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Theory ofConsumerBehavior
Chapter 3
Discussion Topics
Utility theoryIndifference curvesThe budget constraint
Utility Function
A utility function is an algebraic expressionthat allows us to rank consumption bundlesor combinations of goods.
Total utility = Qhamburgers x Qpizza
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Utility Function
A utility function is an algebraic expressionthat allows us to rank consumption bundlesor combinations of goods.
Total utility = Qhamburgers x Qpizza
This approach assumes that utility iscardinally measurable in the same sensethat a ruler measures distance.
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Ranking Total Utility
Bundle
Quantity of hamburgers
Quantity of pizza
Total Utility
A 2.5 10.0 25
B 3.0 7.0 21
C 2.0 12.5 25
Ranking of consumption bundlesRanking of consumption bundles
Ranking Total Utility
Bundle
Quantity of hamburgers
Quantity of pizza
Total Utility
A 2.5 10.0 25
B 3.0 7.0 21
C 2.0 12.5 25
Rank A and C over BIndifferent between A and C
Rank A and C over BIndifferent between A and C
Marginal UtilityMarginal utility is the change in utility derived from an increase in consumptionof a particular good.
MUhamburgers = utility ÷ hamburgers
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Marginal UtilityMarginal utility is the change in utility derived from an increase in consumptionof a particular good.
MUhamburgers = utility ÷ hamburgers
This value will fall (rise) as consumptionincreases (decreases).
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Marginal utility goesto zero at the peak ofthe total utility curve
Marginal utility goesto zero at the peak ofthe total utility curve
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Indifference CurvesCardinal measurement of utility is bothunreasonable and unnecessary. We caninstead use an ordinal measurement of utility,which means all we need to know is that onebundle is preferred over another.
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Indifference CurvesCardinal measurement of utility is bothunreasonable and unnecessary. We caninstead use an ordinal measurement of utility,which means all we need to know is that onebundle is preferred over another.
Modern consumption theory is based upon the notion of isoutility curves, where “iso” isthe Greek for “equal”. The consumer isassumed to be indifferent among differentcombinations of goods along a isoutility curve.
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Increasingutility
Increasingutility
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The two indifferencecurves here can be thought of as providing 200 and 700 utils of utility.
The two indifferencecurves here can be thought of as providing 200 and 700 utils of utility.
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One would normally expect a number of additional isoutilityor indifference curves.
One would normally expect a number of additional isoutilityor indifference curves.
The two indifferencecurves here can be thought of as providing 200 and 700 utils of utility.
The two indifferencecurves here can be thought of as providing 200 and 700 utils of utility.
Slope of Indifference Curve
The slope of an indifference curve is knownas the marginal rate of substitution (MRS).The marginal rate of substitution of hamburgersfor tacos is given by:
MRS = tacos ÷ hamburgers
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Slope of Indifference Curve
The slope of an indifference curve is knownas the marginal rate of substitution (MRS).The marginal rate of substitution of hamburgersfor tacos is given by:
MRS = tacos ÷ hamburgers
The MRS reflects the number of tacos a consumeris willing to give up for an additional hamburger.
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The MRS between points M and Q is equal to: -2.0 = -2 ÷ 1.0
The MRS between points M and Q is equal to: -2.0 = -2 ÷ 1.0
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This means the consumer is willing to give up 2 tacos in exchange for one additional hamburger!
This means the consumer is willing to give up 2 tacos in exchange for one additional hamburger!
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This means the consumer is willing to give up 2 tacos in exchange for one additional hamburger!
This means the consumer is willing to give up 2 tacos in exchange for one additional hamburger!
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Which bundle would you prefer more…bundle M or bundle Q?
Which bundle would you prefer more…bundle M or bundle Q?
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The answer is that this we would be indifferent because they give us the same utility. The ultimate choice will depend on the prices of these two products.
The answer is that this we would be indifferent because they give us the same utility. The ultimate choice will depend on the prices of these two products.
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What about the choice between bundle M and bundle P?
What about the choice between bundle M and bundle P?
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We would prefer bundle P over bundle M because it gives us more utility or satisfaction. The question is whether we can afford to buy 5 tacos and 5 hamburgers!
We would prefer bundle P over bundle M because it gives us more utility or satisfaction. The question is whether we can afford to buy 5 tacos and 5 hamburgers!
Concept of Budget Constraint
PHAMBURGERS x QHAMBURGERS + PTACOS x QTACOS BUDGET
Weekly budget for fast food:
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where PHAMBURGERS and PTACOS represent the current price of hamburgers and tacos while QHAMBURGERS and QTACOS repre- sent the quantities you plan to consume during the week.
Concept of Budget Constraint
PHAMBURGERS x QHAMBURGERS + PTACOS x QTACOS BUDGET
Weekly budget for fast food:
Slope of budget line = - (PHAMBURGERS ÷ PTACOS)
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where PHAMBURGERS and PTACOS represent the current price of hamburgers and tacos while QHAMBURGERS and QTACOS repre- sent the quantities you plan to consume during the week.
The budget constraint limits the amount that you can be spent on these items. A graph depicting this constraint is referred to as the budget line. The slope of this line is given by:
Example of a Budget Constraint
Tacos
($0.50 each)
Hamburgers
($1.25 each) Expenditure
10 0 $5.00
5 2 $5.00
0 4 $5.00
Each of these combinationsrepresent a point on thebudget line….
Each of these combinationsrepresent a point on thebudget line…. Page 55
Original budget line Change in income or both prices
Change in taco price Change in hamburger price
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Line BA is the original budget line. It says that Carl can afford either 10 tacos or two hamburgers a week with his $5 weekly budget.
Line BA is the original budget line. It says that Carl can afford either 10 tacos or two hamburgers a week with his $5 weekly budget.
Original budget line Change in disposable income
Change in taco price Change in hamburger price
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The original budget linewould shift in to line FGif Carl’s available incomefell in half (or both pricesdoubled). It would shift out to line ED if Carl’s income doubled (or bothprices fell in half).
The original budget linewould shift in to line FGif Carl’s available incomefell in half (or both pricesdoubled). It would shift out to line ED if Carl’s income doubled (or bothprices fell in half).
Original budget line Change in disposable income
Change in taco price Change in hamburger price
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The budget line would shiftout to line AE if the price oftacos fell in half or shift into line AF if taco prices fellin half. Note the price ofhamburgers did not change!
The budget line would shiftout to line AE if the price oftacos fell in half or shift into line AF if taco prices fellin half. Note the price ofhamburgers did not change!
Original budget line Change in income or both prices
Change in taco price Change in hamburger price
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Finally, the budget line wouldshift out to line BD if the priceof hamburgers fell in half, orin to line line BG if the priceof hamburgers doubled.
Finally, the budget line wouldshift out to line BD if the priceof hamburgers fell in half, orin to line line BG if the priceof hamburgers doubled.
In SummaryConsumers rank preferences
based upon utility or the satisfaction derived from consumption
Businesses spend millions of dollars on product research
A budget constraint limits the amount we can buy in a particular period
Price is therefore important
Chapter 4 unites the concepts of indifference curves with a budget constraint to determine consumer equilibrium….
