Chapter 3 Consumer Behavior Topics to be Discussed

Chapter 3 Consumer Behavior

Topics to be Discussed • Consumer Preferences • Budget Constraints • Consumer Choice • Revealed Preferences Chapter 1 2

Topics to be Discussed • Marginal Utility and Consumer Choices • Cost-of-Living Indexes Chapter 1 3

Consumer Behavior • Two applications that illustrate the importance of the economic theory of consumer behavior are: – – Apple-Cinnamon Cheerios The Food Stamp Program. Chapter 1 4

Consumer Behavior • General Mills had to determine how high a price to charge for Apple-Cinnamon Cheerios before it went to the market. Chapter 1 5

Consumer Behavior • When the food stamp program was established in the early 1960 s, the designers had to determine to what extent the food stamps would provide people with more food and not just simply subsidize the food they would have bought anyway. Chapter 1 6

Consumer Behavior • These two problems require an understanding of the economic theory of consumer behavior. Chapter 1 7

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. Chapter 1 8

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. Chapter 1 9

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? Chapter 1 10

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. Chapter 1 11

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. Chapter 1 12

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 1 13

Consumer Preferences Indifference Curves • Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person. Chapter 1 14

Consumer Preferences Clothing The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A. (units per week) 50 B 40 H E A 30 D G 20 10 10 20 30 Chapter 1 40 Food (units per week) 15

Consumer Preferences Clothing Combination B, A, & D yield the same satisfaction • E is preferred to U 1 • U 1 is preferred to H & G (units per week) B 50 40 H E A 30 D 20 G U 1 10 10 20 30 Chapter 1 40 Food (units per week) 16

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. Chapter 1 17

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. Chapter 1 18

Consumer Preferences Indifference Maps • An indifference map is a set of indifference curves that describes a person’s preferences for all combinations of two commodities. – Each indifference curve in the map shows the market baskets among which the person is indifferent. Chapter 1 19

Consumer Preferences • Indifference Curves – Finally, indifference curves cannot cross. • This would violate the assumption that more is preferred to less. Chapter 1 20

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 1 21

Consumer Preferences Indifference Curves Clothing (units per week) U 2 Cannot Cross U 1 The consumer should be indifferent between A, B and D. However, B contains more of both goods than D. A B D Food (units per week) Chapter 1 22

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 Question: Does this relation hold for giving up food to get clothing? D 6 1 -2 4 E G 1 -1 1 2 3 4 Chapter 1 5 Food (units per week) 23

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. Chapter 1 24

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 3 4 Chapter 1 5 Food (units per week) 25

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. Chapter 1 26

Consumer Preferences Marginal Rate of Substitution • Question – What are the first three assumptions? Chapter 1 27

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 Chapter 1 28

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. Chapter 1 29

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. Chapter 1 30

Consumer Preferences Apple Juice (glasses) 4 Perfect Substitutes 3 2 1 0 1 2 3 Chapter 1 4 Orange Juice (glasses) 31

Consumer Preferences Left Shoes 4 Perfect Complements 3 2 1 0 1 2 3 Chapter 1 4 Right Shoes 32

Consumer Preferences • Utility – Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket. Chapter 1 33

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. Chapter 1 34

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 U 3 = 100 (Preferred to U 2) A 5 B 0 5 10 Chapter 1 15 U 2 = 50 (Preferred to U 1) U 1 = 25 Food (units per week) 35

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. Chapter 1 36

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. Chapter 1 37

Budget Constraints • Preferences do not explain all of consumer behavior. • Budget constraints also limit an individual’s ability to consume in light of the prices they must pay for various goods and services. Chapter 1 38

Budget Constraints • The Budget Line – The budget line indicates all combinations of two commodities for which total money spent equals total income. Chapter 1 39

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. Chapter 1 40

Budget Constraints • The budget line then can be written: Chapter 1 41

Budget Constraints Market Basket Food (F) Clothing (C) Total Spending P f. F + P c C = I Pf = ($1) Pc = ($2) A 0 40 $80 B 20 30 $80 D 40 20 $80 E 60 10 $80 G 80 0 $80 Chapter 1 42

Budget Constraints Clothing Pc = $2 (units per week) (I/PC) = 40 Pf = $1 I = $80 Budget Line F + 2 C = $80 A B 30 10 20 D 20 E 10 G 0 20 40 60 Chapter 1 80 = (I/PF) Food (units per week) 43

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. Chapter 1 44

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. Chapter 1 45

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. Chapter 1 46

Consumer Choice • Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them. Chapter 1 47

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. Chapter 1 48

Consumer Choice Recall, the slope of an indifference curve is: Further, the slope of the budget line is: Chapter 1 49

Consumer Choice • Therefore, it can be said that satisfaction is maximized where: Chapter 1 50

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). Chapter 1 51

Consumer Choice Clothing (units per week) Pc = $2 Pf = $1 I = $80 Point B does not maximize satisfaction because the MRS (-(-10/10) = 1 is greater than the price ratio (1/2). 40 30 B -10 C Budget Line 20 U 1 +10 F 0 20 40 80 Chapter 1 Food (units per week) 52

Consumer Choice Clothing (units per week) Pc = $2 Pf = $1 I = $80 40 Market basket D cannot be attained given the current budget constraint. D 30 20 U 3 Budget Line 0 20 40 80 Chapter 1 Food (units per week) 53

Consumer Choice Clothing (units per week) Pc = $2 Pf = $1 I = $80 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 80 Chapter 1 Food (units per week) 54

Summary • People behave rationally in an attempt to maximize satisfaction from a particular combination of goods and services. • Consumer choice has two related parts: the consumer’s preferences and the budget line. Chapter 1 55

Summary • Consumers make choices by comparing market baskets or bundles of commodities. • Indifference curves are downward sloping and cannot intersect one another. • Consumer preferences can be completely described by an indifference map. Chapter 1 56

Summary • The marginal rate of substitution of F for C is the maximum amount of C that a person is willing to give up to obtain one additional unit of F. • Budget lines represent all combinations of goods for which consumers expend all their income. Chapter 1 57

Summary • Consumers maximize satisfaction subject to budget constraints. • The theory of revealed preference shows how the choices that individuals make when prices and income vary can be used to determine their preferences. Chapter 1 58

End of Chapter 3 Consumer Behavior