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CONSUMER BEHAVIOR
theory of consumer behavior: Description
of how consumers allocate incomes among
different goods and services to maximize their
well-being or utility or satisfaction.
Consumer behavior is best understood in three
distinct steps:
1. Consumer preferences (willingness factor)
2. Budget constraints (ability factor)
3. Consumer choices (demanding for the goods)
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CONSUMER PREFERENCES
Market Baskets
● market basket (or bundle) List with specific quantities
of one or more goods.
A 20 30
B 10 50
Chapter 3: Consumer Behavior
D 40 20
E 30 40
G 10 20
H 10 40
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 8e. 4 of 37
Consumer Theory
Assumes buyers are completely informed
about:
Range of products available
Prices of all products
Capacity of products to satisfy
Their income
Requires that consumers can rank all
consumption bundles based on the level of
satisfaction they would receive from
consuming the various bundles
5-5
CONSUMER PREFERENCES
Few assumptions
Completeness: Preferences are assumed to be
complete. In other words, consumers can compare
and rank all possible baskets. Thus, for any two
market baskets A and B, a consumer will prefer A to
B, will prefer B to A, or will be indifferent between the
two.
Transitivity: Preferences are transitive.
Transitivity means that if a consumer prefers
basket A to basket B and basket B to basket C, then
the consumer also prefers A to C.
More is better than less: Goods are assumed to
be socially desirable. Consumer would prefer a 6
basket with 2X and 2Y over a basket of 4X and 3Y.
Consumption Choice
Preferences
Total Utility
Marginal Utility
MUS/PS = MUM/PM.
Lisa is maximizing utility.
MU X MUY
PX PY
5-13
Example
The price of television ads is $400 per ad, the price of Radio Ad. Is $ 300
Example
Example
a. If the decision maker chooses to use one unit of X, one unit of Y, and one unit of Z,
the total benefit that results is $ .
b. For the fourth unit of activity Y, each dollar spent increases total benefit by
$ . The fourth unit of activity Y increases total benefit by $ .
c . Suppose the decision maker can spend a total of only $18 on the three activities.
What is the optimal level of X, Y, and Z? Why is this combination optimal? Why is
the combination 2X, 2Y, and 4Z not optimal?
d. Now suppose the decision maker has $33 to spend on the three activities. What is
the optimal level of X, Y, and Z?
3.1 CONSUMER PREFERENCES
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 8e. 17 of 37
CONSUMER PREFERENCES:
MEASURING UTILITY
Indifference curve
(IC): Curve
representing all
combinations of
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market baskets that
provide a consumer
with the same level of
satisfaction.
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UTILITY FUNCTION
Formula that assigns a level of utility to
individual market basket. For example,
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U(F, C) = F + 2C is the utility function
8 units food (F) and 3 units clothing (C) would
provide utility = 8 + 2(3) = 14.
6 unit foods and 4 units clothing will provide the
same utility.
But 4 units of food and 4 units of clothing do not
yield the same utility.
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INDIFFERENCE CURVE (IC)
Features or characteristics of IC
1. IC is downward slopping (because, with the
fixed income, a consumer has to reduce
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consumption of a product when consumption of
another product rises)
2. IC is convex to the origin (because of
diminishing marginal rate of substitution)
3. ICs can’t intersect each other (by doing so, it
violates transitivity rule)
4. Higher the indifference curve more is the
satisfaction (because in a higher IC, consumer
gets more products than a lower IC)
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Four Properties of Indifference Curves
Cloth
1. Indifference curves
are downward-
sloping.
A
I1
Food
Cloth
2. Higher indifference
curves are preferred
to lower ones.
C
D
A I2
I1
I0
Food
Cloth
3. Indifference curves
cannot cross.
C A
I1 I4
Food
Cloth
4. Indifference curves
are bowed inward.
1
B
2
1 I1
Food
Y MU X
MRS
X MUY
5-25
3.1 CONSUMER PREFERENCES
Indifference Maps
● indifference map Graph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.
Figure 3.3
An Indifference Map
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 8e. 26 of 37
EXCEPTIONS OF IC
Substitute products: Two goods for which the
marginal rate of substitution of one for the other is
a constant.
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perfect complements Two goods for which
the MRS is zero or infinite; the indifference curves
are shaped as right angles.
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MATHEMATICAL EXAMPLES
Suppose that Rahim and Karim spend their incomes
on two goods, food (F) and clothing (C). Rahim’s
preferences are represented by the utility function
U(F,C) = 10FC , while Karim’s preferences are
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represented by the utility function U(F,C)= 0.20F2C2.
With food on the horizontal axis and clothing on the
vertical axis, identify on a graph the set of points that
give Rahim the same level of utility as the bundle
(10,5). Do the same for Karim on a separate graph.
On the same two graphs, identify the set of bundles
that give Rahim and Karim the same level of utility
as the bundle (15,8).
Do you think Rahim and Karim have the same
preferences or different preferences? Explain.
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BUDGET LINE
It shows different combinations of goods and services
that an individual can buy with his/her income.
Show the impact of change in income on budget line
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CHANGE IN BUDGET LINE WITH A CHANGE IN PRICE
Price Changes A
change in the
price of one good (with
income unchanged)
causes the budget line
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to rotate about one
intercept.
When the price of food
falls from $1.00 to
$0.50, the budget line
rotates outward from
L1 to L2.
However, when the
price increases
from $1.00 to $2.00,
the line rotates
inward from L1 to L3.
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MATHEMATICAL EXAMPLE
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announces that there will be a 10 percent
increase in the price of new books and a 5 percent
increase in the price of used books, Samira’s
father offers him $40 extra.
A) What happens to Samira’s budget line?
Illustrate the change with new books on the
vertical axis.
B) Is Samira worse or better off after the
price change? Explain. 31
MATHEMATICAL EXAMPLE
Sonia has a monthly income of $200 that she
allocates among two goods: meat and potatoes.
Suppose meat costs $4 per pound and potatoes $2
per pound. Draw her budget constraint.
Suppose also that her utility function is given by
the equation U(M, P) = 0.20M2P2. What
combination of meat and potatoes should she buy
to maximize her utility?
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EXAMPLE
Suppose a consumer has the indifference map shown below. The relevant
budget line
is LZ. The price of good Y is $10.
a. What is the consumer’s income?
b. What is the price of X?
c. Write the equation for the budget line LZ.
d. What combination of X and Y will the consumer choose? Why?
e. What is the marginal rate of substitution at this combination?
f. Explain in terms of the MRS why the consumer would not choose
combinations designated by A or B.
g. Suppose the budget line pivots to LM, income remaining constant. What is
the new
price of X? What combination of X and Y is now chosen?
h. What is the new MRS?
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INCOME AND SUBSTITUTION EFFECT
When price of a product declines, it has two
important effects
1) People can get that product at a cheaper price
thus the ability or purchasing power rises
2) People may not increase the consumption of the
product to maximum thus there is an income
gain.
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PRICE, INCOME AND SUBSTITUTION
EFFECT: NORMAL GOODS
Substitution effect: It
shows the change in
consumption of a
If income increases
with price constant,
the consumers will
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ENGEL CURVE
Curve relating the
quantity of a good
consumed to income.