Lecture 3: Consumer BehaviorSlide 1 Topics to be Discussed Consumer Preferences Budget Constraints...

Lecture 3: Consumer Behavior Slide 1

Topics to be Discussed

Consumer Preferences

Budget Constraints

Consumer Choice


Consumer Behavior

Example 1: General Mills had to determine how high a price to charge for Apple-Cinnamon Cheerios before it went to the market.

Example 2: When the food stamp program was established in the early 1960s, the designers had to determine to what extent the food stamps would provide people with more food and not just simply subsidize the food they would have bought anyway.


Consumer Behavior

Three steps involved in the study of consumer behavior.

1) Consumer preferences: how and why people prefer one good to another.

2) Budget constraints: people have limited incomes.

3) Combine the two to determine consumer choices.



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

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

Market BasketsMarket Baskets



Three Basic Assumptions

1) Preferences are complete.

2) Preferences are transitive.

3) Consumers always prefer more of any good to less.

Market BasketsMarket 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



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

Indifference CurvesIndifference Curves


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

box are preferred to A.


Food(units per week)

10

20

30

40

10 20 30 40

Clothing(units per week)

50

G

A

EH

B

D


U1

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

•U1 is preferred to H & G



10

20

30

40

10 20 30 40


50

G

D

A

EH

B



Indifference CurvesIndifference curves slope downward to the

right.If it sloped upward it would violate the assumption that more of any commodity is preferred to less.

Indifference curves cannot cross.This would violate the assumption that more is preferred to less.



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

the market baskets among which the person is indifferent.

Indifference MapsIndifference Maps


U2

U3




U1

AB

D

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


U1U2




A

D

B

The consumer shouldbe indifferent betweenA, B and D. However,B contains more ofboth goods than D.

Indifference CurvesCannot Cross


A

B

D

EG-1

-6

1

1

-4

-21

1

Observation: The amountof clothing given up for a unit of food decreasesfrom 6 to 1



Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16



The marginal rate of substitution (MRS) 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.

Marginal Rate of SubstitutionMarginal Rate of Substitution




Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16 A

B

D

EG

-6

1

1

11

-4

-2-1

MRS = 6

MRS = 2

FCMRS



We will now add a fourth assumption regarding consumer preference:

Along an indifference curve there is a diminishing marginal rate of substitution.

Note the MRS for AB was 6, while that for DE was 2.




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 prefer a balanced market basket




Perfect Substitutes and Perfect ComplementsTwo goods are perfect substitutes when

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




Perfect Substitutes and Perfect ComplementsTwo goods are perfect complements when

the indifference curves for the goods are shaped as right angles.




Orange Juice(glasses)

Apple Juice

(glasses)

2 3 41

1

2

3

4

0

PerfectSubstitutes

PerfectSubstitutes



Right Shoes

LeftShoes

2 3 41

1

2

3

4

0

PerfectComplements

PerfectComplements



UtilityUtility: Numerical score representing the

satisfaction that a consumer gets from a given market basket.



Utility Functions

Assume:The utility function for food (F) and clothing (C)

U(F,C) = F + 2C

Market Baskets: F units C units U(F,C) = F + 2C A 8 3 8 + 2(3)

= 14 B 6 4 6 + 2(4) = 14 C 4 4 4 + 2(4) = 12 The consumer is indifferent to A & B

The consumer prefers A & B to C



Food(units per week)10 155

5

10

15

0

Clothing(units

per week)

U1 = 25

U2 = 50 (Preferred to U1)

U3 = 100 (Preferred to U2)A

B

C

Assume: U = FCMarket Basket U = FC

C 25 = 2.5(10)A 25 = 5(5)B 25 = 10(2.5)

Utility Functions & Indifference CurvesUtility Functions & Indifference Curves



Ordinal Versus Cardinal UtilityOrdinal 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.


Budget Constraints

Preferences do not explain all of consumer behavior.

Budget constraints limit an individual’s ability to consume in light of the prices they must pay.

The budget line indicates all combinations of commodities for which total money spent equals total income.


Budget Constraints

The Budget LineLet 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.


Budget Constraints

The budget line then can be written:

ICPFP CF


Budget Line F + 2C = $80

CF/PPFC - 2

1- / Slope

10

20

(I/PC) = 40

Budget Constraints

Food(units per week)40 60 80 = (I/PF)20

10

20

30

0

A

B

D

E

G

Clothing(units

per week)

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


Budget Constraints

The slope is the negative of the ratio of the prices: it indicates the rate at which the two goods can be substituted without changing the amount of money spent.

The vertical intercept (I/PC), illustrates the maximum amount of C that can be purchased with income I.


Budget Constraints

The Effects of Changes in Income and PricesIncome Changes

An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant).


Budget Constraints

The Effects of Changes in Income and PricesIncome Changes. A decrease in income causes

the budget line to shift inward, parallel to the original line (holding prices constant).

Price Changes. If the price of one good increases, the budget line shifts inward, pivoting from the other good’s intercept.


Budget Constraints


Clothing(units

per week)

80 120 16040

20

40

60

80

0

A increase inincome shifts

the budget lineoutward

(I = $160)L2

(I = $80)

L1

L3

(I =$40)

A decrease inincome shifts

the budget lineinward


Budget Constraints


Clothing(units

per week)

80 120 16040

40

(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.


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 market basket must satisfy two conditions:

1) It must be located on the budget line.

2) Must give the consumer the most preferred combination of

goods and services.


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:

C

F

P

PMRS


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 theMRS (-(-10/10) = 1 is greater than the

price ratio (1/2).

-10C

+10F


Consumer Choice

Budget Line

U3

D Market basket D cannot be attainedgiven the current

budget constraint.

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


Clothing(units per

week)

40 8020

20

30

40

0


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


Clothing(units per

week)

40 8020

20

30

40

0


Consumer Choice

A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another. This exists where the indifference curves

are tangent to the horizontal and vertical axis.

MRS is not equal to PA/PB

A Corner SolutionA Corner Solution


A Corner Solution

Ice Cream (cup/month)

FrozenYogurt

(cupsmonthly)

B

A

U2 U3U1

A corner solutionexists at point B.


Consumer Choice

A Corner SolutionWhen a corner solution arises, the

consumer’s MRS does not necessarily equal the price ratio.

In this instance it can be said that:

YogurtFrozenIceCream PPMRS /


When consumers maximize satisfaction the:

CF/P PMRS

CFC F /P P /MUMU

Marginal Utility andConsumer Choice

Since the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it follows that:


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.

Marginal Utility andConsumer Choice


Summary

People behave rationally in an attempt to maximize satisfaction from a particular combination of goods and services.

Consumer choice has two related parts: the consumer’s preferences and the budget line.


Summary

Consumers make choices by comparing market baskets or bundles of commodities.

Indifference curves are downward sloping and cannot intersect one another.

Consumer preferences can be completely described by an indifference map.


Summary

The marginal rate of substitution of F for C is the maximum amount of C that a person is willing to give up to obtain one additional unit of F.

Budget lines represent all combinations of goods for which consumers expend all their income.

Consumers maximize satisfaction subject to budget constraints.

Lecture 3: Consumer BehaviorSlide 1 Topics to be Discussed Consumer Preferences Budget Constraints...

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Transcript of Lecture 3: Consumer BehaviorSlide 1 Topics to be Discussed Consumer Preferences Budget Constraints...