topic iii consumer behaviour analysis

8/8/2019 Topic III Consumer Behaviour Analysis

1/61

Consumer BehaviourAnalysis

1.Marginal Utility Theory2.Indifference Curve Analysis


2/61

The Consumer Theory

How Consumers Make Choices under

Income Constraints


3/61

Some Questions

What is behind a consumers demand

curve?

How do consumers choose from among

various consumer goods?

What determines the value of a consumer

good?

3


4/61

Utility The value a consumer places on a unit of a good or

service depends on the pleasure or satisfaction he or she

expects to derive form having or consuming it at thepoint of making a consumption (consumer) choice.

In economics the satisfaction or pleasure consumersderive from the consumption of consumer goods is calledutility.

Consumers, however, cannot have every thing they wishto have. Consumers choices are constrained by their

incomes.

Within the limits of their incomes, consumers make theirconsumption choices by evaluating and comparing

consumer goods with regard to their utilities. 4


5/61

Our basic assumptions about a

rational consumer: Consumers are utility maximizers

Consumers prefer more of a good (thing) to less of it.

Facing choices X and Y, a consumer would either prefer X to

Y or Y to X, or would be indifferent between them. Transitivity: If a consumer prefers X to Y and Y to Z, we

conclude he/she prefers X to Z

Diminishing marginal utility: As more and more of good is

consumed by a consumer, ceteris paribus, beyond a certainpoint the utility of each additional unit starts to fall.

5


6/61

How to Measure Utility

Measuring utility in utils (Cardinal): Ramesh derives 10 utils from having one slice of pizza but only 5 utils from

having a burger.

In many introductory microeconomics textbooks this approach to

measuring utility is still considered effective for teaching purposes.

Measuring utility by comparison (Ordinal): Ramesh prefers a burger to a slice of pizza and a slice of pizza to a Cake.

Often consumers are able to be more precise in expressing their preferences.For example, we could say:

Ramesh is willing to trade a burger for four Pizzas but he will give up onlytwo Pizzas for a slice of cake.

6


7/61

Utility and Money Because we use money (rather than goods) in just about all of

our trade transactions, we might as well use it as ourcomparative measure of utility.

(Note: This way of measuring utility is not much different

from measuring utility in utils)

Mr. A could say: I am willing to pay Rs. 40 for a burger, Rs.

20 for a slice of pizza; and Rs. 10 for cake.

Note: Even though Mr. A obviously values a burger more (four

times as much) than a cake, he may still choose to buy acake, even if he has enough money to buy a burger, or a slice

of pizza, for that matter. (We will see why and how shortly.)

7


8/61

Total Utility versus Marginal Utility

Marginal utility is the utility a consumerderives from the last unit of a consumer goodshe or he consumes (during a givenconsumption period), ceteris paribus.

Total utility is the total utility a consumerderives from the consumption of all of theunits of a good or a combination of goods overa given consumption period, ceteris paribus.

Total utility = Sum of marginal utilities

8


9/61

The Law of Diminishing Marginal

Utility

Over a given consumption period, the more of a good a

consumer has, or has consumed, the less marginal

utility an additional unit contributes to his or her overall

satisfaction (total utility).

Alternatively, we could say: over a given consumption

period, as more and more of a good is consumed by a

consumer, beyond a certain point, the marginal utility of

additional units begins to fall.

9


10/61

Total and Marginal Utility for Ice

CreamQ ($) TU ($) MU0 0

1 40 40

2 85 45

3 120 35

4 140 20

5 150 10

6 157 7

7 160 3

8 160 0

9 155 -5

10 145 -10

145

10


11/61

Total Utility

0

50

100

150

200

1 2 3 4 5 6 7 8 9 10 11

($) MU

-20

-10

0

10

20

30

40

50

1 2 3 4 5 6 7 8 9 1 11

Q ($ ) TU ($ ) M U

0 0

1 4 0 4 0

2 8 5 4 5

3 1 2 0 3 5

4 1 4 0 2 0

5 1 5 0 1 0

6 1 5 7 7

7 1 6 0 3

8 1 6 0 0

9 1 5 5 -5

1 0 1 4 5 -1 0

1 4 5

11

H h i d M A b i


12/61

How much ice cream does Mr. A buy in a

month?

Some facts of life: Limited income

Opportunity cost of making a choice:

Buying ice cream leaves Mr. A less money tobuy other things: each Rupee spent on icecream could be spent on burger.

In fact, consumers compare the (expected)utility derived from one additional rupeespent on one good to the utility derived fromone additional rupee spent on another good.

12


13/61

More facts

The prices of burger and ice cream are market-given;the consumer cannot change the price of a good.

Mr. A, like any other rational consumer, wishes tomaximize her utility.

The opportunity cost of one rupee spent on ice cream isthe forgone utility of one rupee that could be on burger.

If the utility of one additional rupee of ice cream isgreater than the utility of the last rupee spent on burger,

Mr. A can increase his total utility by spending onerupee less on burger and one rupee more one ice cream.

13


14/61

burger or cake

If based on their perceived marginal utilities

Mr. A values a burger four times as muchas a cake, but the market price of a burger is

eight times the price of a cake, he will buy

a cake. That is because one rupees worthof cakes would give him more utility that

one rupees worth of burgers. That is:

MUB/P

B> MU

C/P

C

14


15/61

Utility Maximizing Rules A rational consumer would buy an additional unit of a

good as long as the perceived dollar value of the

utility of one additional unit of that good (say, its

marginal rupee utility) is greater than its market price.

The Two-Good Rule

MUX MUY

--------- = ----------

PX PY

15

A Al i A h h


16/61

An Alternative Approach to the

Consumer Theory

Indifference curves

An indifference curve is a line drawn in a two-

dimensional space showing different combinations of

two goods from which the consumer draws the same

amount of utility and therefore he/she is indifferent

about.

Budget lines

A budget line is a line drawn in a two-dimensionalspace representing a certain level of income with which

the consumer can purchase various combinations of

two goods at given prices.16


17/61

Properties of Indifference curves

Indifference curves for two goods are generallynegatively sloped

The slope of an indifference curve reflects the degree ofsubstitutability of two goods for one another

Indifference curves are generally convex, reflecting theprinciple of diminishing returns

Indifference curves never cross

Indifference curves that are farther from the origin

represent higher levels of utility Indifference curves for a good and a bad are

positively sloped

17


18/61

Consumption Possibilities

Consumption choices are limited by incomeand prices.

Abudget line describes the limits to ahouseholds consumption choices.


19/61

Consumption Possibilities

Divisible and Indivisible Goods

Divisible goods can be bought in any

quantity desiredex. Petrol

Indivisible goods cannot be bought in allquantities

ex. Car / A Flat / textbook


20/61

Consumption Cakes (Rs. 6) Softies (Rs. 3)

possibility (per week) (per week)

a 0 10

b 1 8

c 2 6

d 3 4

e 4 2

f 5 0

The Budget LineMr. MBAs Income is Rs.

30


21/61

Affordable

The Budget Line

0 1 2 3 4 5 6 7 8 9 10

2

4

6

8

10

Cakes (per week)

Softies(p

erw

eek)

Unaffordable

Income Rs.30

Cakes Rs.6

Softies Rs.3

a

b

c

d

e

f


22/61

The Budget Equation

The budget equation is based upon:

Expenditure = Income

Rs.3Qs + Rs.6Qc = Rs.30

Qs = 10 2Qc

The quantity of Softies can be found by first settingthe quantity of Cakes.


23/61

The Budget Equation

Real Income is the maximum quantity of a goodthat a household can afford to buy.

Or, it is the value of money income expressed interms of goods

Mr. MBAs Real Income (in terms of Softies) is:

Income/Price of Softies = y/Ps

Rs.30/Rs.3 = 10


24/61

The Budget Equation

Relative Price

A relative price is the price of one good

divided by the price of another good.

Mr. MBAs relative price of a Cake in termsof Softies: Rs.6/Rs.3 = 2 per Cake

In other words, to see one more Cake, Mr.MBA must give up 2 Softies (i.e. opportunitycost)


25/61

Changes in Prices and Income

0 1 2 3 4 5 6 7 8 9 10

Softies(perw

eek)

2

4

6

8

10

Cakes (per week)

a

f

Price of a

Cake is...

Rs.6Rs.12 Rs.3

A Change in Price


26/61

Changes in Prices and Income

0 1 2 3 4 5 6 7 8 9 10

Softies

(perwee

k)

2

4

6

8

10

Cakes (per week)

a

f

A Change in Income

Income

Rs.30

Income

Rs.15

P f d


27/61

Preferences and

Indifference Curves

Between two alternatives A and B, there can bemaximum of three possibilities

1. A is preferred to B2. B is preferred to A

3. Consumer is indifferent between A and B

An indifference curve is a line that showscombinations of goods among which a consumer

is indifferent.


28/61

Preferred

Not

preferred

A Preference Map

0 2 4 6 8 10

Softies

(perwee

k)

2

4

6

8

10

Cakes (per week)

g

c

An indifference curve


29/61

A Preference Map

Apreference map is a series of indifference

curves.

A preference map consists of an infinite

number of indifference curves; each one

slopes downward, and none of themintersects.


30/61

I2

I1

0 2 4 6 8 10

Softies

(perwee

k)

2

4

6

8

10

Cakes (per week)

A Preference Map

g

c

I0

j


31/61

Marginal Rate of Substitution

TheMarginal Rate of Substitution (MRS) is

the rate at which a person will give up one

good in order to get more of another goodand at the same time remain indifferent.


32/61


The MRS is measured by the slope of an

indifference curve.

Steep indifference curves have a high MRS.

Flat indifference curves have a low MRS.


33/61

I1

0 2 4 6 8 10

Softies

(perwee

k)

2

4

6

8

10

Cakes (per week)


c

g

MRS = 2

MRS = 1/2


34/61


Note:

As the consumption of Cakes increases, theMRS decreases.

This is referred to as the diminishingmarginal rate of substitution.


35/61

The Degree of Substitutability

The shape of the indifference curves revealsthe degree of substitutability between twogoods.

Three typical shapes can be considered here

Convex curves (higher/ lower convexity)

Downward sloping Straight lines

Right Angled lines


36/61

0 2 4 6 8 10

Softies

(cans)

2

4

6

8

10

Cakes

Degree of SubstitutabilityOrdinary goods


37/61

0 2 4 6 8 10

Marker

pensatt

helocal

superm

arket

2

4

6

8

10

Degree of SubstitutabilityPerfect substitutes

Marker pens at the campus bookstore


38/61

0 1 2 3 4 5

Leftrun

ningsho

es

1

2

3

4

5

Degree of SubstitutabilityPerfect complements

Right running shoes


39/61

Predicting Consumer Behavior

Individuals maximize their utility given

their income budget line when they:

Are on their their highest attainableindifference curve.

Have a marginal rate of substitution between

the two goods equal to their relative price.


40/61

0 2 4 6 8 10

Softies

(perweek)

2

4

6

8

10

Cakes (per week)

h

The Best Affordable Point

f

1

Best

affordable

point

i

I2

I0I1

c


41/61

Learning Objectives (contd..)

Explain the choices that households make

Predict the effects of price and incomechanges on consumption choices

Predict the effects of wage changes onwork-leisure choices


42/61


What effect will changes in prices and income

have on the best affordable point?


43/61

A Change in Price

Price effect

The effect of a change inpriceon quantity

of a good consumed.

A change in the price of a good will shift

the budget line and will change the best

affordable combination.


44/61

0 2 4 6 8 10

Softies (

perweek)

2

4

6

8

10

Cakes (per week)

Price Effect and Demand Curve

I1

I2

Best affordable

point: Cakes Rs.6

c Best affordablepoint: Cakes Rs.3j

5

5


45/61

Price Effect and Demand Curve

0 2 4 6 8 10

1

2

3

4

5

Cakes (per week)

6

Mr. MBAs demandcurve for Cakes

a

b

Price(R

s.per

Cake)

5


46/61


What effect will changes in Mr. MBAs income

have on the best affordable point?


47/61

A Change in Income

Income effect

The effect of a change in income on

consumption.

A change in income will shift the budget

line and will change the best affordablecombination.


48/61

0 2 4 6 8 10

S

ofties

(perweek

)

2

4

6

8

10

Cakes (per week)

Income

Rs.30

3 I2

I1

Income

Rs.21

j

Income Effect and

Change in Demand

ff d


49/61

0 2 4 6 8 10

Price(Rs

.per

Cake)

1

2

3

4

5

Cakes (per week)

6

D0

b

D1

c

Income Effect and

Change in Demand

S b i i Eff d


50/61

Substitution Effect and

Income Effect

Substitution effect

The effect of a change in price on thequantity bought when the consumer

(hypothetically) remains indifferent

between the original and the new situation.

S b i i Eff d


51/61


Income Effect

Income effect

The change in consumption that results

from a change in the consumers income,

ceteris paribus.

The substitution and income effects can becalculated using the indifference curves and

budget line.

S b i i Eff d


52/61

0 2 4 6 8 10

Softies

(perwe e

k)

2

4

6

8

10

Cakes (per week)

I1

I2

cj

Income Rs.30

Cakes Rs.3

Income Rs.30

Cakes Rs.6

Price Effect

5

5


Income Effect

S b tit ti Eff t d


53/61

0 2 4 6 8 10

Softies(perwe

ek)

2

4

6

8

10

Cakes (per week)

I1

I2

cj

5

5

3

7

k

Income

effect

Substitution

effect

Substitution

effect

Substitution effect and price effect


Income Effect


54/61

Work-Leisure Choices

Households must also make choices on howto allocate their time between labour and

leisure.

More leisure means less income. We buyleisure by foregoing income.

The relationship between leisure andincome is described by the income-time

budget line.


55/61

Work-Leisure Choices

As wage rates increase, people substituteLabour for leisure substitution effect.

However, higher wage rates lead to higherincome which causes people to shift toward

more leisure income effect.


56/61

The Supply of Labour

Leisure (hours per week)

100 168

Income(Rs.pe

rweek

)

0

350

I1

133 138 148

100

450

Rs.5

Rs.10

I0

aZ

I2I1

Rs.15

b

c

Time allocation decision


57/61

The Supply of Labour

LS

Labour (hour per week)

Wagera

te(Rs.perhou

r)

0 20 30 35

5

10

15

a

b

c


58/61

Labour Supply

Real World Applications

Work week declines.

Women in the workforce.

er s o over y


59/61

er s o over yAnalysis

Better approach (ordinal) to measure utility

No controversy of constancy of MU of Money

Explains better how the price effect can be

decomposed

Helps to understand the nature of goods as substitutes/complements


60/61

Limitations of IC Analysis

Not all consumers are capable of equating theMRS with price ratio for equilibrium

Buying in many cases takes place more as

custom/ habit and price changes (particularlysmaller) tend to get ignored.

Indivisibility of commodities prevent precise

price adjustments

For many consumers, lack of time and patience


61/61

The End

topic iii consumer behaviour analysis

Documents