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Chapter 3
Consumer Behavior
Chapter 3 2 ©2005 Pearson Education, Inc.
Introduction
How are consumer preferences used to determine demand?
How do consumers allocate income to the purchase of different goods?
How do consumers with limited income decide what to buy?
Chapter 3 3 ©2005 Pearson Education, Inc.
Consumer Behavior
Theory of consumer behavior The explanation of how consumers allocate
income to the purchase of different goods and services
Chapter 3 4 ©2005 Pearson Education, Inc.
Consumer Behavior
There are three steps involved in the study of consumer behavior
1. Consumer Preferences To describe how and why people prefer
one good to another
2. Budget Constraints People have limited incomes
Chapter 3 5 ©2005 Pearson Education, Inc.
Consumer Behavior
3. Given preferences and limited incomes, what amount and type of goods will be purchased?
What combination of goods will consumers buy to maximize their satisfaction?
Chapter 3 6 ©2005 Pearson Education, Inc.
Consumer Preferences
How might a consumer compare different groups of items available for purchase?
A market basket is a collection of one or more commodities.
Individuals can choose between market baskets containing different goods
Chapter 3 7 ©2005 Pearson Education, Inc.
Consumer Preferences – Basic Assumptions
1. Preferences are complete. Consumers can rank market baskets
2. Preferences are transitive. If prefer A to B, and B to C, the must prefer
A to C
3. Consumers always prefer more of any good to less.
More is better
Chapter 3 8 ©2005 Pearson Education, Inc.
Consumer Preferences
Consumer preferences can be represented graphically using indifference curves
Indifference curves represent all combinations of market baskets that the person is indifferent A person will be equally satisfied with either
choice
Chapter 3 9 ©2005 Pearson Education, Inc.
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
Chapter 3 10 ©2005 Pearson Education, Inc.
Indifference Curves: An Example
Graph the points with one good on the x-axis and one good on the y-axis
Plotting the points we can make some immediate observations about preferences More is better
Chapter 3 11 ©2005 Pearson Education, Inc.
The consumer prefersA to all combinationsin the blue box, whileall those in the pink
box are preferred to A.
Indifference Curves: An Example
Food
10
20
30
40
10 20 30 40
Clothing
50
G
A
EH
B
D
Chapter 3 12 ©2005 Pearson Education, Inc.
Indifference Curves: An Example
Points such as B & D have more of one good but less of another compared to A Need more information about consumer
ranking Consumer may decide they are
indifference between B, A and D We can then connect those points with an
indifference curve
Chapter 3 13 ©2005 Pearson Education, Inc.
•Indifferent between B, A, & D•E is preferred to U1
•U1 is preferred to H & G
Indifference Curves: An Example
Food
10
20
30
40
10 20 30 40
Clothing
50
U1
G
D
A
EH
B
Chapter 3 14 ©2005 Pearson Education, Inc.
Indifference Curves
Any market basket lying northeast of an indifference curve is preferred to any market basket that lies on the indifference curve.
Points on the curve are preferred to points southwest of the curve
Chapter 3 15 ©2005 Pearson Education, Inc.
Indifference Curves
Indifference curves slope downward to the right. If it sloped upward it would violate the
assumption that more is preferred to less.
Chapter 3 16 ©2005 Pearson Education, Inc.
Indifference Curves
To describe preferences for all combinations of goods/services, we have a set of indifference curves – an indifference map Each indifference curve in the map shows
the market baskets among which the person is indifferent.
Chapter 3 17 ©2005 Pearson Education, Inc.
U2
U3
Indifference Map
Food
Clothing
U1
ABD
Market basket Ais preferred to B.Market basket B ispreferred to D.
Chapter 3 18 ©2005 Pearson Education, Inc.
Indifference Maps
Indifference maps give more information about shapes of indifference curves Indifference curves can not cross Why? What if we assume they can cross.
Chapter 3 19 ©2005 Pearson Education, Inc.
Indifference Maps
Food
Clothing •B is preferred to D•A is indifferent to B & D•B must be indifferent to D but that can’t be if B is preferred to D
U1
U1
U2
U2
A
B
D
Chapter 3 20 ©2005 Pearson Education, Inc.
Indifference Curves
The shapes of indifference curves describes how a consumer is willing to substitute 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 to get more food
Chapter 3 21 ©2005 Pearson Education, Inc.
A
B
D
EG
-1
-6
1
1
-4
-21
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
Chapter 3 22 ©2005 Pearson Education, Inc.
Indifference Curves
We measure how a person trades one good for another using the marginal rate of substitution (MRS) It 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 3 23 ©2005 Pearson Education, Inc.
Marginal Rate of Substitution
Food2 3 4 51
Clothing
2
4
6
8
10
12
14
16 A
B
D
EG
-6
1
1
11
-4
-2-1
MRS = 6
MRS = 2
FCMRS
Chapter 3 24 ©2005 Pearson Education, Inc.
Marginal Rate of Substitution
Indifference curves are convex 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 generally prefer a balanced market basket
Chapter 3 25 ©2005 Pearson Education, Inc.
Marginal Rate of Substitution
The MRS decreases as we move down the indifference curve Along an indifference curve there is a
diminishing marginal rate of substitution. The MRS went from 6 to 4 to 1
Chapter 3 26 ©2005 Pearson Education, Inc.
Marginal Rate of Substitution
Indifference curves with different shapes imply a different willingness to substitute
Two polar cases are of interest Perfect substitutes Perfect complements
Chapter 3 27 ©2005 Pearson Education, Inc.
Marginal Rate of Substitution
Perfect Substitutes Two goods are perfect substitutes when the
marginal rate of substitution of one good for the other is constant.
Example: a person might consider apple juice and orange juice perfect substitutes
They would always trade 1 glass of OJ for 1 glass of Apple Juice
Chapter 3 28 ©2005 Pearson Education, Inc.
Consumer Preferences
Orange Juice(glasses)
Apple Juice
(glasses)
2 3 41
1
2
3
4
0
PerfectSubstitute
s
Chapter 3 29 ©2005 Pearson Education, Inc.
Consumer Preferences
Perfect Complements Two goods are perfect complements when
the indifference curves for the goods are shaped as right angles.
Example: If have 1 left shoe and 1 right shoe, you are indifferent between having more left shoes only
Chapter 3 30 ©2005 Pearson Education, Inc.
Consumer Preferences
Right Shoes
LeftShoes
2 3 41
1
2
3
4
0
PerfectComplements
Chapter 3 31 ©2005 Pearson Education, Inc.
Consumer Preferences
We have assumed all our commodities are “goods”
There are commodities we don’t want more of - bads Things for which less is preferred to more
Examples Air pollution Asbestos
Chapter 3 32 ©2005 Pearson Education, Inc.
Consumer Preferences
How do we account for bads in our preference analysis? We redefine the commodity
Clean airPollution reductionAsbestos removal
Chapter 3 33 ©2005 Pearson Education, Inc.
Consumer Preferences
The theory of consumer behavior does not require assigning a numerical value to the level of satisfaction
Although ranking of market baskets are good, sometimes numerical value are useful
Chapter 3 34 ©2005 Pearson Education, Inc.
Consumer Preferences
Utility A numerical score representing the
satisfaction that a consumer gets from a given market basket.
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 3 35 ©2005 Pearson Education, Inc.
Utility
Utility function Formula that assigns a level of utility to
individual 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)
Chapter 3 36 ©2005 Pearson Education, Inc.
Utility - Example
Market Basket
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 and prefers both to C
Chapter 3 37 ©2005 Pearson Education, Inc.
Utility - Example
Baskets for each level of utility can be plotted to get an indifference curve To find the indifference curve for a utility of
14, we can change the combinations of food and clothing that give us a utility of 14
Chapter 3 38 ©2005 Pearson Education, Inc.
Utility - Example
Food10 155
5
10
15
0
Clothing
U1 = 25
U2 = 50
U3 = 100A
B
C
Basket U = FC C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5)
Chapter 3 39 ©2005 Pearson Education, Inc.
Utility
Although we numerically rank baskets and indifference curves, numbers are ONLY for ranking
A utility of 4 is not necessarily twice as good as utility of 2
Chapter 3 40 ©2005 Pearson Education, Inc.
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 3 41 ©2005 Pearson Education, Inc.
Utility
The actual unit of measurement for utility is not important.
An ordinal ranking is sufficient to explain how most individual decisions are made.
Chapter 3 42 ©2005 Pearson Education, Inc.
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 3 43 ©2005 Pearson Education, Inc.
Budget Constraints
The Budget Line Indicates all combinations of two
commodities for which total money spent equals total income.
We assume only 2 goods are consumed, so we do not consider savings
Chapter 3 44 ©2005 Pearson Education, Inc.
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 3 45 ©2005 Pearson Education, Inc.
ICPFP CF
The Budget Line
The budget line then can be written:
All income is allocated to food (F) and/or clothing (C)
Chapter 3 46 ©2005 Pearson Education, Inc.
The Budget Line
Different choices of food and clothing can be calculated that use all income
Example: Assume income of $80/week, PF = $1 and PC
= $2
Chapter 3 47 ©2005 Pearson Education, Inc.
Budget Constraints
Market Basket
Food
PF = $1
Clothing
PC = $2
IncomeI = PFF + PCC
A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
Chapter 3 48 ©2005 Pearson Education, Inc.
C
F
P
P
F
C Slope -
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
Chapter 3 49 ©2005 Pearson Education, Inc.
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 3 50 ©2005 Pearson Education, Inc.
The Budget Line
The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent.
We can rearrange the budget line equation to make this more clear
Chapter 3 51 ©2005 Pearson Education, Inc.
The Budget Line
YXP
P
P
I
YPXPI
YPXPI
Y
X
Y
YX
YX
Chapter 3 52 ©2005 Pearson Education, Inc.
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 3 53 ©2005 Pearson Education, Inc.
The Budget Line
As we know, income and prices can change
As incomes and prices change, there are changes in budget lines
We can show the effects of these changes on budget lines and consumer choices
Chapter 3 54 ©2005 Pearson Education, Inc.
The Budget Line - Changes
The Effects of Changes in Income An increase in income causes the budget line
to shift outward, parallel to the original line (holding prices constant).
Can buy more of both goods with more income
Chapter 3 55 ©2005 Pearson Education, Inc.
The Budget Line - Changes
The Effects of Changes in Income A decrease in income causes the budget line
to shift inward, parallel to the original line (holding prices constant).
Can buy less of both goods with less income
Chapter 3 56 ©2005 Pearson Education, Inc.
The Budget Line - Changes
A 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 lineinward
Chapter 3 57 ©2005 Pearson Education, Inc.
The Budget Line - Changes
The Effects of Changes in Prices If the price of one good increases, the budget
line shifts inward, pivoting from the other good’s intercept.
If price of food increases and you buy only food (x-intercept), then can’t buy as much food. The point shifts in
If buy only clothing (y-intercept), can buy the same amount. No change
Chapter 3 58 ©2005 Pearson Education, Inc.
The Budget Line - Changes
The Effects of Changes in Prices If the price of one good decreases, the
budget line shifts outward, pivoting from the other good’s intercept.
If price of food decreases and you buy only food (x-intercept), then can buy more food. The point shifts out.
If buy only clothing (y-intercept), can buy the same amount. No change
Chapter 3 59 ©2005 Pearson Education, Inc.
The Budget Line - Changes
(PF = 1)
L1
An increase in theprice of food to$2.00 changes
the slope of thebudget line and
rotates it inward.L3
(PF = 2)(PF = 1/2)
L2
A decrease in theprice of food to$.50 changes
the slope of thebudget line and
rotates it outward.
40Food(units per week)
Clothing(units
per week)
80 120 160
40
Chapter 3 60 ©2005 Pearson Education, Inc.
The Budget Line - Changes
The Effects of Changes in Prices 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 61 ©2005 Pearson Education, Inc.
The Budget Line - Changes
The Effects of Changes in Prices 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 62 ©2005 Pearson Education, Inc.
Consumer Choice
Given preferences and budget constraints, how do consumers choose what to buy?
Consumers choose a combination of goods that will maximize their satisfaction, given the limited budget available to them.
Chapter 3 63 ©2005 Pearson Education, Inc.
Consumer Choice
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination of goods and services.
Chapter 3 64 ©2005 Pearson Education, Inc.
Consumer Choice
Graphically we can see different indifference curves of a consumer choosing between clothing and food
Remember that U3 > U2 > U1 for our indifference curves
Consumer wants to choose highest utility within their budget
Chapter 3 65 ©2005 Pearson Education, Inc.
Consumer Choice
Consumer will choose highest indifference curve on budget line
In previous graph, point C is where the indifference curve is just tangent to the budget line
Slope of the budget line equals the slope of the indifference curve at this point
Chapter 3 66 ©2005 Pearson Education, Inc.
Consumer Choice
Recall, the slope of an indifference curve is:
F
CMRS
C
F
P
PSlope
Further, the slope of the budget line is:
Chapter 3 67 ©2005 Pearson Education, Inc.
Consumer Choice
Therefore, it can be said at consumer’s optimal consumption point,
C
F
P
PMRS
Chapter 3 68 ©2005 Pearson Education, Inc.
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).
Note this is ONLY true at the optimal consumption point
Chapter 3 69 ©2005 Pearson Education, Inc.
Consumer Choice
Optimal consumption point is where marginal benefits equal marginal costs
MB = MRS = benefit associated with consumption of 1 more unit of food
MC = cost of additional unit of food
Chapter 3 70 ©2005 Pearson Education, Inc.
Consumer Choice
If MRS ≠ PF/PC then individuals can reallocate basket to increase utility
If MRS > PF/PC
Will increase food and decrease clothing until MRS = PF/PC
If MRS < PF/PC
Will increase clothing and decrease food until MRS = PF/PC
Chapter 3 71 ©2005 Pearson Education, Inc.
Consumer Choice
A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another.
Chapter 3 72 ©2005 Pearson Education, Inc.
A Corner Solution
Ice Cream (cup/month)
FrozenYogurt
(cupsmonthly)
B
A
U2 U3U1
A corner solutionexists at point B.
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