chapter 3 consumer behaviour

Chapter 3

Consumer Behavior

Chapter 3: Consumer Behavior Slide 2

Topics to be Discussed

Consumer Preferences

Budget Constraints

Consumer Choice

Revealed Preferences

Topics to be Discussed

Marginal Utility and Consumer Choices

Cost-of-Living Indexes

Consumer Behavior

Two applications that illustrate the importance of the economic theory of consumer behavior are:Apple-Cinnamon Cheerios

The Food Stamp Program.

Consumer Behavior

General Mills had to determine how high a price to charge for Apple-Cinnamon Cheerios before it went to the market.

Consumer Behavior

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.

Consumer Behavior

These two problems require an understanding of the economic theory of consumer behavior.

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.

Consumer Behavior

2) Then we will turn to budget constraints.

People have limited incomes.

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?

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 BasketsMarket Baskets

Three Basic Assumptions

1) Preferences are complete.

2) Preferences are transitive.

3) Consumers always prefer more of any good to less.

Market BasketsMarket Baskets

A 20 30

B 10 50

D 40 20

E 30 40

G 10 20

H 10 40

Market Basket Units of Food Units of Clothing

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

Indifference CurvesIndifference Curves

The consumer prefersA to all combinationsin the blue box, whileall those in the pink

box are preferred to A.

Food(units per week)

10 20 30 40

Clothing(units per week)

Combination B,A, & Dyield the same satisfaction•E is preferred to U1

•U1 is preferred to H & G

10 20 30 40

Indifference CurvesIndifference 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 CurvesAny market basket lying above and to the

right of an indifference curve is preferred to any market basket that lies on the indifference curve.

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 MapsIndifference Maps

Indifference CurvesFinally, indifference curves cannot cross.

This would violate the assumption that more is preferred to less.

Market basket Ais preferred to B.Market basket B ispreferred to D.

The consumer shouldbe indifferent betweenA, B and D. However,B contains more ofboth goods than D.

Indifference CurvesCannot Cross

Observation: The amountof clothing given up for a unit of food decreasesfrom 6 to 1

Clothing(units

per week)

2 3 4 51

Question: Does thisrelation hold for givingup food to get clothing?

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 SubstitutionMarginal Rate of Substitution

Clothing(units

per week)

2 3 4 51

MRS = 6

MRS = 2

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.

Question

What are the first three assumptions?

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

Perfect Substitutes and Perfect ComplementsTwo goods are perfect substitutes when

the marginal rate of substitution of one good for the other is constant.

Perfect Substitutes and Perfect ComplementsTwo goods are perfect complements when

the indifference curves for the goods are shaped as right angles.

Orange Juice(glasses)

Apple Juice

(glasses)

2 3 41

PerfectSubstitutes

Right Shoes

LeftShoes

2 3 41

PerfectComplements

BADSThings for which less is preferred to more

ExamplesAir pollution

Asbestos

What Do You Think?How can we account for Bads in the

analysis of consumer preferences?

Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling.

Designing New Automobiles (I)Designing New Automobiles (I)

An analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars.

These consumers arewilling to give up

considerablestyling for additional

performance

Styling

Performance

ConsumerPreference A:

High MRS

ConsumerPreference A:

High MRS

These consumers arewilling to give up

considerableperformance for additional styling

Styling

Performance

ConsumerPreference B:

Low MRS

ConsumerPreference B:

Low MRS

What Do You Think?

How can we determine the consumers preference?

A recent study of automobile demand in the United States shows that over the past two decades most consumers have preferred styling over performance.

Growth of Japanese Imports

1970’s and 1980’s

15% of domestic cars underwent a style change each year

This compares to 23% for imports

UtilityUtility: Numerical score representing the

satisfaction that a consumer gets from a given market basket.

UtilityIf 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.

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

Food(units per week)10 155

Clothing(units

per week)

U1 = 25

U2 = 50 (Preferred to U1)

U3 = 100 (Preferred to U2)A

Assume: U = FCMarket Basket U = FC

C 25 = 2.5(10)A 25 = 5(5)B 25 = 10(2.5)

Utility Functions & Indifference CurvesUtility Functions & Indifference Curves

Ordinal Versus Cardinal UtilityOrdinal 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.

Ordinal Versus Cardinal RankingsThe actual unit of measurement for utility is

not important.

Therefore, an ordinal ranking is sufficient to explain how most individual decisions are made.

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.

Budget Constraints

The Budget LineThe budget line indicates all combinations

of two commodities for which total money spent equals total income.

Budget Constraints

The Budget LineLet F equal the amount of food purchased,

and C is the amount of clothing.

Price of food = Pf and price of clothing = Pc

Then Pf F is the amount of money spent on food, and Pc C is the amount of money spent on clothing.

Budget Constraints

The budget line then can be written:

ICPFP CF

Budget Constraints

A 0 40 $80

B 20 30 $80

D 40 20 $80

E 60 10 $80

G 80 0 $80

Market Basket Food (F) Clothing (C) Total SpendingPf = ($1) Pc = ($2) PfF + PcC = I

Budget Line F + 2C = $80

CF/PPFC - 2

1- / Slope

(I/PC) = 40

Budget Constraints

Food(units per week)40 60 80 = (I/PF)20

Clothing(units

per week)

Pc = $2 Pf = $1 I = $80

Budget Constraints

The Budget LineAs 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.

Budget Constraints

The Budget LineThe slope indicates the rate at which the

two goods can be substituted without changing the amount of money spent.

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.

Budget Constraints

The Effects of Changes in Income and PricesIncome Changes

An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant).

Budget Constraints

The Effects of Changes in Income and PricesIncome Changes

A decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant).

Budget Constraints

Clothing(units

per week)

80 120 16040

A increase inincome shifts

the budget lineoutward

(I = $160)L2

(I = $80)

(I =$40)

A decrease inincome shifts

the budget lineinward

Budget Constraints

The Effects of Changes in Income and PricesPrice Changes

If the price of one good increases, the budget line shifts inward, pivoting from the other good’s intercept.

Budget Constraints

If the price of one good decreases, the budget line shifts outward, pivoting from the other good’s intercept.

Budget Constraints

Clothing(units

per week)

80 120 16040

(PF = 1)

An increase in theprice of food to$2.00 changes

the slope of thebudget line and

rotates it inward.

(PF = 2)(PF = 1/2)

A decrease in theprice of food to$.50 changes

the slope of thebudget line and

rotates it outward.

Budget Constraints

If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change.

Budget Constraints

However, the budget line will shift inward to a point parallel to the original budget line.

Budget Constraints

If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change.

Budget Constraints

However, the budget line will shift outward to a point parallel to the original budget line.

Consumer Choice

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

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.

Recall, the slope of an indifference curve is:

Consumer Choice

PSlope

Further, the slope of the budget line is:

Consumer Choice

Therefore, it can be said that satisfaction is maximized where:

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).

Consumer Choice

Food (units per week)

Clothing(units per

40 8020

Budget Line

Pc = $2 Pf = $1 I = $80

Point B does not maximize satisfaction

because theMRS (-(-10/10) = 1 is greater than the

price ratio (1/2).

Consumer Choice

Budget Line

D Market basket D cannot be attainedgiven the current

budget constraint.

Pc = $2 Pf = $1 I = $80

Clothing(units per

40 8020

Consumer Choice

Pc = $2 Pf = $1 I = $80

Budget Line

At market basket A the budget line and theindifference curve aretangent and no higherlevel of satisfaction

can be attained.

At A:MRS =Pf/Pc = .5

Clothing(units per

40 8020

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)Designing New Automobiles (II)

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)Designing New Automobiles (II)

Designing New Automobiles (II)

Styling

Performance$10,000

$10,000

$3,000

These consumersare willing to tradeoff a considerableamount of styling

for some additionalperformance

$7,000

Designing New Automobiles (II)

Styling

$10,000

$3,000

These consumersare willing to tradeoff a considerable

amount of performance forsome additional

styling

$7,000

Performance

Consumer Choice

Choosing between a non-matching and matching grant to fund police expenditures

Decision Making & Public PolicyDecision Making & Public Policy

Consumer Choice

Non-matching GrantNon-matching Grant

PoliceExpenditures ($)

PrivateExpenditures ($)

Before Grant• Budget line: PQ•A: Preference maximizing market basket •Expenditure

•OR: Private•OS: Police

After Grant• Budget line: TV•B: Preference maximizing market basket •Expenditure

•OU: Private•OZ: Police

Consumer Choice

Non-matching GrantNon-matching Grant

PoliceExpenditures ($)

Consumer Choice

Matching GrantMatching Grant

Police ($)

Before Grant• Budget line: PQ• A: Preference maximizing market basket After Grant•C: Preference maximizing market basketExpenditures

•OW: Private•OX: Police

Nonmatching Grant•Point B

•OU: Private expenditure•OZ: Police expenditure

Matching Grant•Point C

•OW: Private expenditure•OX: Police expenditure

Consumer Choice

Matching GrantMatching Grant

Police ($)

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 PA/PB

A Corner SolutionA Corner Solution

A Corner Solution

Ice Cream (cup/month)

FrozenYogurt

(cupsmonthly)

U2 U3U1

A corner solutionexists at point B.

Consumer Choice

A Corner SolutionAt 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!

Consumer Choice

A Corner SolutionWhen a corner solution arises, the

consumer’s MRS does not necessarily equal the price ratio.

In this instance it can be said that:

YogurtFrozenIceCream PPMRS /

Consumer Choice

A Corner SolutionIf 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.

Consumer Choice

Suppose Jane Doe’s parents set up a trust fund for her college education.

Originally, the money must be used for education.

A College Trust FundA College Trust Fund

Consumer Choice

If part of the money could be used for the purchase of other goods, her consumption preferences change.

The trust fund shifts the budget line

Consumer Choice

Q Education ($)

OtherConsumption

A: Consumption before the trust fund

B: Requirement that the trust fund must be spent on education

U3 C: If the trust could be spent on other goods

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 incomes vary.

Revealed Preferences--Two Budget Lines

I1: Chose A over B A is revealed preferred to Bl2: Choose B over D B is revealed preferred to D

Food (units per month)

Clothing(units per

month)

B is preferred toall market baskets in the green area

Revealed Preferences--Two Budget Lines

All market basketsin the pink

shaded area are preferred to A.

Clothing(units per

month)

All market baskets in the pink area preferred to A

Revealed Preferences--Four Budget Lines

Clothing(units per

month)

A: preferred to allmarket baskets in the green area

I3: E revealed preferred to A

I4: G revealed preferred to A

Amount of Exercise (hours)

Revealed Preferences for Recreation

OtherRecreational

Activities($)

0 25 50 75

•The rate changes to $1/hr + $30/wk•New budget line I2 & combination B•Reveal preference of B to A

Scenario•Roberta’s recreation budget = $100/wk•Price of exercise = $4/hr/week•Exercises 10 hrs/wk at A given U1 & I1

Would the Club’s profits increase?

Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.

Marginal Utility andConsumer Choice

Marginal UtilityMarginal Utility

ExampleThe 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 UtilityMarginal Utility

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 UtilityDiminishing Marginal Utility

Marginal Utility and the Indifference CurveIf 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).

Formally:

C)( MUF) (MU CF 0

Rearranging:

CF MUMUFC //

Because:

CF/MU MUMRS

CF MUMUFC //

C for F of MRSFC /

When consumers maximize satisfaction the:

CF/P PMRS

CFC F /P P /MUMU

Since the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it follows that:

Which gives the equation for utility maximization:

CCFF PMUPMU //

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.

In 1974 and again in 1979, the government imposed price controls on gasoline.

This resulted in shortages and gasoline was rationed.

Gasoline RationingGasoline Rationing

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 RationingGasoline Rationing

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.

The horizontal axis shows her annual consumption of gasoline at $1/gallon.

The vertical axis shows her remaining income after purchasing gasoline.

20,000

Gasoline(gallons per year)

Spendingon othergoods ($) 20,000

C15,000

With a limit of2,000 gallons,

the consumer movesto a lower

indifference curve(lower level of utility).

18,000

The CPI is calculated each year as the ratio of the cost of a typical bundle of consumer goods and services today in comparison to the cost during a base period.

What Do You Think?

Does the CPI accurately reflect the cost of living for retirees?

Is it appropriate to use the CPI as a cost-of-living index for other government programs, for private union pensions, and for other private wage agreements?

ExampleTwo sisters, Rachel and Sarah, have

identical preferences.

Sarah began college in 1987 with a $500 discretionary budget.

In 1997, Rachel started college and her parents promised her a budget that was equivalent in purchasing power.

Price of books $20/book$100/book

Number of books 15 6

Price of food $2.00/lb. $2.20/lb

Pounds of food 100 300

Expenditure $500 $1,260

1987 (Sarah) 1997 (Rachel)

Rachel’ Expenditure for Equal Utility

$1,260 = 300 lbs. of food x $2.20/lb. + 6 books x $100/book

Sarah’ Expenditure

$500 = 100 lbs. of food x $2.00/lb. + 15 books x $20/book

The ideal cost-of-living adjustment for Rachel is $760.

The ideal cost-of-living index is $1,260/$500 = 2.52 or 252.

This implies a 152% increase in the cost of living.

For Rachel to achievethe same level of utility as

Sarah, with the higher prices, her budget must be sufficient to allow her to consume the bundle

shown by point B.

Food(lb./quarter)

Books(per quarter)

0 60050 100 200 250 300 350 400 550500

The ideal cost of living index represents the cost of attaining a given level of utility at current (1997) prices relative to the cost of attaining the same utility at base (1987) prices.

To do this on an economy-wide basis would entail large amounts of information.

Price indexes, like the CPI, use a fixed consumption bundle in the base period.Called a Laspeyres price index

The Laspeyres index tells us:The amount of money at current year prices

that an individual requires to purchase the bundle of goods and services that was chosen in the base year divided by the cost of purchasing the same bundle at base year prices.

Laspeyres IndexLaspeyres Index

Calculating Rachel’s Laspeyres cost of living index

Setting the quantities of goods in 1997 equal to what were bought by her sister, but setting their prices at their 1997 levels result in an expenditure of $1,720 (100 x 2.20 + 15 x $100)

Her cost of living adjustment would now be $1,220.

The Laspeyres index is: $1,720/$500 = 344.

This overstates the true cost-of-living increase.

Using the Laspeyres index results in thebudget line shifting

up from I2 to I3.

Food(lb./quarter)

Books(per quarter)

0 60050 100 200 250 300 350 400 550500

What Do You Think?

Does the Laspeyres index always overstate the true cost-of-living index?

Yes!The Laspeyres index assumes that

consumers do not alter their consumption patterns as prices change.

Yes!By increasing purchases of those items that

have become relatively cheaper, and decreasing purchases of the relatively more expensive items consumers can achieve the same level of utility without having to consume the same bundle of goods.

The Paasche IndexCalculates the amount of money at current-

year prices that an individual requires to purchase a current bundle of goods and services divided by the cost of purchasing the same bundle in the base year.

Both indexes involve ratios that involve today’s current year prices, PFt and PCt.

However, the Laspeyres index relies on base year consumption, Fb and Cb.

Whereas, the Paasche index relies on today’s current consumption, Ft and Ct .

Comparing the Two IndexesComparing the Two Indexes

Then a comparison of the Laspeyres and Paasche indexes gives the following equations:

tCttFt

CPFP LI

tCttFb

CPFP PI

Suppose:

Two goods: Food (F) and Clothing (C)

PFt & PCt be current year prices

PFb & PCb be base year prices

Ft & Ct be current year quantities

Fb & Cb be base year quantities

Sarah (1990)

Cost of base-year bundle at current prices equals $1,720 (100 lbs x $2.20/lb + 15 books x $100/book)

Cost of same bundle at base year prices is $500 (100 lbs x $2.00/lb + 15 books x $20/book)

Sarah (1990)

344500

Sarah (1990)

Cost of buying current year bundle at current year prices is $1,260 (300 lbs x $2.20/lb + 6 books x $100/book)

Cost of the same bundle at base year prices is $720 (300 lbs x $2/lb + 6 books x $20/book)

Sarah (1990)

175720

The Paasche index will understate the cost of living because it assumes that the individual will buy the current year bundle in the base year.

The Paasche IndexThe Paasche Index

In 1995, the government adopted the chain-weighted price index to deflate its measure of real GDP.Developed to overcome problems that arose

when long-term comparisons of GDP were made using fixed-weight price indexes and prices were rapidly changing.

What Do You Think?

What is the impact on the Federal budget of using the CPI (a Laspeyres index) to adjust social security and other programs for changes in the cost of living?

The Bias of the CPIThe Bias of the CPI

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.

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.

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.

Summary

Consumers maximize satisfaction subject to budget constraints.

The theory of revealed preference shows how the choices that individuals make when prices and income vary can be used to determine their preferences.

End of Chapter 3

Consumer Behavior

chapter 3 consumer behaviour

study of consumer behavior

consumer choices cost

persons preferences

preferences aretransitive

combinations of market

set of indifference

clothing units

food stamps

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