1. Chapter 3 Consumer Behavior

2. Question: Mary goes to the movies eight times a month and seldom goes to a bar. Tom goes to the movies once a month and goes to a bar fifteen times a month. What determine consumers’ choice? Chapter 32©2005 Pearson Education, Inc.

3. Chapter 33©2005 Pearson Education, Inc. Consumer Behavior Three steps involved in the study of consumer behavior 1.Consumer Preferences  How and why people prefer one good to another 2.Budget Constraints  People have limited incomes

4. Chapter 34©2005 Pearson Education, Inc. Consumer Behavior 3.Given preferences and limited incomes, what amount and type of goods will be purchased?  What combination of goods will consumers buy to maximize their satisfaction?

5. Chapter 35©2005 Pearson Education, Inc. Consumer Preferences – Basic Assumptions 1.Preferences are complete.  Consumers can rank market baskets. 2.Preferences are transitive.  If one prefers A to B and B to C, then one must prefer A to C. 3.Consumers always prefer more of any good to less.  The more, the better.  No satiation.

6. Chapter 36©2005 Pearson Education, Inc. Indifference Curves Consumer preferences can be represented graphically using indifference curves Indifference curves represent all combinations of market baskets that the person is indifferent to. Contour Line

7. Chapter 37©2005 Pearson Education, Inc. Indifference Curves: An Example Market BasketUnits of FoodUnits of Clothing A2030 B1050 D4020 E3040 G1020 H1040

8. Chapter 38©2005 Pearson Education, Inc. The consumer prefers A to all combinations in the yellow box, while all those in the pink box are preferred to A. Indifference Curves: An Example Food 10 20 30 40 10203040 Clothin g 50 G A EH B D

9. Chapter 39©2005 Pearson Education, Inc. Indifferent between B, A, & D E is preferred to U 1 U 1 is preferred to H & G Indifference Curves: An Example Food 10 20 30 40 10203040 Clothin g 50 U1U1 G D A E H B

10. Chapter 310©2005 Pearson Education, Inc. Indifference Curves Indifference curves slope downward to the right.  If it sloped upward it would violate the assumption that more is preferred to less.

11. Chapter 311©2005 Pearson Education, Inc. U2U2 U3U3 Indifference Map Food Clothing U1U1 A B D Market basket A is preferred to B. Market basket B is preferred to D.

12. Chapter 312©2005 Pearson Education, Inc. Indifference Maps Indifference curves can not cross  Why?

13. Chapter 313©2005 Pearson Education, Inc. Indifference Maps Food Clothing B is preferred to D A is indifferent to B & D B must be indifferent to D but that can’t be if B is preferred to D U1U1 U1U1 U2U2 U2U2 A B D

14. Chapter 314©2005 Pearson Education, Inc. Indifference Curves The shape of indifference curves describes how a consumer is willing to substitute one good for another  A to B, give up 6 clothing to get 1 food  D to E, give up 2 clothing to get 1 food The more clothing and less food a person has, the more clothing they will give up to get more food

15. Chapter 315©2005 Pearson Education, Inc. A B D E G -6 1 1 -4 -2 1 1 Observation: The amount of clothing given up for 1 unit of food decreases from 6 to 1 Indifference Curves Food Clothing 23451 2 4 6 8 10 12 14 16

16. Chapter 316©2005 Pearson Education, Inc. Indifference Curves We measure how a person trades one good for another using the marginal rate of substitution (MRS)  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.

17. Chapter 317©2005 Pearson Education, Inc. Marginal Rate of Substitution Food 23451 Clothing 2 4 6 8 10 12 14 16 A B D E G -6 1 1 1 1 -4 -2 MRS = 6 MRS = 2

18. Chapter 318©2005 Pearson Education, Inc. Marginal Rate of Substitution Indifference curves are convex  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.

19. Chapter 319©2005 Pearson Education, Inc. Marginal Rate of Substitution The MRS decreases as we move down the indifference curve  Along an indifference curve there is a diminishing marginal rate of substitution.  The MRS went from 6 to 4 to 1

20. Chapter 320©2005 Pearson Education, Inc. Marginal Rate of Substitution Perfect Substitutes  Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant.  Example: a person might consider apple juice and orange juice perfect substitutes

21. Chapter 321©2005 Pearson Education, Inc. Consumer Preferences Orange Juice (glasses) Apple Juice (glasses) 2341 1 2 3 4 0 Perfect Substitutes

22. Chapter 322©2005 Pearson Education, Inc. Consumer Preferences Perfect Complements  Two goods are perfect complements when the indifference curves for the goods are shaped as right angles. Example: An additional left shoe gives her no extra satisfaction unless she also obtains the matching right shoe.

23. Chapter 323©2005 Pearson Education, Inc. Consumer Preferences Right Shoes Left Shoes 2341 1 2 3 4 0 Perfect Complements

24. Chapter 324©2005 Pearson Education, Inc. Consumer Preferences We have assumed all our commodities are “goods” There are things for which less is preferred to more – bads. Examples  Air pollution  Asbestos

25. Chapter 325©2005 Pearson Education, Inc. Consumer Preferences How do we account for bads in our preference analysis?  We redefine the commodity Clean air Pollution reduction Asbestos removal

26. Chapter 326©2005 Pearson Education, Inc. Consumer Preferences Utility  A numerical score representing the satisfaction.

27. Chapter 327©2005 Pearson Education, Inc. Utility Utility function  Formula that assigns a level of utility to individual market baskets  If the utility function is U(F,C) = F + 2C

28. Chapter 328©2005 Pearson Education, Inc. Utility - Example Market Basket FoodClothingUtility A838 + 2(3) = 14 B646 + 2(4) = 14 C444 + 2(4) = 12

29. Chapter 329©2005 Pearson Education, Inc. Utility - Example Baskets for each level of utility can be plotted to get an indifference curve  To find the indifference curve for a utility of 14, we can change the combinations of food and clothing that give us a utility of 14

30. Chapter 330©2005 Pearson Education, Inc. Utility - Example Food 10155 5 10 15 0 Clothing U 1 = 25 U 2 = 50 U 3 = 100 A B C BasketU = FC C25 = 2.5(10) A25 = 5(5) B25 = 10(2.5)

31. Utility - Example Draw the indifference curves of following utility functions. U (X, Y) = 5 XY U (X, Y) = 10 (X + Y) U (X, Y) = 5 min (X, Y) Chapter 331©2005 Pearson Education, Inc.

32. Chapter 332©2005 Pearson Education, Inc. Utility Although we numerically rank baskets and indifference curves, numbers are ONLY for ranking A utility of 4 is not necessarily twice as good as utility of 2 There are two types of ranking  Ordinal ranking  Cardinal ranking

33. Chapter 333©2005 Pearson Education, Inc. Utility Ordinal Utility Function  Places market baskets in the order of most preferred to least preferred, but it does not indicate how much one basket is preferred to another. Cardinal Utility Function  Utility function describing the extent to which one market basket is preferred to another.

34. Chapter 334©2005 Pearson Education, Inc. Budget Constraints The Budget Line  All combinations of two commodities for which total money spent equals total income.  We assume only 2 goods are consumed, so we do not consider savings

35. Chapter 335©2005 Pearson Education, Inc. 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.

36. Chapter 336©2005 Pearson Education, Inc. The Budget Line The budget line then can be written: All income is allocated to food (F) and/or clothing (C)

37. Chapter 337©2005 Pearson Education, Inc. Budget Constraints Market Basket Food P F = $1 Clothing P C = $2 Income I = P F F + P C C A040$80 B2030$80 D4020$80 E6010$80 G800$80

38. Chapter 338©2005 Pearson Education, Inc. The Budget Line 10 20 A B D E G ( I/P C ) = 40 Food 4060 80 = ( I/P F ) 20 10 20 30 0 Clothing

39. Chapter 339©2005 Pearson Education, Inc. The Budget Line The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent. We can rearrange the budget line equation to make this more clear

40. Chapter 340©2005 Pearson Education, Inc. The Budget Line

41. Chapter 341©2005 Pearson Education, Inc. 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.

42. Chapter 342©2005 Pearson Education, Inc. The Budget Line - Changes A increase in income shifts the budget line outward Food (units per week) Clothing (units per week) 8012016040 20 40 60 80 0 ( I = $160) L2L2 ( I = $80) L1L1 L3L3 ( I = $40) A decrease in income shifts the budget line inward

43. Chapter 343©2005 Pearson Education, Inc. The Budget Line - Changes ( 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. 40 Food (units per week) Clothing (units per week) 80 120 160 40

44. Chapter 344©2005 Pearson Education, Inc. Consumer Choice Given preferences and budget constraints, how do consumers choose what to buy? Consumers choose a combination of goods that will maximize their satisfaction, given the limited budget available to them.

45. Chapter 345©2005 Pearson Education, Inc. Consumer Choice The maximizing market basket must satisfy two conditions: 1.It must be located on the budget line. 2.It must give the consumer the most preferred combination of goods and services.

46. Chapter 346©2005 Pearson Education, Inc.Chapter 346©2005 Pearson Education, Inc. Consumer Choice U3U3 D U2U2 C Food (units per week) 408020 Clothing (units per week) 20 30 40 0 U1U1 A B A, B, C on budget line D highest utility but not affordable C highest affordable utility Consumer chooses C

47. Chapter 347©2005 Pearson Education, Inc. Consumer Choice Consumer wants to choose highest utility within their budget In previous graph, point C is where the indifference curve is just tangent to the budget line Slope of the budget line equals the slope of the indifference curve at this point

48. Chapter 348©2005 Pearson Education, Inc. Consumer Choice Recall, the slope of an indifference curve is: Further, the slope of the budget line is:

49. Chapter 349©2005 Pearson Education, Inc. Consumer Choice Therefore, it can be said at consumer’s optimal consumption point,

50. Chapter 350©2005 Pearson Education, Inc.Chapter 350©2005 Pearson Education, Inc. Consumer Choice U3U3 D U2U2 C Food (units per week) 408020 Clothing (units per week) 20 30 40 0 U1U1 A B A, B, C on budget line D highest utility but not affordable C highest affordable utility Consumer chooses C

51. Chapter 351©2005 Pearson Education, Inc. Chapter 351©2005 Pearson Education, Inc. Marginal Utility and Indifference Curves As consumption moves along an indifference curve:  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).

52. Chapter 352©2005 Pearson Education, Inc.Chapter 352©2005 Pearson Education, Inc. Marginal Utility and Consumer Choice Formally: No change in total utility along an indifference curve. Trade off of one good to the other leaves the consumer just as well off

53. Chapter 353©2005 Pearson Education, Inc.Chapter 353©2005 Pearson Education, Inc. Marginal Utility and Consumer Choice Rearranging:

54. Chapter 354©2005 Pearson Education, Inc.Chapter 354©2005 Pearson Education, Inc. Marginal Utility and Consumer Choice When consumers maximize satisfaction: Since the MRS is also equal to the ratio of the marginal utility of consuming F and C

55. Chapter 355©2005 Pearson Education, Inc.Chapter 355©2005 Pearson Education, Inc. Marginal Utility and Consumer Choice Rearranging, gives the equation for utility maximization:

56. Chapter 356©2005 Pearson Education, Inc. Marginal Utility and Consumer Choice 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.