Chapter 3 Consumer Behaviour I --- The Indifference Curve Approach © Pilot Publishing Company Ltd. 2005

Postulates of Consumer Behaviour Good, Bad and Neuter Utility Contents: Postulates of Consumer Behaviour Good, Bad and Neuter Utility Indifference Curve Properties of Indifference Curves of Two Goods Other Shapes of Indifference Curves Budget Line Consumer Equilibrium © Pilot Publishing Company Ltd. 2005

Changes in Consumer Equilibrium in Response to Changes in Constraints Contents: Changes in Consumer Equilibrium in Response to Changes in Constraints Decomposition of Price Effect into Substitution Effect and Income Effect Advanced Material 3.1: Postulate of utility maximization Advanced Material 3.2: Corner solutions © Pilot Publishing Company Ltd. 2005

Postulates of Consumer Behaviour © Pilot Publishing Company Ltd. 2005

A theory has four components - definitions; postulates; test conditions; implications Chapter one: basic definitions This chapter: postulates + test conditions + implications © Pilot Publishing Company Ltd. 2005

A. An economic agent behaves rationally. What are the basic postulates of consumer behaviour? A. An economic agent behaves rationally. Meaning: Behaviour of an economic agent has objectives and involves a prudent (審慎的) choice among alternative means. In other words, consumer behaviour is not random or arbitrary(隨意的). It has patterns and can be explained. Significance: Thus, economic investigation is possible and meaningful. © Pilot Publishing Company Ltd. 2005

B. Postulate of constrained maximization / self-interest / selfishness Then how does an individual make his choice? B. Postulate of constrained maximization / self-interest / selfishness Meaning: An economic agent always chooses the option that _________ the achievement of his goals among the options allowed by existing constraints. maximizes Significance: Without a postulate on economic choice, there is no economics. Without a confirmed postulate on economic choice, economics might not have survived. Note: This is the most important & most useful postulate in economics. © Pilot Publishing Company Ltd. 2005

D. To each individual, some goods are scarce. C. Each individual has many wants. Significance: Hence choice and exchange may arise. D. To each individual, some goods are scarce. Significance: Hence competition and choice are inevitable. They constitute the main content of economics. Scarcity Competition Choice © Pilot Publishing Company Ltd. 2005

E. Scarce goods are substitutable Meaning: One is willing to forgo something to get more of the scarce good — substitution, provided that the value got is larger than the cost paid. Significance: Exchange is possible. © Pilot Publishing Company Ltd. 2005

F. The law of diminishing MRS Marginal rate of substitution (MRS): is the maximum amount of good Y that an individual is willing to forgo for an additional unit of good X. It is equal to marginal use value (MUV) of good X in terms of good Y. The law states that MRS or MUV of a good ____________ as more units of the good are obtained, ceteris paribus. declines Significance: (Both interior and corner solutions are possible.) © Pilot Publishing Company Ltd. 2005

Good, Bad and Neuter © Pilot Publishing Company Ltd. 2005

(Options: more / less / none / some) A good is something desired, i.e., _________ is preferred to _________. some none (Options: more / less / none / some) © Pilot Publishing Company Ltd. 2005

Scarce goods (economic goods) Types of goods: Goods Free goods Scarce goods (economic goods) © Pilot Publishing Company Ltd. 2005

i.e., ________ is preferred. Free good: Features something desired its amount available is ______ than its amount desired at zero price, i.e., ________ is preferred. more no more (Options: more / less / some / no more ) © Pilot Publishing Company Ltd. 2005

i.e., ______ is preferred to _____. Scarce good (economic good): Features something desired its amount available is _____ than its amount desired at zero price, i.e., ______ is preferred to _____. less more less (Options: more / less / some / none ) © Pilot Publishing Company Ltd. 2005

Distinction between free goods and scarce goods: Depends on situations rather than kinds. Any examples? © Pilot Publishing Company Ltd. 2005

A good free-of-charge may not be a free good. Why? Distinction between free goods and goods free-of-charge: A free good must be a good free-of-charge. Why? its amount available is more than its amount desired. no one desires to have more of it no production nor exchange takes place  zero-priced. A good free-of-charge may not be a free good. Why? a scarce good can also be free-of-charge if someone pays the cost for you. Any examples? © Pilot Publishing Company Ltd. 2005

A bad is something undesired, i.e., _________ is preferred to _________. less more (Options: more / less / some / none ) Is sickness a bad ? © Pilot Publishing Company Ltd. 2005

A neuter (中性物品) is something neither desired nor undesired, i.e., the quantity does not matter. Any examples? © Pilot Publishing Company Ltd. 2005

Which of the following are free goods? Explain. Q3.2: Which of the following are free goods? Explain. air pocket money sea water parental care Q3.3: Draw a demand and supply diagram to illustrate a free good and a scarce good respectively. © Pilot Publishing Company Ltd. 2005

Utility © Pilot Publishing Company Ltd. 2005

Utility (效用) is a number What is utility? Utility (效用) is a number arbitrarily assigned to entities to rank them according to one’s preference. the higher the utility, the more one prefers the entity. a criterion of maximization to rank options for making choice. © Pilot Publishing Company Ltd. 2005

Utility reflects preference What is utility? Utility reflects preference  happiness / satisfaction  social welfare Why? © Pilot Publishing Company Ltd. 2005

Measurement of utility Ordinal utility only reflects an order but the difference between the numbers assigned is meaningless Cardinal utility can also reflect an order and the difference between the numbers assigned is meaningful © Pilot Publishing Company Ltd. 2005

Measurement of utility Which measurement of utility is used in the indifference curve approach? Ordinal measure of utility © Pilot Publishing Company Ltd. 2005

Indifference Curve © Pilot Publishing Company Ltd. 2005

What is an indifference curve? An indifference curve (IC, 等優曲線) is a line joining all the points (representing different baskets of goods) giving the same utility to an individual. Good X Good Y U=10 © Pilot Publishing Company Ltd. 2005

What is an indifference map? An indifference map (等優曲 線圖) is a set of ICs showing the _________ of an individual. Good Y Good X preference U=10 U=20 U=30 © Pilot Publishing Company Ltd. 2005

Properties of Indifference Curves of Two Goods © Pilot Publishing Company Ltd. 2005

1. ICs of two goods are negatively sloped Keeping utility constant, along an IC, a basket with more units of good X must have _____ units of good Y. U=10 Good Y Good X fewer Slope of an IC of two goods (= Δ Y/ Δ X) must be ________. +X -Y negative (Options: more / fewer / positive / negative) © Pilot Publishing Company Ltd. 2005

2. Indifference curves are continuous If quantities of good X and good Y can be increased or decreased by infinitesimal amounts, the ICs are continuous. Why? Good Y U=10 Good X © Pilot Publishing Company Ltd. 2005

3. Indifference curves can never intersect Along U1: point A = point B = U1 Along U2: point A = point C = U2  B  C What is the utility of point A, = U1 or U2?  A U of the intersection point  logical contradiction © Pilot Publishing Company Ltd. 2005

4. Full coverage If a consumer knows his preference on every basket of commodities, the commodity plane will be fully covered by ICs. Why? U1 U2 U3 Good Y Good X The higher the IC , the higher the utility (U3 > U2 > U1). Why? © Pilot Publishing Company Ltd. 2005

5. Indifference curves of two goods are convex to the origin The numerical value of the slope of an IC (+1X -?Y) is equal to the MRS. Why? U1 Good Y Good X As the consumption of good X rises, MRS (the slope) falls. Why? +1X -Y As the IC becomes flatter & flatter, its shape is _______ to the origin. convex © Pilot Publishing Company Ltd. 2005

Other Shapes of Indifference Curves © Pilot Publishing Company Ltd. 2005

1. X is a neuter and Y is a good Why? Y (A good) X (A neuter) Any increase or decrease in the quantity of X makes no difference to the consumer. U3>U2>U1 U2 U1 U3 ICs are ___________. horizontal © Pilot Publishing Company Ltd. 2005

What will be the shape of the ICs if (a) X is a good and Y is a neuter What will be the shape of the ICs if (a) X is a good and Y is a neuter? (b) both X and Y are neuters? © Pilot Publishing Company Ltd. 2005

ICs are _________ sloping with a/an _________slope. 2. X is a bad and Y is a good U3>U2>U1 Why? To keep U constant, in a bad (+X) requires in a good (+Y) as a compensation. Y (A good) X (A bad) U1 U2 U3 ICs are _________ sloping with a/an _________slope. +X +Y upward increasing © Pilot Publishing Company Ltd. 2005

What will be the shape of the ICs if (a) X is a good and Y is a bad What will be the shape of the ICs if (a) X is a good and Y is a bad? (b) both X and Y are bads? © Pilot Publishing Company Ltd. 2005

3. X is a commodity with a satiation threshold (beyond which X turns from a good to a bad) U3>U2>U1 ICs are __________. U-shaped Good Y X U1 U2 U3 Why? X is a good X becomes a bad © Pilot Publishing Company Ltd. 2005

What will be the shape of the ICs if both X and Y are goods with a satiation threshold? © Pilot Publishing Company Ltd. 2005

4. X and Y are perfect substitutes ICs are _________ sloping _______ lines. downward Good Y (pack of 8 kg rice) straight Why? U1 U2 U3 U3>U2>U1 Good X (pack of 5 kg rice) © Pilot Publishing Company Ltd. 2005

5. X and Y are perfect complements Good Y (left shoes) ICs are __________. right-angled U1 U2 U3 45o Why? U3>U2>U1 Good X (right shoes) © Pilot Publishing Company Ltd. 2005

Q3.7: Study the indifference maps below and determine if X and Y are goods, bads or neuters. (a) U1 < U2 < U3 (b) U1 > U2 > U3 © Pilot Publishing Company Ltd. 2005

Budget Line © Pilot Publishing Company Ltd. 2005

What is a budget line? Budget line (BL) or consumption possibility curve is a boundary showing the largest possible combinations of goods that a consumer can buy in a market, given his money income and market prices of the goods. It is also called the budget constraint. © Pilot Publishing Company Ltd. 2005

Derivation of a BL: Given I = $100, PX = $20 & PY = $25 The maxi. amount of X one can buy = ___________ The BL is a downward sloping straight line. Y X $100/$20 = 5 4 The maxi. amount of Y one can buy = ___________ The slope of BL = cost of consuming an additional unit of good X in terms of good Y. +1X -0.8Y $100/$25 = 4 To buy 1 more unit of X, one forgoes =____________ unit of Y. $20/$25 = 0.8 5 © Pilot Publishing Company Ltd. 2005

< = > Features: Point A: Expenditure ____ Income Y X = Point B: Expenditure ____ Income > Point C: Expenditure ____ Income  C  (Options: > = < ) B  A © Pilot Publishing Company Ltd. 2005

Equation of budget line Expenditure on good X Expenditure on good Y Money income of the consumer X  PX + Y  PY = I © Pilot Publishing Company Ltd. 2005

Changes in budget constraints 1. Changes in income When one’s income increases, the budget line will shift ______ in a parallel manner, and vice versa. Y X outward in income Why? in income © Pilot Publishing Company Ltd. 2005

2. Proportionate changes in prices Y X When prices of both goods rise by the same proportion, the budget line will shift _______ in a parallel manner, and vice versa. A proportionate in all money prices inward A proportionate in all money prices Why? © Pilot Publishing Company Ltd. 2005

3. Disproportionate changes in prices When PX , the budget line will _________ and become steeper. Why? Y X tilt inward When PX  , the budget line will __________ and become _______. Why? flatter A rise in Px tilt outward A fall in Px © Pilot Publishing Company Ltd. 2005

Q3.8: Under the following situations, what would happen to the budget line? Explain with the aid of diagrams. (a) I and PY are constants, but Px increases from P0 to P1. (b) I and PY are constants, but PX increases as the consumer buys more and more units of the good, i.e., PX and X are positively related. (c) I and PY are constants, but PX decreases as the consumer buys more and more units of the good, i.e., PX and X are negatively related. © Pilot Publishing Company Ltd. 2005

Consumer Equilibrium © Pilot Publishing Company Ltd. 2005

What is a consumer equilibrium? Optimum (最優點) or equilibrium (均衡) is the best choice of an economic agent in achieving his objective. Optimality conditions (最優性條件) or equilibrium conditions (均衡條件) are descriptions on the defining features of the optimum or the equilibrium. © Pilot Publishing Company Ltd. 2005

Interior solution When a consumer buys both goods X & Y, i.e., the equilibrium is not one of the _________ on the budget line, the equilibrium is called an interior solution (內解點). intercepts © Pilot Publishing Company Ltd. 2005

Equilibrium: From observation From observation, the best choice achievable is _____________. U1 U3 Y X U3>U2>U1 E* (X*, Y*) It is the tangency point, the only point on the budget line reaching the highest IC attainable.  E* Y* X* U2 Why? © Pilot Publishing Company Ltd. 2005

Equilibrium conditions: 1. The consumer equilibrium must lie ____ the BL. 2. The consumer equilibrium is the ____________ at which the slope of IC equals the slope of BL. Equilibrium conditions: on U1 U2 U3 Y X U3>U2>U1  E* X* Y* tangency point © Pilot Publishing Company Ltd. 2005

Slope of indifference curve Meaning of the slopes Slope of indifference curve Slope of budget line 1. =ΔY/ΔX, holding utility constant =ΔY/ΔX, holding expenditure or income constant 2. = Marginal rate of substitution in consumption, MRSc = Marginal rate of substitution in exchange, MRSe 3. = The maximum amount of Y one is willing to pay for an additional unit of X = The actual amount of Y one is required to pay for an additional unit of X in exchange 4. = Cost / Value? of an additional unit of X in terms of Y (=MUV) = Cost / Value? of consuming an additional unit of X in terms of Y (= Px/Py) Value Cost © Pilot Publishing Company Ltd. 2005

How is the consumer equilibrium reached? At point A, MRSc > MRSe (_______ of an additional X > its ________), utility can be raised if the consumer _________ units of X. value U2 U1 Y X cost buys more A  Buy X (Options: buys more / sells some / value / cost ) MRSe MRSc  © Pilot Publishing Company Ltd. 2005

How is the consumer equilibrium reached? At point B, MRSc < MRSe (value < cost), utility can be raised if the consumer _________ units of X. U2 U1 Y X sells some (Options: buys some / sells some )  Sell X MRSe B  MRSc © Pilot Publishing Company Ltd. 2005

How is the consumer equilibrium reached? MRSc = MRSe (value = cost), utility is maximized & the equilibrium is attained. Y  E* U2 U1 X © Pilot Publishing Company Ltd. 2005

Changes in Consumer Equilibrium in Response to Changes in Constraints © Pilot Publishing Company Ltd. 2005

When income  with PX and PY unchanged, outward A. Changes in income When income  with PX and PY unchanged, the BL will shift outward / inward? in a parallel manner. outward The effect of income on the consumption of a consumer can be shown by 2 curves: 1. Income consumption curve 2. Engel curve © Pilot Publishing Company Ltd. 2005

1. Income consumption curve Income consumption curve (所得消費曲線, ICC) is a line joining all the equilibrium (X,Y) of a consumer when one’s income changes, holding PX and PY constant. Y ICC    X © Pilot Publishing Company Ltd. 2005

2. Engel curve Engel curve X Engel curve (恩格爾曲線) is a line showing the Income Engel curve (恩格爾曲線) is a line showing the consumption of a good at different income levels, holding PX and PY constant. X3 X2 X1 I1 I2 I3 © Pilot Publishing Company Ltd. 2005

Its consumption is positively related to income. A. Superior good: Its consumption is positively related to income. X Y ICC Engel curve X3 X2 X1 X1 X2 X3 I1 I2 I3 Income X © Pilot Publishing Company Ltd. 2005

Its consumption is negatively related to income. B. Inferior good: Its consumption is negatively related to income. Y X ICC Engel curve X1 X2 X3 I1 I2 I3 I X3X2X1 X © Pilot Publishing Company Ltd. 2005

1. Price consumption curve 2. Demand curve B. Changes in price The effect of price on the consumption of a consumer can be shown by 2 curves: 1. Price consumption curve 2. Demand curve © Pilot Publishing Company Ltd. 2005

1. Price consumption curve Y Price consumption curve (價格消費曲線) is a line joining all the equilibrium of a consumer when PX changes, holding I & PY constant.   PCC   X © Pilot Publishing Company Ltd. 2005

2. Demand curve Demand curve is a line showing the ________________ of a good of a consumer at different prices. Px X quantity demanded Px1 Demand Curve Px2 Px3 X1 X2 X3 © Pilot Publishing Company Ltd. 2005

Y If price (Px) & quantity demanded (X) of the good are negatively related. PCC X Px Demand Curve Px1 Px2 Px3 X X1 X2 X3 © Pilot Publishing Company Ltd. 2005 X4

Y Giffen paradox If price (Px) & quantity demanded (X) of a good are _________ related, the good is called a Giffen good. PCC positively X Px Px1 Demand Curve Px2 X X2 X1 © Pilot Publishing Company Ltd. 2005

Decomposition of the Price Effect into the Substitution Effect & the Income Effect © Pilot Publishing Company Ltd. 2005

in the quantity demanded of a good caused by a change in its price, Price effect Price effect is the overall change in the quantity demanded of a good caused by a change in its price, holding money income constant. Price effect can be decomposed into ___________ effect and __________ effect. substitution income © Pilot Publishing Company Ltd. 2005

Y E1 New equilibrium E3 L2 L3 L1 X S.E. X1 X3 Substitution effect (替代效應) is the change in the quantity demanded of a good caused by a change in its price, holding utility or real income constant. Y X  E1 L1 X1 Px One will buy more good X to substitute good Y So substitution effect must be negative. L3 New equilibrium E3  X3 L2 S.E. © Pilot Publishing Company Ltd. 2005

Y X S.E. E3 E1 X3 X1 E2 X2 I.E. L1 L3 L2 Using the saved income Income effect (所得效應) is the change in the quantity demanded of a good as a result of a change in real income caused by a change in its price. Y X S.E.  E3 E1 L1 L3 X3 X1 L2 When Px, income is saved. Income is further saved by the S.E. as the consumption of an expensive good is substituted by the consumption of a cheaper good. Using the saved income E2  The saved income will raise the consumption of good X if good X is a superior good.  X2 I.E. © Pilot Publishing Company Ltd. 2005

Price effect of different kinds of goods Y X  E1 L1 1. The substitution effect must be negative. Positive I.E. 2. If good X is a superior good, what will be the income effect? L3  E2  E3 3. And what will be the price effect? L2 S.E. © Pilot Publishing Company Ltd. 2005

what will be the price effect? Negative I.E. Y X L1  E1 2. If X is an inferior good with its -ve I.E. < S.E., what will be the price effect? Negative I.E. L2  E2 L3 E3  S.E. © Pilot Publishing Company Ltd. 2005

Y X E1  Negative I.E. 3. If X is an inferior good with its -ve I.E. > S.E., (called Giffen good), what will be the price effect? L2  E2 L3 E3  L1 S.E. © Pilot Publishing Company Ltd. 2005

(b) If good X is an inferior good with its substitution Q3.12: Decompose the price effect into the substitution effect and the income effect, when the price of good X rises. (a) If good X is a superior good (b) If good X is an inferior good with its substitution effect greater than its income effect (c) If good X is an inferior good with its substitution effect smaller than its income effect © Pilot Publishing Company Ltd. 2005

Advanced Material 3.1: Postulate of utility maximization If the utility and the cost of each option can be measured or asserted beforehand the postulate can generate refutable predictions and it is useful if it is not refuted. cannot be measured or asserted beforehand the postulate cannot generate refutable predictions, then it becomes tautological and useless in explanation and prediction. © Pilot Publishing Company Ltd. 2005

Advanced Material 3.2: Corner solutions When a consumer buys one good only, i.e., the equilibrium is one of the intercepts on the budget line, the equilibrium is called a corner solution (角隅解). specialization There is a ___________________ in consumption. © Pilot Publishing Company Ltd. 2005

Advanced Material 3.2: Corner solutions Possible reasons for a corner solution are: 1. The good is too expensive. 2. The entity is a bad. 3. MRS is not decreasing. © Pilot Publishing Company Ltd. 2005

1. The good is too expensive Y (A good) MRSe (= cost) > MRSc (= value) U3 E* U2 U3>U2>U1 U1 X (A good but too expensive) 1X © Pilot Publishing Company Ltd. 2005

2. The entity is a bad Y (A good) U3 U2 E* U1 U3>U2>U1 X (A bad) U3>U2>U1 © Pilot Publishing Company Ltd. 2005

3. MRS is not decreasing Constant MRS Y (A good) X (A good) U1 U3 U2 U3>U2>U1 Y (A good) X (A good) U1 U3 U2 E* Increasing MRS U3>U2>U1 © Pilot Publishing Company Ltd. 2005

Correcting Misconceptions: 1. A free good is a good provided by the government free of charge. 2. A free good is a good without utility and is not preferred. 3. Utility is a measure of individual satisfaction or a measure of social welfare. © Pilot Publishing Company Ltd. 2005

Correcting Misconceptions: 4. Utility of a good must be a positive number and that of a bad must be negative. 5. Postulate of utility maximization is tautological. 6. A straight-line indifference curve denies the postulate of substitution. © Pilot Publishing Company Ltd. 2005

Correcting Misconceptions: 7. A concave indifference map cannot have consumer equilibrium or can have an interior solution. 8. A good with its price and quantity demanded negatively related is a normal good. 9. Holding money income constant is the same as holding real income constant. © Pilot Publishing Company Ltd. 2005

Correcting Misconceptions: 10. Substitution effect is positive for superior good and negative for inferior good. 11. Giffen good has no relation with inferior good. © Pilot Publishing Company Ltd. 2005

Survival Kit in Exam: Question 3. 1 (a) What is utility Survival Kit in Exam: Question 3.1 (a) What is utility? Must the utility of a bad be a negative number? (b) Michael says, “Anderson fails in HKCEE and he commits suicide. Why? He is maximizing utility. Mary also fails in HKCEE but she does not commit suicide. Why? She is maximizing utility. So, the postulate of utility maximization is tautological.” Do you agree? © Pilot Publishing Company Ltd. 2005

Survival Kit in Exam: Question 3 Survival Kit in Exam: Question 3.2 Being a member of a club, a consumer can purchase cosmetics at a reduced price. However, he has to pay a membership fee, and after which he has just enough income to purchase the original basket of goods. Does he prefer to be a member? Use an indifference map to illustrate. © Pilot Publishing Company Ltd. 2005