topic iii consumer behaviour analysis
TRANSCRIPT
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Consumer BehaviourAnalysis
1.Marginal Utility Theory2.Indifference Curve Analysis
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The Consumer Theory
How Consumers Make Choices under
Income Constraints
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Some Questions
What is behind a consumers demand
curve?
How do consumers choose from among
various consumer goods?
What determines the value of a consumer
good?
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Utility The value a consumer places on a unit of a good or
service depends on the pleasure or satisfaction he or she
expects to derive form having or consuming it at thepoint of making a consumption (consumer) choice.
In economics the satisfaction or pleasure consumersderive from the consumption of consumer goods is calledutility.
Consumers, however, cannot have every thing they wishto have. Consumers choices are constrained by their
incomes.
Within the limits of their incomes, consumers make theirconsumption choices by evaluating and comparing
consumer goods with regard to their utilities. 4
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Our basic assumptions about a
rational consumer: Consumers are utility maximizers
Consumers prefer more of a good (thing) to less of it.
Facing choices X and Y, a consumer would either prefer X to
Y or Y to X, or would be indifferent between them. Transitivity: If a consumer prefers X to Y and Y to Z, we
conclude he/she prefers X to Z
Diminishing marginal utility: As more and more of good is
consumed by a consumer, ceteris paribus, beyond a certainpoint the utility of each additional unit starts to fall.
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How to Measure Utility
Measuring utility in utils (Cardinal): Ramesh derives 10 utils from having one slice of pizza but only 5 utils from
having a burger.
In many introductory microeconomics textbooks this approach to
measuring utility is still considered effective for teaching purposes.
Measuring utility by comparison (Ordinal): Ramesh prefers a burger to a slice of pizza and a slice of pizza to a Cake.
Often consumers are able to be more precise in expressing their preferences.For example, we could say:
Ramesh is willing to trade a burger for four Pizzas but he will give up onlytwo Pizzas for a slice of cake.
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Utility and Money Because we use money (rather than goods) in just about all of
our trade transactions, we might as well use it as ourcomparative measure of utility.
(Note: This way of measuring utility is not much different
from measuring utility in utils)
Mr. A could say: I am willing to pay Rs. 40 for a burger, Rs.
20 for a slice of pizza; and Rs. 10 for cake.
Note: Even though Mr. A obviously values a burger more (four
times as much) than a cake, he may still choose to buy acake, even if he has enough money to buy a burger, or a slice
of pizza, for that matter. (We will see why and how shortly.)
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Total Utility versus Marginal Utility
Marginal utility is the utility a consumerderives from the last unit of a consumer goodshe or he consumes (during a givenconsumption period), ceteris paribus.
Total utility is the total utility a consumerderives from the consumption of all of theunits of a good or a combination of goods overa given consumption period, ceteris paribus.
Total utility = Sum of marginal utilities
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The Law of Diminishing Marginal
Utility
Over a given consumption period, the more of a good a
consumer has, or has consumed, the less marginal
utility an additional unit contributes to his or her overall
satisfaction (total utility).
Alternatively, we could say: over a given consumption
period, as more and more of a good is consumed by a
consumer, beyond a certain point, the marginal utility of
additional units begins to fall.
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Total and Marginal Utility for Ice
CreamQ ($) TU ($) MU0 0
1 40 40
2 85 45
3 120 35
4 140 20
5 150 10
6 157 7
7 160 3
8 160 0
9 155 -5
10 145 -10
145
10
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Total Utility
0
50
100
150
200
1 2 3 4 5 6 7 8 9 10 11
($) MU
-20
-10
0
10
20
30
40
50
1 2 3 4 5 6 7 8 9 1 11
Q ($ ) TU ($ ) M U
0 0
1 4 0 4 0
2 8 5 4 5
3 1 2 0 3 5
4 1 4 0 2 0
5 1 5 0 1 0
6 1 5 7 7
7 1 6 0 3
8 1 6 0 0
9 1 5 5 -5
1 0 1 4 5 -1 0
1 4 5
11
H h i d M A b i
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How much ice cream does Mr. A buy in a
month?
Some facts of life: Limited income
Opportunity cost of making a choice:
Buying ice cream leaves Mr. A less money tobuy other things: each Rupee spent on icecream could be spent on burger.
In fact, consumers compare the (expected)utility derived from one additional rupeespent on one good to the utility derived fromone additional rupee spent on another good.
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More facts
The prices of burger and ice cream are market-given;the consumer cannot change the price of a good.
Mr. A, like any other rational consumer, wishes tomaximize her utility.
The opportunity cost of one rupee spent on ice cream isthe forgone utility of one rupee that could be on burger.
If the utility of one additional rupee of ice cream isgreater than the utility of the last rupee spent on burger,
Mr. A can increase his total utility by spending onerupee less on burger and one rupee more one ice cream.
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burger or cake
If based on their perceived marginal utilities
Mr. A values a burger four times as muchas a cake, but the market price of a burger is
eight times the price of a cake, he will buy
a cake. That is because one rupees worthof cakes would give him more utility that
one rupees worth of burgers. That is:
MUB/P
B> MU
C/P
C
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Utility Maximizing Rules A rational consumer would buy an additional unit of a
good as long as the perceived dollar value of the
utility of one additional unit of that good (say, its
marginal rupee utility) is greater than its market price.
The Two-Good Rule
MUX MUY
--------- = ----------
PX PY
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A Al i A h h
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An Alternative Approach to the
Consumer Theory
Indifference curves
An indifference curve is a line drawn in a two-
dimensional space showing different combinations of
two goods from which the consumer draws the same
amount of utility and therefore he/she is indifferent
about.
Budget lines
A budget line is a line drawn in a two-dimensionalspace representing a certain level of income with which
the consumer can purchase various combinations of
two goods at given prices.16
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Properties of Indifference curves
Indifference curves for two goods are generallynegatively sloped
The slope of an indifference curve reflects the degree ofsubstitutability of two goods for one another
Indifference curves are generally convex, reflecting theprinciple of diminishing returns
Indifference curves never cross
Indifference curves that are farther from the origin
represent higher levels of utility Indifference curves for a good and a bad are
positively sloped
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Consumption Possibilities
Consumption choices are limited by incomeand prices.
Abudget line describes the limits to ahouseholds consumption choices.
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Consumption Possibilities
Divisible and Indivisible Goods
Divisible goods can be bought in any
quantity desiredex. Petrol
Indivisible goods cannot be bought in allquantities
ex. Car / A Flat / textbook
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Consumption Cakes (Rs. 6) Softies (Rs. 3)
possibility (per week) (per week)
a 0 10
b 1 8
c 2 6
d 3 4
e 4 2
f 5 0
The Budget LineMr. MBAs Income is Rs.
30
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Affordable
The Budget Line
0 1 2 3 4 5 6 7 8 9 10
2
4
6
8
10
Cakes (per week)
Softies(p
erw
eek)
Unaffordable
Income Rs.30
Cakes Rs.6
Softies Rs.3
a
b
c
d
e
f
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The Budget Equation
The budget equation is based upon:
Expenditure = Income
Rs.3Qs + Rs.6Qc = Rs.30
Qs = 10 2Qc
The quantity of Softies can be found by first settingthe quantity of Cakes.
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The Budget Equation
Real Income is the maximum quantity of a goodthat a household can afford to buy.
Or, it is the value of money income expressed interms of goods
Mr. MBAs Real Income (in terms of Softies) is:
Income/Price of Softies = y/Ps
Rs.30/Rs.3 = 10
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The Budget Equation
Relative Price
A relative price is the price of one good
divided by the price of another good.
Mr. MBAs relative price of a Cake in termsof Softies: Rs.6/Rs.3 = 2 per Cake
In other words, to see one more Cake, Mr.MBA must give up 2 Softies (i.e. opportunitycost)
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Changes in Prices and Income
0 1 2 3 4 5 6 7 8 9 10
Softies(perw
eek)
2
4
6
8
10
Cakes (per week)
a
f
Price of a
Cake is...
Rs.6Rs.12 Rs.3
A Change in Price
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Changes in Prices and Income
0 1 2 3 4 5 6 7 8 9 10
Softies
(perwee
k)
2
4
6
8
10
Cakes (per week)
a
f
A Change in Income
Income
Rs.30
Income
Rs.15
P f d
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Preferences and
Indifference Curves
Between two alternatives A and B, there can bemaximum of three possibilities
1. A is preferred to B2. B is preferred to A
3. Consumer is indifferent between A and B
An indifference curve is a line that showscombinations of goods among which a consumer
is indifferent.
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Preferred
Not
preferred
A Preference Map
0 2 4 6 8 10
Softies
(perwee
k)
2
4
6
8
10
Cakes (per week)
g
c
An indifference curve
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A Preference Map
Apreference map is a series of indifference
curves.
A preference map consists of an infinite
number of indifference curves; each one
slopes downward, and none of themintersects.
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I2
I1
0 2 4 6 8 10
Softies
(perwee
k)
2
4
6
8
10
Cakes (per week)
A Preference Map
g
c
I0
j
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Marginal Rate of Substitution
TheMarginal Rate of Substitution (MRS) is
the rate at which a person will give up one
good in order to get more of another goodand at the same time remain indifferent.
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Marginal Rate of Substitution
The MRS is measured by the slope of an
indifference curve.
Steep indifference curves have a high MRS.
Flat indifference curves have a low MRS.
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I1
0 2 4 6 8 10
Softies
(perwee
k)
2
4
6
8
10
Cakes (per week)
Marginal Rate of Substitution
c
g
MRS = 2
MRS = 1/2
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Marginal Rate of Substitution
Note:
As the consumption of Cakes increases, theMRS decreases.
This is referred to as the diminishingmarginal rate of substitution.
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The Degree of Substitutability
The shape of the indifference curves revealsthe degree of substitutability between twogoods.
Three typical shapes can be considered here
Convex curves (higher/ lower convexity)
Downward sloping Straight lines
Right Angled lines
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0 2 4 6 8 10
Softies
(cans)
2
4
6
8
10
Cakes
Degree of SubstitutabilityOrdinary goods
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0 2 4 6 8 10
Marker
pensatt
helocal
superm
arket
2
4
6
8
10
Degree of SubstitutabilityPerfect substitutes
Marker pens at the campus bookstore
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0 1 2 3 4 5
Leftrun
ningsho
es
1
2
3
4
5
Degree of SubstitutabilityPerfect complements
Right running shoes
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Predicting Consumer Behavior
Individuals maximize their utility given
their income budget line when they:
Are on their their highest attainableindifference curve.
Have a marginal rate of substitution between
the two goods equal to their relative price.
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0 2 4 6 8 10
Softies
(perweek)
2
4
6
8
10
Cakes (per week)
h
The Best Affordable Point
f
1
Best
affordable
point
i
I2
I0I1
c
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Learning Objectives (contd..)
Explain the choices that households make
Predict the effects of price and incomechanges on consumption choices
Predict the effects of wage changes onwork-leisure choices
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Predicting Consumer Behavior
What effect will changes in prices and income
have on the best affordable point?
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A Change in Price
Price effect
The effect of a change inpriceon quantity
of a good consumed.
A change in the price of a good will shift
the budget line and will change the best
affordable combination.
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0 2 4 6 8 10
Softies (
perweek)
2
4
6
8
10
Cakes (per week)
Price Effect and Demand Curve
I1
I2
Best affordable
point: Cakes Rs.6
c Best affordablepoint: Cakes Rs.3j
5
5
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Price Effect and Demand Curve
0 2 4 6 8 10
1
2
3
4
5
Cakes (per week)
6
Mr. MBAs demandcurve for Cakes
a
b
Price(R
s.per
Cake)
5
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Predicting Consumer Behavior
What effect will changes in Mr. MBAs income
have on the best affordable point?
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A Change in Income
Income effect
The effect of a change in income on
consumption.
A change in income will shift the budget
line and will change the best affordablecombination.
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0 2 4 6 8 10
S
ofties
(perweek
)
2
4
6
8
10
Cakes (per week)
Income
Rs.30
3 I2
I1
Income
Rs.21
j
Income Effect and
Change in Demand
ff d
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0 2 4 6 8 10
Price(Rs
.per
Cake)
1
2
3
4
5
Cakes (per week)
6
D0
b
D1
c
Income Effect and
Change in Demand
S b i i Eff d
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Substitution Effect and
Income Effect
Substitution effect
The effect of a change in price on thequantity bought when the consumer
(hypothetically) remains indifferent
between the original and the new situation.
S b i i Eff d
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Substitution Effect and
Income Effect
Income effect
The change in consumption that results
from a change in the consumers income,
ceteris paribus.
The substitution and income effects can becalculated using the indifference curves and
budget line.
S b i i Eff d
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0 2 4 6 8 10
Softies
(perwe e
k)
2
4
6
8
10
Cakes (per week)
I1
I2
cj
Income Rs.30
Cakes Rs.3
Income Rs.30
Cakes Rs.6
Price Effect
5
5
Substitution Effect and
Income Effect
S b tit ti Eff t d
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0 2 4 6 8 10
Softies(perwe
ek)
2
4
6
8
10
Cakes (per week)
I1
I2
cj
5
5
3
7
k
Income
effect
Substitution
effect
Substitution
effect
Substitution effect and price effect
Substitution Effect and
Income Effect
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Work-Leisure Choices
Households must also make choices on howto allocate their time between labour and
leisure.
More leisure means less income. We buyleisure by foregoing income.
The relationship between leisure andincome is described by the income-time
budget line.
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Work-Leisure Choices
As wage rates increase, people substituteLabour for leisure substitution effect.
However, higher wage rates lead to higherincome which causes people to shift toward
more leisure income effect.
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The Supply of Labour
Leisure (hours per week)
100 168
Income(Rs.pe
rweek
)
0
350
I1
133 138 148
100
450
Rs.5
Rs.10
I0
aZ
I2I1
Rs.15
b
c
Time allocation decision
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The Supply of Labour
LS
Labour (hour per week)
Wagera
te(Rs.perhou
r)
0 20 30 35
5
10
15
a
b
c
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Labour Supply
Real World Applications
Work week declines.
Women in the workforce.
er s o over y
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er s o over yAnalysis
Better approach (ordinal) to measure utility
No controversy of constancy of MU of Money
Explains better how the price effect can be
decomposed
Helps to understand the nature of goods as substitutes/complements
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Limitations of IC Analysis
Not all consumers are capable of equating theMRS with price ratio for equilibrium
Buying in many cases takes place more as
custom/ habit and price changes (particularlysmaller) tend to get ignored.
Indivisibility of commodities prevent precise
price adjustments
For many consumers, lack of time and patience
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The End