1. Chapter 3 Consumer Behavior

2. Chapter 3: Consumer BehaviorSlide 2 Topics to be Discussed Consumer Preferences Budget Constraints Consumer Choice Revealed Preferences

3. Chapter 3: Consumer BehaviorSlide 3 Topics to be Discussed Marginal Utility and Consumer Choices Cost-of-Living Indexes

4. Chapter 3: Consumer BehaviorSlide 4 Consumer Behavior Two applications that illustrate the importance of the economic theory of consumer behavior are: Apple-Cinnamon Cheerios The Food Stamp Program.

5. Chapter 3: Consumer BehaviorSlide 5 Consumer Behavior General Mills had to determine how high a price to charge for Apple- Cinnamon Cheerios before it went to the market.

6. Chapter 3: Consumer BehaviorSlide 6 Consumer Behavior 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.

7. Chapter 3: Consumer BehaviorSlide 7 Consumer Behavior These two problems require an understanding of the economic theory of consumer behavior.

8. Chapter 3: Consumer BehaviorSlide 8 Consumer Behavior There are three steps involved in the study of consumer behavior. 1) We will study consumer preferences.  To describe how and why people prefer one good to another.

9. Chapter 3: Consumer BehaviorSlide 9 Consumer Behavior There are three steps involved in the study of consumer behavior. 2)Then we will turn to budget constraints.  People have limited incomes.

10. Chapter 3: Consumer BehaviorSlide 10 Consumer Behavior There are three steps involved in the study of consumer behavior. 3) Finally, we will combine consumer preferences and budget constraints to determine consumer choices.  What combination of goods will consumers buy to maximize their satisfaction?

11. Chapter 3: Consumer BehaviorSlide 11 Consumer Preferences 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 Baskets

12. Chapter 3: Consumer BehaviorSlide 12 Consumer Preferences Three Basic Assumptions 1) Preferences are complete. 2) Preferences are transitive. 3) Consumers always prefer more of any good to less. Market Baskets

13. Chapter 3: Consumer BehaviorSlide 13 Consumer Preferences A2030 B1050 D4020 E3040 G1020 H1040 Market BasketUnits of Food Units of Clothing

14. Chapter 3: Consumer BehaviorSlide 14 Consumer Preferences Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person. Indifference Curves

15. Chapter 3: Consumer BehaviorSlide 15 The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A. Consumer Preferences Food (units per week) 10 20 30 40 10203040 Clothing (units per week) 50 G A EH B D

16. Chapter 3: Consumer BehaviorSlide 16 U1U1 Combination B,A, & D yield the same satisfaction E is preferred to U 1 U 1 is preferred to H & G Consumer Preferences Food (units per week) 10 20 30 40 10203040 Clothing (units per week) 50 G D A E H B

17. Chapter 3: Consumer BehaviorSlide 17 Consumer Preferences Indifference Curves Indifference curves slope downward to the right.  If it sloped upward it would violate the assumption that more of any commodity is preferred to less.

18. Chapter 3: Consumer BehaviorSlide 18 Consumer Preferences Indifference Curves Any market basket lying above and to the right of an indifference curve is preferred to any market basket that lies on the indifference curve.

19. Chapter 3: Consumer BehaviorSlide 19 Consumer Preferences 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 Maps

20. Chapter 3: Consumer BehaviorSlide 20 Consumer Preferences Indifference Curves Finally, indifference curves cannot cross.  This would violate the assumption that more is preferred to less.

21. Chapter 3: Consumer BehaviorSlide 21 U2U2 U3U3 Consumer Preferences Food (units per week) Clothing (units per week) U1U1 A B D Market basket A is preferred to B. Market basket B is preferred to D.

22. Chapter 3: Consumer BehaviorSlide 22 U1U1 U2U2 Consumer Preferences Food (units per week) Clothing (units per week) A D B The consumer should be indifferent between A, B and D. However, B contains more of both goods than D. Indifference Curves Cannot Cross

23. Chapter 3: Consumer BehaviorSlide 23 A B D E G -6 1 1 -4 -2 1 1 Observation: The amount of clothing given up for a unit of food decreases from 6 to 1 Consumer Preferences Food (units per week) Clothing (units per week) 23451 2 4 6 8 10 12 14 16 Question: Does this relation hold for giving up food to get clothing?

24. Chapter 3: Consumer BehaviorSlide 24 Consumer Preferences 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 Substitution

25. Chapter 3: Consumer BehaviorSlide 25 Consumer Preferences Food (units per week) Clothing (units per week) 23451 2 4 6 8 10 12 14 16 A B D E G -6 1 1 1 1 -4 -2 MRS = 6 MRS = 2

26. Chapter 3: Consumer BehaviorSlide 26 Consumer Preferences 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. Marginal Rate of Substitution

27. Chapter 3: Consumer BehaviorSlide 27 Consumer Preferences Question What are the first three assumptions? Marginal Rate of Substitution

28. Chapter 3: Consumer BehaviorSlide 28 Consumer Preferences 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 Marginal Rate of Substitution

29. Chapter 3: Consumer BehaviorSlide 29 Consumer Preferences Perfect Substitutes and Perfect Complements Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant. Marginal Rate of Substitution

30. Chapter 3: Consumer BehaviorSlide 30 Consumer Preferences Perfect Substitutes and Perfect Complements Two goods are perfect complements when the indifference curves for the goods are shaped as right angles. Marginal Rate of Substitution

31. Chapter 3: Consumer BehaviorSlide 31 Consumer Preferences Orange Juice (glasses) Apple Juice (glasses) 2341 1 2 3 4 0 Perfect Substitutes Perfect Substitutes

32. Chapter 3: Consumer BehaviorSlide 32 Consumer Preferences Right Shoes Left Shoes 2341 1 2 3 4 0 Perfect Complements Perfect Complements

33. Chapter 3: Consumer BehaviorSlide 33 Consumer Preferences BADS Things for which less is preferred to more Examples Air pollution Asbestos

34. Chapter 3: Consumer BehaviorSlide 34 Consumer Preferences What Do You Think? How can we account for Bads in the analysis of consumer preferences?

35. Chapter 3: Consumer BehaviorSlide 35 Consumer Preferences Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling. Designing New Automobiles (I)

36. Chapter 3: Consumer BehaviorSlide 36 Consumer Preferences An analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars. Designing New Automobiles (I)

37. Chapter 3: Consumer BehaviorSlide 37 Consumer Preferences These consumers are willing to give up considerable styling for additional performance Styling Performance Consumer Preference A: High MRS Consumer Preference A: High MRS

38. Chapter 3: Consumer BehaviorSlide 38 Consumer Preferences These consumers are willing to give up considerable performance for additional styling Styling Performance Consumer Preference B: Low MRS Consumer Preference B: Low MRS

39. Chapter 3: Consumer BehaviorSlide 39 Consumer Preferences What Do You Think? How can we determine the consumers preference? Designing New Automobiles (I)

40. Chapter 3: Consumer BehaviorSlide 40 Consumer Preferences A recent study of automobile demand in the United States shows that over the past two decades most consumers have preferred styling over performance. Designing New Automobiles (I)

41. Chapter 3: Consumer BehaviorSlide 41 Consumer Preferences Growth of Japanese Imports 1970’s and 1980’s  15% of domestic cars underwent a style change each year  This compares to 23% for imports Designing New Automobiles (I)

42. Chapter 3: Consumer BehaviorSlide 42 Consumer Preferences Utility Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket.

43. Chapter 3: Consumer BehaviorSlide 43 Consumer Preferences Utility If 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.

44. Chapter 3: Consumer BehaviorSlide 44 Consumer Preferences 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

45. Chapter 3: Consumer BehaviorSlide 45 Consumer Preferences Food (units per week) 10155 5 10 15 0 Clothing (units per week ) U 1 = 25 U 2 = 50 (Preferred to U 1 ) U 3 = 100 (Preferred to U 2 ) A B C Assume: U = FC Market Basket U = FC C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5) Utility Functions & Indifference Curves

46. Chapter 3: Consumer BehaviorSlide 46 Consumer Preferences Ordinal Versus Cardinal Utility Ordinal 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.

47. Chapter 3: Consumer BehaviorSlide 47 Consumer Preferences Ordinal Versus Cardinal Rankings The actual unit of measurement for utility is not important. Therefore, an ordinal ranking is sufficient to explain how most individual decisions are made.

48. Chapter 3: Consumer BehaviorSlide 48 Budget Constraints Preferences do not explain all of consumer behavior. Budget constraints also limit an individual’s ability to consume in light of the prices they must pay for various goods and services.

49. Chapter 3: Consumer BehaviorSlide 49 Budget Constraints The Budget Line The budget line indicates all combinations of two commodities for which total money spent equals total income.

50. Chapter 3: Consumer BehaviorSlide 50 Budget Constraints The Budget Line Let F equal the amount of food purchased, and C is the amount of clothing. Price of food = P f and price of clothing = P c Then P f F is the amount of money spent on food, and P c C is the amount of money spent on clothing.

51. Chapter 3: Consumer BehaviorSlide 51 Budget Constraints The budget line then can be written:

52. Chapter 3: Consumer BehaviorSlide 52 Budget Constraints A040$80 B2030$80 D4020$80 E6010$80 G800$80 Market BasketFood (F) Clothing (C)Total Spending P f = ($1)P c = ($2)P f F + P c C = I

53. Chapter 3: Consumer BehaviorSlide 53 Budget Line F + 2C = $80 10 20 (I/P C ) = 40 Budget Constraints Food (units per week) 406080 = (I/P F )20 10 20 30 0 A B D E G Clothing (units per week ) Pc = $2 P f = $1 I = $80

54. Chapter 3: Consumer BehaviorSlide 54 Budget Constraints The Budget Line As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other. The slope of the line measures the relative cost of food and clothing. The slope is the negative of the ratio of the prices of the two goods.

55. Chapter 3: Consumer BehaviorSlide 55 Budget Constraints The Budget Line The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent.

56. Chapter 3: Consumer BehaviorSlide 56 Budget Constraints The Budget Line The vertical intercept (I/P C ), illustrates the maximum amount of C that can be purchased with income I. The horizontal intercept (I/P F ), illustrates the maximum amount of F that can be purchased with income I.

57. Chapter 3: Consumer BehaviorSlide 57 Budget Constraints The Effects of Changes in Income and Prices Income Changes  An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant).

58. Chapter 3: Consumer BehaviorSlide 58 Budget Constraints The Effects of Changes in Income and Prices Income Changes  A decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant).

59. Chapter 3: Consumer BehaviorSlide 59 Budget Constraints Food (units per week) Clothing (units per week) 8012016040 20 40 60 80 0 A increase in income shifts the budget line outward (I = $160) L2L2 (I = $80) L1L1 L3L3 (I = $40) A decrease in income shifts the budget line inward

60. Chapter 3: Consumer BehaviorSlide 60 Budget Constraints The Effects of Changes in Income and Prices Price Changes  If the price of one good increases, the budget line shifts inward, pivoting from the other good’s intercept.

61. Chapter 3: Consumer BehaviorSlide 61 Budget Constraints The Effects of Changes in Income and Prices Price Changes  If the price of one good decreases, the budget line shifts outward, pivoting from the other good’s intercept.

62. Chapter 3: Consumer BehaviorSlide 62 Budget Constraints Food (units per week) Clothing (units per week) 8012016040 (P F = 1) L1L1 An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward. L3L3 (P F = 2) (P F = 1/2) L2L2 A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward.

63. Chapter 3: Consumer BehaviorSlide 63 Budget Constraints The Effects of Changes in Income and Prices Price Changes  If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change.

64. Chapter 3: Consumer BehaviorSlide 64 Budget Constraints The Effects of Changes in Income and Prices Price Changes  However, the budget line will shift inward to a point parallel to the original budget line.

65. Chapter 3: Consumer BehaviorSlide 65 Budget Constraints The Effects of Changes in Income and Prices Price Changes  If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change.

66. Chapter 3: Consumer BehaviorSlide 66 Budget Constraints The Effects of Changes in Income and Prices Price Changes  However, the budget line will shift outward to a point parallel to the original budget line.

67. Chapter 3: Consumer BehaviorSlide 67 Consumer Choice Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.

68. Chapter 3: Consumer BehaviorSlide 68 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.

69. Chapter 3: Consumer BehaviorSlide 69 Recall, the slope of an indifference curve is: Consumer Choice Further, the slope of the budget line is:

70. Chapter 3: Consumer BehaviorSlide 70 Consumer Choice Therefore, it can be said that satisfaction is maximized where:

71. Chapter 3: Consumer BehaviorSlide 71 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).

72. Chapter 3: Consumer BehaviorSlide 72 Consumer Choice Food (units per week) Clothing (units per week) 408020 30 40 0 U1U1 B Budget Line Pc = $2 P f = $1 I = $80 Point B does not maximize satisfaction because the MRS (-(-10/10) = 1 is greater than the price ratio (1/2). -10C +10F

73. Chapter 3: Consumer BehaviorSlide 73 Consumer Choice Budget Line U3U3 D Market basket D cannot be attained given the current budget constraint. Pc = $2 P f = $1 I = $80 Food (units per week) Clothing (units per week) 408020 30 40 0

74. Chapter 3: Consumer BehaviorSlide 74 U2U2 Consumer Choice Pc = $2 P f = $1 I = $80 Budget Line A At market basket A the budget line and the indifference curve are tangent and no higher level of satisfaction can be attained. At A: MRS =P f /P c =.5 Food (units per week) Clothing (units per week) 408020 30 40 0

75. Chapter 3: Consumer BehaviorSlide 75 Consumer Choice Consider two groups of consumers, each wishing to spend $10,000 on the styling and performance of cars. Each group has different preferences. Designing New Automobiles (II)

76. Chapter 3: Consumer BehaviorSlide 76 Consumer Choice By finding the point of tangency between a group’s indifference curve and the budget constraint auto companies can design a production and marketing plan. Designing New Automobiles (II)

77. Chapter 3: Consumer BehaviorSlide 77 Designing New Automobiles (II) Styling Performance $10,000 $3,000 These consumers are willing to trade off a considerable amount of styling for some additional performance $7,000

78. Chapter 3: Consumer BehaviorSlide 78 Designing New Automobiles (II) Styling $10,000 $3,000 These consumers are willing to trade off a considerable amount of performance for some additional styling $7,000 Performance

79. Chapter 3: Consumer BehaviorSlide 79 Consumer Choice Choosing between a non-matching and matching grant to fund police expenditures Decision Making & Public Policy

80. Chapter 3: Consumer BehaviorSlide 80 Consumer Choice Non-matching Grant Police Expenditures ($) Private Expenditures ($) O P Q U1U1 A Before Grant Budget line: PQ A: Preference maximizing market basket Expenditure OR: Private OS: Police R S

81. Chapter 3: Consumer BehaviorSlide 81 V T U3U3 U1U1 After Grant Budget line: TV B: Preference maximizing market basket Expenditure OU: Private OZ: Police B U Z R Consumer Choice Non-matching Grant P Police Expenditures ($) Private Expenditures ($) OSQ A

82. Chapter 3: Consumer BehaviorSlide 82 P R U2U2 T U1U1 Consumer Choice Matching Grant Police ($) Private Expenditures ($) OQS R Before Grant Budget line: PQ A: Preference maximizing market basket After Grant C: Preference maximizing market basket Expenditures OW: Private OX: Police C X W A

83. Chapter 3: Consumer BehaviorSlide 83 T U3U3 U1U1 Nonmatching Grant Point B OU: Private expenditure OZ: Police expenditure Matching Grant Point C OW: Private expenditure OX: Police expenditure W X Consumer Choice Matching Grant P Police ($) Private Expenditures ($) OQ A U2U2 C R B U Z

84. Chapter 3: Consumer BehaviorSlide 84 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 P A /P B A Corner Solution

85. Chapter 3: Consumer BehaviorSlide 85 A Corner Solution Ice Cream (cup/month) Frozen Yogurt (cups monthly) B A U2U2 U3U3 U1U1 A corner solution exists at point B.

86. Chapter 3: Consumer BehaviorSlide 86 Consumer Choice A Corner Solution At point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line. This suggests that 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!

87. Chapter 3: Consumer BehaviorSlide 87 Consumer Choice 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:

88. Chapter 3: Consumer BehaviorSlide 88 Consumer Choice 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.

89. Chapter 3: Consumer BehaviorSlide 89 Consumer Choice Suppose Jane Doe’s parents set up a trust fund for her college education. Originally, the money must be used for education. A College Trust Fund

90. Chapter 3: Consumer BehaviorSlide 90 Consumer Choice If part of the money could be used for the purchase of other goods, her consumption preferences change. A College Trust Fund

91. Chapter 3: Consumer BehaviorSlide 91 The trust fund shifts the budget line Consumer Choice P Q Education ($) Other Consumption ($) U2U2 A College Trust Fund A U1U1 A: Consumption before the trust fund B B: Requirement that the trust fund must be spent on education C U3U3 C: If the trust could be spent on other goods

92. Chapter 3: Consumer BehaviorSlide 92 Revealed Preferences If we know the choices a consumer has made, we can determine what her preferences are if we have information about a sufficient number of choices that are made when prices and incomes vary.

93. Chapter 3: Consumer BehaviorSlide 93 D Revealed Preferences-- Two Budget Lines l1l1 l2l2 B A I 1 : Chose A over B A is revealed preferred to B l 2 : Choose B over D B is revealed preferred to D Food (units per month) Clothing (units per month)

94. Chapter 3: Consumer BehaviorSlide 94 B is preferred to all market baskets in the green area Revealed Preferences-- Two Budget Lines l2l2 B l1l1 D A All market baskets in the pink shaded area are preferred to A. Food (units per month) Clothing (units per month)

95. Chapter 3: Consumer BehaviorSlide 95 All market baskets in the pink area preferred to A Food (units per month) Revealed Preferences-- Four Budget Lines Clothing (units per month) l1l1 l2l2 l3l3 l4l4 A: preferred to all market baskets in the green area E B A G I 3 : E revealed preferred to A I 4 : G revealed preferred to A

96. Chapter 3: Consumer BehaviorSlide 96 Amount of Exercise (hours) Revealed Preferences for Recreation Other Recreational Activities ($) 0 255075 20 40 60 80 100 l1l1 C l2l2 U2U2 B The rate changes to $1/hr + $30/wk New budget line I 2 & combination B Reveal preference of B to A U1U1 A Scenario Roberta’s recreation budget = $100/wk Price of exercise = $4/hr/week Exercises 10 hrs/wk at A given U 1 & I 1 Would the Club’s profits increase?

97. Chapter 3: Consumer BehaviorSlide 97 Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good. Marginal Utility and Consumer Choice Marginal Utility

98. Chapter 3: Consumer BehaviorSlide 98 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 Marginal Utility Marginal Utility and Consumer Choice

99. Chapter 3: Consumer BehaviorSlide 99 The principle of diminishing marginal utility states that as more and more of a good is consumed, consuming additional amounts will yield smaller and smaller additions to utility. Diminishing Marginal Utility Marginal Utility and Consumer Choice

100. Chapter 3: Consumer BehaviorSlide 100 Marginal Utility and the Indifference Curve If consumption moves along an indifference curve, the 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

101. Chapter 3: Consumer BehaviorSlide 101 Formally: Marginal Utility and Consumer Choice

102. Chapter 3: Consumer BehaviorSlide 102 Rearranging: Marginal Utility and Consumer Choice

103. Chapter 3: Consumer BehaviorSlide 103 Because: Marginal Utility and Consumer Choice

104. Chapter 3: Consumer BehaviorSlide 104 When consumers maximize satisfaction the: Marginal Utility and Consumer Choice Since the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it follows that:

105. Chapter 3: Consumer BehaviorSlide 105 Which gives the equation for utility maximization: Marginal Utility and Consumer Choice

106. Chapter 3: Consumer BehaviorSlide 106 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 and Consumer Choice

107. Chapter 3: Consumer BehaviorSlide 107 In 1974 and again in 1979, the government imposed price controls on gasoline. This resulted in shortages and gasoline was rationed. Gasoline Rationing Marginal Utility and Consumer Choice

108. Chapter 3: Consumer BehaviorSlide 108 Nonprice rationing is an alternative to market rationing. Under one form everyone has an equal chance to purchase a rationed good. Gasoline is rationed by long lines at the gas pumps. Gasoline Rationing Marginal Utility and Consumer Choice

109. Chapter 3: Consumer BehaviorSlide 109 Rationing hurts some by limiting the amount of gasoline they can buy. This can be seen in the following model. It applies to a woman with an annual income of $20,000. Marginal Utility and Consumer Choice

110. Chapter 3: Consumer BehaviorSlide 110 The horizontal axis shows her annual consumption of gasoline at $1/gallon. The vertical axis shows her remaining income after purchasing gasoline. Marginal Utility and Consumer Choice

111. Chapter 3: Consumer BehaviorSlide 111 B 20,000 A Gasoline (gallons per year) Spending on other goods ($) 20,000 5,000 U1U1 C 15,000 2,000 D With a limit of 2,000 gallons, the consumer moves to a lower indifference curve (lower level of utility). 18,000 U2U2 Marginal Utility and Consumer Choice

112. Chapter 3: Consumer BehaviorSlide 112 Cost-of-Living Indexes The CPI is calculated each year as the ratio of the cost of a typical bundle of consumer goods and services today in comparison to the cost during a base period.

113. Chapter 3: Consumer BehaviorSlide 113 Cost-of-Living Indexes What Do You Think? Does the CPI accurately reflect the cost of living for retirees? Is it appropriate to use the CPI as a cost- of-living index for other government programs, for private union pensions, and for other private wage agreements?

114. Chapter 3: Consumer BehaviorSlide 114 Cost-of-Living Indexes Example Two sisters, Rachel and Sarah, have identical preferences. Sarah began college in 1987 with a $500 discretionary budget. In 1997, Rachel started college and her parents promised her a budget that was equivalent in purchasing power.

115. Chapter 3: Consumer BehaviorSlide 115 Cost-of-Living Indexes Price of books$20/book$100/book Number of books156 Price of food$2.00/lb.$2.20/lb Pounds of food100300 Expenditure$500$1,260 1987 (Sarah) 1997 (Rachel)

116. Chapter 3: Consumer BehaviorSlide 116 Cost-of-Living Indexes Rachel’ Expenditure for Equal Utility $1,260 = 300 lbs. of food x $2.20/lb. + 6 books x $100/book Sarah’ Expenditure $500 = 100 lbs. of food x $2.00/lb. + 15 books x $20/book

117. Chapter 3: Consumer BehaviorSlide 117 Cost-of-Living Indexes The ideal cost-of-living adjustment for Rachel is $760. The ideal cost-of-living index is $1,260/$500 = 2.52 or 252. This implies a 152% increase in the cost of living.

118. Chapter 3: Consumer BehaviorSlide 118 For Rachel to achieve the same level of utility as Sarah, with the higher prices, her budget must be sufficient to allow her to consume the bundle shown by point B. l2l2 B l1l1 U1U1 A Cost-of-Living Indexes Food (lb./quarter) Books (per quarter) 450 25 20 15 10 5 060050100200250300350400550500

119. Chapter 3: Consumer BehaviorSlide 119 Cost-of-Living Indexes The ideal cost of living index represents the cost of attaining a given level of utility at current (1997) prices relative to the cost of attaining the same utility at base (1987) prices.

120. Chapter 3: Consumer BehaviorSlide 120 Cost-of-Living Indexes To do this on an economy-wide basis would entail large amounts of information. Price indexes, like the CPI, use a fixed consumption bundle in the base period. Called a Laspeyres price index

121. Chapter 3: Consumer BehaviorSlide 121 Cost-of-Living Indexes The Laspeyres index tells us: The amount of money at current year prices that an individual requires to purchase the bundle of goods and services that was chosen in the base year divided by the cost of purchasing the same bundle at base year prices. Laspeyres Index

122. Chapter 3: Consumer BehaviorSlide 122 Cost-of-Living Indexes Calculating Rachel’s Laspeyres cost of living index Setting the quantities of goods in 1997 equal to what were bought by her sister, but setting their prices at their 1997 levels result in an expenditure of $1,720 (100 x 2.20 + 15 x $100)

123. Chapter 3: Consumer BehaviorSlide 123 Cost-of-Living Indexes Her cost of living adjustment would now be $1,220. The Laspeyres index is: $1,720/$500 = 344. This overstates the true cost-of-living increase.

124. Chapter 3: Consumer BehaviorSlide 124 l2l2 Using the Laspeyres index results in the budget line shifting up from I 2 to I 3. l3l3 B l1l1 U1U1 A Cost-of-Living Indexes Food (lb./quarter) Books (per quarter) 450 25 20 15 10 5 060050100200250300350400550500

125. Chapter 3: Consumer BehaviorSlide 125 Cost-of-Living Indexes What Do You Think? Does the Laspeyres index always overstate the true cost-of-living index?

126. Chapter 3: Consumer BehaviorSlide 126 Cost-of-Living Indexes Yes! The Laspeyres index assumes that consumers do not alter their consumption patterns as prices change.

127. Chapter 3: Consumer BehaviorSlide 127 Cost-of-Living Indexes Yes! By increasing purchases of those items that have become relatively cheaper, and decreasing purchases of the relatively more expensive items consumers can achieve the same level of utility without having to consume the same bundle of goods.

128. Chapter 3: Consumer BehaviorSlide 128 Cost-of-Living Indexes The Paasche Index Calculates the amount of money at current- year prices that an individual requires to purchase a current bundle of goods and services divided by the cost of purchasing the same bundle in the base year.

129. Chapter 3: Consumer BehaviorSlide 129 Cost-of-Living Indexes Both indexes involve ratios that involve today’s current year prices, P Ft and P Ct. However, the Laspeyres index relies on base year consumption, F b and C b. Whereas, the Paasche index relies on today’s current consumption, F t and C t. Comparing the Two Indexes

130. Chapter 3: Consumer BehaviorSlide 130 Cost-of-Living Indexes Then a comparison of the Laspeyres and Paasche indexes gives the following equations:

131. Chapter 3: Consumer BehaviorSlide 131 Cost-of-Living Indexes Suppose: Two goods: Food (F) and Clothing (C) Comparing the Two Indexes

132. Chapter 3: Consumer BehaviorSlide 132 Cost-of-Living Indexes Let: P Ft & P Ct be current year prices P Fb & P Cb be base year prices F t & C t be current year quantities F b & C b be base year quantities Comparing the Two Indexes

133. Chapter 3: Consumer BehaviorSlide 133 Cost-of-Living Indexes Sarah (1990) Cost of base-year bundle at current prices equals $1,720 (100 lbs x $2.20/lb + 15 books x $100/book) Cost of same bundle at base year prices is $500 (100 lbs x $2.00/lb + 15 books x $20/book) Comparing the Two Indexes

134. Chapter 3: Consumer BehaviorSlide 134 Cost-of-Living Indexes Sarah (1990) Comparing the Two Indexes

135. Chapter 3: Consumer BehaviorSlide 135 Cost-of-Living Indexes Sarah (1990) Cost of buying current year bundle at current year prices is $1,260 (300 lbs x $2.20/lb + 6 books x $100/book) Cost of the same bundle at base year prices is $720 (300 lbs x $2/lb + 6 books x $20/book) Comparing the Two Indexes

136. Chapter 3: Consumer BehaviorSlide 136 Cost-of-Living Indexes Sarah (1990) Comparing the Two Indexes

137. Chapter 3: Consumer BehaviorSlide 137 Cost-of-Living Indexes The Paasche index will understate the cost of living because it assumes that the individual will buy the current year bundle in the base year. The Paasche Index

138. Chapter 3: Consumer BehaviorSlide 138 Cost-of-Living Indexes In 1995, the government adopted the chain-weighted price index to deflate its measure of real GDP. Developed to overcome problems that arose when long-term comparisons of GDP were made using fixed-weight price indexes and prices were rapidly changing.

139. Chapter 3: Consumer BehaviorSlide 139 Cost-of-Living Indexes What Do You Think? What is the impact on the Federal budget of using the CPI (a Laspeyres index) to adjust social security and other programs for changes in the cost of living? The Bias of the CPI

140. Chapter 3: Consumer BehaviorSlide 140 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.

141. Chapter 3: Consumer BehaviorSlide 141 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.

142. Chapter 3: Consumer BehaviorSlide 142 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.

143. Chapter 3: Consumer BehaviorSlide 143 Summary Consumers maximize satisfaction subject to budget constraints. The theory of revealed preference shows how the choices that individuals make when prices and income vary can be used to determine their preferences.

144. End of Chapter 3 Consumer Behavior