Chapter 3
Consumer
Behavior
Topics to be Discussed
• Consumer Preferences
• Budget Constraints
• Consumer Choice
• Revealed Preferences
Chapter 1
2
Topics to be Discussed
• Marginal Utility and Consumer Choices
• Cost-of-Living Indexes
Chapter 1
3
Consumer Behavior
• Two applications that illustrate the
importance of the economic theory of
consumer behavior are:
–
–
Apple-Cinnamon Cheerios
The Food Stamp Program.
Chapter 1
4
Consumer Behavior
• General Mills had to determine how high a
price to charge for Apple-Cinnamon
Cheerios before it went to the market.
Chapter 1
5
Consumer Behavior
• When the food stamp program was
established in the early 1960s, the
designers had to determine to what extent
the food stamps would provide people
with more food and not just simply
subsidize the food they would have
bought anyway.
Chapter 1
6
Consumer Behavior
• These two problems require an
understanding of the economic theory of
consumer behavior.
Chapter 1
7
Consumer Behavior
• There are three steps involved in the
study of consumer behavior.
1) We will study consumer preferences.
• To describe how and why people prefer one good
to another.
Chapter 1
8
Consumer Behavior
• There are three steps involved in the
study of consumer behavior.
2) Then we will turn to budget
constraints.
• People have limited incomes.
Chapter 1
9
Consumer Behavior
• There are three steps involved in the
study of consumer behavior.
3) Finally, we will combine consumer
preferences and budget constraints
to determine consumer choices.
• What combination of goods will consumers buy to
maximize their satisfaction?
Chapter 1
10
Consumer Preferences
Market Baskets
• A market basket is a collection of one or
more commodities.
• One market basket may be preferred over
another market basket containing a
different combination of goods.
Chapter 1
11
Consumer Preferences
Market Baskets
• Three Basic Assumptions
1) Preferences are complete.
2) Preferences are transitive.
3) Consumers always prefer more of
any good to less.
Chapter 1
12
Consumer
Preferences
Market Basket Units of Food Units of Clothing
A
20
30
B
10
50
D
40
20
E
30
40
G
10
20
H
10
40
Chapter 1
13
Consumer Preferences
Indifference Curves
• Indifference curves represent all
combinations of market baskets that
provide the same level of satisfaction to a
person.
Chapter 1
14
Consumer
Preferences
Clothing
The consumer prefers
A to all combinations
in the blue box, while
all those in the pink
box are preferred to A.
(units per week)
50
B
40
H
E
A
30
D
G
20
10
10
20
30
Chapter 1
40
Food
(units per week)
15
Consumer
Preferences
Clothing
Combination B,A, & D
yield the same satisfaction
•E is preferred to U1
•U1 is preferred to H & G
(units per week)
B
50
H
E
40
A
30
D
20
U1
G
10
10
20
30
Chapter 1
40
Food
(units per week)
16
Consumer Preferences
• Indifference Curves
–
Indifference curves slope downward to the
right.
•
If it sloped upward it would violate the assumption
that more of any commodity is preferred to less.
Chapter 1
17
Consumer Preferences
• Indifference Curves
–
Any market basket lying above and to the
right of an indifference curve is preferred to
any market basket that lies on the
indifference curve.
Chapter 1
18
Consumer Preferences
Indifference Maps
• An indifference map is a set of
indifference curves that describes a
person’s preferences for all combinations
of two commodities.
–
Each indifference curve in the map shows the
market baskets among which the person is
indifferent.
Chapter 1
19
Consumer Preferences
• Indifference Curves
–
Finally, indifference curves cannot cross.
•
This would violate the assumption that more is
preferred to less.
Chapter 1
20
Consumer
Preferences
Clothing
(units per week)
Market basket A
is preferred to B.
Market basket B is
preferred to D.
D
B
A
U3
U2
U1
Food
(units per week)
Chapter 1
21
Consumer
Preferences
Indifference Curves
Clothing
(units per week)
U2
Cannot Cross
U1
The consumer should
be indifferent between
A, B and D. However,
B contains more of
both goods than D.
A
B
D
Food
(units per week)
Chapter 1
22
Consumer Preferences
A
Clothing 16
(units
per week) 14
12
Observation: The amount
of clothing given up for
a unit of food decreases
from 6 to 1
-6
10
B
1
8
Question: Does this
relation hold for giving
up food to get clothing?
-4
D
6
1
-2
4
E
G
1 -1
1
2
1
2
3
4
Chapter 1
5
Food
(units per week)
23
Consumer Preferences
Marginal Rate of Substitution
• The marginal rate of substitution (MRS)
quantifies 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.
Chapter 1
24
Consumer Preferences
A
Clothing 16
(units
per week) 14
12
MRS   C
MRS = 6
F
-6
10
B
1
8
-4
D
6
MRS = 2
1
-2
4
E
G
1 -1
1
2
1
2
3
4
Chapter 1
5
Food
(units per week)
25
Consumer Preferences
Marginal Rate of Substitution
• We will now add a fourth assumption
regarding consumer preference:
– Along an indifference curve there is a
diminishing marginal rate of substitution.
• Note the MRS for AB was 6, while that for DE
was 2.
Chapter 1
26
Consumer Preferences
Marginal Rate of Substitution
• Question
– What are the first three assumptions?
Chapter 1
27
Consumer Preferences
Marginal Rate of Substitution
• Indifference curves are convex because 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.
• Consumers prefer a balanced market
basket
Chapter 1
28
Consumer Preferences
Marginal Rate of Substitution
• Perfect Substitutes and Perfect
Complements
–
Two goods are perfect substitutes when
the marginal rate of substitution of one
good for the other is constant.
Chapter 1
29
Consumer Preferences
Marginal Rate of Substitution
• Perfect Substitutes and Perfect
Complements
–
Two goods are perfect complements when
the indifference curves for the goods are
shaped as right angles.
Chapter 1
30
Consumer
Preferences
Apple
Juice
(glasses) 4
Perfect
Substitutes
3
2
1
0
1
2
3
Chapter 1
4
Orange Juice
(glasses)
31
Consumer
Preferences
Left
Shoes
4
Perfect
Complements
3
2
1
0
1
2
3
Chapter 1
4
Right Shoes
32
Consumer Preferences
• Utility
–
Utility: Numerical score representing the
satisfaction that a consumer gets from a given
market basket.
Chapter 1
33
Consumer Preferences
• Utility
–
If buying 3 copies of Microeconomics makes
you happier than buying one shirt, then we
say that the books give you more utility than
the shirt.
Chapter 1
34
Consumer
Preferences
Utility Functions & Indifference Curves
Clothing
(units
per week)
Assume: U = FC
Market Basket
U = FC
C
25 = 2.5(10)
A
25 = 5(5)
B
25 = 10(2.5)
15
C
10
U3 = 100 (Preferred to U2)
A
5
B
0
5
10
Chapter 1
U2 = 50 (Preferred to U1)
U1 = 25
Food
15
(units per week)
35
Consumer Preferences
• Ordinal Versus Cardinal Utility
–
–
Ordinal Utility Function: places market baskets
in the order of most preferred to least
preferred, but it does not indicate how much
one market basket is preferred to another.
Cardinal Utility Function: utility function
describing the extent to which one market
basket is preferred to another.
Chapter 1
36
Consumer Preferences
• Ordinal Versus Cardinal Rankings
–
–
The actual unit of measurement for utility is
not important.
Therefore, an ordinal ranking is sufficient to
explain how most individual decisions are
made.
Chapter 1
37
Budget Constraints
• Preferences do not explain all of consumer
behavior.
• Budget constraints also limit an
individual’s ability to consume in light of
the prices they must pay for various goods
and services.
Chapter 1
38
Budget Constraints
• The Budget Line
–
The budget line indicates all combinations of
two commodities for which total money spent
equals total income.
Chapter 1
39
Budget Constraints
• The Budget Line
–
–
–
Let F equal the amount of food purchased,
and C is the amount of clothing.
Price of food = Pf and price of
clothing
= Pc
Then Pf F is the amount of money spent on
food, and Pc C is the amount of money spent
on clothing.
Chapter 1
40
Budget Constraints
• The budget line then can be written:
P FF  P C C  I
Chapter 1
41
Budget
Constraints
Market Basket Food (F) Clothing (C)
Total Spending
PfF + PcC = I
Pf = ($1)
Pc = ($2)
A
0
40
$80
B
20
30
$80
D
40
20
$80
E
60
10
$80
G
80
0
$80
Chapter 1
42
Budget
Constraints
Clothing
Pc = $2
(units
per week)
(I/PC) = 40
Pf = $1
I = $80
Budget Line F + 2C = $80
A
1
Slope  C/F  -  - PF/PC
2
B
30
10
D
20
20
E
10
G
0
20
40
60
Chapter 1
80 = (I/PF)
Food
(units per week)
43
Budget Constraints
• The Budget Line
–
–
–
As consumption moves along a budget line
from the intercept, the consumer spends less
on one item and more on the other.
The slope of the line measures the relative
cost of food and clothing.
The slope is the negative of the ratio of the
prices of the two goods.
Chapter 1
44
Budget Constraints
• The Budget Line
–
The slope indicates the rate at which the two
goods can be substituted without changing
the amount of money spent.
Chapter 1
45
Budget Constraints
• The Budget Line
–
–
The vertical intercept (I/PC), illustrates the
maximum amount of C that can be purchased
with income I.
The horizontal intercept (I/PF), illustrates the
maximum amount of F that can be purchased
with income I.
Chapter 1
46
Consumer Choice
• Consumers choose a combination of goods
that will maximize the satisfaction they
can achieve, given the limited budget
available to them.
Chapter 1
47
Consumer Choice
• The maximizing market basket must
satisfy two conditions:
1) It must be located on the budget line.
2) Must give the consumer the most
preferred combination of goods and
services.
Chapter 1
48
Consumer Choice
Recall, the slope of an indifference curve
is:
C
MRS  
F
Further, the slope of the budget line is:
PF
Slope  
PC
Chapter 1
49
Consumer Choice
• Therefore, it can be said that satisfaction
is maximized where:
PF
MRS 
PC
Chapter 1
50
Consumer Choice
• It can be said that satisfaction is
maximized when marginal rate of
substitution (of F and C) is equal to the
ratio of the prices (of F and C).
Chapter 1
51
Consumer Choice
Clothing
(units per
week)
Pc = $2
Pf = $1
I = $80
Point B does not
maximize satisfaction
because the
MRS (-(-10/10) = 1
is greater than the
price ratio (1/2).
40
30
B
-10C
Budget Line
20
U1
+10F
0
20
40
80
Chapter 1
Food (units per week)
52
Consumer Choice
Clothing
(units per
week)
Pc = $2
Pf = $1
I = $80
40
Market basket D
cannot be attained
given the current
budget constraint.
D
30
20
U3
Budget Line
0
20
40
80
Chapter 1
Food (units per week)
53
Consumer Choice
Clothing
(units per
week)
Pc = $2
Pf = $1
I = $80
At market basket A
the budget line and the
indifference curve are
tangent and no higher
level of satisfaction
can be attained.
40
30
A
At A:
MRS =Pf/Pc = .5
20
U2
Budget Line
0
20
40
80
Chapter 1
Food (units per week)
54
Summary
• People behave rationally in an attempt to
maximize satisfaction from a particular
combination of goods and services.
• Consumer choice has two related parts:
the consumer’s preferences and the
budget line.
Chapter 1
55
Summary
• Consumers make choices by comparing
market baskets or bundles of
commodities.
• Indifference curves are downward sloping
and cannot intersect one another.
• Consumer preferences can be completely
described by an indifference map.
Chapter 1
56
Summary
• The marginal rate of substitution of F for C
is the maximum amount of C that a
person is willing to give up to obtain one
additional unit of F.
• Budget lines represent all combinations of
goods for which consumers expend all
their income.
Chapter 1
57
Summary
• Consumers maximize satisfaction subject
to budget constraints.
• The theory of revealed preference shows
how the choices that individuals make
when prices and income vary can be used
to determine their preferences.
Chapter 1
58
End of Chapter 3
Consumer
Behavior