Chapter 3 Consumer Behavior Consumer Behavior n It

Chapter 3 Consumer Behavior

Consumer Behavior n It is behavior when a person keep at the time of purchasing of any thing is called consumer behavior. Chapter 3: Consumer Behavior Slide 2

Consumer Behavior n There are three steps involved in the study of consumer behavior. 1) We will study consumer preferences. u To describe how and why people prefer one good to another. Chapter 3: Consumer Behavior Slide 3

Consumer Behavior 2) Then we will turn to budget constraints. People have limited incomes. 3) Finally, we will combine consumer preferences and budget constraints to determine consumer choices. u What combination of goods will consumers buy to maximize their satisfaction? Chapter 3: Consumer Behavior Slide 4

Consumer Preferences Market Baskets n A market basket is a collection of one or more commodities. n One market basket may be preferred over another market basket containing a different combination of goods. Chapter 3: Consumer Behavior Slide 5

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 Chapter 3: Consumer Behavior Slide 6

Consumer Preferences Indifference Curves n Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person. Chapter 3: Consumer Behavior Slide 7

Consumer Preferences Clothing (units per week) 50 B 40 H The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A. E A 30 D G 20 10 10 20 Chapter 3: Consumer Behavior 30 40 Food (units per week) Slide 8

Consumer Preferences Clothing (units per week) B 50 40 Combination B, A, & D yield the same satisfaction • E is preferred to U 1 • U 1 is preferred to H & G H E A 30 D 20 G U 1 10 10 20 Chapter 3: Consumer Behavior 30 40 Food (units per week) Slide 9

Consumer Preferences n Indifference Curves l Indifference curves slope downward to the right. l 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. Chapter 3: Consumer Behavior Slide 10

Consumer Preferences Indifference Maps n An indifference map is a set of indifference curves that describes a person’s preferences for all combinations of two commodities. l Each indifference curve in the map shows the market baskets among which the person is indifferent. Chapter 3: Consumer Behavior Slide 11

Consumer Preferences Clothing (units per week) Market basket A is preferred to B. Market basket B is preferred to D. D B A U 3 U 2 U 1 Food (units per week) Chapter 3: Consumer Behavior Slide 12

Consumer Preferences A Clothing 16 (units per week) 14 12 Observation: The amount of clothing given up for a unit of food decreases from 6 to 1 -6 10 B 1 8 -4 D 6 1 -2 4 E G 1 -1 1 2 Chapter 3: Consumer Behavior 3 4 5 Food (units per week) Slide 13

Consumer Preferences Marginal Rate of Substitution n The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good. l It is measured by the slope of the indifference curve. Chapter 3: Consumer Behavior Slide 14

Consumer Preferences A Clothing 16 (units per week) 14 12 MRS = 6 -6 10 B 1 8 -4 D 6 MRS = 2 1 -2 4 E G 1 -1 1 2 Chapter 3: Consumer Behavior 3 4 5 Food (units per week) Slide 15

Consumer Preferences Marginal Rate of Substitution l Along an indifference curve there is a diminishing marginal rate of substitution. u Note the MRS for AB was 6, while that for DE was 2. Chapter 3: Consumer Behavior Slide 16

Consumer Preferences Marginal Rate of Substitution n Perfect Substitutes and Perfect Complements l Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant. l Two goods are perfect complements when the indifference curves for the goods are shaped as right angles. Chapter 3: Consumer Behavior Slide 17

Consumer Preferences Apple Juice (glasses) 4 Perfect Substitutes 3 2 1 0 1 Chapter 3: Consumer Behavior 2 3 4 Orange Juice (glasses) Slide 18

Consumer Preferences Left Shoes 4 Perfect Complements 3 2 1 0 1 Chapter 3: Consumer Behavior 2 3 4 Right Shoes Slide 19

Consumer Preferences Designing New Automobiles n Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling. n An analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars. Chapter 3: Consumer Behavior Slide 20

Consumer Preferences Styling Consumer Preference A: High MRS These consumers are willing to give up considerable styling for additional performance Performance Chapter 3: Consumer Behavior Slide 21

Consumer Preferences Styling Consumer Preference B: Low MRS These consumers are willing to give up considerable performance for additional styling Performance Chapter 3: Consumer Behavior Slide 22

Consumer Preferences Designing New Automobiles (I) n A recent study of automobile demand in the United States shows that over the past two decades most consumers have preferred styling over performance. Chapter 3: Consumer Behavior Slide 23

Consumer Preferences n Utility l Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket. l Initial Utility: satisfaction level with the utilization of first unit of any good. l Marginal Utility: satisfaction obtained from the utilization of every next unit Chapter 3: Consumer Behavior Slide 24

Consumer Preferences n Total Utility: Satisfaction level achieved with the utilization of all units of good. n Positive Utility: The increase in overall satisfaction level until get zero by the utilization of every next unit of good. n Zero Utility: when there will be no change in satisfaction by utilization of good. n Negative Utility: When the utilization of every next unit harm the consumer. Chapter 3: Consumer Behavior Slide 25

Consumer Preferences n Utility l If buying 3 books of Microeconomics makes you happier than buying one shirt, then we say that the books give you more utility than the shirt. Chapter 3: Consumer Behavior Slide 26

Consumer Preferences n Utility Functions l Assume: The utility function for food (F) and clothing (C) U(F, C) = F + 2 C Market Baskets: F units C units U(F, C) = F + 2 C A 8 3 8 + 2(3) = 14 B 6 4 6 + 2(4) = 14 C 4 4 4 + 2(4) = 12 The consumer prefers A & B to C Chapter 3: Consumer Behavior Slide 27

Consumer Preferences Utility Functions & Indifference Curves Clothing (units per week) Assume: U = FC Market Basket U = FC C 25 = 2. 5(10) A 25 = 5(5) B 25 = 10(2. 5) 15 C 10 A 5 B 0 5 Chapter 3: Consumer Behavior 10 15 Food (units per week) Slide 28

Consumer Preferences n Ordinal Versus Cardinal Utility l 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. l Cardinal Utility Function: utility function describing by how much one market basket is preferred to another. Chapter 3: Consumer Behavior Slide 29

Budget Constraints n Budget constraints that consumers face as a result of limited incomes. n Budget constraints also limit an individual’s ability to consume in light of the prices they must pay for various goods and services. Chapter 3: Consumer Behavior Slide 30

Budget Constraints n The Budget Line l The budget line indicates all combinations of two commodities for which total money spent equals total income. Chapter 3: Consumer Behavior Slide 31

Budget Constraints n The Budget Line l Let F equal the amount of food purchased, and C is the amount of clothing. l Price of food = Pf and price of = Pc l Then Pf F is the amount of money spent on food, and Pc C is the amount of money spent on clothing. Chapter 3: Consumer Behavior clothing Slide 32

Budget Constraints n The budget line then can be written: Chapter 3: Consumer Behavior Slide 33

Budget Constraints Market Basket Food (F) Clothing (C) Total Spending Pf = ($100) Pc = ($200) P f. F + P c C = I A 0 40 $8000 B 20 30 $8000 D 40 20 $8000 E 60 10 $8000 G 80 0 $8000 Chapter 3: Consumer Behavior Slide 34

Budget Constraints Clothing (units per week) (I/PC) = 40 Pc = $200 Pf = $100 I = $8000 Budget Line 100 F + 200 C = $8000 A B 30 10 20 D 20 E 10 G 0 20 40 Chapter 3: Consumer Behavior 60 80 = (I/PF) Food (units per week) Slide 35

Budget Constraints n The Budget Line l As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other. l The slope of the line measures the relative cost of food and clothing. l The slope is the negative of the ratio of the prices of the two goods. Chapter 3: Consumer Behavior Slide 36

Budget Constraints n The Budget Line l The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent. Chapter 3: Consumer Behavior Slide 37

Budget Constraints n The Budget Line l The vertical intercept (I/PC), illustrates the maximum amount of C that can be purchased with income I. l The horizontal intercept (I/PF), illustrates the maximum amount of F that can be purchased with income I. Chapter 3: Consumer Behavior Slide 38

Budget Constraints n The Effects of Changes in Income and Prices l Income Changes u u An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant). A decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant). Chapter 3: Consumer Behavior Slide 39

Budget Constraints Clothing (units per week) An increase in income shifts the budget line outward 80 60 A decrease in income shifts the budget line inward 40 20 0 L 3 L 1 (I = $4000) (I = $8000) 40 80 Chapter 3: Consumer Behavior 120 L 2 (I = $16000) 160 Food (units per week) Slide 40

Budget Constraints n The Effects of Changes in Income and Prices l Price Changes u If the price of one good increases, the budget line shifts inward, turning from the other good’s intercept. Chapter 3: Consumer Behavior Slide 41

Budget Constraints n The Effects of Changes in Income and Prices l Price Changes u If the price of one good decreases, the budget line shifts outward, turning from the other good’s intercept. Chapter 3: Consumer Behavior Slide 42

Budget Constraints Clothing (units per week) An increase in the price of food to $2. 00 changes the slope of the budget line and rotates it inward. A decrease in the price of food to $. 50 changes the slope of the budget line and rotates it outward. 40 L 3 (PF = 200) L 1 L 2 (PF = 1) 40 80 Chapter 3: Consumer Behavior (PF = 1/2) 120 160 Food (units per week) Slide 43

Budget Constraints n The Effects of Changes in Income and Prices l Price Changes u u If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change. However, the budget line will shift inward to a point parallel to the original budget line. Chapter 3: Consumer Behavior Slide 44

Budget Constraints n The Effects of Changes in Income and Prices l Price Changes u u If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change. However, the budget line will shift outward to a point parallel to the original budget line. Chapter 3: Consumer Behavior Slide 45

Consumer Choice n Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them. Chapter 3: Consumer Behavior Slide 46

Consumer Choice n The 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. Chapter 3: Consumer Behavior Slide 47

Consumer Choice Recall, the slope of an indifference curve is: Further, the slope of the budget line is: Chapter 3: Consumer Behavior Slide 48

Consumer Choice n Therefore, it can be said that satisfaction is maximized where: Chapter 3: Consumer Behavior Slide 49

Consumer Choice n 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). Chapter 3: Consumer Behavior Slide 50

Consumer Choice Clothing (units per week) Pc = $200 Pf = $100 I = $8000 Point B does not maximize satisfaction because the MRS (-(-10/10) = 1 is greater than the price ratio (100/200)= 0. 5 40 30 B -10 C Budget Line 20 U 1 +10 F 0 10 20 Chapter 3: Consumer Behavior 80 Food (units per week) Slide 51

Consumer Choice Clothing (units per week) Pc = $200 Pf = $100 I = $8000 40 Market basket D cannot be attained given the current budget constraint. D 30 20 U 3 Budget Line 0 20 40 Chapter 3: Consumer Behavior 80 Food (units per week) Slide 52

Consumer Choice Clothing (units per week) Pc = $200 Pf = $100 I = $8000 At market basket A the budget line and the indifference curve are tangent and no higher level of satisfaction can be attained. 40 30 A At A: MRS =Pf/Pc =. 5 20 U 2 Budget Line 0 20 40 Chapter 3: Consumer Behavior 80 Food (units per week) Slide 53

Consumer Choice Designing New Automobiles (II) n Consider two groups of consumers, each wishing to spend $10, 000 on the styling and performance of cars. n Each group has different preferences. Chapter 3: Consumer Behavior Slide 54

Consumer Choice Designing New Automobiles (II) n By finding the point of tangency between a group’s indifference curve and the budget constraint auto companies can design a production and marketing plan. Chapter 3: Consumer Behavior Slide 55

Designing New Automobiles (II) Styling These consumers are willing to trade off a considerable amount of styling for some additional performance $10, 000 $3, 000 $7, 000 Chapter 3: Consumer Behavior $10, 000 Performance Slide 56

Designing New Automobiles (II) Styling These consumers are willing to trade off a considerable amount of performance for some additional styling $10, 000 $7, 000 $3, 000 Chapter 3: Consumer Behavior $10, 000 Performance Slide 57

Consumer Choice A Corner Solution n A corner solution is the situation in which the marginal rate of substitution of a good in a chosen market basket is not equal to the slope of the budget line. n A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another. Chapter 3: Consumer Behavior Slide 58

Consumer Choice A Corner Solution n This exists where the indifference curves are tangent to the horizontal and vertical axis. n MRS is not equal to PA/PB Chapter 3: Consumer Behavior Slide 59

A Corner Solution Frozen Yogurt (cups monthly) A U 1 U 2 U 3 B Chapter 3: Consumer Behavior A corner solution exists at point B. Ice Cream A (cup/month) Slide 60

Consumer Choice n A Corner Solution l At point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line. l This suggests that if the consumer could give up more frozen yogurt for ice cream he would do so. l However, there is no more frozen yogurt to give up! Chapter 3: Consumer Behavior Slide 61

Consumer Choice n A Corner Solution l n When a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio. In this instance it can be said that: Chapter 3: Consumer Behavior Slide 62

Consumer Choice n A Corner Solution l 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 consumer’s market basket. Chapter 3: Consumer Behavior Slide 63

Consumer Choice A College Trust Fund n Suppose Jane parents set up a trust fund for her college education. n Originally, the money must be used for education. Chapter 3: Consumer Behavior Slide 64

Consumer Choice A College Trust Fund n If part of the money could be used for the purchase of other goods, her consumption preferences change. Chapter 3: Consumer Behavior Slide 65

Consumer Choice Other Consumption ($) A College Trust Fund A: Consumption before the trust fund The trust fund shifts the budget line B: Requirement that the trust fund must be spent on education U 3 C: If the trust could be spent on other goods C P A B U 2 U 1 Q Chapter 3: Consumer Behavior Education ($) Slide 66

Marginal Utility and Consumer Choice Marginal Utility n Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good. Chapter 3: Consumer Behavior Slide 67

Marginal Utility and Consumer Choice Marginal Utility n n Example l The marginal utility derived from increasing from 0 to 1 units of food might be 9 l Increasing from 1 to 2 might be 7 l Increasing from 2 to 3 might be 5 Observation: Marginal utility is diminishing Chapter 3: Consumer Behavior Slide 68

Marginal Utility and Consumer Choice Diminishing Marginal Utility n The principle of diminishing marginal utility states that as more and more of a good is consumed, consuming additional amounts will give up smaller and smaller additions to utility. Chapter 3: Consumer Behavior Slide 69

Marginal Utility and Consumer Choice n Marginal Utility and the Indifference Curve l 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). Chapter 3: Consumer Behavior Slide 70

Marginal Utility and Consumer Choice n Formally: Chapter 3: Consumer Behavior Slide 71

Marginal Utility and Consumer Choice n Rearranging: Chapter 3: Consumer Behavior Slide 72

Marginal Utility and Consumer Choice n Because: Chapter 3: Consumer Behavior Slide 73

Marginal Utility and Consumer Choice n When consumers maximize satisfaction the: n Since the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it follows that: Chapter 3: Consumer Behavior Slide 74

Marginal Utility and Consumer Choice n Which gives the equation for utility maximization: Chapter 3: Consumer Behavior Slide 75

Marginal Utility and Consumer Choice Gasoline Rationing n In 1974 and again in 1979, the government imposed price controls on gasoline. n This resulted in shortages. Chapter 3: Consumer Behavior Slide 76

Marginal Utility and Consumer Choice n The horizontal axis shows her annual consumption of gasoline at $1/gallon. n The vertical axis shows her remaining income after purchasing gasoline. Chapter 3: Consumer Behavior Slide 77

Marginal Utility and Consumer Choice Spending on other goods ($) A 20, 000 18, 000 15, 000 D C U 1 U 2 B 2, 000 5, 000 Chapter 3: Consumer Behavior 20, 000 Gasoline (gallons per year) Slide 78

Cost-of-Living Indexes n The CPI is calculated each year of consumer goods and services today in comparison to the cost during a base period. Chapter 3: Consumer Behavior Slide 79

Cost-of-Living Indexes n Example l Two sisters, Rachel and Sarah, have identical preferences. l Sarah began college in 1987 with a $500 budget. l In 1997, Rachel started college and her parents promised her a budget that was equivalent in purchasing power. Chapter 3: Consumer Behavior Slide 80

Cost-of-Living Indexes 1987 (Sarah) 1997(Rachel) Price of books $20/book $100/book Number of books 15 6 Price of food $2. 00 $2. 20 Pounds of food 100 300 Expenditure $500 $1, 260 Chapter 3: Consumer Behavior Slide 81

Cost-of-Living Indexes Sarah’ Expenditure $500 = 100. of food x $2. 00 + 15 books x $20/book Rachel’ Expenditure for Equal Utility $1, 260 = 300. of food x $2. 20. + 6 books x $100/book Chapter 3: Consumer Behavior Slide 82

Summary n People behave rationally in an attempt to maximize satisfaction from a particular combination of goods and services. n Consumer choice has two related parts: the consumer’s preferences and the budget line. Chapter 3: Consumer Behavior Slide 83

Summary n Consumers make choices by comparing market baskets or bundles of commodities. n Indifference curves are downward sloping and cannot intersect one another. n Consumer preferences can be completely described by an indifference map. Chapter 3: Consumer Behavior Slide 84

Summary n Budget lines represent all combinations of goods for which consumers expend all their income. n Consumers maximize satisfaction subject to budget constraints. Chapter 3: Consumer Behavior Slide 85