consumer behavior | microeconomics | expertsmind.com

Aims:1. To provide students with an understanding of

the standard theoretical analysis of consumer and producer behaviour.

2. To provide students with an appreciation of the economic efficiency and equity effects of economic actions and policies.

3. To stress the relevance and application of microeconomics for decision-making.

A short word about microeconomics

This course will provide you with an understanding of neo-classical/traditional microeconomic theory. The course has this focus because the traditional theory is: Currently very influential Currently the ‘dominant’ view on

economic theory However, traditional microeconomics is

also very contentious You need to know this theory even if

you don’t agree with it!

Traditional Microeconomics

Focuses on individuals; that is, on consumers, producers and workers, and their involvement in markets Consumers – buy/demand goods and services Producers/firms

Buy/demand labour and other inputs to produce goods and services

Sell/supply goods and services Workers – sell their labour Markets – are ‘places’ where individuals interact to achieve

their needs and wants and negotiate prices Largely ignores social, inter-personal and cultural

factors and assigns government and multi-national institutions a marginal role

Is optimistic about the ability of individuals to achieve their needs and wants through their involvement in market exchange

Is optimistic about the ability of markets to ensure an efficient allocation of resources

Focuses on efficiency rather than equity

Consumer Theory focuses on the decisions made by individuals about their purchases of goods and services It relies on assumptions of rationality &

maximisation It studies how a rational consumer will

make decisions about using her income How she will respond to changing prices

(e.g. higher food prices) How her consumption patterns reflect

her preferences How her consumption pattern and level

will change when her income changes

Producer Theory focuses on the decisions made by firms about their levels of production and production methods

• It relies on assumptions of rationality & maximisation

• It studies how a rational producer will make key decisions, such as

• How much to produce• How many labour and other inputs to

hire• How to respond to changes in wages or

new technologies

Rationality & Maximisation imply individuals will attempt to make the best use of their resources

• And before they make any decision they will weigh up the opportunity costs and benefits of alternative actions

• For example, before a consumer decides to spend all her week’s pay on a new pair of shoes she will consider the trade-offs (such as the consequences of not paying the rent)

Rationality & Maximisation also imply that individuals will make the decisions that they think are best for them

Thus, the theory generally predicts negative consequences if, for example, government policy restricts or alters the choices available to individuals

Is challenged by many economists and non-economists

Many question:i) The realism of the theory’s

assumptions (e.g. about rationality)

ii) The accuracy of the theory’s predictions

iii) The theory’s focus (e.g. on efficiency over equity)

However, although it is far from perfect, the theory is useful for examining some important issues.

For example, we can use the theory to study some of the effects of carbon taxes on:

- Consumers’ budgets- Consumers’ choices- Firms’ cost of production- Firms’ input choices

This unit provides you with several key resources to help you further your knowledge of microeconomic theory and its applications:

1. Text2. Lectures and Tutorials3. Challenges and Feedback

The Text

Pindyck, R.S and D. L. Rubinfeld (2009), Microeconomics, 7th edition, Pearson Prentice Hall, New Jersey.

Other resources

Blackboard Lecture slides posted before the lecture Unit outlines Tutorial questions Messages and announcements

Some final tips

Keep reading Attempt the tutorial exercises each

week Practice and re-practice the

diagrams Listen carefully! Take many notes!!!

CONSUMER BEHAVIOUR PART 1

Read Textbook Chapter 3.1 & 3.2

Introduction to Consumer Theory

This part of traditional microeconomic theory is used to analyse and predict how individuals make decisions about the consumption of goods and services.

An important focus of the theory is on the effects of changes in prices and incomes on consumers’ demand for goods and services.

The theory has 2 key components

An individual’s demand for different goods & services is seen to depend on

1) her preferences (how she values different commodities)

2) her budget (what she can afford given her income and the prices of different goods and services)

Key Learning Outcomes

Part 1: Consumer preferencesAssumptions of consumer choice theoryIndifference curvesIndifference mapsUtility Marginal Rate of Substitution (MRS)

Formula Graphical representationSpecial cases

Assumptions about Preferences

The assumptions about preferences need to be known.

The theory assumes consumers are rational. This implies:

1. Completeness 2. Transitivity 3. Greed

1. Preferences are complete Consumers can rank all available

consumption choices. That is, they can say they

Consumer Preferences: Assumptions

Prefer to

Or, they’re indifferent between &

If I prefer choc milk to tea, AND I prefer tea to lemonade, THEN I must prefer choc milk to lemonade.

This is a contentious assumption.

2. Preferences are transitive

Chocolate milk Tea Lemonade

3. Preferences are for more goods than less

= Assumption of GREED, (Except in the case of ‘bads’

where less is preferred to more e.g. pollution)

Consumer Preferences: Showing Preferences on a Graph

Market Basket

Units of Food

Units of Clothing

A 20 30

B 10 50

D 40 20

E 30 40

G 10 20

HOW WOULD YOU RANK THESE BASKETS???Are there any baskets you definitely prefer?

The graphical presentation of these ideas about consumer preferences focuses on how a rational consumer would rank different baskets of goods and services

Step 1: Graph the market baskets from the example

Food (units)

10 20 30 40

Clothing (units)

Market Basket

Units of F

Units of C

A 20 30

B 10 50

D 40 20

E 30 40

G 10 20

Step 2: Identify all baskets that will be preferred to A (green); and all the baskets that are inferior to A (red).

Food (units)

10 20 30 40

Clothing (units)

DD has more food but less clothing than A.

E has more food & more clothing than A.

B has less food but more clothing than A.

G has less food & less clothing than A.

SUPPOSE the consumer is indifferent between points B, A, & D.They will all be on the SAME INDIFFERENCE CURVE.

Indifference Curves

Food (units)

10 20 30 40

Clothing

(units)50

This is REALLY IMPORTANT

Indifference Curves, Satisfaction & Utility

An indifference curve represents all combinations of market baskets that the person is _______________.

Any basket located on the one indifference curve will give a consumer the same level of satisfaction or ________.

Important: Indifference Curves ARE NOT Demand Curves

Food (units)

Clothing (units)

Food (units)

Price of food ($)

_______________ curve __________ curve

Indifference Curves: Are used to describe how consumers “feel” about different commodities

Food (units)

10 20 30 40

Clothing (units)50

If we take some clothing away from this consumer

We need to compensate him with more food

If the consumer needs a lot of compensation clothing must be important to him and vice versa

Special Case: Indifference Curves for “Bads”

Food (units)

Pollution (units)

NB Indifference curves slope upwards if one of commodities is a “bad”. If both commodities are goods the IC slopes downward

RIf we take some pollution away from this consumer

We can reduce her level of food and she wouldmaintain the same satisfaction level

Special Case: Indifference Curve for a“Bad”

Return

Special Case: Indifference Curves: Neutrals

Neutral (units)

Clothing (units)

No matter how much or how little of a neutral commodity– same satisfaction level

Indifference Curves: Neutrals

Clothing (units)

Neutral (units)

SUPPOSE the consumer PREFERS point E to points B, A, & D.It will all be on a HIGHER INDIFFERENCE CURVE.

Indifference Map

Food (units)

10 20 30 40

Clothing

(units)50

This is REALLY IMPORTANT

Indifference Map: Goods

Food (units)

Clothing (units)

Indifference maps: • Comprise a

set of indifference curves

E is preferred to A.A is preferred to G.

Direction of ___________ satisfaction/utility

Special Case: Indifference Map for “Bads”

Food (units)

Pollution (units)

S is preferred to T, which is preferred to U

Indifference Curves: Neutrals

Neutral (units)

Clothing (units)

Neutral commodity does not change

utility level.

Utility can only be increased by

increasing clothing (a

‘good’).

Indifference Curves Maps

Every commodity bundle must be on an IC

ICs cannot intersect Shape must reflect preferences

Question on the Indifference Maps

Good A

Good B Refer to the indifference curve in the figure opposite. Which of the following statements is correct?A. This individual will only

consume A and B in fixed proportions.

B. This individual receives no satisfaction from Good A.

C. This individual receives no satisfaction from Good B.

D. None of the above.

Increasing utility

This question is from a past year test and more than half of the students got it right. How about U?

Marginal Rate of Substitution: Measuring the Strength of Consumer’s Preferences

Food (units)

10 20 30 40

Clothing (units)50

We’ve already learnt that if the consumer needs a lot of compensation if we reduce his clothing allowance, the good must be important to him and vice versa

The technical term used to measure this trade-off and, thus, to describe the strength of consumer preferences for different commodities is MRS

Suppose Jo is willing to give up 3 units of C to get 1 additional unit of F.

Jo’s MRS of F for C is the maximum amount of C she’s willing to give up to obtain 1 additional unit of F.

MRS (F for C) = –C/F= –(–3)/1 = 3 43

Give up 3 units of C

To get 1 unit of F

Marginal Rate of Substitution MRSF = Food, C = Clothing

MRS (F for C) = -C/F

General definition of MRS:The maximum amount of a good that a consumer is willing to give up to get one additional unit of another good.

Need to know: Formula Use/Meaning Graphical representation

Suppose BOB is willing to give up 2 units of C to get 1 additional unit of F.

Give up 2 units of C

To get 1 unit of F

Meaning/Use of MRSMRS describes the intensity of prefs

Notice Bob will give up fewer C to get 1 extra F. This implies C is more valuable and F is less valuable to him, as compared to Jo

MRS (F for C) = –C/F

= –(–2)/1 = 2

MRS: What is being Substituted for What?

We say “MRS of F for C”, what is the consumer giving up?Answer: ____

“MRS of F for C” – consumer is giving up C.

“MRS of C for F” – consumer is giving up F.

MRS X for Y

Marginal Rate of Substitution: Graphs

Food (units)

1 2 3 4

Clothing (units)5

The SLOPE of the Indifference Curve measures MRS

BOB is willing to give up 2C for 1F. His MRS (F for C)=2

Marginal Rate of Substitution: Graphs

Food (units)

1 2 3 4

Clothing (units)5

The SLOPE of the Indifference Curve measures MRS

Jo is willing to give up 3C for 1F. Her MRS (F for C)=3

Her stronger preference for F/weaker preference for C shows up in a steeper IC

MRS: Diminishing MRS

Food (units)2 3 4 51

Clothing (units)

MRS is diminishing (6 4 2 1) making the slope convex.

Notice that the slope of the IC changes along its length. This shows that MRS isn’t constant for

any individual

If you have lots of clothing you will be willing to trade lots of it to get an additional unit of food and vice versa

MRSF for C = - C/F = 2

MRSF for C = - C/F= 6

SLOPE OF INDIFFERENCE CURVE

Assumptions about Preferences

Our Assumptions about preferences can now be expanded to:

1. Completeness 2. Transitivity 3. Greed 4. Diminishing MRS or “Convexity”

Special MRS Cases: Perfect Substitutes

Orange Juice(glasses)

Apple Juice

(glasses)

2 3 41

Perfect substitutes: This consumer will always trade

N units of one good for 1 unit of another

MRS is constant: Slope of indifference curve

does not change

Special MRS Cases: Perfect Complements

Right Shoes

LeftShoes

2 3 41

Perfect complements: An increase in one good must be

complemented by an increase in another good to increase satisfaction

MRS is infinite:Indifference curves have

right angles

Question on Special MRS cases

Good X

Good YAlvin’s preferences for good X and good Y are shown in the diagram opposite. Which assumption concerning preferences do Alvin’s indifference curves violate?A. Diminishing marginal rates of substitutionB. Transitivity of preferencesC. More is preferred to lessD. CompletenessThis was a moderately difficult

question in a past year test. Did U get it right?

Recap: Theory of Consumer Behavior

1. Different consumers prefer different goods Consumer preferences

2. Consumers have limited incomes to spend Budget constraint

3. Given their preferences and budget constraints, rational consumers choose combinations of goods that maximise their satisfaction Consumer choice

Part 2: Budget constraintsBudget line

Formula Graphical representation

Effects of income changes on budget lineEffects of price changes on budget line

Budget Line (Constraint) The budget line shows all combinations

of two goods that can be purchased by a given income level. Let I = income level Let F = units of food Let C = units of clothing PF = price per unit of food PC = price per unit of clothing

The budget line formula is:

PFF + PCC = ITotal spend on food

Total spend on clothes

Assume we draw the budget line with C on the vertical axis...the equation can be re-arranged as:

So the slope is

P F P C I

PIC FP P

Budget Line Formula: An Example

Assume income of $80/week, price per unit of food is $1 and price per unit of clothing is $2o I = $80o PF = $1o PC = $2

Substituting the numbers into the budget line formula

PFF + PCC = I 1F + 2C = 80

F & C are unknown

Budget Line Formula: An Example

Different choices of food and clothing that use all the income of $80 can be identified

Basket Units of Food (F)

Units of Clothing (C)

Budget line1F + 2C = 80

A 0 40 1(0) + 2(40) = 80

B 20 30 1(20) + 2(30) = 80

D 40 20 1(40) + 2(20) = 80

E 60 10 1(60) + 2(10) = 80

G 80 0 1(80) + 2(0) = 80

Budget Line (Clothing on vertical axis): Drawing the budget line 1F + 2C = 80

Units of Food (F)40 60 8020

Clothing (Units) 1. Find the vertical intercept:

I/PC = 80/2 = 40

2. Find the horizontal intercept:I/PF = 80/1 = 80

3. Join the 2 intercepts in a straight line to create the budget line

If I spent all my income (80) on clothing at p=2, how many clothes

could I buy? (80/20=40)

If I spent all my income (80) on food at p=1 how much

food could I buy? (80/1=80)

Slope of the Budget Line (Clothing on Vertical Axis)

Using the slope in the graph= rise/run= C/F= –40/80= –1/2

Using the price of the goods(PF

= $1; PC = $2)= –PF/PC

= –1/2

If Food is on the vertical axis, the formula is F/C

If Food is on the vertical axis, the formula is -PC/PF

Question on Budget LinesA consumer has $200 per day to spend on product A, which has a unit price of $21, and product B, which has a unit price of $7. What is the slope of the budget line if good A is on the horizontal axis and good B is on the vertical axis??A. -7/21B. 7/21C. 21/7D. -21/7

This question from a past year test was supposed to be an EASY one !Make sure you’re clear that the formula changes depending on what’s on the vertical axis!

You’re given the price of the goods. Good B is on the vertical axis. Formula is - PA/PB

Budget Line: Change in Income

Increase in income - Parallel outward

shift in the budget line

Food(units)

Clothing(units)

80 120 16040

L3L1L2

Decrease in income - Parallel inward shift

in the budget line

Budget Line: Change in Income – Example

Assume price per unit of food is $1 and price per unit of clothing is $2 but income increases from $80 to $160.

Using the budget line formula PFF + PCC = I

L1 = 1F + 2C = 80

L2 = 1F + 2C = 160 Using the steps in previous slides, graph

the budget lines L1 and L2.

Budget Line: Change in Income - Example

Food(units)

Clothing(units)

80 120 16040

Budget Line Policy Application: Planned Compensation for Families affected by Carbon Tax

LABOR is preparing a multibillion-dollar carbon tax compensation package that could leave up to 2.6 million low-income households better off and a further 1.7 million middle-income households no worse off.

Budget Line: Change in Income - Example

Electricity(units)

Other goods(units)

80 120 16040

Budget Line: Change in Price

Increase in the price of food –> Rotates budget line inward along food

Decrease in price of food – >

Rotates budget line outward along food axis.

40Food(units)

Clothing(units)

80 120 160

Budget Line: Change in Price – Example

Assume income stays the same at $80, and price per unit of clothing is $2 but price per unit of food falls from $1 to $0.50.

Using the budget line formula PFF + PCC = I

L1 = 1F + 2C = 80

L2 = 0.5F + 2C = 80 Using the steps in previous slides, graph the

budget lines L1 and L2.

Budget Line: Change in Price - Example

40Food(units)

Clothing(units)

80 120 160

Budget Line Policy Application: Change in Price of Electricity

“With a tax of $26 a tonne of carbon dioxide, the opposition estimates the annual additional cost of electricity at $300 a household.

The cost to households estimated by the opposition appears to be based on an electricity bill of $1400 a year.”

Budget Line Policy Application:

Change in Price of Electricity

L1Electricity(units)

Other goods(units)

An increase in theprice of electricity by

20% in rotates the budget line inward.

Question on Budget LinesIf the prices of two goods, X and Y, increase by 50%, and income rises by 100%, A. The slope of the consumer’s budget line will change, becoming flatter to indicate that X and Y are now relatively less expensive.B. The consumer’s budget line will shift out from the original and its slope will also change, reflecting the lower prices for X and Y.C. The consumer’s budget line will shift out from the origin with its slope unchanged.D. The consumer’s budget line will remain unchanged.

Have to draw diagram for this one! If you know what happens when price and income changes, you should get this one right!

Good Y

Good X

Key Learning Outcomes Consumer preferences

Assumptions of consumer preferences Indifference curves Indifference maps Utility MRS

Special MRS cases

Budget constraints Budget line

Effects of income changes on budget line Effects of price changes on budget line

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consumer behavior | microeconomics | expertsmind.com

traditional theory

services workers

differentgoods services

rational consumer

prices ofdifferent goods

key resources

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theconsumption of goods

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