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Chapter 3

Consumer Behavior

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Chapter 3 22005 Pearson Education, Inc.

Introduction

How are consumer preferences used todetermine demand?

How do consumers allocate income tothe purchase of different goods?

How do consumers with limited incomedecide what to buy?

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Introduction

How can we determine the nature ofconsumer preferences for observationsof consumer behavior?

How can cost of living indexes measurethe well-being of consumers?

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Consumer Behavior -Applications

1. How would General Mills determine theprice to charge for a new cereal beforeit went to the market?

2. To what extent did the food stampprogram provide individuals with morefood versus merely subsidizing food

they bought anyway?

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Consumer Behavior

The theory of consumer behavior can beused to help answer these and manymore questions

Theory of consumer behavior

The explanation of how consumers allocateincome to the purchase of different goods

and services

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Consumer Behavior

There are three steps involved in thestudy of consumer behavior

1. Consumer Preferences To describe how and why people prefer

one good to another

2. Budget Constraints

People have limited incomes

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Consumer Behavior

3. Given preferences and limited incomes,what amount and type of goods will bepurchased?

What combination of goods will consumersbuy to maximize their satisfaction?

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Consumer Preferences

How might a consumer compare differentgroups of items available for purchase?

A market basketis a collection of one ormore commodities

Individuals can choose between marketbaskets containing different goods

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Consumer Preferences BasicAssumptions

1. Preferences are complete Consumers can rank market baskets

2. Preferences are transitive If they prefer A to B, and B to C, they must

prefer A to C

3. Consumers always prefer more of anygood to less More is better

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Consumer preferences can berepresented graphically usingindifference curves

Indifference curves represent allcombinations of market baskets that theperson is indifferent to

A person will be equally satisfied with eitherchoice

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Indifference Curves:An Example

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

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Graph the points with one good on the x-axis and one good on the y-axis

Plotting the points, we can make someimmediate observations aboutpreferences

More is better

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The consumer prefersA to all combinations

in the yellow box, while

all those in the pinkbox are preferred to A.


Food

10

20

30

40

10 20 30 40

Clothing

50

G

A

EH

B

D

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Points such as B & D have more of onegood but less of another compared to ANeed more information about consumer

rankingConsumer may decide they are

indifferent between B, A and DWe can then connect those points with an

indifference curve

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Indifferentbetween pointsB, A, & DE is preferred

to points on U1Points on U1are preferred toH & G


Food

10

20

30

40

10 20 30 40

Clothing

50

U1G

D

A

E

H

B

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Indifference Curves

Any market basket lying northeast of anindifference curve is preferred to anymarket basket that lies on theindifference curve

Points on the curve are preferred topoints southwest of the curve

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Indifference Curves

Indifference curves slope downward tothe right

If they sloped upward, they would violate theassumption that more is preferred to less

Some points that had more of both goods wouldbe indifferent to a basket with less of both goods

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Indifference Curves

To describe preferences for allcombinations of goods/services, we havea set of indifference curves anindifference map

Each indifference curve in the map showsthe market baskets among which the person

is indifferent

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U2

U3

Indifference Map

Food

Clothing

U1

ABD

Market basketAis preferred to B.Market basket B is

preferred to D.

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Indifference Maps

Indifference maps give more informationabout shapes of indifference curves

Indifference curves cannot cross

Violates assumption that more is better

Why? What if we assume they can cross?

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Indifference Maps

Food

Clothing B is preferred to DA is indifferent to B & DB must be indifferent toD but that cant be if B is

preferred to D

U1

U1

U2

U2

A

B

D

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Indifference Curves

The shapes of indifference curvesdescribe how a consumer is willing tosubstitute one good for another

A to B, give up 6 clothing to get 1 food

D to E, give up 2 clothing to get 1 food

The more clothing and less food a person

has, the more clothing they will give up toget more food

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A

B

D

EG

-1

-6

1

1

-4

-2

1

1

Observation: The amountof clothing given up for

1 unit of food decreasesfrom 6 to 1

Indifference Curves

Food

Clothing

2 3 4 51

2

4

6

8

10

12

14

16

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Indifference Curves

We measure how a person trades onegood for another using the marginal rateof substitution (MRS)

It quantifies the amount of one good aconsumer will give up to obtain more ofanother good

It is measured by the slope of theindifference curve

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Marginal Rate of Substitution

Food2 3 4 51

Clothing

2

4

6

8

10

12

14

16 A

B

D

EG

-6

1

1

1

1

-4

-2

-1

MRS = 6

MRS = 2

FCMRS

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Indifference curves are convex

As more of one good is consumed, aconsumer would prefer to give up fewer units

of a second good to get additional units ofthe first one

Consumers generally prefer a balanced

market basket

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The MRS decreases as we move downthe indifference curve

Along an indifference curve there is adiminishing marginal rate of substitution.

The MRS went from 6 to 4 to 1

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Indifference curves with different shapesimply a different willingness to substitute

Two polar cases are of interestPerfect substitutes

Perfect complements

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Perfect Substitutes

Two goods are perfect substitutes when themarginal rate of substitution of one good for

the other is constant

Example: a person might consider applejuice and orange juice perfect substitutes

They would always trade 1 glass of OJ for 1

glass of Apple Juice

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Orange Juice(glasses)

AppleJuice

(glasses)

2 3 41

1

2

3

4

0

Perfect

Substitutes

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Perfect Complements

Two goods are perfect complements whenthe indifference curves for the goods are

shaped as right angles

Example: If you have 1 left shoe and 1 rightshoe, you are indifferent between havingmore left shoes only

Must have one right for one left

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Right Shoes

LeftShoes

2 3 41

1

2

3

4

0

PerfectComplements

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We have assumed all our commoditiesare goods

There are commodities we dont wantmore of - bads

Things for which less is preferred to more

Examples

Air pollution

Asbestos

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How do we account for bads in ourpreference analysis?

We redefine the commodity

Clean air

Pollution reduction

Asbestos removal

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Consumer Preferences:An Application

In designing new cars, automobileexecutives must determine how muchtime and money to invest in restylingversus increased performance

Higher demand for car with better styling andperformance

Both cost more to improve

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An analysis of consumer preferenceswould help to determine where to spendmore on change: performance or styling

Some consumers will prefer better stylingand some will prefer better performance

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These consumersplace a greater

value onperformancethan styling

Styling

Performance

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These consumersplace a greater

value on styling than

performance

Styling

Performance

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Knowing which group dominates themarket will help decide whereredesigning dollars should go

A recent study in the US shows that overthe past two decades, most consumershave preferred styling over performance

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The theory of consumer behavior doesnot required assigning a numerical valueto the level of satisfaction

Although ranking of market baskets isgood, sometimes numerical value isuseful

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Utility

A numerical score representing thesatisfaction that a consumer gets from a

given market basketIf buying 3 copies ofMicroeconomics makes

you happier than buying one shirt, then wesay that the books give you more utility than

the shirt

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Utility

Utility function

Formula that assigns a level of utility toindividual market baskets

If the utility function is

U(F,C) = F + 2CA market basket with 8 units of food and 3 units of

clothing gives a utility of

14 = 8 + 2(3)

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Utility - Example

MarketBasket

Food Clothing Utility

A 8 3 8 + 2(3) = 14

B 6 4 6 + 2(4) = 14

C 4 4 4 + 2(4) = 12

Consumer is indifferent between A & B andprefers both to C

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Utility - Example

Baskets for each level of utility can beplotted to get an indifference curve

To find the indifference curve for a utility of

14, we can change the combinations of foodand clothing that give us a utility of 14

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Utility - Example

Food10 155

5

10

15

0

Clothing

U1 = 25

U2 = 50

U3 = 100A

B

C

Basket U = FCC 25 = 2.5(10)A 25 = 5(5)B 25 = 10(2.5)

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Utility

Although we numerically rank basketsand indifference curves, numbers areONLY for ranking

A utility of 4 is not necessarily twice asgood as a utility of 2

There are two types of rankings

Ordinal rankingCardinal ranking

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Utility

Ordinal Utility FunctionPlaces market baskets in the order of most

preferred to least preferred, but it does not

indicate how much one market basket ispreferred to another

Cardinal Utility FunctionUtility function describing the extent to which

one market basket is preferred to another

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Utility

The actual unit of measurement for utilityis not important

An ordinal ranking is sufficient to explainhow most individual decisions are made

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Budget Constraints

Preferences do not explain all ofconsumer behavior

Budget constraints also limit anindividuals ability to consume in light of

the prices they must pay for variousgoods and services

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Budget Constraints

The Budget Line

Indicates all combinations of twocommodities for which total money spent

equals total incomeWe assume only 2 goods are consumed, so

we do not consider savings

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The Budget Line

Let F equal the amount of foodpurchased, and C is the amount ofclothing

Price of food = PF and price ofclothing = PC

Then PFF is the amount of money spenton food, and PCC is the amount of moneyspent on clothing

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ICPFP CF

The Budget Line

The budget line then can be written:

All income is allocated to food (F) and/or clothing(C)

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The Budget Line

Different choices of food and clothing canbe calculated that use all income

These choices can be graphed as the budget

line

Example:

Assume income of $80/week, PF = $1 and PC

= $2

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Budget Constraints

MarketBasket

Food

PF = $1

Clothing

PC = $2

IncomeI = PFF + PCC

A 0 40 $80B 20 30 $80

D 40 20 $80

E 60 10 $80

G 80 0 $80

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C

F

P

P

F

CSlope -

2

1-

The Budget Line

10

20

A

B

D

E

G

(I/PC) = 40

Food40 60 80 = (I/PF)20

10

20

30

0

Clothing

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The Budget Line

As consumption moves along a budgetline from the intercept, the consumerspends 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

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The Budget Line

The slope indicates the rate at which thetwo goods can be substituted withoutchanging the amount of money spent

We can rearrange the budget lineequation to make this more clear

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The Budget Line

YXP

P

P

I

YPXPI

YPXPI

Y

X

Y

YX

YX

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Budget Constraints

The Budget Line

The vertical intercept, I/PC, illustrates themaximum amount of C that can be

purchased with income IThe horizontal intercept, I/PF, illustrates the

maximum amount of F that can bepurchased with income I

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The Budget Line

As we know, income and prices canchange

As incomes and prices change, there arechanges in budget lines

We can show the effects of thesechanges on budget lines and consumer

choices

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The Budget Line - Changes

The Effects of Changes in Income

An increase in income causes the budgetline to shift outward, parallel to the original

line (holding prices constant).Can buy more of both goods with more

income

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The Effects of Changes in Income

A decrease in income causes the budget lineto shift inward, parallel to the original line

(holding prices constant)Can buy less of both goods with less income

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An increase inincome shifts

the budget lineoutward

Food(units per week)

Clothing(units

per week)

80 120 16040

20

40

60

80

0

(I = $160)

L2(I = $80)

L1

L3

(I =$40)

A decrease inincome shifts

the budget line

inward

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The Effects of Changes in PricesIf the price of one good decreases, the

budget line shifts outward, pivoting from the

other goods intercept.If the price of food decreases and you buy

only food (x-intercept), then you can buymore food. The x-intercept shifts out.

If you buy only clothing (y-intercept), you canbuy the same amount. No change in y-intercept.

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(PF = 1)

L1

An increase in theprice of food to$2.00 changesthe slope of the

budget line androtates it inward.L3

(PF = 2)

(PF = 1/2)

L2

A decrease in theprice of food to$.50 changes

the slope of the

budget line androtates it outward.

40Food(units per week)

Clothing(units

per week)

80 120 160

40

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The Effects of Changes in Prices

If the two goods increase in price, but theratio of the two prices is unchanged, the

slope will not changeHowever, the budget line will shift inward

parallel to the original budget line

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The Effects of Changes in Prices

If the two goods decrease in price, but theratio of the two prices is unchanged, the

slope will not changeHowever, the budget line will shift outward

parallel to the original budget line

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Consumer Choice

Given preferences and budgetconstraints, how do consumers choosewhat to buy?

Consumers choose a combination ofgoods that will maximize theirsatisfaction, given the limited budget

available to them

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Consumer Choice

The maximizing market basket mustsatisfy two conditions:

1. It must be located on the budget line

They spend all their income more is better

2. It must give the consumer the mostpreferred combination of goods and

services

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Consumer Choice

Graphically, we can see differentindifference curves of a consumerchoosing between clothing and food

Remember that U3 > U2 > U1 for ourindifference curves

Consumer wants to choose highest utility

within their budget

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Consumer Choice

Consumer will choose highestindifference curve on budget line

In previous graph, point C is where theindifference curve is just tangent to thebudget line

Slope of the budget line equals the slope

of the indifference curve at this point

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Consumer Choice

Recall, the slope of an indifference curveis:

FCMRS

C

F

P

PSlope

Further, the slope of the budget line is:

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Consumer Choice

Therefore, it can be said at consumers

optimal consumption point,

C

F

P

PMRS

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Consumer Choice

It can be said that satisfaction ismaximized when marginal rate ofsubstitution (of F and C) is equal to the

ratio of the prices (of F and C)

Note this is ONLY true at the optimalconsumption point

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Consumer Choice

Optimal consumption point is wheremarginal benefits equal marginal costs

MB = MRS = benefit associated withconsumption of 1 more unit of food

MC = cost of additional unit of food

1 unit food = unit clothing

PF/PC

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Consumer Choice

If MRS PF/PC then individuals canreallocate basket to increase utility

If MRS > PF/PCWill increase food and decrease clothing until

MRS = PF/PC

If MRS < PF/PC

Will increase clothing and decrease food untilMRS = PF/PC

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Consumer Choice

Food (units per week)

Clothing(units per

week)

40 8020

20

30

40

0

Point B does notmaximize satisfaction

because theMRS = -10/10 = 1

is greater than theprice ratio = 1/2

+10F U1

-10C

B

Consumer Choice:

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Consumer Choice:An Application Revisited

Consider two groups of consumers, eachwishing to spend $10,000 on the stylingand performance of a car

Each group has different preferences

Consumer Choice:

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By finding the point of tangency betweena groups indifference curve and the

budget constraint, auto companies can

see how much consumers value eachattribute

Consumer Choice:

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Styling

Performance$10,000

$10,000 These consumerswant performance

worth $7000 and stylingworth $3000

$3,000

$7,000

Consumer Choice:

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These consumerswant styling worth

$7000 andperformance worth

$3000

$3,000

$7,000

Styling

$10,000

$10,000

Performance

Consumer Choice:

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Once a company knows preferences, itcan design a production and marketingplan

Company can then make a sensiblestrategic business decision on how toallocate performance and styling on new

cars

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Consumer Choice

A corner solution exists if a consumerbuys in extremes, and buys all of onecategory of good and none of another

MRS is not necessarily equal to PA/PB

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A Corner Solution

Ice Cream (cup/month)

FrozenYogurt(cups

monthly)

B

A

U2 U3U1

A corner solutionexists at point B.

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A Corner Solution

If the MRS is, in fact, significantly greaterthan the price ratio, then a smalldecrease in the price of frozen yogurt will

not alter the consumers market basket

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A Corner Solution - Example

Suppose 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 unrestrictedgift might be better

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Original budget line, PQ, with a marketbasket, A, of education and other goods

Trust fund shifts out the budget line as

long as trust fund, PB, is spent oneducation

Jane increases satisfaction, moving tohigher indifference curve, U2

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P

Q Education ($)

OtherConsumption

($)

U2A

U1

B

Jane better offon U2B is corner

solutionMRS PE/POG

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P

Q Education ($)

OtherConsumption

($)

U2A

U1

B

If gift isunrestricted, Janecan be at point Con U

3Better off thanwith restricted gift

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Revealed Preferences

If we know the choices a consumer hasmade, we can determine what theirpreferences are if we have information

about a sufficient number of choices thatare made when prices and incomes vary.

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Two Budget Lines

l1

l2

B

A

Food (units per month)

Clothing(units permonth)

D

All market basketsin the pink

shaded area are

preferred toA.

B ispreferred to

all marketbasketsin theyellow area

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Revealed Preference

As you continue to change the budgetline, individuals can tell you which basketthey prefer to others

The more the individual reveals, the moreyou can discern about their preferences

Eventually you can map out an

indifference curve


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All market baskets in thepink area preferred to A

Food (units per month)

Four Budget Lines

Clothing(units permonth)

l1

l2

l3

l4

A: preferred to allmarket baskets inthe yellow area

E

B

A

G

I3: E revealed preferred to A

I4: G revealed preferred to A

Marginal Utility and Consumer

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g yChoice

Marginal utilitymeasures the additionalsatisfaction obtained from consumingone additional unit of a good

How much happier is the individual fromconsuming one more unit of food?

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Marginal Utility

The principle ofdiminishing marginalutilitystates that as more of a good isconsumed, the additional utility the

consumer gains will be smaller andsmaller

Note that total utility will continue to

increase since consumer makes choicesthat make them happier

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Choice

Formally:

C)(MUF)(MU CF 0

No change in total utility along an indifference curve.Trade off of one good to the other leaves the consumer

just as well off.


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Choice

Rearranging:

CF

CF

/MUMUMRS

saycanWe

CforFofMRSFC

Since

MUMUFC

/

//


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Choice

When consumers maximize satisfaction:

CF /PPMRS

CFCF/PP/MUMU

Since the MRS is also equal to the ratio of themarginal utility of consuming F and C


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Choice

Rearranging, gives the equation for utilitymaximization:

CCFF PMUPMU //

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Cost-of-Living Indexes

Social Security payments are given toqualifying individuals

Each year the benefit increases equal to

the rate of increase of the ConsumerPrice Index (CPI)

Ratio of the present cost of typical bundle ofgoods/services in comparison to the costduring a base period

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Does the CPI give a good measure ofinflation and therefore a measure of thecost of living changes?

Should the CPI be used to measure howmuch cost of living has increased,determining increases in government

payment programs?

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The ideal cost of living index representsthe cost of attaining a given level of utilityat current prices relative to the cost of

attaining the same utility at base prices

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To obtain the ideal cost of living indexwould require too much information, suchas consumer preferences as well as

prices and expendituresActual price indexes are based on

consumer purchases, not preferences

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Laspeyres price index

Amount of money at current year prices thatan individual requires to purchase a bundle

of goods/services chosen in a base yeardivided by the cost of purchasing the samebundle at base-year prices

Ex: CPI

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The Laspeyres price index assumes thatconsumers do not alter their consumptionpatterns as prices change

Tends to overstate the true cost of livingindex

Using the CPI to adjust retirementbenefits will tend to overcompensate

most recipients, requiring greatergovernment expenditure

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C f Li i I d

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Comparison of indexes

Both are fixed weight indexes

Quantities of various goods and services in

each index remain unchangedLaspeyres index keeps quantities at base

year levels

Paasche index keeps unchanged quantities

at current year levels

C t f Li i I d

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Chain-Weighted Indexes

Cost-of-living index that accounts forchanges in quantities of goods and services

Introduced to overcome problems that arosewhen long-term comparisons were madeusing fixed weight price indexes

Documents

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