Topic 4

Consumer Choice
COMM 295
Ratna K. Shrestha

Introduction
How much compensation Facebook needs to
provide to induce some of its employees to
relocate from California to London?
The theory of consumer behavior can help
answer this and many other questions such
as:
1. How should consumers allocate their limited
income on different goods and services?

Introduction
The model of consumer behavior is based
on the following premises:
1. Individual preferences determine the amount
of pleasure they derive from a basket of
goods they consume.
2. Consumers face budget constraint.
3. Consumers maximize their satisfaction
subject to the constraint they face.

4.1 Consumer Preferences

Basic Assumptions
1. Preferences are complete.
Consumers can rank market baskets.
2. Preferences are transitive.
If one prefers bundle A to B, and B to C,
then he must prefer A to C.
3. Consumers always prefer more of any
good to less .
More is better.
4

Consumer Preferences
Consumer preferences can be represented
graphically using indifference curves.
Indifference curves represent all combinations
of market baskets that a consumer views as
equally desirable.
Points such as B & D have more of one good
but less of another compared to A.
Consumer may be indifferent between B, A and
D. All of them give the same utility U1.
5

Indifference Curves: An Example

Market Basket

Units of Food

Units of Clothing

20

30

10

50

40

20

30

40

10

20

10

40

Indifference Curves: An Example

Clothin
g

50
40

E
A

30
20

Indifferent among
B, A, & D.
E is preferred to
U1
U1 is preferred to H
&G
D

10

10

20

30

40

Food
7

Indifference Curves: Properties

1. Indifference curves slope downward .
If it sloped upward it would violate the
assumption that more is preferred to less.
That is, some points that had more of both
goods would be indifferent to a basket with
less of both goods.
2. Indifference curves can not cross.
If they do, it would violate the assumption
of more is better.
8

Indifference Maps
Clothing

U1

B is preferred to D (due
to more is better rule)
A is indifferent to B & D
B must be indifferent to
D but that cant be if B is
preferred to D
B
D

U2
U1
Food
9

Indifference Maps
3. A set of indifference curvesan
indifference map--describes preferences for
all combinations of goods and services.
4. Bundles on indifference curves farther
from the origin are preferred to those on
indifference curves closer to the origin.
5. There is an indifference curve through
every possible bundle.
10

Indifference Map
Market basket A
is preferred to B.
Market basket B is
preferred to D.

Clothing

D
B

A
U3
U2
U1
Food
11

Willingness to Substitute
The shapes of indifference curves describes
how a consumer is willing to substitute one
good for another (next slide).
A to B, give up 6 Burritos to get 1 Pizza
D to E, give up 2 Burritos to get 1 Pizza
The more Burritos and less Pizza a person
has, the more Burritos they are willing to give
up to get more Pizzas.
12

Indifference Curves
A

Burritos16

Observation: The amount

of Burritos given up for 1
Pizza decreases from 6 to
1 as the consumer have
more and more Pizzas.

14
12

-6

10

1
-4

8
6

D
1
-2

E
1 -1

2
1

Pizzas
13

Indifference Curves
Marginal rate of substitution (MRS)
measures how a person trades one good for
another.
It 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.

14

Marginal Rate of Substitution

A

Burritos (B)
16

MRS =
6

14
12

MRS B

-6

10
1
-4

8
6

B
D
1
-2

MRS = 2
E

1 -1

G
Pizza (Z)
15

Marginal Rate of Substitution

6. 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.
MRS decreases as we move down the
indifference curve--diminishing marginal
rate of substitution.

16

Marginal Rate of Substitution

Two Extreme Cases of MRS:
1. Perfect Substitutes
Two goods are perfect substitutes when
the MRS of one good for the other is
constant.
If a person always trades 1 glass of OJ for
1 glass of AJ, they are perfect substitutes.
To be perfect substitutes the trade ratio has
to be constant but not necessarily 1/1.
17

Consumer Preferences
Apple
4
Juice
(glasses)

Perfect
Substitutes

1
0

Orange Juice
(glasses)
18

Consumer Preferences
2. Perfect Complements
Two goods are perfect complements when
the indifference curves for the goods are
shaped as right angles.
Example: If have 1 left shoe and 1 right
shoe, you are indifferent between having
more left shoes only (for free). One extra
left shoe without a matching pair does not
add to your utility.
19

Consumer Preferences
Perfect
Complements

Left
Shoes

4
3
2
1
0

Right Shoes
20

Consumer Preferences: An
Application
Styling

Steeper ID curve reflects

that consumers are
willing to give up more
styling for one more unit
of performance.

Performance
21

Consumer Preferences: An
Application
Styling

Flatter ID curves:
These consumers
place a greater value
on styling than
performance

Performance
22

4.2 Utility
Utility Function
A numerical score representing the
satisfaction that a consumer gets from a
given market basket.
If 3 copies of Microeconomics make you
happier than one shirt, then books give you
more utility than the shirt.
If Lisas utility function U = U (B, Z) =
(BZ)1/2, then given B = 4 and Z=9, U = 6.
23

Utility
Utility function
Assume U(B,Z) = B + 2Z. In this case,
MUB = dU/dB =1, and MUZ = dU/dZ = 2.
If U = BZ, then MUB = dU/dB = Z, and
MUZ = dU/dZ = B.
Suppose that Lisa gives up some B to gain
more Z (without affecting her U). She gains
MU from the extra Z but loses MU from
fewer B. That is, MRS = B/Z = MUZ /MUB
24

Utility - Example
Basket
C
A
B

15

10

U3 = 100

U = BZ
25 = 2.5(10)
25 = 5(5)
25 = 10(2.5)

10

U2 = 50

15

U1 = 25
Z
25

Utility
Utility values are ONLY for ranking. A utility of
4 is not necessarily twice as good as utility of
2. There are two types of rankings.
1. 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.

26

Utility
2. Cardinal Utility Function
Utility function describing the extent to
which one market basket is preferred to
another.
The actual unit of measurement for utility is
not important. An ordinal ranking is sufficient
to explain how most individual decisions are
made.

27

4.3 Budget Constraints

Budget constraints limit an individuals ability
to consume in light of the prices they must pay
for various goods and services.
The Budget Line
Indicates all combinations of two goods for
which total money spent equals total
income.
For simplicity, assume only 2 goods are
consumed and that consumers dont save.
28

The Budget Line

Let price of Burrito = PB and price of Pizza =
PZ, then budget constraint is:
PB B + P Z Z = Y
We can rewrite this equation as:

Y
PZ
B

Z
P B PB
This is a liner line with Y/PB as y-intercept and
- PZ /PB as the slope of the line.
29

The Budget Line

Burrito

(Y/PB) = 40

Assume Y = $80, PZ = $1
and PB = $2.

B
1
PZ
Slope
- Z
2
PB

30
10
20

D
20
E

10
G

20

40

60

Pizza
80 = (Y/PZ)
30

The Budget Line

The slope of the line measures the relative
cost of Pizza and Burrito.
The slope indicates the rate at which the two
goods can be substituted without changing
the amount of money spent and so is called
the marginal rate of transformation (MRT).
The vertical intercept (Y/PB), illustrates the
maximum amount of B that can be
purchased with income Y. Similarly for Z.
31

The Budget Line - Changes

The Effects of Changes in Income
An increase in income causes the budget
line to shift outward, parallel to the original
line (holding prices constant).
Can buy more of both goods with more
income

32

The Budget Line - Changes

Burrito (units
per week)

A increase in
income shifts
the budget line
outward

80
60

A decrease in
income shifts
the budget line
inward

40
20
0

L3
(Y
=$40)

40

L1

L2
(Y= $80)

80

120

(Y = $160)

160

Pizza
units per week)
33

The Budget Line - Changes

The Effects of Changes in Prices
If the price of one good increases, the
budget line shifts inward, pivoting from the
other goods intercept.
If price of Pizza increases and you buy only
Pizza (x-intercept), then you cant buy as
much Pizza as before.
If buy only Burrito (y-intercept), can buy the
same amount.
34

The Budget Line - Changes

Burrito
(units
per week)

When PZ decreases to
$0.5, you can buy twice
as much with the same
income

40

L3

L2

L1
(PZ = $1)

(PZ =$ 2)

40

80

120

(PZ =$ 1/2)
160

Pizza
(units per week)
35

4.4 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. That is they
choose the highest utility curve within their
budget.
Remember that ID curves U3 > U2 > U1.

36

Consumer Choice
A, B, C on budget line
D highest utility but not
affordable
C highest affordable utility
Consumer chooses C

Burrito
(units per
week)

40
A
30

20

C
U3
U1

B
0

20

40

80

U2

Piza (units per week)

37

Consumer Choice
In the previous graph, point C is where the
indifference curve is just tangent to the
budget line and is the point on the budget line
that can give you the highest possible utility.
At this point, slope of the budget line equals
the slope of the indifference curve.
So at the utility maximum point:
Slope of ID curve = Slope of budget line
MRS = MRT.
38

Consumer Choice
If MRS > PZ/PB, Lisa can increase her utility
by increasing Pizza and decreasing Burrito
until MRS = PZ/PB
If MRS < PZ/PB, Lisa can increase her utility
by increasing Burrito and decreasing Pizza
until MRS = PZ/PB.
We can rewrite the utility maximizing
MU B
condition as: MU Z

PZ

PB
39

Consumer Choice
Utility is maximized if the last dollar spent on
pizza gives you as much extra utility as the
last dollar spent on burritos.
However, if
MU
MU
Z

PZ

PB

you could increase your utility by spending

more on pizza (Z) and less on Burrito (B).

40

Consumer Choice
Burrito
(units per
week)

Point B does not maximize

satisfaction because the
MRS = 10/10 = 1 is greater
than the price ratio = . You
can increase your utility by
buying more Z and less B.

40
30

-10

20

+10

20

40

U1
80

Pizza (units per week)

41

Learning By Doing: Example

Bob makes $ 600/month and spends his
income in buying food (X) and clothing (Y).
His utility function is: U = 2X0.5Y. The prices
of X and Y are $20 and $40, respectively.
a) Find Bobs optimal consumption bundle
and his maximum utility.
b) If government regulations restrict Bob
consumption of clothing to 5 units, what
happens to his utility?
42

Learning By Doing Example

a) Budget Equation: 20X +40Y = 600
At U max, MUx / Px = MUy /Py
X- 0.5 Y/20 = 2X0.5/40
X=Y
Substituting the value of X = Y into budget
equation: 20Y + 40Y = 600
Y = 10 and X = 10
Maximum U = 2 (10)0.5 10 = 63.25
43

Learning By Doing Example

b) If Y = 5, from budget equation 20X +40*5 =
600 and so X = 20.
At this level of X = 20 and Y = 5, Bobs
U = 2(20)0.5 *5 = 44.72 (which is less
than his maximum utility)

44