Chapter 3Consumer Behavior

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IntroductionHow 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?

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IntroductionHow can we determine the nature of consumer preferences for observations of consumer behavior?How can cost of living indexes measure the well-being of consumers?

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Consumer Behavior - ApplicationsHow would General Mills determine the price to charge for a new cereal before it went to the market?To what extent did the food stamp program provide individuals with more food versus merely subsidizing food they bought anyway?

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Consumer BehaviorThe theory of consumer behavior can be used to help answer these and many more questionsTheory of consumer behaviorThe explanation of how consumers allocate income to the purchase of different goods and services

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Consumer BehaviorThere are three steps involved in the study of consumer behaviorConsumer PreferencesTo describe how and why people prefer one good to anotherBudget ConstraintsPeople have limited incomes

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Consumer BehaviorGiven preferences and limited incomes, what amount and type of goods will be purchased?What combination of goods will consumers buy to maximize their satisfaction?

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Consumer PreferencesHow might a consumer compare different groups of items available for purchase?A market basket is a collection of one or more commoditiesIndividuals can choose between market baskets containing different goods

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Consumer Preferences Basic AssumptionsPreferences are completeConsumers can rank market basketsPreferences are transitiveIf they prefer A to B, and B to C, they must prefer A to CConsumers always prefer more of any good to lessMore is better

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Consumer PreferencesConsumer preferences can be represented graphically using indifference curvesIndifference curves represent all combinations of market baskets that the person is indifferent toA person will be equally satisfied with either choice

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Indifference Curves: An Example

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Indifference Curves: An ExampleGraph the points with one good on the x-axis and one good on the y-axisPlotting the points, we can make some immediate observations about preferencesMore is better

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Indifference Curves: An ExampleThe consumer prefersA to all combinationsin the yellow box, whileall those in the pinkbox are preferred to A.

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Indifference Curves: An ExamplePoints such as B & D have more of one good but less of another compared to ANeed more information about consumer ranking Consumer may decide they are indifferent between B, A and DWe can then connect those points with an indifference curve

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Indifference Curves: An ExampleIndifferent between points B, A, & DE is preferred to points on U1Points on U1 are preferred to H & G

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Indifference CurvesAny market basket lying northeast of an indifference curve is preferred to any market basket that lies on the indifference curvePoints on the curve are preferred to points southwest of the curve

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Indifference CurvesIndifference curves slope downward to the rightIf they sloped upward, they would violate the assumption that more is preferred to lessSome points that had more of both goods would be indifferent to a basket with less of both goods

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Indifference CurvesTo describe preferences for all combinations of goods/services, we have a set of indifference curves an indifference mapEach indifference curve in the map shows the market baskets among which the person is indifferent

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

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Indifference MapsIndifference maps give more information about shapes of indifference curvesIndifference curves cannot crossViolates assumption that more is betterWhy? What if we assume they can cross?

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Indifference MapsB is preferred to DA is indifferent to B & DB must be indifferent to D but that cant be if B is preferred to D

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Indifference CurvesThe shapes of indifference curves describe how a consumer is willing to substitute one good for anotherA to B, give up 6 clothing to get 1 foodD to E, give up 2 clothing to get 1 foodThe more clothing and less food a person has, the more clothing they will give up to get more food

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Indifference CurvesObservation: The amountof clothing given up for 1 unit of food decreasesfrom 6 to 1

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Indifference CurvesWe 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 goodIt is measured by the slope of the indifference curve

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Marginal Rate of SubstitutionMRS = 6MRS = 2

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Marginal Rate of SubstitutionIndifference 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 oneConsumers generally prefer a balanced market basket

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Marginal Rate of SubstitutionThe MRS decreases as we move down the indifference curveAlong an indifference curve there is a diminishing marginal rate of substitution.The MRS went from 6 to 4 to 1

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Marginal Rate of SubstitutionIndifference curves with different shapes imply a different willingness to substituteTwo polar cases are of interestPerfect substitutesPerfect complements

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Marginal Rate of SubstitutionPerfect Substitutes Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constantExample: a person might consider apple juice and orange juice perfect substitutesThey would always trade 1 glass of OJ for 1 glass of Apple Juice

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Consumer PreferencesPerfectSubstitutes

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Consumer PreferencesPerfect ComplementsTwo goods are perfect complements when the indifference curves for the goods are shaped as right anglesExample: If you have 1 left shoe and 1 right shoe, you are indifferent between having more left shoes onlyMust have one right for one left

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Consumer PreferencesPerfectComplements

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Consumer PreferencesWe have assumed all our commodities are goodsThere are commodities we dont want more of - badsThings for which less is preferred to moreExamplesAir pollutionAsbestos

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Consumer PreferencesHow do we account for bads in our preference analysis?We redefine the commodityClean airPollution reductionAsbestos removal

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Consumer Preferences: An ApplicationIn designing new cars, automobile executives must determine how much time and money to invest in restyling versus increased performanceHigher demand for car with better styling and performanceBoth cost more to improve

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Consumer Preferences: An ApplicationAn analysis of consumer preferences would help to determine where to spend more on change: performance or stylingSome consumers will prefer better styling and some will prefer better performance

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Consumer Preferences: An ApplicationThese consumers place a greater value on performance than styling

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Consumer Preferences: An ApplicationThese consumers place a greater value on styling than performance

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Consumer Preferences: An ApplicationKnowing which group dominates the market will help decide where redesigning dollars should goA recent study in the US shows that over the past two decades, most consumers have preferred styling over performance

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Consumer PreferencesThe theory of consumer behavior does not required assigning a numerical value to the level of satisfactionAlthough ranking of market baskets is good, sometimes numerical value is useful

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Consumer PreferencesUtilityA numerical score representing the satisfaction that a consumer gets from a given market basketIf 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

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UtilityUtility functionFormula that assigns a level of utility to individual market basketsIf the utility function isU(F,C) = F + 2CA market basket with 8 units of food and 3 units of clothing gives a utility of 14 = 8 + 2(3)

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Utility - ExampleConsumer is indifferent between A & B and prefers both to C

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Utility - ExampleBaskets for each level of utility can be plotted to get an indifference curveTo 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

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Utility - Example BasketU = FC C25 = 2.5(10) A25 = 5(5) B25 = 10(2.5)

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UtilityAlthough we numerically rank baskets and indifference curves, numbers are ONLY for rankingA utility of 4 is not necessarily twice as good as a utility of 2There are two types of rankingsOrdinal rankingCardinal ranking

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UtilityOrdinal Utility FunctionPlaces market baskets in the order of most preferred to least preferred, but it does not indicate how much one market basket is preferred to anotherCardinal Utility FunctionUtility function describing the extent to which one market basket is preferred to another

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UtilityThe actual unit of measurement for utility is not importantAn ordinal ranking is sufficient to explain how most individual decisions are made

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Budget ConstraintsPreferences do not explain all of consumer behaviorBudget constraints also limit an individuals ability to consume in light of the prices they must pay for various goods and services

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Budget ConstraintsThe Budget LineIndicates all combinations of two commodities for which total money spent equals total incomeWe assume only 2 goods are consumed, so we do not consider savings

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The Budget LineLet F equal the amount of food purchased, and C is the amount of clothingPrice of food = PF and price of clothing = PCThen PFF is the amount of money spent on food, and PCC is the amount of money spent on clothing

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The Budget LineThe budget line then can be written:All income is allocated to food (F) and/or clothing (C)

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The Budget LineDifferent choices of food and clothing can be calculated that use all incomeThese choices can be graphed as the budget lineExample: Assume income of $80/week, PF = $1 and PC = $2

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Budget Constraints

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The Budget Line

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The Budget LineAs consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the otherThe slope of the line measures the relative cost of food and clothingThe slope is the negative of the ratio of the prices of the two goods

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The Budget LineThe slope indicates the rate at which the two goods can be substituted without changing the amount of money spentWe can rearrange the budget line equation to make this more clear

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The Budget Line

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Budget ConstraintsThe Budget LineThe vertical intercept, I/PC, illustrates the maximum amount of C that can be purchased with income IThe horizontal intercept, I/PF, illustrates the maximum amount of F that can be purchased with income I

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The Budget LineAs we know, income and prices can changeAs incomes and prices change, there are changes in budget linesWe can show the effects of these changes on budget lines and consumer choices

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The Budget Line - ChangesThe 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

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The Budget Line - ChangesThe 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

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The Budget Line - ChangesAn increase inincome shiftsthe budget lineoutwardA decrease inincome shiftsthe budget lineinward

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The Budget Line - ChangesThe Effects of Changes in PricesIf the price of one good increases, the budget line shifts inward, pivoting from the other goods intercept.If the price of food increases and you buy only food (x-intercept), then you cant buy as much food. The x-intercept shifts in.If you buy only clothing (y-intercept), you can buy the same amount. No change in y-intercept.

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The Budget Line - ChangesThe Effects of Changes in PricesIf the price of one good decreases, the budget line shifts outward, pivoting from the other goods intercept.If the price of food decreases and you buy only food (x-intercept), then you can buy more food. The x-intercept shifts out.If you buy only clothing (y-intercept), you can buy the same amount. No change in y-intercept.

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The Budget Line - ChangesAn increase in theprice of food to$2.00 changesthe slope of thebudget line androtates it inward.A decrease in theprice of food to$.50 changesthe slope of thebudget line androtates it outward.

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The Budget Line - ChangesThe Effects of Changes in PricesIf the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not changeHowever, the budget line will shift inward parallel to the original budget line

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The Budget Line - ChangesThe Effects of Changes in PricesIf the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not changeHowever, the budget line will shift outward parallel to the original budget line

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Consumer ChoiceGiven 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

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Consumer ChoiceThe maximizing market basket must satisfy two conditions:It must be located on the budget lineThey spend all their income more is betterIt must give the consumer the most preferred combination of goods and services

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Consumer ChoiceGraphically, we can see different indifference curves of a consumer choosing between clothing and foodRemember that U3 > U2 > U1 for our indifference curvesConsumer wants to choose highest utility within their budget

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Consumer ChoiceA, B, C on budget lineD highest utility but not affordableC highest affordable utilityConsumer chooses C

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Consumer ChoiceConsumer will choose highest indifference curve on budget lineIn previous graph, point C is where the indifference curve is just tangent to the budget lineSlope of the budget line equals the slope of the indifference curve at this point

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Consumer ChoiceRecall, the slope of an indifference curve is:Further, the slope of the budget line is:

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Consumer ChoiceTherefore, it can be said at consumers optimal consumption point,

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Consumer ChoiceIt 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

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Consumer ChoiceOptimal consumption point is where marginal benefits equal marginal costsMB = MRS = benefit associated with consumption of 1 more unit of foodMC = cost of additional unit of food1 unit food = unit clothingPF/PC

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Consumer ChoiceIf MRS PF/PC then individuals can reallocate basket to increase utilityIf MRS > PF/PCWill increase food and decrease clothing until MRS = PF/PCIf MRS < PF/PCWill increase clothing and decrease food until MRS = PF/PC

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Consumer ChoicePoint B does not maximize satisfaction because theMRS = -10/10 = 1 is greater than the price ratio = 1/2

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Consumer Choice: An Application RevisitedConsider two groups of consumers, each wishing to spend $10,000 on the styling and performance of a carEach group has different preferences

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Consumer Choice: An Application RevisitedBy finding the point of tangency between a groups indifference curve and the budget constraint, auto companies can see how much consumers value each attribute

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Consumer Choice: An Application RevisitedThese consumerswant performance worth $7000 and styling worth $3000

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Consumer Choice: An Application RevisitedThese consumers want styling worth $7000 and performance worth $3000

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Consumer Choice: An Application RevisitedOnce a company knows preferences, it can design a production and marketing planCompany can then make a sensible strategic business decision on how to allocate performance and styling on new cars

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Consumer ChoiceA corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another MRS is not necessarily equal to PA/PB

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A Corner SolutionA corner solutionexists at point B.

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A Corner SolutionAt point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget lineIf the consumer could give up more frozen yogurt for ice cream, he would do soHowever, there is no more frozen yogurt to give upOpposite is true if corner solution was at point A

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A Corner SolutionWhen a corner solution arises, the consumers MRS does not necessarily equal the price ratioIn this instance it can be said that:

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A Corner SolutionIf 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 consumers market basket

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A Corner Solution - ExampleSuppose Jane Does parents set up a trust fund for her college educationThe money must be used only for educationAlthough a welcome gift, an unrestricted gift might be better

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A Corner Solution - ExampleOriginal budget line, PQ, with a market basket, A, of education and other goodsTrust fund shifts out the budget line as long as trust fund, PB, is spent on educationJane increases satisfaction, moving to higher indifference curve, U2

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A Corner Solution - ExampleJane better off on U2B is corner solutionMRS PE/POG

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A Corner Solution - ExampleIf gift is unrestricted, Jane can be at point C on U3Better off than with restricted gift

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Revealed PreferencesIf we know the choices a consumer has made, we can determine what their preferences are if we have information about a sufficient number of choices that are made when prices and incomes vary.

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Revealed Preferences Two Budget LinesI1: Choose A over BA is revealed preferred to Bl2: Choose B over DB is revealed preferred to D

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Revealed Preferences Two Budget LinesAll market basketsin the pinkshaded area are preferred to A.B is preferred toall market baskets in the yellow area

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Revealed PreferenceAs you continue to change the budget line, individuals can tell you which basket they prefer to othersThe more the individual reveals, the more you can discern about their preferencesEventually you can map out an indifference curve

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Revealed Preferences Four Budget LinesFood (units per month)Clothing(units permonth)

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Marginal Utility and Consumer ChoiceMarginal utility measures the additional satisfaction obtained from consuming one additional unit of a goodHow much happier is the individual from consuming one more unit of food?

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Marginal Utility - ExampleThe marginal utility derived from increasing from 0 to 1 units of food might be 9Increasing from 1 to 2 might be 7Increasing from 2 to 3 might be 5Observation: Marginal utility is diminishing as consumption increases

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Marginal UtilityThe principle of diminishing marginal utility states that as more of a good is consumed, the additional utility the consumer gains will be smaller and smallerNote that total utility will continue to increase since consumer makes choices that make them happier

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Marginal Utility and Indifference CurvesAs consumption moves along an indifference curve:Additional utility derived from an increase in the consumption one good, food (F), must balance the loss of utility from the decrease in the consumption in the other good, clothing (C)

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Marginal Utility and Consumer ChoiceFormally:No change in total utility along an indifference curve. Trade off of one good to the other leaves the consumer just as well off.

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Marginal Utility and Consumer ChoiceRearranging:

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Marginal Utility and Consumer ChoiceWhen consumers maximize satisfaction:Since the MRS is also equal to the ratio of the marginal utility of consuming F and C

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Marginal Utility and Consumer ChoiceRearranging, gives the equation for utility maximization:

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Marginal Utility and Consumer ChoiceTotal utility is maximized when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good.This is referred to as the equal marginal principle.

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Cost-of-Living IndexesSocial Security payments are given to qualifying individualsEach year the benefit increases equal to the rate of increase of the Consumer Price Index (CPI)Ratio of the present cost of typical bundle of goods/services in comparison to the cost during a base period

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Cost-of-Living IndexesDoes the CPI give a good measure of inflation and therefore a measure of the cost of living changes?Should the CPI be used to measure how much cost of living has increased, determining increases in government payment programs?

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Cost-of-Living IndexesThe ideal cost of living index represents the cost of attaining a given level of utility at current prices relative to the cost of attaining the same utility at base prices

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Cost-of-Living IndexesTo obtain the ideal cost of living index would require too much information, such as consumer preferences as well as prices and expendituresActual price indexes are based on consumer purchases, not preferences

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Cost-of-Living IndexesLaspeyres price indexAmount of money at current year prices that an individual requires to purchase a bundle of goods/services chosen in a base year divided by the cost of purchasing the same bundle at base-year pricesEx: CPI

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Cost-of-Living IndexesThe Laspeyres price index assumes that consumers do not alter their consumption patterns as prices changeTends to overstate the true cost of living indexUsing the CPI to adjust retirement benefits will tend to overcompensate most recipients, requiring greater government expenditure

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Cost-of-Living IndexesPaasche indexFocuses on the cost of buying the current years bundleAmount of money at current-year prices that an individual requires to purchase a current bundle of goods/services divided by the cost of purchasing the same bundle in a base year

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Cost-of-Living IndexesComparison of indexesBoth are fixed weight indexesQuantities of various goods and services in each index remain unchangedLaspeyres index keeps quantities at base year levelsPaasche index keeps unchanged quantities at current year levels

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Cost-of-Living IndexesChain-Weighted IndexesCost-of-living index that accounts for changes in quantities of goods and servicesIntroduced to overcome problems that arose when long-term comparisons were made using fixed weight price indexes

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