CHAPTER 3 OUTLINE... · 3.1 CONSUMER PREFERENCES Figure 3.2 Indifference Curves: Consumer...

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1 of 37Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e.

CHAPTER 3 OUTLINE

3.1 Consumer Preferences

3.2 Budget Constraints

3.3 Consumer Choice

3.4 Revealed Preference

3.5 Marginal Utility and Consumer Choice

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Consumer Behavior

● theory of consumer behavior Description of how

consumers allocate incomes among different goods and

services to maximize their well-being.

Consumer behavior is best understood in three distinct steps:

1. Consumer preferences: how and why people prefer one goof to

another

2. Budget constraints: people have limited incomes

3. Consumer choices: what combination of goods consumers buy

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Chapter 3 3©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

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CONSUMER PREFERENCES3.1

Market Baskets

● market basket (or bundle) List with specific quantities

of one or more goods.

TABLE 3.1 Alternative Market Baskets

A 20 30

B 10 50

D 40 20

E 30 40

G 10 20

H 10 40

Market Basket Units of Food Units of Clothing

To explain the theory of consumer behavior, we will ask

whether consumers prefer one market basket to another.

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Some Basic Assumptions about Preferences

1. Completeness: Preferences are assumed to be complete.

In other words, consumers can compare and rank all possible

baskets. Thus, for any two market baskets A and B, a consumer

will prefer A to B, will prefer B to A, or will be indifferent between

the two.

By indifferent we mean that a person will be equally satisfied

with either basket.

Note that these preferences ignore costs. A consumer might

prefer steak to hamburger but buy hamburger because it is

cheaper.

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Some Basic Assumptions about Preferences

2. Transitivity:

if a consumer prefers basket A to basket B and basket B to

basket C, then the consumer also prefers A to C.

Transitivity is normally regarded as necessary for consumer

consistency.

3. More is better than less: Goods are assumed to be

desirable—i.e., to be good.

Consequently, consumers always prefer more of any good to

less. In addition, consumers are never satisfied or satiated;

more is always better, even if just a little better.

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Describing Individual Preferences

Because more of each good is

preferred to less, we can

compare market baskets in the

shaded areas. Basket A is clearly

preferred to basket G, while E is

clearly preferred to A.

However, A cannot be compared

with B, D, or H without additional

information.


Figure 3.1

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The indifference curve U1 that

passes through market basket

A shows all baskets that give

the consumer the same level of

satisfaction as does market

basket A; these include

baskets B and D.

An Indifference Curve


Figure 3.2

Indifference Curves: Consumer preferences represented graphically

● indifference curve Curve representing all combinations of market

baskets that provide a consumer with the same level of satisfaction.

Our consumer prefers basket

E, which lies above U1, to A,

but prefers A to H or G, which

lie below U1.

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An indifference map is a set of

indifference curves that

describes a person's

preferences.

An Indifference Map


Figure 3.3

Indifference Maps

● indifference map Graph containing a set of indifference curves

showing the market baskets among which a consumer is indifferent.

Any market basket on

indifference curve U3, such as

basket A, is preferred to any

basket on curve U2 (e.g.,

basket B), which in turn is

preferred to any basket on U1,

such as D.

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If indifference curves U1 and U2

intersect, one of the

assumptions of consumer

theory is violated.

Indifference Curves Cannot Intersect


Figure 3.4

Indifference Maps

According to this diagram, the

consumer should be indifferent

among market baskets A, B,

and D. Yet B should be

preferred to D because B has

more of both goods.

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If they sloped upward, they would

violate the assumption that more is

preferred to less

Some points that had more of

both goods would be

indifferent to a basket with less

of both goods

Indifference Curves Slope Downward


Indifference Curves

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The shapes of indifference curves

describe 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


Indifference Curves

A

B

D

EG

-1

-6

1

1

-4

-2

1

1

Food

Clothing

2 3 4 51

2

4

6

8

10

12

14

16

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The slope of an indifference curve

measures the consumer’s marginal

rate of substitution (MRS) between two

goods.

The Marginal Rate of Substitution


Figure 3.5

The Marginal Rate of Substitution

In this figure, the MRS between clothing

(C) and food (F) falls from 6 (between A

and B) to 4 (between B and D) to 2

(between D and E) to 1 (between E and

G).

Convexity The decline in the MRS

reflects a diminishing marginal rate of

substitution. When the MRS

diminishes along an indifference curve,

the curve is convex.

● marginal rate of substitution (MRS) the amount of a good that a

consumer is willing to give up in order to obtain one additional unit of

another good.

FCMRS

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Perfect Substitutes and Perfect Complements

●perfect substitutes Two goods for which

the marginal rate of substitution of one for the

other is a 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

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In (a), Bob views orange juice and

apple juice as perfect substitutes:

He is always indifferent between a

glass of one and a glass of the

other.



Figure 3.6


In (b), Jane views left shoes and

right shoes as perfect complements:

An additional left shoe gives her no

extra satisfaction unless she also

obtains the matching right shoe.

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● perfect complements Two goods for which the MRS is

zero or infinite; the indifference curves are shaped as right

angles.

Example: If you have 1 left shoe and 1 right shoe, you are

indifferent between having more left shoes only

Must have one right for one left

Good for which less is preferred rather than more.

Bads

How do we account for bads in our preference analysis?

We redefine the commodity

• Clean air

• Pollution reduction

• Asbestos removal

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Preferences for automobile attributes can be described by

indifference curves. Each curve shows the combination of

acceleration and interior space that give the same satisfaction.

Preferences for Automobile Attributes


Owners of Ford Mustang coupes (a) are

willing to give up considerable interior

space for additional acceleration.

Figure 3.7

The opposite is true for owners of

Ford Explorers (b). They prefer

interior space to acceleration.

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Consumer Preferences: An Application

• In designing new cars, automobile executives

must determine how much time and money to

invest in restyling versus increased performance

- Higher demand for car with better styling and performance

- Both cost more to improve

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• An analysis of consumer preferences would help to

determine where to spend more on change: performance

or styling

• Some consumers will prefer better styling and some will

prefer better performance

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Consumer Preferences:

An Application

These consumers

place a greater

value on

performance

than styling

Styling

Performance

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Consumer Preferences:

An Application

These consumers

place a greater

value on styling than

performance

Styling

Performance

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• Knowing which group dominates the market will help

decide where redesigning dollars should go

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A utility function can be

represented by a set of

indifference curves, each

with a numerical

indicator.

This figure shows three

indifference curves (with

utility levels of 25, 50,

and 100, respectively)

associated with the utility

function FC.

Utility and Utility Functions

● utility Numerical score representing the satisfaction from a given

market basket.

● utility function Formula that assigns a level of utility to individual

market baskets.

Utility Functions and Indifference Curves

Figure 3.8

Basket U = FC

C 25 = 2.5(10)

A 25 = 5(5)

B 25 = 10(2.5)

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Utility – Example

U(F,C) = F + 2C

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

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Ordinal versus Cardinal Utility

● ordinal utility function Utility function that generates a

ranking of market baskets in order of most to least

preferred.

● cardinal utility function Utility function describing

by how much one market basket is preferred to

another.

●ordinal ranking is sufficient to explain how

most individuals decisions are made!

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Clothing (C)

BUDGET CONSTRAINTS3.2

Example: Assume income of $80/week, PF = $1 and PC = $2

The Budget Line

● budget constraints Constraints that consumers face

as a result of limited incomes.

● budget line All combinations of 2 goods for which total

money spent equals to income.

TABLE 3.2 Market Baskets and the Budget Line

A 0 40 $80

B 20 30 $80

D 40 20 $80

E 60 10 $80

G 80 0 $80

Market Basket Food (F) Total Spending

F CP F P C I (3.1)

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A budget line describes the

combinations of goods that can be

purchased given the consumer’s

income and the prices of the goods.

Line AG (which passes through

points B, D, and E) shows the

budget associated with an income

of $80, a price of food of PF = $1 per

unit, and a price of clothing of PC =

$2 per unit.

The slope of the budget line

(measured between points B and D)

is −PF/PC = −10/20 = −1/2.

The Budget Line

A Budget Line

Figure 3.10

( / ) ( / )C F CC I P P P F (3.2)

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Income Changes A change in

income (with prices unchanged)

causes the budget line to shift

parallel to the original line (L1).

When the income of $80 (on L1) is

increased to $160, the budget line

shifts outward to L2.

If the income falls to $40, the line

shifts inward to L3.

The Effects of Changes in Income and Prices

Effects of a Change in Income on the

Budget Line

Figure 3.11

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Price Changes A change in the

price of one good (with income

unchanged) causes the budget line

to rotate about one intercept.

When the price of food falls from

$1.00 to $0.50, the budget line

rotates outward from L1 to L2.

However, when the price increases

from $1.00 to $2.00, the line rotates

inward from L1 to L3.

The Effects of Changes in Income and Prices

Effects of a Change in Price on the

Budget Line

Figure 3.12

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


Consumer Choice

• The maximizing market basket must

satisfy two conditions:

1. It must be located on the budget line

– They spend all their income – more is better

2. It must give the consumer the most

preferred combination of goods and

services


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


Consumer Choice

Chapter 3

U3

D

C

Food (units per week)40 8020

Clothing

(units per

week)

20

30

40

0

U1

A

B

•A, B, C on budget line

•D highest utility but not

affordable

•C highest affordable

utility

•Consumer chooses C

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 34

Consumer Choice

• Recall, the slope of an indifference curve

is:

Chapter 3 35

F

CMRS

C

F

P

PSlope

Further, the slope of the budget line is:

Consumer Choice

• Therefore, it can be said at consumer’s

optimal consumption point,

Chapter 3 36

C

F

P

PMRS

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 37

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

– 1 unit food = ½ unit clothing

– PF/PC

Chapter 3 38

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 39

Consumer Choice

Chapter 340

Food (units per week)

Clothing

(units per

week)

40 8020

20

30

40

0

Point B does not

maximize satisfaction

because the

MRS = -10/10 = 1

is greater than the

price ratio = 1/2

+10F U1

-10C

B

Consumer Choice: An Application Revisited• Consider two groups of consumers, each

wishing to spend $10,000 on the styling

and performance of a car

• Each group has different preferences

Chapter 3 41

Consumer Choice: An Application Revisited• By finding the point of tangency between a

group’s indifference curve and the budget

constraint, auto companies can see how

much consumers value each attribute


Consumer Choice: An Application Revisited

Chapter 3

Styling

Performance$10,000

$10,000 These consumers

want performance

worth $7000 and styling

worth $3000

$3,000

$7,000

Consumer Choice: An Application Revisited


These consumers

want styling worth

$7000 and

performance worth

$3000

$3,000

$7,000

Styling

$10,000

$10,000

Performance

Consumer Choice: An Application Revisited• Once a company knows preferences, it

can design a production and marketing

plan

• Company can then make a sensible

strategic business decision on how to

allocate performance and styling on new

cars


Consumer Choice

• A 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


A Corner Solution

Chapter 3Ice Cream (cup/month)

Frozen

Yogurt

(cups

monthly)

B

A

U2 U3U1

A corner solution

exists at point B.

A Corner Solution

• At point B, the MRS of ice cream for frozen yogurt is

greater than the slope of the budget line

• If the consumer could give up more frozen yogurt for

ice cream, he would do so

• However, there is no more frozen yogurt to give up

• Opposite is true if corner solution was at point A

Chapter 3 48

A Corner Solution

• When a corner solution arises, the

consumer’s MRS does not necessarily

equal the price ratio

• In this instance it can be said that:


YogurtFrozen

IceCream

P

PMRS

A Corner Solution

• If 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 consumer’s market basket


A Corner Solution - Example

• Suppose Jane Doe’s parents set up a trust

fund for her college education

• The money must be used only for

education

• Although a welcome gift, an unrestricted

gift might be better



• Original budget line, PQ, with a market basket, A, of education and other goods

• Trust fund shifts out the budget line as long as trust fund, PB, is spent on education

• Jane increases satisfaction, moving to higher indifference curve, U2



Chapter 3©2005 Pearson Education, Inc.

P

Q Education ($)

Other

Consumption

($)

U2A

U1

B

•Jane better off

on U2

•B is corner

solution

•MRS ≠ PE/POG


Chapter 3 54

P

Q Education ($)

Other

Consumption

($)

U2A

U1

B

•If gift is

unrestricted, Jane

can be at point C

on U3

•Better off than

with restricted gift

Revealed Preferences

• If 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.


Revealed Preferences –Two Budget Lines


l1

l2

B

A

•I1: Choose A over B•A is revealed

preferred to B

•l2: Choose B over D

•B is revealed

preferred to D

Food (units per month)

Clothing

(units per

month)

D

Revealed Preferences –Two Budget Lines

Chapter 3 57

l1

l2

B

A

Food (units per month)

Clothing

(units per

month)

D

All market baskets

in the pink

shaded area are

preferred to A.

B is

preferred to

all market

baskets

in the yellow

area

Revealed Preference

• As you continue to change the budget line,

individuals can tell you which basket they

prefer to others

• The more the individual reveals, the more

you can discern about their preferences

• Eventually you can map out an

indifference curve


Marginal Utility and Consumer Choice• Marginal utility measures the additional

satisfaction obtained from consuming one

additional unit of a good

– How much happier is the individual from

consuming one more unit of food?


Marginal Utility - Example

• The marginal utility derived from increasing from 0 to 1 units of food might be 9

• Increasing from 1 to 2 might be 7

• Increasing from 2 to 3 might be 5

• Observation: Marginal utility is diminishing as consumption increases


Marginal Utility

• The principle of diminishing marginal utility

states that as more of a good is

consumed, the additional utility the

consumer gains will be smaller and

smaller

• Note that total utility will continue to

increase since consumer makes choices

that make them happier


Marginal Utility and Indifference Curves• As 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)


Marginal Utility and Consumer Choice• MU of any good is the rate at which total U

changes as the consumption rises, holding

constant the levels of consumption of all

other goods.

• MU of food measures how the level of

satisfaction changes (ΔU) in response to

change in the consumption of food (ΔF)

holding consumption of clothing constant.

Chapter 3 63 FUMUF /

Marginal Utility and Consumer Choice• Similarly, MU of food measures how the level of

satisfaction changes (ΔU) in response to change in the

consumption of Clothing (ΔC) holding consumption of

Food constant.

• Since all points on IC generate same level of U, the gain

in utility from an increase in Food consumption must

exactly equal to loss in utility from a decrease in

consumption if clothing.

Chapter 3 64

CUMUC /

Marginal Utility and Consumer Choice• Rearranging:


CF

CF

CF

/MU MUMRS

MRSFC

Since

MUMUFC

CMUFMU

saycan We

Cfor F of /

//

**

Marginal Utility and Consumer Choice• When consumers maximize satisfaction:


CF /P PMRS

CF CF /P P /MUMU

Since the MRS is also equal to the ratio of the

marginal utility of consuming F and C

Marginal Utility and Consumer Choice• Rearranging, gives the equation for utility

maximization:


CCFF PMUPMU //

Marginal Utility and Consumer Choice• Total 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.


CHAPTER 3 OUTLINE... · 3.1 CONSUMER PREFERENCES Figure 3.2 Indifference Curves: Consumer...

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