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MM/EBM 2143 – Managerial Economics

03.
Consumer Behaviour

Ms. Sanduni Dilanka

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The Consumer’s Optimization Problem

• Individual consumption decisions are made with the goal


of maximizing total satisfaction from consuming various
goods and services
• Subject to the constraint that spending on goods exactly equals
the individual’s money income

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Consumer Optimization
(Marginal Utility Interpretation)
I = $ 11, PX = $ 1, PY = $ 2

Q Marginal Utility MU per dollar spent


X Y MUX MUY
1 100 85
2 50 45
3 40 40
4 30 35
5 20 10
6 10 5
7 5 2
8 2 1
9 1 0.5 3
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

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Typical Consumption Bundles for Two
Goods, X & Y

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Properties of Consumer Preferences
• Completeness
• For every pair of consumption bundles, A and B, the
consumer can say one of the following:
• A is preferred to B
• B is preferred to A
• The consumer is indifferent between A and B
• Transitivity
• If A is preferred to B, and B is preferred to C, then A
must be preferred to C
• Nonsatiation
• More of a good is always preferred to less 6
Utility

• Benefits consumers obtain from goods & services they


consume is utility
• A utility function shows an individual’s perception of the
utility level attained from consuming each conceivable
bundle of goods

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Indifference Curves

• Locus of points representing different bundles of goods,


each of which yields the same level of total utility
• Negatively sloped & convex

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Typical Indifference Curve

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Marginal Rate of Substitution
• MRS shows the rate at which one good can be
substituted for another while keeping utility
constant
• Negative of the slope of the indifference curve
• Diminishes along the indifference curve as X
increases & Y decreases
• Ratio of the marginal utilities of the goods

Y MU X
MRS   
X MUY
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Slope of an Indifference Curve & the MRS

A
600
Quantity of good Y

C (360,320)
320

I
T’

B
0 360 800
Quantity of good X

11
Two Polar Cases

• Two goods are perfect substitutes when the marginal rate


of substitution of one good for the other is constant
• Ex: A person might consider apple juice and orange juice perfect
substitutes
• Two goods are perfect complements when the
indifference curves for the goods are shaped as right
angles
• Ex: If you have 1 left shoe and 1 right shoe, you are indifferent
between having more left shoes only

12
Product Attributes and Indifference
Curves

• In designing automobiles firms must identify consumer


preference on style versus performance
• Risk and return preference of investors in financial
investments
• Price and quality consciousness of consumers

13
Indifference Map

Quantity of Y

IV

III

II

Quantity of X
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Marginal Utility

• Addition to total utility attributable to the addition of one


unit of a good to the current rate of consumption, holding
constant the amounts of all other goods consumed

MU  U X

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Consumer’s Budget Line

• Shows all possible commodity bundles that can be


purchased at given prices with a fixed money income

M  PX X  PY Y
or
M PX
Y   X
PY PY
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Consumer’s Budget Constraint

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Typical Budget Line
M
PY
•A

M PX
Y 
Quantity of Y

X
PY PY

B

M
Quantity of X PX 18
Shifting Budget Lines

R
120
A A

Quantity of Y
Quantity of Y

100 100
F
80

Z B N C B D
160 200 240 125 200 250

Quantity of X Quantity of X

Panel A – Changes in money income Panel B – Changes in price of X

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Utility Maximization
• The benefits of consumption are described by the
utility function.
• The costs of consumption are described by the budget
constraint.
• Utility maximization subject to a limited money income
occurs at the combination of goods for which the
indifference curve is just tangent to the budget line.

Y MU X PX
MRS    
X MUY PY 20
Utility Maximization

• Consumer allocates income so that the marginal utility per


dollar spent on each good is the same for all commodities
purchased

MU X MUY

PX PY

21
Constrained Utility Maximization

50
45 •A
40 •B •D
Quantity of pizzas

E IV
30
R

III
20

15 •C II
T
10 I

0 10 20 30 40 50 60 70 80 90 100

Quantity of burgers

22
Individual Consumer Demand

• An individual’s demand curve for a specific commodity


relates utility-maximizing quantities purchased to market
prices
• Money income & prices held constant
• Slope of demand curve illustrates law of demand—quantity
demanded varies inversely with price

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Deriving a Demand Curve
100
Quantity of Y

Px=$10

Px=$8

Px=$5

0
50 65 90 100 125 200
Quantity of X

10
Price of X ($)

Demand for X

0 50 65 90 24
Quantity of X
Substitution & Income Effects
• When price changes, total change in quantity demanded is
composed of two parts
• Substitution effect
• Income effect
• Substitution effect
• Change in consumption of a good after a change in its price, when
the consumer is forced by a change in money income to consume at
some point on the original indifference curve
• Income effect
• Change in consumption of a good resulting strictly from a change in
purchasing power

25
Income & Substitution Effects: Decrease in
Px
Total effect of = Substitution + Income Total effect of = Substitution + Income
price decrease effect effect price decrease effect effect
9 = 5 + 4 3 = 5 + (-2)

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Substitution & Income Effects

• Consider the substitution effect alone:


• Amount of good consumed must vary inversely with price
• Income effect reinforces the substitution effect for a normal
good & offsets it for an inferior good

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Thank you…!!!

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