Consumer Behavior

1
Chapter 3

• Consumer Behavior

2
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.

3
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.

4
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?

5
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.

6
Consumer Preferences

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

7
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

8
Consumer Preferences
Indifference Curves

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

9
Consumer Preferences
Clothing (units per week)
50
40
30
20
10
Food (units per week)
10
20
30
40
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)
Food (units per week)
12
Consumer Preferences
Indifference Curves Cannot Cross
Clothing (units per week)
Food (units per week)
13
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
14
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.

15
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
16
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

17
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.

18
Consumer Preferences
Apple Juice (glasses)
4
Perfect Substitutes
3
2
1
Orange Juice (glasses)
2
3
4
1
0
19
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.

20
Consumer Preferences
Left Shoes
4
Perfect Complements
3
2
1
2
3
4
1
0
Right Shoes
21
Consumer Preferences

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

22
Consumer Preferences

• What Do You Think?
• How can we account for Bads in the analysis of
  consumer preferences?

23
Consumer Preferences
Designing New Automobiles (I)

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

24
Consumer Preferences
Consumer Preference A High MRS
Styling
Performance
25
Consumer Preferences
Consumer Preference B Low MRS
Styling
Performance
26
Consumer Preferences
Designing New Automobiles (I)

• What Do You Think?
• How can we determine the consumers preference?

27
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.

28
Consumer Preferences

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

29
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

30
Consumer Preferences
Utility Functions Indifference Curves
Clothing (units per week)
15
10
5
Food (units per week)
10
15
5
0
31
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.

32
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.

33
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.

34
Budget Constraints

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

35
Budget Constraints

• The budget line then can be written

36
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

37
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
38
Budget Constraints
Clothing (units per week)
80
60
40
20
Food (units per week)
80
120
160
40
0
39
Budget Constraints
Clothing (units per week)
40
Food (units per week)
80
120
160
40
40
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.

41
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.

42
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.

43
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.

44
Consumer Choice

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

45
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.

46
Consumer Choice

• Recall, the slope of an indifference curve is

Further, the slope of the budget line is
47
Consumer Choice

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

48
Consumer Choice
Clothing (units per week)
40
30
20
40
80
20
0
Food (units per week)
49
Consumer Choice
Clothing (units per week)
Pc 2 Pf 1 I 80
40
30
20
40
80
20
0
Food (units per week)
50
Consumer Choice
Pc 2 Pf 1 I 80
Clothing (units per week)
40
30
20
40
80
20
0
Food (units per week)
51
Consumer Choice
Decision Making Public Policy

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

52
Consumer Choice
Non-matching Grant
Private Expenditures ()
Police Expenditures ()
O
53
Consumer Choice
Non-matching Grant
Private Expenditures ()
P
A
R
Police Expenditures ()
O
S
Q
54
Consumer Choice
Matching Grant
Private Expenditures ()
T
A
R
O
Q
S
Police ()
55
Consumer Choice
Non-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 ()
56
Consumer Choice
A Corner Solution

• 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/or vertical axis.
• MRS is not equal to PA/PB at the chosen bundle.

57
A Corner Solution
Frozen Yogurt (cups monthly)
A
B
Ice Cream (cup/month)
58
Consumer Choice

• A Corner Solution
• When a corner solution arises, the consumers MRS
  does not necessarily equal the price ratio.
• In this instance it can be said that

59
Consumer Choice

• A Corner Solution
• If 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.

60
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 income vary.

61
Revealed Preferences--Two Budget Lines
I1 Chose A over B A is revealed preferred
to B l2 Choose B over D B is revealed
preferred to D
l1
Clothing (units per month)
A
D
Food (units per month)
62
Revealed Preferences--Two Budget Lines
Clothing (units per month)
B is preferred to all market baskets in the
green area
Food (units per month)
63
Revealed Preferences--Four Budget Lines
Clothing (units per month)
Food (units per month)
64
Marginal Utility andConsumer Choice
Marginal Utility

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

65
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.

66
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 of one good, food (F), must
  balance the loss of utility from the decrease in
  the consumption in the other good, clothing (C).

67
Marginal Utility andConsumer Choice

• The equation for utility maximization

68
Marginal Utility andConsumer Choice
Gasoline Rationing

• In 1974 and again in 1979, the government imposed
  price controls on gasoline.
• This resulted in shortages and gasoline was
  rationed.

69
Marginal Utility andConsumer Choice
Gasoline Rationing

• 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.

70
Marginal Utility andConsumer Choice

• 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.

71
Marginal Utility andConsumer Choice

• The horizontal axis shows her annual consumption
  of gasoline at 1/gallon.
• The vertical axis shows her remaining income
  after purchasing gasoline.

72
Marginal Utility andConsumer Choice
Spending on other goods ()
20,000
Gasoline (gallons per year)