Consumer Behavior

1
Chapter 3

• Consumer Behavior

2
Topics to be Discussed

• Consumer Preferences
• Budget Constraints
• Consumer Choice

3
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.

4
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.

5
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?

6
Consumer Preferences
Market Baskets

• 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.

7
Consumer Preferences
Market Baskets

• Three Basic Assumptions
• 1) Preferences are complete.
• 2) Preferences are transitive.
• 3) Consumers always prefer more of any good
  to less.

8
Consumer Preferences
Market Basket Units of Food Units of Clothing

• A 20 30
• B 10 50
• D 40 20
• E 30 40
• G 10 20
• H 10 40

9
Consumer Preferences
Indifference Curves

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

10
Consumer Preferences
Clothing (units per week)
50
40
30
20
10
Food (units per week)
10
20
30
40
11
Consumer Preferences
Clothing (units per week)
50
40
30
20
10
Food (units per week)
10
20
30
40
12
Consumer Preferences

• Indifference Curves
• Indifference curves slope downward to the right.
• If it sloped upward it would violate the
  assumption that more of any commodity is
  preferred to less.

13
Consumer Preferences

• Indifference Curves
• Any market basket lying above and to the right of
  an indifference curve is preferred to any market
  basket that lies on the indifference curve.

14
Consumer Preferences
Indifference Maps

• An indifference map is a set of indifference
  curves that describes a persons preferences for
  all combinations of two commodities.
• Each indifference curve in the map shows the
  market baskets among which the person is
  indifferent.

15
Consumer Preferences

• Indifference Curves
• Finally, indifference curves cannot cross.
• This would violate the assumption that more is
  preferred to less.

16
Consumer Preferences
Clothing (units per week)
Food (units per week)
17
Consumer Preferences
Indifference Curves Cannot Cross
Clothing (units per week)
Food (units per week)
18
Consumer Preferences
Clothing (units per week)
16
14
12
10
Question Does this relation hold for giving up
food to get clothing?
8
6
4
2
Food (units per week)
2
3
4
5
1
19
Consumer Preferences
Marginal Rate of Substitution

• 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.

20
Consumer Preferences
A
Clothing (units per week)
16
14
MRS 6
-6
12
10
B
1
8
-4
D
MRS 2
6
1
E
-2
G
4
1
-1
1
2
Food (units per week)
2
3
4
5
1
21
Consumer Preferences
Marginal Rate of Substitution

• 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.

22
Consumer Preferences
Marginal Rate of Substitution

• 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

23
Consumer Preferences
Marginal Rate of Substitution

• Perfect Substitutes and Perfect Complements
• Two goods are perfect substitutes when the
  marginal rate of substitution of one good for the
  other is constant.

24
Consumer Preferences
Marginal Rate of Substitution

• Perfect Substitutes and Perfect Complements
• Two goods are perfect complements when the
  indifference curves for the goods are shaped as
  right angles.

25
Consumer Preferences
Apple Juice (glasses)
4
Perfect Substitutes
3
2
1
Orange Juice (glasses)
2
3
4
1
0
26
Consumer Preferences
Left Shoes
4
Perfect Complements
3
2
1
2
3
4
1
0
Right Shoes
27
Consumer Preferences

• BADS
• Things for which less is preferred to more
• Examples
• Air pollution
• Asbestos

28
Consumer Preferences
Designing New Automobiles (I)

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

29
Consumer Preferences
Designing New Automobiles (I)

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

30
Consumer Preferences
Consumer Preference A High MRS
Styling
Performance
31
Consumer Preferences
Consumer Preference B Low MRS
Styling
Performance
32
Consumer Preferences
Designing New Automobiles (I)

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

33
Consumer Preferences
Designing New Automobiles (I)

• Growth of Japanese Imports
• 1970s and 1980s
• 15 of domestic cars underwent a style change
  each year
• This compares to 23 for imports

34
Consumer Preferences

• Utility
• Utility Numerical score representing the
  satisfaction that a consumer gets from a given
  market basket.

35
Consumer Preferences

• Utility
• 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.

36
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

37
Consumer Preferences
Utility Functions Indifference Curves
Clothing (units per week)
15
10
5
Food (units per week)
10
15
5
0
38
Consumer Preferences

• Ordinal Versus Cardinal Utility
• Ordinal 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.

39
Consumer Preferences

• Ordinal Versus Cardinal Rankings
• The actual unit of measurement for utility is not
  important.
• Therefore, an ordinal ranking is sufficient to
  explain how most individual decisions are made.

40
Budget Constraints

• Preferences 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.

41
Budget Constraints

• The Budget Line
• The budget line indicates all combinations of two
  commodities for which total money spent equals
  total income.

42
Budget Constraints

• The Budget Line
• Let 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.

43
Budget Constraints

• The budget line then can be written

44
Budget Constraints
Market Basket Food (F) Clothing (C) Total
Spending Pf (1) Pc (2) PfF PcC I

• A 0 40 80
• B 20 30 80
• D 40 20 80
• E 60 10 80
• G 80 0 80

45
Budget Constraints
Clothing (units per week)
Pc 2 Pf 1 I 80
(I/PC) 40
30
20
10
Food (units per week)
40
60
80 (I/PF)
20
0
46
Budget Constraints

• The Budget Line
• As 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.

47
Budget Constraints

• The Budget Line
• The slope indicates the rate at which the two
  goods can be substituted without changing the
  amount of money spent.

48
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.

49
Budget Constraints

• The Effects of Changes in Income and Prices
• Income Changes
• An increase in income causes the budget line to
  shift outward, parallel to the original line
  (holding prices constant).

50
Budget Constraints

• The Effects of Changes in Income and Prices
• Income Changes
• A decrease in income causes the budget line to
  shift inward, parallel to the original line
  (holding prices constant).

51
Budget Constraints
Clothing (units per week)
80
60
40
20
Food (units per week)
80
120
160
40
0
52
Budget Constraints

• The Effects of Changes in Income and Prices
• Price Changes
• If the price of one good increases, the budget
  line shifts inward, pivoting from the other
  goods intercept.

53
Budget Constraints

• The Effects of Changes in Income and Prices
• Price Changes
• If the price of one good decreases, the budget
  line shifts outward, pivoting from the other
  goods intercept.

54
Budget Constraints
Clothing (units per week)
40
Food (units per week)
80
120
160
40
55
Budget Constraints

• The Effects of Changes in Income and Prices
• Price Changes
• If the two goods increase in price, but the ratio
  of the two prices is unchanged, the slope will
  not change.

56
Budget Constraints

• The Effects of Changes in Income and Prices
• Price Changes
• However, the budget line will shift inward to a
  point parallel to the original budget line.

57
Budget Constraints

• The Effects of Changes in Income and Prices
• Price Changes
• If the two goods decrease in price, but the ratio
  of the two prices is unchanged, the slope will
  not change.

58
Budget Constraints

• The Effects of Changes in Income and Prices
• Price Changes
• However, the budget line will shift outward to a
  point parallel to the original budget line.

59
Consumer Choice

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

60
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.

61
Consumer Choice

• Recall, the slope of an indifference curve is

Further, the slope of the budget line is
62
Consumer Choice

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

63
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).

64
Consumer Choice
Clothing (units per week)
40
30
20
40
80
20
0
Food (units per week)
65
Consumer Choice
Clothing (units per week)
Pc 2 Pf 1 I 80
40
30
20
40
80
20
0
Food (units per week)
66
Consumer Choice
Pc 2 Pf 1 I 80
Clothing (units per week)
40
30
20
40
80
20
0
Food (units per week)
67
Consumer Choice
Designing New Automobiles (II)

• Consider two groups of consumers, each wishing to
  spend 10,000 on the styling and performance of
  cars.
• Each group has different preferences.

68
Consumer Choice
Designing New Automobiles (II)

• By finding the point of tangency between a
  groups indifference curve and the budget
  constraint auto companies can design a production
  and marketing plan.

69
Designing New Automobiles (II)
Styling
10,000
3,000
Performance
7,000
10,000
70
Designing New Automobiles (II)
Styling
10,000
Performance
10,000
71
Consumer Choice
Decision Making Public Policy

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

72
Consumer Choice
Non-matching Grant
Private Expenditures ()
Police Expenditures ()
O
73
Consumer Choice
Non-matching Grant
Private Expenditures ()
P
A
R
Police Expenditures ()
O
S
Q
74
Consumer Choice
Matching Grant
Private Expenditures ()
T
A
R
O
Q
S
Police ()
75
Consumer Choice
Matching Grant
Private Expenditures ()
T

• Nonmatching Grant
• Point B
• OU Private expenditure
• OZ Police expenditure
• Matching Grant
• Point C
• OW Private expenditure
• OX Police expenditure

P
W
A
C
U2
X
O
Q
R
Police ()
76
Consumer Choice
A College Trust Fund

• Suppose Jane Does parents set up a trust fund
  for her college education.
• Originally, the money must be used for education.

77
Consumer Choice
A College Trust Fund

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

78
Consumer Choice
A College Trust Fund
Other Consumption ()
Education ()
79
Marginal Utility andConsumer Choice
Marginal Utility

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

80
Marginal Utility andConsumer Choice
Marginal Utility

• Example
• The 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

81
Marginal Utility andConsumer Choice
Diminishing Marginal Utility

• The principle of diminishing marginal utility
  states that as more and more of a good is
  consumed, consuming additional amounts will yield
  smaller and smaller additions to utility.

82
Marginal Utility andConsumer Choice

• Marginal Utility and the Indifference Curve
• If 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).

83
Marginal Utility andConsumer Choice

• Formally

84
Marginal Utility andConsumer Choice

• Rearranging

85
Marginal Utility andConsumer Choice

• Because

86
Marginal Utility andConsumer Choice

• When consumers maximize satisfaction the

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

87
Marginal Utility andConsumer Choice

• Which gives the equation for utility maximization

88
Marginal Utility andConsumer Choice

• 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.