chapter 3 consumer behavior. chapter 3: consumer behaviorslide 2 topics to be discussed consumer...
TRANSCRIPT
Chapter 3
Consumer Behavior
Consumer Behavior
Chapter 3: Consumer Behavior Slide 2
Topics to be Discussed
Consumer Preferences
Budget Constraints
Consumer Choice
Revealed Preferences
Chapter 3: Consumer Behavior Slide 3
Topics to be Discussed
Marginal Utility and Consumer Choices
Cost-of-Living Indexes
Chapter 3: Consumer Behavior Slide 4
Consumer Behavior
Two applications that illustrate the importance of the economic theory of consumer behavior are:Apple-Cinnamon Cheerios
The Food Stamp Program.
Chapter 3: Consumer Behavior Slide 5
Consumer Behavior
General Mills had to determine how high a price to charge for Apple-Cinnamon Cheerios before it went to the market.
Chapter 3: Consumer Behavior Slide 6
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.
Chapter 3: Consumer Behavior Slide 7
Consumer Behavior
These two problems require an understanding of the economic theory of consumer behavior.
Chapter 3: Consumer Behavior Slide 8
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.
Chapter 3: Consumer Behavior Slide 9
Consumer Behavior
There are three steps involved in the study of consumer behavior.
2) Then we will turn to budget constraints.
People have limited incomes.
Chapter 3: Consumer Behavior Slide 10
Consumer Behavior
There are three steps involved in the study of 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?
Chapter 3: Consumer Behavior Slide 11
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 BasketsMarket Baskets
Chapter 3: Consumer Behavior Slide 12
Consumer Preferences
Three Basic Assumptions
1) Preferences are complete.
2) Preferences are transitive.
3) Consumers always prefer more of any good to less.
Market BasketsMarket Baskets
Chapter 3: Consumer Behavior Slide 13
Consumer Preferences
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
Chapter 3: Consumer Behavior Slide 14
Consumer Preferences
Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person.
Indifference CurvesIndifference Curves
Chapter 3: Consumer Behavior Slide 15
The consumer prefersA to all combinationsin the blue box, whileall those in the pink
box are preferred to A.
Consumer Preferences
Food(units per week)
10
20
30
40
10 20 30 40
Clothing(units per week)
50
G
A
EH
B
D
Chapter 3: Consumer Behavior Slide 16
U1
Combination B,A, & Dyield the same satisfaction•E is preferred to U1
•U1 is preferred to H & G
Consumer Preferences
Food(units per week)
10
20
30
40
10 20 30 40
Clothing(units per week)
50
G
D
A
EH
B
Chapter 3: Consumer Behavior Slide 17
Consumer Preferences
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.
Chapter 3: Consumer Behavior Slide 18
Consumer Preferences
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.
Chapter 3: Consumer Behavior Slide 19
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 MapsIndifference Maps
Chapter 3: Consumer Behavior Slide 20
Consumer Preferences
Indifference CurvesFinally, indifference curves cannot cross.
This would violate the assumption that more is preferred to less.
Chapter 3: Consumer Behavior Slide 21
U2
U3
Consumer Preferences
Food(units per week)
Clothing(units per week)
U1
AB
D
Market basket Ais preferred to B.Market basket B ispreferred to D.
Chapter 3: Consumer Behavior Slide 22
U1U2
Consumer Preferences
Food(units per week)
Clothing(units per week)
A
D
B
The consumer shouldbe indifferent betweenA, B and D. However,B contains more ofboth goods than D.
Indifference CurvesCannot Cross
Chapter 3: Consumer Behavior Slide 23
A
B
D
EG-1
-6
1
1
-4
-21
1
Observation: The amountof clothing given up for a unit of food decreasesfrom 6 to 1
Consumer Preferences
Food(units per week)
Clothing(units
per week)
2 3 4 51
2
4
6
8
10
12
14
16
Question: Does thisrelation hold for givingup food to get clothing?
Chapter 3: Consumer Behavior Slide 24
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 SubstitutionMarginal Rate of Substitution
Chapter 3: Consumer Behavior Slide 25
Consumer Preferences
Food(units per week)
Clothing(units
per week)
2 3 4 51
2
4
6
8
10
12
14
16 A
B
D
EG
-6
1
1
11
-4
-2-1
MRS = 6
MRS = 2
FCMRS
Chapter 3: Consumer Behavior Slide 26
Consumer Preferences
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.
Marginal Rate of SubstitutionMarginal Rate of Substitution
Chapter 3: Consumer Behavior Slide 27
Consumer Preferences
Question
What are the first three assumptions?
Marginal Rate of SubstitutionMarginal Rate of Substitution
Chapter 3: Consumer Behavior Slide 28
Consumer Preferences
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
Marginal Rate of SubstitutionMarginal Rate of Substitution
Chapter 3: Consumer Behavior Slide 29
Consumer Preferences
Perfect Substitutes and Perfect ComplementsTwo goods are perfect substitutes when
the marginal rate of substitution of one good for the other is constant.
Marginal Rate of SubstitutionMarginal Rate of Substitution
Chapter 3: Consumer Behavior Slide 30
Consumer Preferences
Perfect Substitutes and Perfect ComplementsTwo goods are perfect complements when
the indifference curves for the goods are shaped as right angles.
Marginal Rate of SubstitutionMarginal Rate of Substitution
Chapter 3: Consumer Behavior Slide 31
Consumer Preferences
Orange Juice(glasses)
Apple Juice
(glasses)
2 3 41
1
2
3
4
0
PerfectSubstitutes
PerfectSubstitutes
Chapter 3: Consumer Behavior Slide 32
Consumer Preferences
Right Shoes
LeftShoes
2 3 41
1
2
3
4
0
PerfectComplements
PerfectComplements
Chapter 3: Consumer Behavior Slide 33
Consumer Preferences
BADSThings for which less is preferred to more
ExamplesAir pollution
Asbestos
Chapter 3: Consumer Behavior Slide 34
Consumer Preferences
What Do You Think?How can we account for Bads in the
analysis of consumer preferences?
Chapter 3: Consumer Behavior Slide 35
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)
Chapter 3: Consumer Behavior Slide 36
Consumer Preferences
An analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars.
Designing New Automobiles (I)Designing New Automobiles (I)
Chapter 3: Consumer Behavior Slide 37
Consumer Preferences
These consumers arewilling to give up
considerablestyling for additional
performance
Styling
Performance
ConsumerPreference A:
High MRS
ConsumerPreference A:
High MRS
Chapter 3: Consumer Behavior Slide 38
Consumer Preferences
These consumers arewilling to give up
considerableperformance for additional styling
Styling
Performance
ConsumerPreference B:
Low MRS
ConsumerPreference B:
Low MRS
Chapter 3: Consumer Behavior Slide 39
Consumer Preferences
What Do You Think?
How can we determine the consumers preference?
Designing New Automobiles (I)Designing New Automobiles (I)
Chapter 3: Consumer Behavior Slide 40
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)Designing New Automobiles (I)
Chapter 3: Consumer Behavior Slide 41
Consumer Preferences
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
Designing New Automobiles (I)Designing New Automobiles (I)
Chapter 3: Consumer Behavior Slide 42
Consumer Preferences
UtilityUtility: Numerical score representing the
satisfaction that a consumer gets from a given market basket.
Chapter 3: Consumer Behavior Slide 43
Consumer Preferences
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.
Chapter 3: Consumer Behavior Slide 44
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 is indifferent to A & B
The consumer prefers A & B to C
Chapter 3: Consumer Behavior Slide 45
Consumer Preferences
Food(units per week)10 155
5
10
15
0
Clothing(units
per week)
U1 = 25
U2 = 50 (Preferred to U1)
U3 = 100 (Preferred to U2)A
B
C
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
Chapter 3: Consumer Behavior Slide 46
Consumer Preferences
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.
Chapter 3: Consumer Behavior Slide 47
Consumer Preferences
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.
Chapter 3: Consumer Behavior Slide 48
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.
Chapter 3: Consumer Behavior Slide 49
Budget Constraints
The Budget LineThe budget line indicates all combinations
of two commodities for which total money spent equals total income.
Chapter 3: Consumer Behavior Slide 50
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.
Chapter 3: Consumer Behavior Slide 51
Budget Constraints
The budget line then can be written:
ICPFP CF
Chapter 3: Consumer Behavior Slide 52
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
Chapter 3: Consumer Behavior Slide 53
Budget Line F + 2C = $80
CF/PPFC - 2
1- / Slope
10
20
(I/PC) = 40
Budget Constraints
Food(units per week)40 60 80 = (I/PF)20
10
20
30
0
A
B
D
E
G
Clothing(units
per week)
Pc = $2 Pf = $1 I = $80
Chapter 3: Consumer Behavior Slide 54
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.
Chapter 3: Consumer Behavior Slide 55
Budget Constraints
The Budget LineThe slope indicates the rate at which the
two goods can be substituted without changing the amount of money spent.
Chapter 3: Consumer Behavior Slide 56
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.
Chapter 3: Consumer Behavior Slide 57
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).
Chapter 3: Consumer Behavior Slide 58
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).
Chapter 3: Consumer Behavior Slide 59
Budget Constraints
Food(units per week)
Clothing(units
per week)
80 120 16040
20
40
60
80
0
A increase inincome shifts
the budget lineoutward
(I = $160)L2
(I = $80)
L1
L3
(I =$40)
A decrease inincome shifts
the budget lineinward
Chapter 3: Consumer Behavior Slide 60
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.
Chapter 3: Consumer Behavior Slide 61
Budget Constraints
The Effects of Changes in Income and PricesPrice Changes
If the price of one good decreases, the budget line shifts outward, pivoting from the other good’s intercept.
Chapter 3: Consumer Behavior Slide 62
Budget Constraints
Food(units per week)
Clothing(units
per week)
80 120 16040
40
(PF = 1)
L1
An increase in theprice of food to$2.00 changes
the slope of thebudget line and
rotates it inward.
L3
(PF = 2)(PF = 1/2)
L2
A decrease in theprice of food to$.50 changes
the slope of thebudget line and
rotates it outward.
Chapter 3: Consumer Behavior Slide 63
Budget Constraints
The Effects of Changes in Income and PricesPrice Changes
If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change.
Chapter 3: Consumer Behavior Slide 64
Budget Constraints
The Effects of Changes in Income and PricesPrice Changes
However, the budget line will shift inward to a point parallel to the original budget line.
Chapter 3: Consumer Behavior Slide 65
Budget Constraints
The Effects of Changes in Income and PricesPrice Changes
If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change.
Chapter 3: Consumer Behavior Slide 66
Budget Constraints
The Effects of Changes in Income and PricesPrice Changes
However, the budget line will shift outward to a point parallel to the original budget line.
Chapter 3: Consumer Behavior Slide 67
Consumer Choice
Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.
Chapter 3: Consumer Behavior Slide 68
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.
Chapter 3: Consumer Behavior Slide 69
Recall, the slope of an indifference curve is:
Consumer Choice
F
CMRS
C
F
P
PSlope
Further, the slope of the budget line is:
Chapter 3: Consumer Behavior Slide 70
Consumer Choice
Therefore, it can be said that satisfaction is maximized where:
C
F
P
PMRS
Chapter 3: Consumer Behavior Slide 71
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).
Chapter 3: Consumer Behavior Slide 72
Consumer Choice
Food (units per week)
Clothing(units per
week)
40 8020
20
30
40
0
U1
B
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).
-10C
+10F
Chapter 3: Consumer Behavior Slide 73
Consumer Choice
Budget Line
U3
D Market basket D cannot be attainedgiven the current
budget constraint.
Pc = $2 Pf = $1 I = $80
Food (units per week)
Clothing(units per
week)
40 8020
20
30
40
0
Chapter 3: Consumer Behavior Slide 74
U2
Consumer Choice
Pc = $2 Pf = $1 I = $80
Budget Line
A
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
Food (units per week)
Clothing(units per
week)
40 8020
20
30
40
0
Chapter 3: Consumer Behavior Slide 75
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)
Chapter 3: Consumer Behavior Slide 76
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)
Chapter 3: Consumer Behavior Slide 77
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
Chapter 3: Consumer Behavior Slide 78
Designing New Automobiles (II)
Styling
$10,000
$10,000
$3,000
These consumersare willing to tradeoff a considerable
amount of performance forsome additional
styling
$7,000
Performance
Chapter 3: Consumer Behavior Slide 79
Consumer Choice
Choosing between a non-matching and matching grant to fund police expenditures
Decision Making & Public PolicyDecision Making & Public Policy
Chapter 3: Consumer Behavior Slide 80
Consumer Choice
Non-matching GrantNon-matching Grant
PoliceExpenditures ($)
PrivateExpenditures ($)
O
P
Q
U1
A
Before Grant• Budget line: PQ•A: Preference maximizing market basket •Expenditure
•OR: Private•OS: Police
R
S
Chapter 3: Consumer Behavior Slide 81
V
T
U3
U1
After Grant• Budget line: TV•B: Preference maximizing market basket •Expenditure
•OU: Private•OZ: Police
BU
Z
R
Consumer Choice
Non-matching GrantNon-matching Grant
P
PoliceExpenditures ($)
PrivateExpenditures ($)
O S Q
A
Chapter 3: Consumer Behavior Slide 82
P
R
U2
T
U1
Consumer Choice
Matching GrantMatching Grant
Police ($)
PrivateExpenditures ($)
O QS
R
Before Grant• Budget line: PQ• A: Preference maximizing market basket After Grant•C: Preference maximizing market basketExpenditures
•OW: Private•OX: Police
C
X
W A
Chapter 3: Consumer Behavior Slide 83
T
U3
U1
Nonmatching Grant•Point B
•OU: Private expenditure•OZ: Police expenditure
Matching Grant•Point C
•OW: Private expenditure•OX: Police expenditure
W
X
Consumer Choice
Matching GrantMatching Grant
P
Police ($)
PrivateExpenditures ($)
O Q
A
U2
C
R
BU
Z
Chapter 3: Consumer Behavior Slide 84
Consumer Choice
A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another. This exists where the indifference curves
are tangent to the horizontal and vertical axis.
MRS is not equal to PA/PB
A Corner SolutionA Corner Solution
Chapter 3: Consumer Behavior Slide 85
A Corner Solution
Ice Cream (cup/month)
FrozenYogurt
(cupsmonthly)
B
A
U2 U3U1
A corner solutionexists at point B.
Chapter 3: Consumer Behavior Slide 86
Consumer Choice
A Corner SolutionAt point B, the MRS of ice cream for frozen
yogurt is greater than the slope of the budget line.
This suggests that if the consumer could give up more frozen yogurt for ice cream he would do so.
However, there is no more frozen yogurt to give up!
Chapter 3: Consumer Behavior Slide 87
Consumer Choice
A Corner SolutionWhen a corner solution arises, the
consumer’s MRS does not necessarily equal the price ratio.
In this instance it can be said that:
YogurtFrozenIceCream PPMRS /
Chapter 3: Consumer Behavior Slide 88
Consumer Choice
A Corner SolutionIf the MRS is, in fact, significantly greater
than the price ratio, then a small decrease in the price of frozen yogurt will not alter the consumer’s market basket.
Chapter 3: Consumer Behavior Slide 89
Consumer Choice
Suppose Jane Doe’s parents set up a trust fund for her college education.
Originally, the money must be used for education.
A College Trust FundA College Trust Fund
Chapter 3: Consumer Behavior Slide 90
Consumer Choice
If part of the money could be used for the purchase of other goods, her consumption preferences change.
A College Trust FundA College Trust Fund
Chapter 3: Consumer Behavior Slide 91
The trust fund shifts the budget line
Consumer Choice
P
Q Education ($)
OtherConsumption
($)
U2
A College Trust FundA College Trust Fund
A
U1
A: Consumption before the trust fund
B
B: Requirement that the trust fund must be spent on education
C
U3 C: If the trust could be spent on other goods
Chapter 3: Consumer Behavior Slide 92
Revealed Preferences
If we know the choices a consumer has made, we can determine what her preferences are if we have information about a sufficient number of choices that are made when prices and incomes vary.
Chapter 3: Consumer Behavior Slide 93
D
Revealed Preferences--Two Budget Lines
l1
l2
B
A
I1: Chose A over B A is revealed preferred to Bl2: Choose B over D B is revealed preferred to D
Food (units per month)
Clothing(units per
month)
Chapter 3: Consumer Behavior Slide 94
B is preferred toall market baskets in the green area
Revealed Preferences--Two Budget Lines
l2
B
l1
D
A
All market basketsin the pink
shaded area are preferred to A.
Food (units per month)
Clothing(units per
month)
Chapter 3: Consumer Behavior Slide 95
All market baskets in the pink area preferred to A
Food (units per month)
Revealed Preferences--Four Budget Lines
Clothing(units per
month)
l1
l2
l3
l4
A: preferred to allmarket baskets in the green area
E
B
A
G
I3: E revealed preferred to A
I4: G revealed preferred to A
Chapter 3: Consumer Behavior Slide 96
Amount of Exercise (hours)
Revealed Preferences for Recreation
OtherRecreational
Activities($)
0 25 50 75
20
40
60
80
100
l1
C
l2
U2
B
•The rate changes to $1/hr + $30/wk•New budget line I2 & combination B•Reveal preference of B to A
U1
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?
Chapter 3: Consumer Behavior Slide 97
Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.
Marginal Utility andConsumer Choice
Marginal UtilityMarginal Utility
Chapter 3: Consumer Behavior Slide 98
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
Marginal Utility andConsumer Choice
Chapter 3: Consumer Behavior Slide 99
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 andConsumer Choice
Chapter 3: Consumer Behavior Slide 100
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).
Marginal Utility andConsumer Choice
Chapter 3: Consumer Behavior Slide 101
Formally:
C)( MUF) (MU CF 0
Marginal Utility andConsumer Choice
Chapter 3: Consumer Behavior Slide 102
Rearranging:
Marginal Utility andConsumer Choice
CF MUMUFC //
Chapter 3: Consumer Behavior Slide 103
Because:
CF/MU MUMRS
Marginal Utility andConsumer Choice
CF MUMUFC //
C for F of MRSFC /
Chapter 3: Consumer Behavior Slide 104
When consumers maximize satisfaction the:
CF/P PMRS
CFC F /P P /MUMU
Marginal Utility andConsumer Choice
Since the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it follows that:
Chapter 3: Consumer Behavior Slide 105
Which gives the equation for utility maximization:
CCFF PMUPMU //
Marginal Utility andConsumer Choice
Chapter 3: Consumer Behavior Slide 106
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.
Marginal Utility andConsumer Choice
Chapter 3: Consumer Behavior Slide 107
In 1974 and again in 1979, the government imposed price controls on gasoline.
This resulted in shortages and gasoline was rationed.
Gasoline RationingGasoline Rationing
Marginal Utility andConsumer Choice
Chapter 3: Consumer Behavior Slide 108
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
Marginal Utility andConsumer Choice
Chapter 3: Consumer Behavior Slide 109
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.
Marginal Utility andConsumer Choice
Chapter 3: Consumer Behavior Slide 110
The horizontal axis shows her annual consumption of gasoline at $1/gallon.
The vertical axis shows her remaining income after purchasing gasoline.
Marginal Utility andConsumer Choice
Chapter 3: Consumer Behavior Slide 111
B
20,000
A
Gasoline(gallons per year)
Spendingon othergoods ($) 20,000
5,000
U1
C15,000
2,000
D
With a limit of2,000 gallons,
the consumer movesto a lower
indifference curve(lower level of utility).
18,000
U2
Marginal Utility andConsumer Choice
Chapter 3: Consumer Behavior Slide 112
Cost-of-Living Indexes
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.
Chapter 3: Consumer Behavior Slide 113
Cost-of-Living Indexes
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?
Chapter 3: Consumer Behavior Slide 114
Cost-of-Living Indexes
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.
Chapter 3: Consumer Behavior Slide 115
Cost-of-Living Indexes
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)
Chapter 3: Consumer Behavior Slide 116
Cost-of-Living Indexes
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
Chapter 3: Consumer Behavior Slide 117
Cost-of-Living Indexes
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.
Chapter 3: Consumer Behavior Slide 118
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.
l2
B
l1
U1
A
Cost-of-Living Indexes
Food(lb./quarter)
Books(per quarter)
450
25
20
15
10
5
0 60050 100 200 250 300 350 400 550500
Chapter 3: Consumer Behavior Slide 119
Cost-of-Living Indexes
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.
Chapter 3: Consumer Behavior Slide 120
Cost-of-Living Indexes
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
Chapter 3: Consumer Behavior Slide 121
Cost-of-Living Indexes
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
Chapter 3: Consumer Behavior Slide 122
Cost-of-Living Indexes
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)
Chapter 3: Consumer Behavior Slide 123
Cost-of-Living Indexes
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.
Chapter 3: Consumer Behavior Slide 124
l2
Using the Laspeyres index results in thebudget line shifting
up from I2 to I3.
l3B
l1
U1
A
Cost-of-Living Indexes
Food(lb./quarter)
Books(per quarter)
450
25
20
15
10
5
0 60050 100 200 250 300 350 400 550500
Chapter 3: Consumer Behavior Slide 125
Cost-of-Living Indexes
What Do You Think?
Does the Laspeyres index always overstate the true cost-of-living index?
Chapter 3: Consumer Behavior Slide 126
Cost-of-Living Indexes
Yes!The Laspeyres index assumes that
consumers do not alter their consumption patterns as prices change.
Chapter 3: Consumer Behavior Slide 127
Cost-of-Living Indexes
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.
Chapter 3: Consumer Behavior Slide 128
Cost-of-Living Indexes
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.
Chapter 3: Consumer Behavior Slide 129
Cost-of-Living Indexes
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
Chapter 3: Consumer Behavior Slide 130
Cost-of-Living Indexes
Then a comparison of the Laspeyres and Paasche indexes gives the following equations:
tCttFt
tCttFt
CPFP
CPFP LI
tCttFb
tCttFb
CPFP
CPFP PI
Chapter 3: Consumer Behavior Slide 131
Cost-of-Living Indexes
Suppose:
Two goods: Food (F) and Clothing (C)
Comparing the Two IndexesComparing the Two Indexes
Chapter 3: Consumer Behavior Slide 132
Cost-of-Living Indexes
Let:
PFt & PCt be current year prices
PFb & PCb be base year prices
Ft & Ct be current year quantities
Fb & Cb be base year quantities
Comparing the Two IndexesComparing the Two Indexes
Chapter 3: Consumer Behavior Slide 133
Cost-of-Living Indexes
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)
Comparing the Two IndexesComparing the Two Indexes
Chapter 3: Consumer Behavior Slide 134
Cost-of-Living Indexes
Sarah (1990)
Comparing the Two IndexesComparing the Two Indexes
344500
7201
$
,$LI
Chapter 3: Consumer Behavior Slide 135
Cost-of-Living Indexes
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)
Comparing the Two IndexesComparing the Two Indexes
Chapter 3: Consumer Behavior Slide 136
Cost-of-Living Indexes
Sarah (1990)
Comparing the Two IndexesComparing the Two Indexes
175720
2601
$
,$PI
Chapter 3: Consumer Behavior Slide 137
Cost-of-Living Indexes
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
Chapter 3: Consumer Behavior Slide 138
Cost-of-Living Indexes
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.
Chapter 3: Consumer Behavior Slide 139
Cost-of-Living Indexes
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
Chapter 3: Consumer Behavior Slide 140
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.
Chapter 3: Consumer Behavior Slide 141
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.
Chapter 3: Consumer Behavior Slide 142
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.
Chapter 3: Consumer Behavior Slide 143
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
Consumer Behavior