Consumer Behavior

 There are 3 steps involved in studying consumer

behavior.
1) Consumer preferences: describe how and why
people prefer one good to another.
2) Budget constraints: people have limited incomes.
3) We will combine consumer preferences and budget
constraints to determine consumer choices.
 What combination of goods will consumers
buy to maximize their satisfaction?

Chapter 3: Consumer Behavior Slide 1

 Consumer Preferences
Market
Market Baskets
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.
 Three Basic Assumptions
1) Preferences are complete.
2) Preferences are transitive.
3) Consumers always prefer more of a good to less.

Chapter 3: Consumer Behavior Slide 2

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 3: Consumer Behavior Slide 3

 Consumer Preferences
Clothing Combination B,A, & D
(units per week) yield the same satisfaction
50 B •E is preferred to U1
•U1 is preferred to H & G
H
40 E

A
30

D
20 U1
G

10

Food
10 20 30 40 (units per week)
Chapter 3: Consumer Behavior Slide 4
Consumer Preferences
 Indifference curves represent all
combinations of market baskets that
provide the same level of satisfaction to
a person.
 Indifference Curves slope downward to
the right.
If they sloped upward it would violate
the assumption that more of any
commodity is preferred to less.

Chapter 3: Consumer Behavior Slide 5

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.

 Indifference Curves
 Indifference curves cannot cross as this
would violate the assumption that more is
preferred to less

Chapter 3: Consumer Behavior Slide 6

Consumer Preferences
Indifference
Indifference Maps
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 3: Consumer Behavior Slide 7

 Consumer Preferences
Clothing
(units per week) Market basket A
is preferred to B.
Market basket B is
D preferred to D.

B A
U3

U2

U1

Food
(units per week)
Chapter 3: Consumer Behavior Slide 8
Consumer Preferences

Clothing 16 A Observation: The amount

(units of clothing given up for
per week) 14 a unit of food decreases
from 6 to 1
12 -6

10 B
1 Question: Does this
8 -4 relation hold for giving
D up food to get clothing?
6 1
-2 E
4 G
1 -1
2 1
Food
1 2 3 4 5 (units per week)
Chapter 3: Consumer Behavior Slide 9
 Consumer Preferences
Marginal
Marginal Rate
Rate of
of Substitution
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.
 Along an indifference curve there is a
diminishing marginal rate of substitution.

Chapter 3: Consumer Behavior Slide 10

Consumer Preferences

Clothing 16 A
(units
MRS   C
per week) 14 MRS = 6 F
12 -6

10 B
1
8 -4
D MRS = 2
6 1
-2 E
4 G
1 -1
2 1
Food
1 2 3 4 5 (units per week)
Chapter 3: Consumer Behavior Slide 11
 Consumer Preferences
Marginal
Marginal Rate
Rate of
of Substitution
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.
 Two goods are perfect complements when
the indifference curves for the goods are
shaped as right angles.
Chapter 3: Consumer Behavior Slide 12
Consumer Preferences
 BADS
 Things for which less is preferred to more
 Examples
 Air pollution
 Asbestos
 What Do You Think?
 How can we account for Bads in the analysis of
consumer preferences?

Chapter 3: Consumer Behavior Slide 13

Consumer Preferences
Application:
Application: Designing
Designing New
New Automobiles
Automobiles
 Car executives must regularly decide when to
introduce new models and how much money
to invest in restyling.
 An analysis of consumer preferences would
help to determine when and if car companies
should change the styling of their cars.
 What Do You Think? How can we determine
the consumers’ preferences?

Chapter 3: Consumer Behavior Slide 14

Consumer Preferences
 Utility
 Utility: Numerical score representing the
satisfaction that a consumer gets from a
given market basket.
 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 3: Consumer Behavior Slide 15

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

Chapter 3: Consumer Behavior Slide 16

Consumer Preferences
Clothing Utility
UtilityFunctions
Functions&&Indifference
IndifferenceCurves
Curves
(units
per week) Assume: U = FC
Market Basket U = FC
15 C 25 = 2.5(10)
A 25 = 5(5)
C B 25 = 10(2.5)
10

A U3 = 100 (Preferred to U2)

5
B
U2 = 50 (Preferred to U1)
U1 = 25
Food
0 5 10 15 (units per week)

Chapter 3: Consumer Behavior Slide 17

Consumer Preferences
 Ordinal Versus Cardinal Utility
 Ordinal Utility Function: places market baskets from
most preferred to least preferred, but does not
indicate how much one market basket is preferred
to another.
 Cardinal Utility Function: describes the extent to
which one market basket is preferred to another.
 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 3: Consumer Behavior Slide 18

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.
 The Budget Line: indicates all combinations
of two commodities for which total money
spent equals total income.

Chapter 3: Consumer Behavior Slide 19

Budget Constraints
 The Budget Line
 LetF equal the amount of food purchased,
and C is the amount of clothing.
 Ifthe 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.

P FF  P C C  I
Chapter 3: Consumer Behavior Slide 20
 Budget Constraints
Market Basket Food (F) Clothing (C) Total Spending
Pf = ($1) Pc = ($2) PfF + PcC = I

A 040 $80
B 2030 $80
D 4020 $80
E 6010 $80
G 800 $80

Chapter 3: Consumer Behavior Slide 21

Budget Constraints
Clothing
Pc = $2 Pf = $1 I = $80
(units
per week)
A Budget Line F + 2C = $80
(I/PC) = 40

B 1
30 Slope  C/F  -  - PF/PC
2
10
D
20
20
E
10
G Food
0 20 40 60 80 = (I/PF) (units per week)

Chapter 3: Consumer Behavior Slide 22

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 negative of the ratio of the
prices of the two goods.
 The slope indicates the rate at which the two
goods can be substituted without changing the
amount of money spent.

Chapter 3: Consumer Behavior Slide 23

Budget Constraints: Changes in Income and Prices

Clothing
(units An increase in
per week) income shifts
80 the budget line
outward (holding
prices constant)
60
A decrease in
income shifts
40 the budget line
inward

20 L3
(I = L1 L2
$40) (I = $80) (I = $160)
Food
0 40 80 120 160 (units per week)

Chapter 3: Consumer Behavior Slide 24

Budget Constraints: Changes in Income and Prices

Clothing
(units An increase in PF
per week) to $2.00 changes
the slope of the
budget line and
rotates it inward
pivoting from the
other good’s intercept. A decrease in the
40 price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.
L3 L1 L2
(PF = 1) (PF = 1/2)
(PF = 2) Food
40 80 120 160 (units per week)

Chapter 3: Consumer Behavior Slide 25

Budget Constraints
 The Effects of Changes in Income and Prices
 Price Changes: If the two goods increase in price,
but the ratio of the two prices is unchanged, the
slope will not change. However, the budget line
will shift inward to a point parallel to the original
budget line.
 Price Changes: If the two goods decrease in price,
but the ratio of the two prices is unchanged, the
slope will not change. However, the budget line
will shift outward to a point parallel to the original
budget line.

Chapter 3: Consumer Behavior Slide 26

Consumer Choice
 Consumers choose a combination of goods
that maximizes their satisfaction, given the
limited budget available to them.
 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.

Chapter 3: Consumer Behavior Slide 27

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 3: Consumer Behavior Slide 28
Consumer Choice
 Therefore, it can be said that
satisfaction is maximized where:

PF
MRS 
PC

Chapter 3: Consumer Behavior Slide 29

Consumer Choice
Clothing Pc = $2 Pf = $1 I = $80
(units per
week) Point B does not
maximize satisfaction
40 because the
MRS (-(-10/10) = 1
is greater than the
B price ratio (1/2).
30
-10C
Budget Line
20

U1
+10F

0 20 40 80 Food (units per week)

Chapter 3: Consumer Behavior Slide 30

Consumer Choice
Clothing Pc = $2 Pf = $1 I = $80
(units per
week)

40

D Market basket D
30 cannot be attained
given the current
budget constraint.

20
U3

Budget Line

0 20 40 80 Food (units per week)

Chapter 3: Consumer Behavior Slide 31

Consumer Choice
Clothing Pc = $2 Pf = $1 I = $80
(units per
week) At market basket A
the budget line and the
40 indifference curve are
tangent and no higher
level of satisfaction
can be attained.
30

A
20 At A:
MRS =Pf/Pc = .5

U2
Budget Line
0 20 40 80 Food (units per week)

Chapter 3: Consumer Behavior Slide 32

Consumer Choice
Application:
Application: Designing
Designing New
New Automobiles
Automobiles
 Consider two groups of consumers, each
wishing to spend $10,000 on the styling and
performance of cars.
 Each group has different preferences.
 By finding the point of tangency between a
group’s indifference curve and the budget
constraint auto companies can design a
production and marketing plan.

Chapter 3: Consumer Behavior Slide 33

Consumer Choice
A
A Corner
Corner Solution
Solution
 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/or vertical
axis.
 MRS is not equal to PA/PB at the chosen
bundle.

Chapter 3: Consumer Behavior Slide 34

A Corner Solution
Frozen
Yogurt
(cups
monthly) A A corner solution
exists at point B.
U1 U2 U3

B Ice Cream (cup/month)

Chapter 3: Consumer Behavior Slide 35

Consumer Choice
 A Corner Solution
 When a corner solution arises, the
consumer’s MRS does not necessarily
equal the price ratio.

 In this instance it can be said that:

MRS  PIceCream / PFrozen Yogurt

Chapter 3: Consumer Behavior Slide 36

 Consumer Choice
A
A College
College Trust
Trust Fund
Fund
 Suppose Jane Doe’s parents set up a trust
fund for her college education.
 Originally, the money must be used for
education.
 If part of the money could be used for the
purchase of other goods, her preferred
consumption bundle changes.

Chapter 3: Consumer Behavior Slide 37

Consumer Choice
Other
A
A College
College Trust
Trust Fund
Fund
Consumption
($) A: Consumption before the trust fund
The trust fund shifts the budget line
B: Requirement that the trust fund
C
must be spent on education
P U3 C: If the trust could be spent on
B other goods
A U2

U1

Q Education ($)

Chapter 3: Consumer Behavior Slide 38

Revealed Preferences
 If we know the choices a consumer has
made, we can determine what her
preferences are if we have information
about a sufficient number of choices
that are made when prices and income
vary.

Chapter 3: Consumer Behavior Slide 39

Revealed Preferences – 2 Budget Lines

Clothing l1 I1: Chose A over B

(units per A is revealed preferred to B
month)
l2: Choose B over D
l2 B is revealed preferred to D

B
D

Food (units per month)

Chapter 3: Consumer Behavior Slide 40

Revealed Preferences for Recreation

Other Scenario
Recreational •Roberta’s recreation budget = $100/wk
Activities •Price of exercise = $4/hr/week
($) •Exercises 10 hrs/wk at A given U1 & I1
100 C

80
•The rate changes to $1/hr + $30/wk
60 •New budget line I2 & combination B
A
B •Reveal preference of B to A

40 U1 U2
Would the Club’s
20 profits increase?
l1 l2
Amount of Exercise
0 25 50 75 (hours)

Chapter 3: Consumer Behavior Slide 41

Marginal Utility and Consumer Choice
Marginal
Marginal Utility
Utility
 Marginal utility = the additional satisfaction obtained
from consuming one additional unit of a good.
 Example
 The marginal utility derived from increasing from 0 to
1 units of food might be 9
 Increasing from 1 to 2 might be 7
 Increasing from 2 to 3 might be 5
 Observation: Marginal utility is diminishing: as more and
more of a good is consumed, consuming additional
amounts will yield smaller and smaller additions to utility.

Chapter 3: Consumer Behavior Slide 42

Marginal Utility and
Consumer Choice

 Marginal Utility and the Indifference

Curve
 If consumption moves along an
indifference curve, the 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).

Chapter 3: Consumer Behavior Slide 43

Marginal Utility and
Consumer Choice

 Formally:

0  MUF(F)  MUC(C)
 Rearranging:

  C / F   MU F / MU C

Chapter 3: Consumer Behavior Slide 44

Marginal Utility and
Consumer Choice

  C / F   MU F / MU C

 Because:

  C / F   MRS of F for C

MRS  MUF/MUC
Chapter 3: Consumer Behavior Slide 45
Marginal Utility and
Consumer Choice

 When consumers maximize satisfaction

the:
MRS  PF/PC
 Since the MRS is also equal to the ratio of the
marginal utilities of consuming F and C, it follows
that:

MUF/MUC  PF/PC
Chapter 3: Consumer Behavior Slide 46
Marginal Utility and
Consumer Choice

 Which gives the equation for utility

maximization:

MU F / PF  MU C / PC

Chapter 3: Consumer Behavior Slide 47