consumer behavior

Consumer Behavior

• Three steps involved in the study of consumer behavior

1) Study consumer preferences• To describe how and why people prefer one good

to another.

2) Turn to budget constraint• People have limited incomes.

3) Determine consumer choices• What combination of goods will consumers buy to

maximize their satisfaction?

Consumer Preferences

• A bundle of goods or market basket is a collection of one or more commodities.

• A market basket may be preferred over another market basket containing a different combination of goods.

Three Basic Assumptions of Consumer Preferences

• Preferences are complete.

– Give me any two baskets of goods (A and B), I will be able to tell you on of the followings:

• I prefer A to B

• I prefer B to A

• I am indifferent between A and B.

Three Basic Assumptions of Consumer Preferences

• Preferences are transitive.

– If I prefer A to B and B to C, I must also prefer A to C.

• Non-satiation: Consumers always prefer more of any good to less.

The consumer prefersA to all combinationsin the blue box, whileall those in the pink

box are preferred to A.

Preferences over Market Basket

Food(units per week)

10

20

30

40

10 20 30 40

Clothing(units per week)

50

G

A

EH

B

D

Combination B,A, & Dyield the same satisfaction•E is preferred to U1

•U1 is preferred to H & G

U1

Indifference Curve

Food(units per week)

10

20

30

40

10 20 30 40

Clothing(units per week)

50

G

D

A

EH

B

Indifference curves represent all combinations of bundles that provide the same level of satisfaction to a person.

Indifference Curve

U1

Food(units per week)

10

20

30

40

10 20 30 40

Clothing(units per week)

50

GD

A

EH

B 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.

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.

U2

U3

Indifference Map

Food(units per week)

Clothing(units per week)

U1

AB

D

Market basket Ais preferred to B.Market basket B ispreferred to D.

Each indifference curve in the map shows the market baskets among which the person is indifferent.

An indifference map is a set of indifference curves that describes a person’s preferences for all combinations of two commodities.

U1U2

Indifference Curve

Food(units per week)

Clothing(units per week)

A

D

B

If crossed, the consumer shouldbe indifferent between A, B and D. However, B contains more of both goods than D.

Indifference CurvesCannot Cross

A

B

D

EG-1

-6

-4

-2

Observation: The amount of clothing given up for a unit of food decreases from 6 to 1.

The Amount of Clothing Given up per Unit of Food Decreases with Food Increase

Food(units per week)

Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16

Marginal Rate of Substitution

Food(units per week)

Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16 A

B

D

E

-6

1

1

-2

MRS = 6

MRS = 2 FCMRS

The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good

MRS is measured by the slope of the indifference curve:

Diminishing Marginal Rate of Substitution

Food(units per week)

Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16 A

B

D

E

-6

1

1

-2

MRS = 6

MRS = 2

Along an indifference curve there is a diminishing 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 like variety.

Perfect Substitutes

Orange juice (glasses)

Apple juice

(glasses)

2 3 41

1

2

3

4

0

PerfectSubstitutes

PerfectSubstitutes

Two goods are perfect substitutes when the marginal

rate of substitution of one good for the other is constant.

Perfect Complements

Two goods are perfect complements when

the indifference curves for the goods are shaped as right

angles.

Right Shoes

LeftShoes

2 3 41

1

2

3

4

0

PerfectComplements

PerfectComplements

Consumer Choice

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

Consumer Choice

• The maximizing bundle 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.

Consumer Choice

Budget Line

U3

D Market basket D cannot be attainedgiven the current

budget constraint.

Pc = $2 Pf = $1 I = $80

Food (units per week)

Clothing(units per

week)

40 8020

20

30

40

0

Consumer Choice

Food (units per week)

Clothing(units per

week)

40 8020

20

30

40

0

U1

B

Budget Line

Pc = $2 Pf = $1 I = $80

Point B does not maximize satisfaction because there exist a point A which is attainable and yields a higher satisfaction.

Note that the MRS (-(-10/10) = 1 is greater than the price ratio (1/2).

-10C

+10F

A

U2

Consumer Choice

Pc = $2 Pf = $1 I = $80

Budget Line

A

At market basket A the budget line and theindifference curve aretangent and no higherlevel of satisfaction

can be attained.

At A:MRS =Pf/Pc = .5

Food (units per week)

Clothing(units per

week)

40 8020

20

30

40

0

Recall, the slope of an indifference curve is:

Consumer Choice

F

CMRS

C

F

P

PSlope

Further, the slope of the budget line is:

Consumer Choice

• Therefore, it can be said that satisfaction is maximized where:

• Satisfaction is maximized when the marginal rate of substitution (of F and C) is equal to the ratio of the prices (of F and C).

C

F

P

PMRS

Benefit of consuming food as compared to

cloth.

Opportunity cost of food in terms of cloth.

Example : Tina’s Indifference Curve

INDIFFERENCE CURVES

Figure A11.1 shows an indifference curve and map.

INDIFFERENCE CURVES

In part (a), Tina is equally happy consuming at any point along the green indifference curve.

INDIFFERENCE CURVES

Point C is neither better nor worse than any other point along the indifference curve.

INDIFFERENCE CURVES

Points below the indifference curve are worse than points on the indifference curve—are not preferred.

INDIFFERENCE CURVES

Points above the indifference curve are better than points on the indifference curve—are preferred.

INDIFFERENCE CURVES

Part (b) shows three indifference curves—I0, I1, and I2—that are part of Tina’s indifference map.

INDIFFERENCE CURVES

The indifference curve in part (a) is curve I1 in part (b). Tina is indifferent between points C and G.

INDIFFERENCE CURVES

Tina prefers point J to points C and G. And she prefers C and G to any point on curve I0.

INDIFFERENCE CURVES

• Marginal Rate of Substitution– The marginal rate of substitution is the rate at

which a person will give up good y (the good measured on the y-axis) to get more of good x (the good measured on the x-axis) and at the same time remain on the same indifference curve.

– Diminishing marginal rate of substitution is the general tendency for the marginal rate of substitution to decrease as the consumer moves down along the indifference curve, increasing consumption of good x and decreasing consumption of good y.

INDIFFERENCE CURVES

Figure A11.2 shows the calculation of the marginal rate of substitution.

The marginal rate of substitution (MRS) is the magnitude of the slope of an indifference curve.

First, we’ll calculate the MRS at point C.

INDIFFERENCE CURVES

Draw a straight line with the same slope as the indifference curve at point C.

The slope of this line is 8 packs of gum divided by 4 bottles of water, which equals 2 packs of gum per bottle of water.

INDIFFERENCE CURVES

This number is Tina’s marginal rate of substitution. Her MRS = 2.

At point C, when she consumes 2 bottles of water and 4 packs of gum, Tina is willing to give up gum for water at the rate of 2 packs of gum per bottle of water.

INDIFFERENCE CURVES

The red line at point G tells us that Tina is willing to give up 4 packs of gum to get 8 bottles of water.

Her marginal rate of substitution at point G is 4 divided by 8, which equals 1 ⁄2.

Now calculate Tina’s MRS at point G.

INDIFFERENCE CURVES

• Tina’s Equilibrium– The goal of the Tina is to buy the affordable

quantities of water and gum that make the her as well off as possible.

– Her preference map describe the way a she values different combinations of goods.

– Budget and the prices of the water and gum limit her choices.

INDIFFERENCE CURVES

Figure A11.3 shows Tina’s equilibrium.Tina’s indifference curves describe her preferences.Tina’s budget line describes the limits to what she can afford.

Tina’s best affordable point is C. At that point, she is on her budget line and also on the highest attainable indifference curve.

INDIFFERENCE CURVESTina can consume the same quantity of water at point J but less gum. She prefers C to J.

Point J is equally preferred to points F and H, which Tina can also afford.

Points on the budget line between F and H are preferred to F and H. And of all those points, C is the best affordable point for Tina.

INDIFFERENCE CURVES

• Deriving the Demand Curve– To derive Tina’s demand curve for bottled

water:• Change the price of water• Shift the budget line• Work out the new best affordable point

Figure A11.4 shows how to derive Tina’s demand curve.

When the price of water is $1 a bottle, Tina’s best affordable point is C in part (a) and at point A on her demand curve in part (b).

When the price of water is 50 cents a bottle, Tina’s best affordable point is K in part (a) and at point B on her demand curve in part (b).

INDIFFERENCE CURVES

Tina’s demand curve in part (b) passes through points A and B.

INDIFFERENCE CURVES