BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen CHAPTER 7 CONSUMER BEHAVIOR ANALYSIS 2 nd Semester, S.Y 2013 – 2014

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Economic Models of Consumer Behavior  Marginal utility approach  Indifference approach  Budget line approach

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Utility Approach to Consumer Behavior

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Characteristics of Utility 1.Utility and “usefulness” are not synonymous. 2.Utility is subjective. 3.Utility is difficult to quantify. But for purposes of illustration we assume that people can measure satisfaction with units called utils (units of utility)

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Total Utility and Marginal Utility Total utility is the total level of satisfaction a consumer derives from consuming all units or some specific quantity of a good or service. Marginal utility is the extra satisfaction a consumer realizes from an additional unit of the good. It is the change in total utility from a 1- unit change in the quantity of a good or service consumed.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Total Utility Schedule Chocolate bars consumed Total Utility Marginal Utility

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Utility Quantity Total Utility Curve Chocolate bars consumed Total Utility Quantity

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen The marginal utility of the 3rd chocolate bars = 24 utils – 18 utils = 6 utils Marginal Utility Schedule Chocolate bars consumed Total Utility Marginal Utility

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Marginal Utility Curve Chocolate bars consumed Total Utility Marginal Utility Quantityt

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen This shows total utility and marginal utility curves This graphs a consumer’s total utility from consumption of chocolate bars Total Utility and Marginal Utility Curves Each bar shows the extra total utility a consumer from each additional chocolate bar - his marginal utility. The downward sloping blue line is marginal utility curve.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Total Utility and Marginal Utility Curves Initially, TU increases at an increasing rate. Eventually, as more and more of a good are consumed in a given time period, TU continues to increase but at a decreasing rate; MU decreases. This is called the point of “diminishing marginal utility”. When TU reaches its maximum, MU is zero and when TU begins to decline, MU is negative.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Let’s Check Your Understanding! Units Consumed Total Utility Marginal Utility Complete the following table. Units Consumed Total Utility Marginal Utility

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Preferences: what the consumer wants A consumer’s preference among consumption bundles may be illustrated with indifference curves.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen An indifference curve is a curve that shows consumption bundles that give the consumer the same level of satisfaction. A curve showing the different combinations of two products that yield the same satisfaction or total utility to a consumer. Indifference Curve

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Points A, B, C, D, and each point along the curve represent a combination of banana cue and kamote cue that yields equal total utility for a given consumer. Stated differently, the consumer is indifferent between consuming servings having quantities represented by all points composing the indifference curve. Indifference Curve Analysis

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Marginal rate of substitution (MRS)  It is the negative slope of the indifference curve, and the maximum amount of good Y that a consumer is willing to give up in order to get an additional unit of X, while maintaining the same level of utility as before.  The rate at which a consumer is willing to substitute one good for another without a change in total utility. The MRS equals the slope of the indifference curve at any point on the curve. Marginal Rate of Substitution (MRS)

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Quantity of Pizza Quantity of Pepsi 0 Indifference curve,I1I1 I2I2 C B A D Indifference Curve

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Representing Preferences with Indifference Curves The Consumer’s Preferences –The consumer is indifferent, or equally happy, with the combinations shown at points A, B, and C because they are all on the same curve. The Marginal Rate of Substitution –The slope at any point on an indifference curve is the marginal rate of substitution. It is the rate at which a consumer is willing to trade one good for another. It is the amount of one good that a consumer requires as compensation to give up one unit of the other good.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Indifference Curves Quantity of Pizza Quantity of Pepsi 0 Indifference curve,I1I1 I2I2 1 MRS C B A D

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Four Properties of Indifference Curves 1.Higher indifference curves are preferred to lower ones. 2.Indifference curves are downward sloping. 3.Indifference curves do not cross. 4.Indifference curves are bowed inward.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Four Properties of Indifference Curves Property 1: Higher indifference curves are preferred to lower ones. –Consumers usually prefer more of something to less of it. –Higher indifference curves represent larger quantities of goods than do lower indifference curves.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Quantity of Pizza Quantity of Pepsi 0 Indifference curve,I1I1 I2I2 C B A D Higher indifference curves are preferred to lower ones

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Four Properties of Indifference Curves Property 2: Indifference curves are downward sloping. –A consumer is willing to give up one good only if he or she gets more of the other good in order to remain equally happy. –If the quantity of one good is reduced, the quantity of the other good must increase. –For this reason, most indifference curves slope downward.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Quantityof Pizza Quantity of Pepsi 0 Indifference curve,I1I1 Indifference curves are downward sloping

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Four Properties of Indifference Curves Property 3: Indifference curves do not cross. –Points A and B should make the consumer equally happy. –Points B and C should make the consumer equally happy. –This implies that A and C would make the consumer equally happy. –But C has more of both goods compared to A.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Quantity of Pizza Quantity of Pepsi 0 C A B Indifference curves do not cross

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Four Properties of Indifference Curves Property 4: Indifference curves are bowed inward. –People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little. –These differences in a consumer’s marginal substitution rates cause his or her indifference curve to bow inward.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Quantity of Pizza Quantity of Pepsi 0 Indifference curve 8 3 A 3 7 B 1 MRS = 6 1 MRS = Indifference curves are bowed inward

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Two Extreme Examples of Indifference Curves Perfect substitutes Perfect complements

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Perfect Substitutes –Two goods with straight-line indifference curves are perfect substitutes. –The marginal rate of substitution is a fixed number.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Perfect Substitutes Dimes 0 Nickels I1I1 I2I2 I3I

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Perfect Complements –Two goods with right-angle indifference curves are perfect complements. Perfect Complements

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Right Shoes 0 Left Shoes I1I1 I2I Perfect Complements

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen The budget constraint: what the consumer can afford The budget constraint depicts the limit on the consumption “bundles” that a consumer can afford. –People consume less than they desire because their spending is constrained, or limited, by their income.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Budget Line  The line that shows the various combinations of goods the consumer can afford given his income and the prices of the two goods.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Budget Line Analysis

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen The slope of the budget line equals the ratio of the price of good X on the horizontal axis divided by the price of good Y on the vertical axis. Expressed as a formula: Budget Line Equation Maximum amount of X that a consumer can purchase : Maximum amount of Y that a consumer can purchase : Where: I – income, P – prices, and X, Y – commodities

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Marginal Rate of Transformation  The slope of the budget constraint line equals the relative price of the two goods, that is, the price of one good compared to the price of the other.  It measures the rate at which the consumer can trade one good for the other.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen A consumer has an income of P3,000. Flash drive costs P300 per unit, and MP3 player costs P600 per unit. Draw the consumer’s budget line and determine its slope. Let’s Check Your Understanding

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Optimization: what the consumer chooses Consumers want to get the combination of goods on the highest possible indifference curve. However, the consumer must also end up on or below his budget constraint.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen The Consumer’s Optimal Choices  Combining the indifference curve and the budget constraint determines the consumer’s optimal choice.  Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen The Consumer’s Optimum Quantity of Pizza Quantity of Pepsi 0 Budget constraint I1I1 I2I2 I3I3 Optimum A B Copyright©2004 South-Western

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Consumer equilibrium occurs where the budget line is tangent to the highest attainable indifference curve. At this unique point, MRS = slope (price ratio of P x /P y ). Consumer Equilibrium

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Utility-Maximizing Rule This outcome occurs when a person follows the utility-maximizing rule: 1. Allocate the entire available budget. 2. Make the marginal utility per peso spent the same for all goods.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Allocate the Available Budget  The available budget is the amount available after choosing how much to save and how much to spend on other items.  The saving decision and all other spending decisions are based on the same utility maximizing rule. Utility-Maximizing Rule

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Equalize the Marginal Utility Per Peso Spent  Spending the entire available budget doesn’t automatically maximize utility.  Peso might be misallocated—spend in ways that don’t maximize utility.  Making the marginal utility per peso spent the same for all goods gets the most out of a budget. Utility-Maximizing Rule

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Utility-Maximizing Rule

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen QuantityTU (Good X) MU (Good X) TU (Good Y) MU (Good Y) Let’s Check Your Understanding The following table shows the marginal utility schedules for goods X and Y for a hypothetical consumer. The price of Good X is P2 and the price of Good Y is P1. If the income is P20, how many units of Good X and Good Y should be purchased to maximize satisfaction?

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen The Consumer’s Optimal Choice The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen How Changes in Income Affect the Consumer’s Choices  An increase in income shifts the budget constraint outward. –The consumer is able to choose a better combination of goods on a higher indifference curve.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen An Increase in Income Quantity of Pizza Quantity of Pepsi 0 New budget constraint I1I1 I2I raising pizza consumption and Pepsi consumption. Initial budget constraint 1. An increase in income shifts the budget constraint outward... Initial optimum New optimum

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen How Changes in Income Affect the Consumer’s Choices  Normal versus Inferior Goods –If a consumer buys more of a good when his or her income rises, the good is called a normal good. –If a consumer buys less of a good when his or her income rises, the good is called an inferior good.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen An Inferior Good Quantity of Pizza Quantity of Pepsi 0 Initial budget constraint New budget constraint I1I1 I2I2 1. When an increase in income shifts the budget constraint outward but Pepsi consumption falls, making Pepsi an inferior good pizza consumption rises, making pizza a normal good... Initial optimum New optimum

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen How Changes in Prices Affect Consumer’s Choices A fall in the price of any good rotates the budget constraint outward and changes the slope of the budget constraint.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen A Change in Price Quantity of Pizza Quantity of Pepsi 0 1,000 D 500 B 100 A I1I1 I2I2 Initial optimum New budget constraint Initial budget constraint 1. A fall in the price of Pepsi rotates the budget constraint outward and raising Pepsi consumption reducing pizza consumption... New optimum

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Income and Substitution Effects A price change has two effects on consumption. –An income effect –A substitution effect

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Income and Substitution Effects The Income Effect –The income effect is the change in consumption that results when a price change moves the consumer to a higher or lower indifference curve. The Substitution Effect –The substitution effect is the change in consumption that results when a price change moves the consumer along an indifference curve to a point with a different marginal rate of substitution.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Income and Substitution Effects A Change in Price: Substitution Effect –A price change first causes the consumer to move from one point on an indifference curve to another on the same curve. Illustrated by movement from point A to point B. A Change in Price: Income Effect –After moving from one point to another on the same curve, the consumer will move to another indifference curve. Illustrated by movement from point B to point C.

BACHELOR OF ARTS IN ECONOMICS Econ 111 – ECONOMIC ANALYSIS Pangasinan State University Social Science Department – PSU Lingayen Income and Substitution Effects Quantity of Pizza Quantity of Pepsi 0 I1I1 I2I2 A Initial optimum New budget constraint Initial budget constraint Substitution effect Substitution effect Income effect Income effect B CNew optimum