Lecture 3: Consumer Behavior Slide 1
Topics to be Discussed
Consumer Preferences
Budget Constraints
Consumer Choice
Lecture 3: Consumer Behavior Slide 2
Consumer Behavior
Example 1: General Mills had to determine how high a price to charge for Apple-Cinnamon Cheerios before it went to the market.
Example 2: 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.
Lecture 3: Consumer Behavior Slide 3
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.
3) Combine the two to determine consumer choices.
Lecture 3: Consumer Behavior Slide 4
Consumer Preferences
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.
Market BasketsMarket Baskets
Lecture 3: Consumer Behavior Slide 5
Consumer Preferences
Three Basic Assumptions
1) Preferences are complete.
2) Preferences are transitive.
3) Consumers always prefer more of any good to less.
Market BasketsMarket Baskets
Lecture 3: Consumer Behavior Slide 6
Consumer Preferences
A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
Market Basket Units of Food Units of Clothing
Lecture 3: Consumer Behavior Slide 7
Consumer Preferences
Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person.
Indifference CurvesIndifference Curves
Lecture 3: Consumer Behavior Slide 8
The consumer prefersA to all combinationsin the blue box, whileall those in the pink
box are preferred to A.
Consumer Preferences
Food(units per week)
10
20
30
40
10 20 30 40
Clothing(units per week)
50
G
A
EH
B
D
Lecture 3: Consumer Behavior Slide 9
U1
Combination B,A, & Dyield the same satisfaction•E is preferred to U1
•U1 is preferred to H & G
Consumer Preferences
Food(units per week)
10
20
30
40
10 20 30 40
Clothing(units per week)
50
G
D
A
EH
B
Lecture 3: Consumer Behavior Slide 10
Consumer Preferences
Indifference CurvesIndifference curves slope downward to the
right.If it sloped upward it would violate the assumption that more of any commodity is preferred to less.
Indifference curves cannot cross.This would violate the assumption that more is preferred to less.
Lecture 3: Consumer Behavior Slide 11
Consumer Preferences
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.
Indifference MapsIndifference Maps
Lecture 3: Consumer Behavior Slide 12
U2
U3
Consumer Preferences
Food(units per week)
Clothing(units per week)
U1
AB
D
Market basket Ais preferred to B.Market basket B ispreferred to D.
Lecture 3: Consumer Behavior Slide 13
U1U2
Consumer Preferences
Food(units per week)
Clothing(units per week)
A
D
B
The consumer shouldbe indifferent betweenA, B and D. However,B contains more ofboth goods than D.
Indifference CurvesCannot Cross
Lecture 3: Consumer Behavior Slide 14
A
B
D
EG-1
-6
1
1
-4
-21
1
Observation: The amountof clothing given up for a unit of food decreasesfrom 6 to 1
Consumer Preferences
Food(units per week)
Clothing(units
per week)
2 3 4 51
2
4
6
8
10
12
14
16
Lecture 3: Consumer Behavior Slide 15
Consumer Preferences
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.
Marginal Rate of SubstitutionMarginal Rate of Substitution
Lecture 3: Consumer Behavior Slide 16
Consumer Preferences
Food(units per week)
Clothing(units
per week)
2 3 4 51
2
4
6
8
10
12
14
16 A
B
D
EG
-6
1
1
11
-4
-2-1
MRS = 6
MRS = 2
FCMRS
Lecture 3: Consumer Behavior Slide 17
Consumer Preferences
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.
Marginal Rate of SubstitutionMarginal Rate of Substitution
Lecture 3: Consumer Behavior Slide 18
Consumer Preferences
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
Marginal Rate of SubstitutionMarginal Rate of Substitution
Lecture 3: Consumer Behavior Slide 19
Consumer Preferences
Perfect Substitutes and Perfect ComplementsTwo goods are perfect substitutes when
the marginal rate of substitution of one good for the other is constant.
Marginal Rate of SubstitutionMarginal Rate of Substitution
Lecture 3: Consumer Behavior Slide 20
Consumer Preferences
Perfect Substitutes and Perfect ComplementsTwo goods are perfect complements when
the indifference curves for the goods are shaped as right angles.
Marginal Rate of SubstitutionMarginal Rate of Substitution
Lecture 3: Consumer Behavior Slide 21
Consumer Preferences
Orange Juice(glasses)
Apple Juice
(glasses)
2 3 41
1
2
3
4
0
PerfectSubstitutes
PerfectSubstitutes
Lecture 3: Consumer Behavior Slide 22
Consumer Preferences
Right Shoes
LeftShoes
2 3 41
1
2
3
4
0
PerfectComplements
PerfectComplements
Lecture 3: Consumer Behavior Slide 23
Consumer Preferences
UtilityUtility: Numerical score representing the
satisfaction that a consumer gets from a given market basket.
Lecture 3: Consumer Behavior Slide 24
Consumer Preferences
Utility Functions
Assume:The utility function for food (F) and clothing (C)
U(F,C) = F + 2C
Market Baskets: F units C units U(F,C) = F + 2C A 8 3 8 + 2(3)
= 14 B 6 4 6 + 2(4) = 14 C 4 4 4 + 2(4) = 12 The consumer is indifferent to A & B
The consumer prefers A & B to C
Lecture 3: Consumer Behavior Slide 25
Consumer Preferences
Food(units per week)10 155
5
10
15
0
Clothing(units
per week)
U1 = 25
U2 = 50 (Preferred to U1)
U3 = 100 (Preferred to U2)A
B
C
Assume: U = FCMarket Basket U = FC
C 25 = 2.5(10)A 25 = 5(5)B 25 = 10(2.5)
Utility Functions & Indifference CurvesUtility Functions & Indifference Curves
Lecture 3: Consumer Behavior Slide 26
Consumer Preferences
Ordinal Versus Cardinal UtilityOrdinal 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.
Lecture 3: Consumer Behavior Slide 27
Budget Constraints
Preferences do not explain all of consumer behavior.
Budget constraints limit an individual’s ability to consume in light of the prices they must pay.
The budget line indicates all combinations of commodities for which total money spent equals total income.
Lecture 3: Consumer Behavior Slide 28
Budget Constraints
The Budget LineLet 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.
Lecture 3: Consumer Behavior Slide 29
Budget Constraints
The budget line then can be written:
ICPFP CF
Lecture 3: Consumer Behavior Slide 30
Budget Line F + 2C = $80
CF/PPFC - 2
1- / Slope
10
20
(I/PC) = 40
Budget Constraints
Food(units per week)40 60 80 = (I/PF)20
10
20
30
0
A
B
D
E
G
Clothing(units
per week)
Pc = $2 Pf = $1 I = $80
Lecture 3: Consumer Behavior Slide 31
Budget Constraints
The slope is the negative of the ratio of the prices: it indicates the rate at which the two goods can be substituted without changing the amount of money spent.
The vertical intercept (I/PC), illustrates the maximum amount of C that can be purchased with income I.
Lecture 3: Consumer Behavior Slide 32
Budget Constraints
The Effects of Changes in Income and PricesIncome Changes
An increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant).
Lecture 3: Consumer Behavior Slide 33
Budget Constraints
The Effects of Changes in Income and PricesIncome Changes. A decrease in income causes
the budget line to shift inward, parallel to the original line (holding prices constant).
Price Changes. If the price of one good increases, the budget line shifts inward, pivoting from the other good’s intercept.
Lecture 3: Consumer Behavior Slide 34
Budget Constraints
Food(units per week)
Clothing(units
per week)
80 120 16040
20
40
60
80
0
A increase inincome shifts
the budget lineoutward
(I = $160)L2
(I = $80)
L1
L3
(I =$40)
A decrease inincome shifts
the budget lineinward
Lecture 3: Consumer Behavior Slide 35
Budget Constraints
Food(units per week)
Clothing(units
per week)
80 120 16040
40
(PF = 1)
L1
An increase in theprice of food to$2.00 changes
the slope of thebudget line and
rotates it inward.
L3
(PF = 2)(PF = 1/2)
L2
A decrease in theprice of food to$.50 changes
the slope of thebudget line and
rotates it outward.
Lecture 3: Consumer Behavior Slide 36
Consumer Choice
Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.
Lecture 3: Consumer Behavior Slide 37
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.
Lecture 3: Consumer Behavior Slide 38
Recall, the slope of an indifference curve is:
Consumer Choice
F
CMRS
C
F
P
PSlope
Further, the slope of the budget line is:
Lecture 3: Consumer Behavior Slide 39
Consumer Choice
Therefore, it can be said that satisfaction is maximized where:
C
F
P
PMRS
Lecture 3: Consumer Behavior Slide 40
Consumer Choice
Food (units per week)
Clothing(units per
week)
40 8020
20
30
40
0
U1
B
Budget Line
Pc = $2 Pf = $1 I = $80
Point B does not maximize satisfaction
because theMRS (-(-10/10) = 1 is greater than the
price ratio (1/2).
-10C
+10F
Lecture 3: Consumer Behavior Slide 41
Consumer Choice
Budget Line
U3
D Market basket D cannot be attainedgiven the current
budget constraint.
Pc = $2 Pf = $1 I = $80
Food (units per week)
Clothing(units per
week)
40 8020
20
30
40
0
Lecture 3: Consumer Behavior Slide 42
U2
Consumer Choice
Pc = $2 Pf = $1 I = $80
Budget Line
A
At market basket A the budget line and theindifference curve aretangent and no higherlevel of satisfaction
can be attained.
At A:MRS =Pf/Pc = .5
Food (units per week)
Clothing(units per
week)
40 8020
20
30
40
0
Lecture 3: Consumer Behavior Slide 43
Consumer Choice
A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another. This exists where the indifference curves
are tangent to the horizontal and vertical axis.
MRS is not equal to PA/PB
A Corner SolutionA Corner Solution
Lecture 3: Consumer Behavior Slide 44
A Corner Solution
Ice Cream (cup/month)
FrozenYogurt
(cupsmonthly)
B
A
U2 U3U1
A corner solutionexists at point B.
Lecture 3: Consumer Behavior Slide 45
Consumer Choice
A Corner SolutionWhen a corner solution arises, the
consumer’s MRS does not necessarily equal the price ratio.
In this instance it can be said that:
YogurtFrozenIceCream PPMRS /
Lecture 3: Consumer Behavior Slide 46
When consumers maximize satisfaction the:
CF/P PMRS
CFC F /P P /MUMU
Marginal Utility andConsumer Choice
Since the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it follows that:
Lecture 3: Consumer Behavior Slide 47
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.
Marginal Utility andConsumer Choice
Lecture 3: Consumer Behavior Slide 48
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.
Lecture 3: Consumer Behavior Slide 49
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.
Lecture 3: Consumer Behavior Slide 50
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.
Consumers maximize satisfaction subject to budget constraints.