Lecture 4Consumer Behavior

Recommended Text: Franks and Bernanke - Chapter 5

Consumption Decision

Consumers choose from a “menu” of items in various combinations Must be affordable, given income and prices of goods

Factors affecting the consumption decision: An individual’s taste & preferences

Microeconomists take people’s taste & preference as given How much money an individual has to spend (budget) Price of the goods in the marketplace

Consumption & Utility

Utility – a measure of the satisfaction derived from consuming a product, good, or service

Since utility is derived from the inherent characteristics or qualities that make a product desirable, utility may be objective or subjective.

Util - a hypothetical numerical measurement of utility (used to represent the satisfaction derived from consuming products).

Total Utility and Marginal Utility

Total Utility (TU) – total satisfaction derived from consumption of a good.

Marginal Utility (MU) – The amount of additional utility derived from the consumption of an additional unit of a good when the quantity of consumption of all other goods are held constant MU = ΔTU / ΔQ = ∂TU/∂Q MU is the utility provided by the last unit of the good

consumed

Example

Consumption Total Utility(doughnuts)

0 01 242 443 604 695 736 737 68

Total Utility Curve

0

10

20

30

40

50

60

70

80

0 1 2 3 4 5 6 7 8

DoughnutsTo

tal U

tility

Example (Cont.)

Consumption Total Marginal (doughnuts) Utility Utility

0 0> 24

1 24> 20

2 44> 16

3 60> 9

4 69> 4

5 73> 0

6 73> -5

7 68

Marginal Utility Curve

-10

-5

0

5

10

15

20

25

30

0 1 2 3 4 5 6 7 8

Doughnuts

Mar

gina

l Util

ity

Law of Diminishing Marginal Utility

As additional units of a good are consumed a point is always reached where the utility derived from each additional unit declines.

Example (Cont.)

Consumption Total Marginal (doughnuts) Utility Utility

0 0> 24

1 24> 18

2 42> 10

3 52> 4

4 56> 0

5 56> -1

6 55> -10

7 45

Indifference Curves Indifference Curve (IC) - a line showing all combinations of two

goods (products) that provide the same level of utility i.e., the consumeris indifferentbetween them

As we move along theIC, the utility levelremains the same butquantities of goods consumedchange as one good replaces(or substitutes) for the other.

IC

Qy

QxX1 X2

Y2

Y1

Characteristics of Indifference Curves The closer to the origin, the

lower the level of utility and vice versa.

Each IC represents a unique utility level - - Hence, ICs never intersect

ICs are negatively sloped and convex. The downward slope of the IC indicates that if the consumer consumes less of one good, she would consume more of the other (for utility to remain constant).

The whole set of IC is called an indifference map.

IC1

Qy

Qx

IC2

Indifference Curves Marginal rate of substitution (MRS) – The number of units of one

good that must be given up to receive an extra unit of another good, holding the level of satisfaction constant.

MRSXY = Y / X

MRS is the slope of the

indifference curve.IC

Qy

Qx

Y1

Y2

X1 X2

Y

X

Marginal Rate of Substitution

157

205-0.40

-0.751110

-1.33814

-2.50619

-6525

MRSXY= Y/X XY Y X

-6 1

-5 2

-4

-3

-2

3

4

5

Diminishing Marginal Rate of Substitution

More the consumer has of a particular good, say X, the less of another good, say Y, he would be willing to give up to obtain an additional unit of X.

That is, MRS of X for Ygets smaller as theconsumer has more of Xand less of Y.

This is applicable onlyif Y and X areimperfect substitutes.

IC

Y

X

Budget Constraint

Budget Constraint – price & availability of goods in the market, along with the size of the budget, place a constraint on consumption.

Budget and budgetconstraint arerepresented bythe budget line.

X

Y

Budget Line

Budget Line – a line indicating all combinations of two goods that can be purchased using all of the consumer’s budget, i.e., I = X Px + Y Py

Assume I = 30, PX = 1, & PY = 2

3015030912306183032430030

Total ExpenditureYX

Budget Line

Every combination of goods along the budget line can be purchased for the same total expenditure. The distance from

the origin is an indicationof the size of the budget.

The closer to the origin,the lower the budgetand vice versa.

Only purchases on thebudget line use all of theconsumer’s budget.

X

Y

Budget Line

I = X Px + Y Py

OR

Y = I/Py – (Px / Py) X

Where, I/Py is the

Y-intercept, I/PX is

the X-intercept and - (Px / Py) is the slope

X

Y

I/PY

I/PX

Slope = - (Px / Py)

Changes in Budget

A budget increase (decrease) will result in a parallel shift of the budget line to the right (left)

If the price of one good changes, slope of budget line changes

X

Y

X

Y

Review of Budget Line andIndifference Curve

Budget Line: a line indicating allcombinations of two goods that can bepurchased using all of the consumer’sbudget.

Only purchases on the budget line useall of the consumer’s budget.

Indifference Curve (IC): a line showingall combinations of two goods (products)that provide the same level of utility.

ICs that are higher in graphsrepresent greater level of satisfaction.

X

Y

IC1

IC2

IC3

X

Y

Consumer Choice Problem

The basic problem a consumer faces is how to allocate the budget among various goods to maximize utility (satisfaction).

That is, the consumer’s objective is to select from all combinations of goods within her means (i.e., combinations on his budget line) the one that gives him the maximum utility (i.e., the one that lies on the highest indifference curve.)

Utility Maximization Decision

V

W

X

Y

S

UT

IC1

IC2

IC3

Utility Maximization Decision

V

WX

Y

S

UT

IC1

IC2

IC3

It is then clear that from all the market baskets that are within the consumer’s reach, market basket “V” would give the consumer the maximum utility.

Note that the market basket V is at a point where the budget line is tangent to IC2.

Thus, the slope of the budget line should be equal to the slope of the indifference curve.

Utility Maximization Decision

Slope of the budget line = PX / PY

Slope of the indifference curve= MRSXY = Y / X

Thus at the point of tangency:MRS = Y / X = PX / PY

Thus, the consumer maximizes his utility where MRS is equal to the ratio of prices.

If the consumer’s income and the price of good Y remains the same, a change in the price of X causes the consumer’s budget line to pivot around its Y-intercept A rise in the price of X causes the budget line to pivot

inward A fall in the price of X causes the budget line to pivot

outward

Impact of Changes in Product Prices

Impact of Changes in Product Prices:Non-Giffen Goods

IF PX increases- X becomes relatively more expensive than Y The (absolute) slope of the budget

line increases and the budgetline rotates inward

The consumer can no longerafford to remain on originalindifference curve and mustmove to a lower indifferencecurve

The new equilibrium will be at S.

V

WX

Y

S

IC2

IC1

Impact of Changes in Product Prices

IF PX decreases- X becomes cheaper relative to Y

The slope of the budget linedecreases and the budget linerotates outward

The consumer can afford tomove to a higher indifferencecurve

The new equilibrium will be at S

V

X

Y

IC1

S

IC2

Price Consumption Curve (PCC)

The PCC connects points representing equilibrium market baskets corresponding to all possible levels of the price of good X, while price of Y and income remain the same.

b

X

Y

IC2

c

IC3

aPCC

IC1

Deriving a Demand Curve

An individual’s demand curve for a particular good is derived from the individual’s budget (budget line) & taste & preferences (indifference curve) or the PCC.

The law of demand states that, ceteris paribus, the quantity of a product demanded will vary inversely to the price of that product.

V

X

Y

IC2

W

IC3

S

IC1

X1 X2 X3

Y3

Y2

Y1

X

Price

of X

X1 X2 X3

P1

P2

P3

Demand Curve for X

PCC

Deriving a Demand Curve Demand Curve – a line

connecting all combinations of price and quantities consumed

Each point on a demand curve gives the price and quantity combination of a good that a consumer will buy, given his or her budget constraint and the prices of other goods.

Each point on the demand curve gives a quantity of the good that a consumer will buy to maximize utility.

XPr

ice o

f XX1 X2 X3

P1

P2

P3

Demand Curve for X

Non-Giffen and Giffen Goods

Non-Giffen Good - A good that follows the law of demand, so that when price goes up, the quantity demanded goes down

Giffen Good - A good that violates the law of demand, so that when price goes up, the quantity demanded goes up

Giffen goods are rare or nonexistent Using the theory of indifference curves indicates

exception to the law of demand

Non-Giffen Goods and Giffen Goods

Impact of Changes in Income

A change in income results in a parallel shift of the budget line (slope stays unaffected as long as the prices remain constant) An increase in income shifts the budget line to the right

(outward) A decrease in income shifts the budget line to the left

(inward) Normal Good – a good that you consume more (less)

as your income rises (falls) Inferior good – a good that you consume less (more)

as your income rises (falls)

Normal and Inferior Goods

Changes in Income and Changes in the Optimum Point

Assume that both goods X and Y are normal goods – the consumer consumes more of X and Y as her income rises With rising income, the

consumer’s utility maximizing market baskets change from “u” to “v” to “w.”

If we connect all of the points representing utility maximizing market baskets (u, v, and w) corresponding to all possible levels of income, the resulting curve is called the Income Consumption Curve.

W

X

Y

IC3

IC2IC1

ICC

U V

w

Deriving an Engel Curve

The ICC can be used to derive an Engel Curve, which are important for studies of family expenditure patterns.

For fixed prices, the Engel Curve describes the relationship between a consumer’s income and his expenditure on a specific good.

X

Y

IC3

IC2IC1

ICC

U V

w

X

I

X1 X2 X3

I3

I2

I1

Engel Curve

Deriving an Engel Curve Engel Curve – a line connecting all

combinations of income and quantities consumed

Each point on an Engel curve gives the income and quantity combination of a good that a consumer will buy, given the prices of all goods.

As the income increases (decreases), the quantity demanded of that product increases (decreases). This is true only for normal goods.

The shape of the Engel curve for a particular good will depend on the nature of the good, the nature of the consumer’s taste, and the level at which the commodity prices are held constant.

X

I

X1 X3

I3

I2

I1

Engel Curve

X2