction obtained from the utilization of every next unit

25. Consumer Preferences Total Utility: Satisfaction level achieved with the utilization of all units of good. Positive Utility: The increase in overall satisfaction level until get zero by the utilization of every next unit of good. Zero Utility: when there will be no change in satisfaction by utilization of good. Negative Utility: When the utilization of every next unit harm the consumer. Chapter 3: Consumer BehaviorSlide 25

26. Chapter 3: Consumer BehaviorSlide 26 Consumer Preferences Utility If buying 3 books of Microeconomics makes you happier than buying one shirt, then we say that the books give you more utility than the shirt.

27. Chapter 3: Consumer BehaviorSlide 27 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 prefers A & B to C

28. Chapter 3: Consumer BehaviorSlide 28 Consumer Preferences Food (units per week) 10155 5 10 15 0 Clothing (units per week ) 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

29. Chapter 3: Consumer BehaviorSlide 29 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 by how much one market basket is preferred to another.

30. Chapter 3: Consumer BehaviorSlide 30 Budget Constraints Budget constraints that consumers face as a result of limited incomes. Budget constraints also limit an individual’s ability to consume in light of the prices they must pay for various goods and services.

31. Chapter 3: Consumer BehaviorSlide 31 Budget Constraints The Budget Line The budget line indicates all combinations of two commodities for which total money spent equals total income.

32. Chapter 3: Consumer BehaviorSlide 32 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.

33. Chapter 3: Consumer BehaviorSlide 33 Budget Constraints The budget line then can be written:

34. Chapter 3: Consumer BehaviorSlide 34 Budget Constraints A040$8000 B2030$8000 D4020$8000 E6010$8000 G800$8000 Market BasketFood (F) Clothing (C)Total Spending P f = ($100)P c = ($200)P f F + P c C = I

35. Chapter 3: Consumer BehaviorSlide 35 Budget Line 100F + 200C = $8000 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 = $200 P f = $100 I = $8000

36. Chapter 3: Consumer BehaviorSlide 36 Budget Constraints 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.

37. Chapter 3: Consumer BehaviorSlide 37 Budget Constraints The Budget Line The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent.

38. Chapter 3: Consumer BehaviorSlide 38 Budget Constraints The Budget Line The vertical intercept (I/P C ), illustrates the maximum amount of C that can be purchased with income I. The horizontal intercept (I/P F ), illustrates the maximum amount of F that can be purchased with income I.

39. Chapter 3: Consumer BehaviorSlide 39 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).  A decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant).

40. Chapter 3: Consumer BehaviorSlide 40 Budget Constraints Food (units per week) Clothing (units per week) 8012016040 20 40 60 80 0 An increase in income shifts the budget line outward (I = $16000) L2L2 (I = $8000) L1L1 L3L3 (I = $4000) A decrease in income shifts the budget line inward

41. Chapter 3: Consumer BehaviorSlide 41 Budget Constraints The Effects of Changes in Income and Prices Price Changes  If the price of one good increases, the budget line shifts inward, turning from the other good’s intercept.

42. Chapter 3: Consumer BehaviorSlide 42 Budget Constraints The Effects of Changes in Income and Prices Price Changes  If the price of one good decreases, the budget line shifts outward, turning from the other good’s intercept.

43. Chapter 3: Consumer BehaviorSlide 43 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 = 200) (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.

44. Chapter 3: Consumer BehaviorSlide 44 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.  However, the budget line will shift inward to a point parallel to the original budget line.

45. Chapter 3: Consumer BehaviorSlide 45 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.  However, the budget line will shift outward to a point parallel to the original budget line.

46. Chapter 3: Consumer BehaviorSlide 46 Consumer Choice Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.

47. Chapter 3: Consumer BehaviorSlide 47 Consumer Choice The 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.

48. Chapter 3: Consumer BehaviorSlide 48 Recall, the slope of an indifference curve is: Consumer Choice Further, the slope of the budget line is:

49. Chapter 3: Consumer BehaviorSlide 49 Consumer Choice Therefore, it can be said that satisfaction is maximized where:

50. Chapter 3: Consumer BehaviorSlide 50 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).

51. Chapter 3: Consumer BehaviorSlide 51 Consumer Choice Food (units per week) Clothing (units per week) 208010 20 30 40 0 U1U1 B Budget Line Pc = $200 P f = $100 I = $8000 Point B does not maximize satisfaction because the MRS (-(-10/10) = 1 is greater than the price ratio (100/200)= 0.5 -10C +10F

52. Chapter 3: Consumer BehaviorSlide 52 Consumer Choice Budget Line U3U3 D Market basket D cannot be attained given the current budget constraint. Pc = $200 P f = $100 I = $8000 Food (units per week) Clothing (units per week) 408020 30 40 0

53. Chapter 3: Consumer BehaviorSlide 53 U2U2 Consumer Choice Pc = $200 P f = $100 I = $8000 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

54. Chapter 3: Consumer BehaviorSlide 54 Consumer Choice Consider two groups of consumers, each wishing to spend $10,000 on the styling and performance of cars. Each group has different preferences. Designing New Automobiles (II)

55. Chapter 3: Consumer BehaviorSlide 55 Consumer Choice By finding the point of tangency between a group’s indifference curve and the budget constraint auto companies can design a production and marketing plan. Designing New Automobiles (II)

56. Chapter 3: Consumer BehaviorSlide 56 Designing New Automobiles (II) Styling Performance $10,000 $3,000 These consumers are willing to trade off a considerable amount of styling for some additional performance $7,000

57. Chapter 3: Consumer BehaviorSlide 57 Designing New Automobiles (II) Styling $10,000 $3,000 These consumers are willing to trade off a considerable amount of performance for some additional styling $7,000 Performance

58. Chapter 3: Consumer BehaviorSlide 58 Consumer Choice A corner solution is the situation in which the marginal rate of substitution of a good in a chosen market basket is not equal to the slope of the budget line. A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another. A Corner Solution

59. Consumer Choice A Corner Solution This exists where the indifference curves are tangent to the horizontal and vertical axis. MRS is not equal to PA/PB Chapter 3: Consumer BehaviorSlide 59

60. Chapter 3: Consumer BehaviorSlide 60 A Corner Solution Ice Cream A (cup/month) Frozen Yogurt (cups monthly) B A U2U2 U3U3 U1U1 A corner solution exists at point B.

61. Chapter 3: Consumer BehaviorSlide 61 Consumer Choice A Corner Solution At point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line. This suggests that if 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!

62. Chapter 3: Consumer BehaviorSlide 62 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:

63. Chapter 3: Consumer BehaviorSlide 63 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.

64. Chapter 3: Consumer BehaviorSlide 64 Consumer Choice Suppose Jane parents set up a trust fund for her college education. Originally, the money must be used for education. A College Trust Fund

65. Chapter 3: Consumer BehaviorSlide 65 Consumer Choice If part of the money could be used for the purchase of other goods, her consumption preferences change. A College Trust Fund

66. Chapter 3: Consumer BehaviorSlide 66 The trust fund shifts the budget line Consumer Choice P Q Education ($) Other Consumption ($) U2U2 A College Trust Fund A U1U1 A: Consumption before the trust fund B B: Requirement that the trust fund must be spent on education C U3U3 C: If the trust could be spent on other goods

67. Chapter 3: Consumer BehaviorSlide 67 Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good. Marginal Utility and Consumer Choice Marginal Utility

68. Chapter 3: Consumer BehaviorSlide 68 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 Marginal Utility Marginal Utility and Consumer Choice

69. Chapter 3: Consumer BehaviorSlide 69 The principle of diminishing marginal utility states that as more and more of a good is consumed, consuming additional amounts will give up smaller and smaller additions to utility. Diminishing Marginal Utility Marginal Utility and Consumer Choice

70. Chapter 3: Consumer BehaviorSlide 70 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

71. Chapter 3: Consumer BehaviorSlide 71 Formally: Marginal Utility and Consumer Choice

72. Chapter 3: Consumer BehaviorSlide 72 Rearranging: Marginal Utility and Consumer Choice

73. Chapter 3: Consumer BehaviorSlide 73 Because: Marginal Utility and Consumer Choice

74. Chapter 3: Consumer BehaviorSlide 74 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:

75. Chapter 3: Consumer BehaviorSlide 75 Which gives the equation for utility maximization: Marginal Utility and Consumer Choice

76. Chapter 3: Consumer BehaviorSlide 76 In 1974 and again in 1979, the government imposed price controls on gasoline. This resulted in shortages. Gasoline Rationing Marginal Utility and Consumer Choice

77. Chapter 3: Consumer BehaviorSlide 77 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

78. Chapter 3: Consumer BehaviorSlide 78 B 20,000 A Gasoline (gallons per year) Spending on other goods ($) 20,000 5,000 U1U1 C 15,000 2,000 D 18,000 U2U2 Marginal Utility and Consumer Choice

79. Chapter 3: Consumer BehaviorSlide 79 Cost-of-Living Indexes The CPI is calculated each year of consumer goods and services today in comparison to the cost during a base period.

80. Chapter 3: Consumer BehaviorSlide 80 Cost-of-Living Indexes Example Two sisters, Rachel and Sarah, have identical preferences. Sarah began college in 1987 with a $500 budget. In 1997, Rachel started college and her parents promised her a budget that was equivalent in purchasing power.

81. Chapter 3: Consumer BehaviorSlide 81 Cost-of-Living Indexes Price of books$20/book$100/book Number of books156 Price of food$2.00$2.20 Pounds of food100300 Expenditure$500$1,260 1987 (Sarah) 1997(Rachel)

82. Chapter 3: Consumer BehaviorSlide 82 Cost-of-Living Indexes Rachel’ Expenditure for Equal Utility $1,260 = 300. of food x $2.20. + 6 books x $100/book Sarah’ Expenditure $500 = 100. of food x $2.00 + 15 books x $20/book

83. Chapter 3: Consumer BehaviorSlide 83 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.

84. Chapter 3: Consumer BehaviorSlide 84 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.

85. Chapter 3: Consumer BehaviorSlide 85 Summary Budget lines represent all combinations of goods for which consumers expend all their income. Consumers maximize satisfaction subject to budget constraints.