Chapter 5 Theory of Consumer Behavior

Learning Objectives Explain the concept of utility and basic assumptions underlying consumer preferences Define the concept of indifference curves and explain the properties of indifference curves and maps Construct a consumer’s budget line and explain how to rotate or shift the line when prices or income change Derive/interpret equilibrium conditions for a consumer to be maximizing utility subject to a budget constraint Use indifference curves to derive a demand curve for an individual consumer and construct a market demand curve by horizontally summing individual demands Define a corner solution and explain the condition that creates a corner solution

The Consumer’s Optimization Problem Individual consumption decisions are made with the goal of maximizing total satisfaction from consuming various goods and services Subject to the constraint that spending on goods exactly equals the individual’s money income

Consumer Theory Assumes buyers are completely informed about: Range of products available Prices of all products Capacity of products to satisfy Their incomes Requires that consumers can rank all consumption bundles based on the level of satisfaction they would receive from consuming the various bundles

Typical Consumption Bundles for Two Goods, X & Y (Figure 5.1)

Properties of Consumer Preferences Completeness For every pair of consumption bundles, A and B, the consumer can say one of the following: A is preferred to B B is preferred to A The consumer is indifferent between A and B Transitivity If A is preferred to B, and B is preferred to C, then A must be preferred to C Nonsatiation More of a good is always preferred to less

Utility Benefits consumers obtain from goods & services they consume is utility A utility function shows an individual’s perception of the utility level attained from consuming each conceivable bundle of goods U = f(X, Y)

Indifference Curves Set of points representing different bundles of goods & services, each of which yields the same level of total utility Downward-sloping & convex

Typical Indifference Curve (Figure 5.2)

Marginal Rate of Substitution MRS measures the number of units of Y that must be given up per unit of X added so as to keep utility constant Negative of the slope of the indifference curve Diminishes along the indifference curve as X increases & Y decreases Ratio of the marginal utilities of the goods

Slope of an Indifference Curve & the MRS (Figure 5.3) 600 800 A B T T’ Quantity of good Y C (360,320) 320 360 Quantity of good X

Indifference Maps An indifference map consists of several indifference curves The higher (or further to the right) an indifference curve, the greater the level of utility associated with the curve Combinations of goods on higher indifference curves are preferred to combinations on lower curves

Indifference Map (Figure 5.4) II III IV Quantity of Y Quantity of X

Marginal Utility Addition to total utility attributable to the addition of one unit of a good to the current rate of consumption, holding constant the amounts of all other goods consumed

Consumer’s Budget Line Shows all possible bundles of goods that can be purchased at given prices if the entire income is spent or

Consumer’s Budget Constraint (Figure 5.5)

Typical Budget Line (Figure 5.6) • A B Quantity of Y Quantity of X

Shifting Budget Lines (Figure 5.7) 120 240 A Panel B – Changes in price of X 200 100 A B 100 250 D 125 C F Z 80 160 Quantity of Y Quantity of Y B 200 Quantity of X Quantity of X Panel A – Changes in money income

Utility Maximization Utility maximization subject to a limited income occurs at the combination of goods for which the indifference curve is just tangent to the budget line

Utility Maximization Consumer allocates income so that the marginal utility per dollar spent on each good is the same for all commodities purchased

Constrained Utility Maximization (Figure 5.8) 50 A • I • E III • D IV 45 Quantity of pizzas C • B II R T 40 30 20 15 10 10 20 30 40 50 60 70 80 90 100 Quantity of burgers

Utility Maximization, N Goods The utility maximization principle is easily extended to cover any number of goods

Individual Consumer Demand An individual’s demand curve for a specific commodity relates utility-maximizing quantities purchased to market prices Income & prices held constant Slope of demand curve illustrates law of demand—quantity demanded varies inversely with price

Deriving a Demand Curve (Figure 5.9) 100 Quantity of Y Px=$10 Px=$8 Px=$5 50 65 90 100 125 200 Quantity of X 10 8 Price of X ($) 5 Demand for X 50 65 90 Quantity of X

Market Demand & Marginal Benefit List of prices & quantities consumers are willing & able to purchase at each price, all else constant Derived by horizontally summing demand curves for all individuals in market Because prices along market demand measure the economic value of each unit of the good, it can be interpreted as the marginal benefit curve for a good

Derivation of Market Demand (Table 5.1) Quantity demanded Price Consumer 1 Consumer 2 Consumer 3 Market demand $6 3 12 13 5 8 10 7 10 1 3 5 6 8 1 4 3 5 6 4 12 3 19 2 25 1 31

Derivation of Market Demand Figure (5.10)

Corner Solution In many cases consumers spend their entire budget and choose to purchase none of some specific good A corner solution exists when the utility maximizing bundle lies at one of the endpoints of the budget line and the consumer chooses to consume zero units of a good

Corner Solution: X* = 0 Figure (5.11)

Corner Solution For goods X and Y, a corner solution, in which the consumer purchases none of good X, results when In general, a corner solution, in which the consumer purchases none of good X, results when

Summary Basic premise for analyzing consumer behavior Individuals make consumption decisions with the goal of maximizing their total satisfaction from consuming various goods and services, subject to the constraint that their spending on goods exactly equals their incomes The benefit consumers obtain from the goods and services they consume is called utility The utility function shows an individual's perception of the level of utility from consuming each conceivable bundle of goods Marginal utility is the addition to total utility attributable to adding one unit of a good, holding constant the amounts of all other goods consumed The marginal rate of substitution (MRS) shows the rate at which one good can be substituted for another while keeping utility constant

Summary An indifference curve is a set of points representing different bundles of goods and services, each of which yields the same level of total utility The consumer’s budget line shows the set of all consumption bundles that can be purchased at given prices and income if the entire income is spent A consumer maximizes utility subject to a limited income at the combination of goods for which the indifference curve is just tangent to the budget line At this combination, the MRS is equal to the price ratio

Summary An individual consumer’s demand curve relates utility-maximizing quantities to market prices, holding constant income and prices of all other goods The slope of the demand curve illustrates the law of demand: quantity demanded varies inversely with price Market demand is derived by horizontally summing the demand curves for all individuals in the market When a consumer spends the entire budget and chooses to purchase none of a specific good, this outcome is called a corner solution