Chapter 3Consumer Behavior

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer BehaviorThe theory of consumer behavior can be used to help answer these and many more questionsTheory of consumer behaviorThe explanation of how consumers allocate income to the purchase of different goods and services

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer BehaviorThere are three steps involved in the study of consumer behaviorConsumer PreferencesTo describe how and why people prefer one good to anotherBudget ConstraintsPeople have limited incomes

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer BehaviorGiven preference sand limited incomes, what amount and type of goods will be purchased?What combination of goods will consumers buy to maximize their satisfaction?

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer PreferencesHow 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer Preferences Basic AssumptionsPreferences are complete.Consumers can rank market basketsPreferences are transitive.If prefer A to B, and B to C, the must prefer A to CConsumers always prefer more of any good to less.More is better

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer PreferencesConsumer preferences can be represented graphically using indifference curvesIndifference curves represent all combinations of market baskets that the person is indifferent toA person will be equally satisfied with either choice

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Indifference Curves: An Example

Market BasketUnits of FoodUnits of ClothingA2030B1050D4020E3040G1020H1040

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Indifference Curves: An ExampleGraph the points with one good on the x-axis and one good on the y-axisPlotting the points we can make some immediate observations about preferencesMore is better

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The consumer prefersA to all combinationsin the blue box, whileall those in the pinkbox are preferred to A.Indifference Curves: An Example

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Indifference Curves: An ExamplePoints such as B & D have more of one good but less of another compared to ANeed more information about consumer ranking Consumer may decide they are indifference between B, A and DWe can then connect those points with an indifference curve

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Indifferent between B, A, & DE is preferred to U1U1 is preferred to H & GIndifference Curves: An Example

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Indifference CurvesAny 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Indifference CurvesIndifference 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Indifference CurvesTo describe preferences for all combinations of goods/services, we have a set of indifference curves an indifference mapEach indifference curve in the map shows the market baskets among which the person is indifferent.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Indifference MapMarket basket Ais preferred to B.Market basket B ispreferred to D.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Indifference MapsIndifference maps give more information about shapes of indifference curvesIndifference curves can not crossViolates assumption that more is betterWhy? What if we assume they can cross.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Indifference MapsB is preferred to DA is indifferent to B & DB must be indifferent to D but that cant be if B is preferred to D

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Indifference CurvesThe shapes of indifference curves describes how a consumer is willing to substitute one good for anotherA to B, give up 6 clothing to get 1 foodD to E, give up 2 clothing to get 1 foodThe more clothing and less food a person has, the more clothing they will give up to get more food

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Observation: The amountof clothing given up for 1 unit of food decreasesfrom 6 to 1Indifference Curves

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Indifference CurvesWe 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.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal Rate of SubstitutionMRS = 6MRS = 2

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal Rate of SubstitutionIndifference 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal Rate of SubstitutionThe MRS decreases as we move down the indifference curveAlong an indifference curve there is a diminishing marginal rate of substitution.The MRS went from 6 to 4 to 1

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal Rate of SubstitutionIndifference curves with different shapes imply a different willingness to substituteTwo polar cases are of interestPerfect substitutesPerfect complements

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal Rate of SubstitutionPerfect 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 substitutesThey would always trade 1 glass of OJ for 1 glass of Apple Juice

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer PreferencesPerfectSubstitutes

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer PreferencesPerfect ComplementsTwo 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 onlyMust have one right for one left

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer PreferencesPerfectComplements

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer PreferencesWe have assumed all our commodities are goodsThere are commodities we dont want more of - badsThings for which less is preferred to moreExamplesAir pollutionAsbestos

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer PreferencesHow do we account for bads in our preference analysis?We redefine the commodityClean airPollution reductionAsbestos removal

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer Preferences: An ApplicationIn designing new cars, automobile executives must determine how much time and money to invest in restyling versus increased performanceHigher demand for car with better styling and performanceBoth cost more to improve

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer Preferences: An ApplicationAn analysis of consumer preferences would help to determine where to spend more on change: performance or stylingSome consumers will prefer better styling and some will prefer better performance

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer Preferences: An ApplicationThese consumers place a greater value on performance than styling

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer Preferences: An ApplicationThese consumers place a greater value on styling than performance

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer Preferences: An ApplicationKnowing which groups dominates the market will help decide where redesigning dollars should goA recent study in the US shows that over the past two decades most consumers have preferred styling over performance.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer PreferencesThe theory of consumer behavior does not required assigning a numerical value to the level of satisfactionAlthough ranking of market baskets are good, sometimes numerical value are useful

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer PreferencesUtilityA 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.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.UtilityUtility functionFormula that assigns a level of utility to individual market basketsIf the utility function isU(F,C) = F + 2CA market basket with 8 units of food and 3 units of clothing gives a utility of 14 = 8 + 2(3)

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Utility - ExampleConsumer is indifferent between A & B and prefers both to C

Market BasketFoodClothing UtilityA838 + 2(3) = 14B646 + 2(4) = 14C444 + 2(4) = 12

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Utility - ExampleBaskets for each level of utility can be plotted to get an indifference curveTo 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Utility - Example BasketU = FC C25 = 2.5(10) A25 = 5(5) B25 = 10(2.5)

Chapter 3

Chapter 3*2005 Pearson Education, Inc.UtilityAlthough we numerically rank baskets and indifference curves, numbers are ONLY for rankingA utility of 4 is not necessarily twice as good as utility of 2There are two types of rankingOrdinal rankingCardinal ranking

Chapter 3

Chapter 3*2005 Pearson Education, Inc.UtilityOrdinal Utility FunctionPlaces 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 FunctionUtility function describing the extent to which one market basket is preferred to another.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.UtilityThe actual unit of measurement for utility is not important.An ordinal ranking is sufficient to explain how most individual decisions are made.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Budget ConstraintsPreferences do not explain all of consumer behavior.Budget constraints also limit an individuals ability to consume in light of the prices they must pay for various goods and services.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Budget ConstraintsThe Budget LineIndicates 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.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 = PCThen PF F is the amount of money spent on food, and PC C is the amount of money spent on clothing.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget LineThe budget line then can be written:All income is allocated to food (F) and/or clothing (C)

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget LineDifferent choices of food and clothing can be calculated that use all incomeThese choices can be graphed as the budget lineExample: Assume income of $80/week, PF = $1 and PC = $2

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Budget Constraints

Market BasketFoodPF = $1ClothingPC = $2IncomeI = PFF + PCCA040$80B2030$80D4020$80E6010$80G800$80

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget Line

Chapter 3

Chapter 3*2005 Pearson Education, Inc.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.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget LineThe 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget Line

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Budget ConstraintsThe Budget LineThe 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.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget LineAs we know, income and prices can changeAs incomes and prices change, there are changes in budget linesWe can show the effects of these changes on budget lines and consumer choices

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget Line - ChangesThe 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget Line - ChangesThe 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget Line - ChangesA increase inincome shiftsthe budget lineoutwardA decrease inincome shiftsthe budget lineinward

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget Line - ChangesThe Effects of Changes in PricesIf the price of one good increases, the budget line shifts inward, pivoting from the other goods intercept.If price of food increases and you buy only food (x-intercept), then cant buy as much food. The point shifts inIf buy only clothing (y-intercept), can buy the same amount. No change

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget Line - ChangesThe Effects of Changes in PricesIf the price of one good decreases, the budget line shifts outward, pivoting from the other goods 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget Line - ChangesAn increase in theprice of food to$2.00 changesthe slope of thebudget line androtates it inward.A decrease in theprice of food to$.50 changesthe slope of thebudget line androtates it outward.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget Line - ChangesThe Effects of Changes in PricesIf 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.The Budget Line - ChangesThe Effects of Changes in PricesIf 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer ChoiceGiven 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.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer ChoiceThe maximizing market basket must satisfy two conditions:It must be located on the budget line.They spend all their income more is betterIt must give the consumer the most preferred combination of goods and services.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer ChoiceGraphically we can see different indifference curves of a consumer choosing between clothing and foodRemember that U3 > U2 > U1 for our indifference curvesConsumer wants to choose highest utility within their budget

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer ChoiceA, B, C on budget lineD highest utility but not affordableC highest affordable utilityConsumer chooses C

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer ChoiceConsumer will choose highest indifference curve on budget lineIn previous graph, point C is where the indifference curve is just tangent to the budget lineSlope of the budget line equals the slope of the indifference curve at this point

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer ChoiceRecall, the slope of an indifference curve is:Further, the slope of the budget line is:

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer ChoiceTherefore, it can be said at consumers optimal consumption point,

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer ChoiceIt 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer ChoiceOptimal consumption point is where marginal benefits equal marginal costsMB = MRS = benefit associated with consumption of 1 more unit of foodMC = cost of additional unit of food1 unit food = unit clothingPF/PC

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer ChoiceIf MRS PF/PC then individuals can reallocate basket to increase utilityIf MRS > PF/PCWill increase food and decrease clothing until MRS = PF/PCIf MRS < PF/PCWill increase clothing and decrease food until MRS = PF/PC

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer ChoicePoint B does not maximize satisfaction because theMRS =-10/10 = 1 is greater than the price ratio = 1/2

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer Choice: An Application RevisitedConsider two groups of consumers, each wishing to spend $10,000 on the styling and performance of a car.Each group has different preferences.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer Choice: An Application RevisitedBy finding the point of tangency between a groups indifference curve and the budget constraint auto companies can see how much consumers value each attribute.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer Choice: An Application RevisitedThese consumersWant performance worth $7000 and styling worth $3000

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer Choice: An Application RevisitedThese consumers want styling worth $7000 and performance worth $3000

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer Choice: An Application RevisitedOnce know preferences, can design a production and marketing planCompany can then make a sensible strategic business decision on how to allocate performance and styling on new cars

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Consumer ChoiceA 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.A Corner SolutionA corner solutionexists at point B.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.A Corner SolutionAt 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 upOpposite is true if corner solution was at point A

Chapter 3

Chapter 3*2005 Pearson Education, Inc.A Corner SolutionWhen a corner solution arises, the consumers MRS does not necessarily equal the price ratio.In this instance it can be said that:

Chapter 3

Chapter 3*2005 Pearson Education, Inc.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 consumers market basket.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.A Corner Solution - ExampleSuppose Jane Does 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.A Corner Solution - ExampleOriginal budget line, PQ, with a market basket, A, of education and other goodsTrust fund shifts out the budget line as long as trust fund, PB, spent on educationJane increases satisfaction moving to higher indifference curve, U2

Chapter 3

Chapter 3*2005 Pearson Education, Inc.A Corner Solution - ExampleJane better off on U2B is corner solutionMRS PE/POG

Chapter 3

Chapter 3*2005 Pearson Education, Inc.A Corner Solution - ExampleIf gift is unrestricted, Jane can be at point C on U3Better off than with restricted gift

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Revealed PreferencesIf 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.

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Revealed Preferences Two Budget LinesI1: Chose A over BA is revealed preferred to Bl2: Choose B over DB is revealed preferred to D

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Revealed Preferences--Two Budget LinesAll market basketsin the pinkshaded area are preferred to A.B is preferred toall market baskets in the yellow area

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Revealed PreferenceAs 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 preferencesEventually you can map out an indifference curve

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Food (units per month)Revealed Preferences Four Budget LinesClothing(units permonth)

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal Utility and Consumer ChoiceMarginal 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal Utility - ExampleThe marginal utility derived from increasing from 0 to 1 units of food might be 9Increasing from 1 to 2 might be 7Increasing from 2 to 3 might be 5Observation: Marginal utility is diminishing as consumption increases

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal UtilityThe 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

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal Utility and Indifference CurvesAs 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).

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal Utility and Consumer ChoiceFormally:No change in total utility along an indifference curve. Trade off of one good to the other leaves the consumer just as well off

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal Utility and Consumer ChoiceRearranging:

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal Utility and Consumer ChoiceWhen consumers maximize satisfaction:Since the MRS is also equal to the ratio of the marginal utility of consuming F and C

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal Utility and Consumer ChoiceRearranging, gives the equation for utility maximization:

Chapter 3

Chapter 3*2005 Pearson Education, Inc.Marginal Utility and Consumer ChoiceTotal 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.

Chapter 3

7891011131215171918202421263229323433353836404141434445451031041045442

2728464247424842494250125442

554256425742584258426142624262426542664267426869787071727679798181838485868788889292939797102107108109110111112115116117