Consumer behaviorslide 1 CONSUMER BEHAVIOR Preferences. The conflict between opportunities and desires. Utility maximizing behavior.

Consumer behaviorslide 2 Preferences or Tastes All consumers are endowed with a set of “preferences” among all of the goods and services from which they can choose. These preferences are embodied in a "utility function."

Consumer behaviorslide 3 Economists impose 4 assumptions on the preferences in the “standard” case of the utility function: 1. A consumer can decide for any pair of “bundles” of goods which bundle is preferred, or whether he/she is indifferent. 2. Preferences are transitive (consistent). 3. More is better. 4. Indifference curves are “convex”. (See below for a discussion of indifference curves.)

Consumer behaviorslide 4 A utility function for two goods.

Consumer behaviorslide 5 Definition: All combinations of goods among which the consumer is indifferent. That is, all the combinations of goods that give the consumer a particular level of utility or satisfaction. Indifference curve

Consumer behaviorslide 6 The previous graph can be rotated to show indifference curves:

Consumer behaviorslide 7 Marginal Rate of Substitution Definition: The Marginal Rate of Substitution of X for Y is the amount of Y it takes to make up for the loss of one unit of X. (It’s minus the slope of an indifference curve.)

Consumer behaviorslide 8 TACOS SPAGHETTI U1U1 U2U2 U3U3 Some indifference curves: U 1 < U 2 < U 3

Consumer behaviorslide 9 TACOS SPAGHETTI U2U2 U3U3 MRS is minus the slope of an indifference curve. MRS S for T = -(  T/  S) TT SS

Consumer behaviorslide 10 Characteristics of indifference curves in the “standard” case: 1) They “fill” the goods space. 2)They cannot intersect. 3) Higher curves lie above and to the right of others. 4) They are “convex”. (There is increasing marginal rate of substitution.)

Consumer behaviorslide 11 Woeful tales of preferences Nickels and dimes. Right shoes and left shoes. "I wouldn't eat acorns even if you paid me." "I would eat acorns only if you paid me."

Consumer behaviorslide 12 Budget Constraints Definition: The consumer’s budget constraint shows all of the combinations of goods and services the consumer is able to buy, given income and prices.

Consumer behaviorslide 13 Standard case assumptions: 1.The consumer has a fixed, known money income in each time period. 2.The consumer pays a fixed price (in terms of dollars) for each good.

Consumer behaviorslide 14 Two good case Consumer’s income is I dollars per period. There are two goods, S and T, that have prices P S and P T. The consumer’s spending on the two goods together must be less than or equal to total income in each time period.

Consumer behaviorslide 15 The Budget Constraint is P S S + P T T  I This can be written as T  I/P T - (P S /P T )S

Consumer behaviorslide 16 Remember that income and prices are “givens” here, so the last equation is a linear relationship between T and S. T S I/P T I/P S slope = - P S / P T

Consumer behaviorslide 17 Where are feasible and non-feasible consumption bundles? T S I/P T I/P S

Consumer behaviorslide 18 Changing income and prices What’s the effect on the consumer’s opportunities if income increases? I* > I’ P S S + P T T = I’ P S S + P T T = I*

Consumer behaviorslide 19 Where’s the new budget constraint when I increases to I*? T S I’/P T I’/P S hidden slide

Consumer behaviorslide 20 T S I’/P T I’/P S I*/P T An increase in income expands the consumer's opportunities.

Consumer behaviorslide 21 Changing prices What’s the effect on the consumer’s opportunities if the price of spaghetti falls? P S ' > P* S P S ' S + P T T = I P* S S + P T T = I

Consumer behaviorslide 22 Where’s the new budget constraint when the price of spaghetti falls? T S I/P T I/P' S hidden slide

Consumer behaviorslide 23 Where’s the budget constraint when the price of spaghetti falls? T S I/P T I/P' S I/P* S A fall in the price of spaghetti also expands the consumer's opportunities, but in a different way.

Consumer behaviorslide 24 Choice If a consumer wants to choose S and T so as to maximize total utility, what should he/she do? hidden slide

Consumer behaviorslide 25 TACOS SPAGHETTI Constraints and choices What to choose?? Opportunities U1U1 U2U2 U3U3 Preferences

Consumer behaviorslide 26 TACOS SPAGHETTI U1U1 U2U2 U3U3 Maximizing total utility T* and S* are best. U* T* S*

Consumer behaviorslide 27 To maximize utility: 1)Spend all of your income. 2)Choose a point on the budget constraint where: (a)an indifference curve is tangent to the constraint, or (b)the MRS is equal to the ratio of the prices of the goods. (MRS S for T =P S /P T )

Consumer behaviorslide 28 More woeful tales Nickels & dimes. Left shoes and right shoes. Work for pay. Two part pricing.

Consumer behaviorslide 29 Changes in prices and income 1)Price changes and price consumption curves. 2)Income changes and income consumption curves. 3)Income and substitution effects. 4)Consumer Surplus.

Consumer behaviorslide 30 Effects of a price change If the price of a good declines, consumers will change the amount they want to buy (demand), in general.

Consumer behaviorslide 31 Here the price of spaghetti falls. The consumer changes the amounts chosen. T S I/P T I/P' S I/P* S S' S* U' U*

Consumer behaviorslide 32 Price consumption curve Locus of utility maximizing amounts of goods at different prices for one of the goods. Information from the PCC can be used to derive the consumer's demand curve for a good.

Consumer behaviorslide 33 Finding the consumer's demand curve for spaghetti. T S I/P T I/P' S S' U' PSPS S P' S I/P* S P* S S' S* U* S* DSDS

Consumer behaviorslide 34 Income increases T S I’/P T I’/P S I*/P T U' S' U* S* Are the goods normal or inferior here?

Consumer behaviorslide 35 Choice and inferior goods T S I’/P T I’/P S I*/P T U' S' U* S* Income increases here. Which good is inferior?

Consumer behaviorslide 36 Income consumption curve Locus of utility maximizing amounts of goods at different income levels for the goods. Information from the ICC can be used to derive what is called the Engel Curve (or income demand curve) for a good.

Consumer behaviorslide 37 Income and Substitution Effects The consumer is maximizing utility. The price of one good falls. The change in the demand for the good can be thought of as having two parts: A substitution effect, and An income effect.

Consumer behaviorslide 38 Substitution Effect: The change in demand (due to a decrease in price) holding the consumer's real income constant. Income Effect: The change in demand (due to a decrease in price) because of the increase in real income the consumer receives.

Consumer behaviorslide 39 Start with the consumer maximizing utility by choosing amount S 0 of good S. T S I/P T I/P' S I/P* S S0S0 U'

Consumer behaviorslide 40 The price of good S falls to P* S. The consumer then chooses S 2 of good S. T S I/P T I/P' S I/P* S S0S0 U' S2S2 U*

Consumer behaviorslide 41 To find the substitution effect, we must see what the consumer will choose at the lower price of S, but forcing the consumer to have the same real income (i.e., utility) as at S 0. The substitution effect is a "pure price effect" on demand.

Consumer behaviorslide 42 Isolating the substitution effect is accomplished by reducing the consumer's money income after the price change until the best he or she can do is get to indifference curve U'.

Consumer behaviorslide 43 S 1 - S 0 is the substitution effect. S 2 - S 1 is the income effect. T S I/P T I/P' S I/P* S S0S0 U' S2S2 U* S1S1

Consumer behaviorslide 44 The substitution effect always works in the direction of increasing the demand for a good whose price has fallen. The income effect can work in either direction, depending on whether the good is normal or inferior.

Consumer behaviorslide 45 Income and substitution effects are used to show (among other things) the conditions under which the Law of Demand is “true”.

Consumer behaviorslide 46 Note that for normal goods, the Law of Demand must hold. For inferior goods, it may hold. But if the income effect is of opposite sign from the substitution effect, and is larger in magnitude, a decrease in price will lead to lower demand. (A Giffen Good.)

Consumer behaviorslide 47 THE CARDINAL UTILITY APPROACH TO CHOICE Each person has a utility function which is a rule or equation that determines the consumer’s utility (satisfaction) for any amounts of goods and services consumed. Utility here is assumed to be cardinal, rather than ordinal. (Measured in "utils"??)

Consumer behaviorslide 48 The dependent variable in the utility function is utility or satisfaction. The independent variables are the amounts of the goods and services an individual consumes.

Consumer behaviorslide 49 LIKE THIS: U BROWN = f(beer, bicycles, pizza, spaghetti, tacos,...) “Brown’s utility depends on the number of beers he consumes, the number of bikes he consumes, etc.”

Consumer behaviorslide 50 Brown’s total utility from pizzas. PIZZATOTAL UTILITY

Consumer behaviorslide 51 You can graph the total utility this way. PIZZAS TOTAL UTILITY

Consumer behaviorslide 52 You can graph the total utility this way. PIZZAS TOTAL UTILITY

Consumer behaviorslide 53 MARGINAL UTILITY: The marginal utility is the increase in utility you get from consuming one more unit of the good, holding the consumption of all other goods constant.

Consumer behaviorslide 54 The marginal utility of pizza is the change in utility per unit change in pizza consumption (holding the consumption of all other goods constant, of course). MU PIZZA = the change in U / the change in pizza =  U /  (PIZZA)

Consumer behaviorslide 55 You can compute marginal utility from the total utility curve. (13-5)/(2-1) PIZZATOTAL UTILITYMU

Consumer behaviorslide 56 You can compute marginal utility from the total utility curve. (13-5)/(2-1) PIZZATOTAL UTILITYMU

Consumer behaviorslide 57 Law of Diminishing Marginal Utility The marginal utility of a good will eventually decline as more is consumed.

Consumer behaviorslide 58 Marginal utility begins to decline here with the consumption of the 4th pizza. (29-22)/(4-3) PIZZATOTAL UTILITYMU

Consumer behaviorslide 59 Marginal utility is the slope of the total utility curve. PIZZAS TOTAL UTILITY  U U  P MU =  U /  P

Consumer behaviorslide 60 Draw the marginal utility curve here. Be sure to label the axes correctly. Some points are already shown. marginal utility pizzas The marginal utility of the 4th pizza is 7 utils. The marginal utility of the 4th pizza is 7 utils.

Consumer behaviorslide 61 The 5th pizza is worth less than the 4th pizza. marginal utility pizzas And the marginal utility of the 5th pizza is 6.

Consumer behaviorslide 62 The Law of Diminishing Marginal Utility is assumed to be true for all consumers, and for all of the goods a person consumes.

Consumer behaviorslide 63 The standard problem (same as in ordinal approach) Suppose a person consumes two goods, say, tacos and spaghetti. The person has a fixed money income of I dollars per time period, say a week. Tacos and spaghetti can be bought at fixed, known prices, say P T and P S. What amounts of spaghetti and tacos will maximize utility?

Consumer behaviorslide 64 In the earlier solution to this problem, the marginal rule was to make the MRS equal to the price ratio of the goods. (MRS S for T =P S /P T ) It's easy to show that the MRS can be expressed as a ratio of marginal utilities, land the rule rewritten as:

Consumer behaviorslide 65 Choose S and T so that: MU S / P S = MU T / P T. MU S / P S is the marginal utility per $ spent on S. It is the extra utility you can get from spending another $ on S.

Consumer behaviorslide 66 WHY THE RULE WORKS Suppose the rule were not true, but instead we had: MU S / P S < MU T / P T. or 12 < 20 Spending $1 less on S would lower your utility by 12 utils. Respending that $1 on T would raise your utility by 20 utils. This will give you a net gain of 8 (=20-12) utils.

Consumer behaviorslide 67 So if the MU's per $ spent on two goods are not not equal, then a gain in total utility is possible by reallocating your spending. You should spend more on the good whose MU per $ is the highest. In the example on the last slide, this was tacos, T.

Consumer behaviorslide 68 Note that as you allocate your $ from the good whose MU per $ is lower, the MU of that good will rise (remember the Law of Diminishing MU). And the MU of the good with the higher MU per $ will fall for the same reason. Thus, as you reallocate spending, the degree of inequality between MU’s per $ will diminish.

Consumer behaviorslide 69 Only when the MU per $ spent on S is equal to the MU per $ spent on T will you be unable to make utility larger by reallocating you spending, and total utility will be maximized. MU S / P S = MU T / P T

Consumer behaviorslide 70 Consumer Surplus At the level of the individual consumer, CS is the difference between what the consumer is willing to pay for a good, and the amount the consumer actually pays. It's a measure of the welfare to the consumer of being able to buy the good in a market.

Consumer behaviorslide 71 Consumer surplus can be measured using the demand curve for a product. Demand for tacos D Q* Q P P*

Consumer behaviorslide 72 When Q* is sold, willingness to pay is the shaded area. Demand for tacos D Q* Q P P*

Consumer behaviorslide 73 When Q* is sold at a price P*, consumers pay P* times Q*. Click to see the cost to consumers. Click again to see the shaded area that is consumer surplus. Demand for tacos D Q* Q P P* Cost to consumers Consumer surplus