CHAPTER

Microeconomics Pindyck/Rubinfeld 7e

Consumer Behavior

ENTS630 Fall 2011

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e.

CHAPTER 3 OUTLINE

3.1 Consumer Preferences

3.2 Budget Constraints 3.3 Consumer Choice 3.5 Marginal Utility and Consumer Choice

Consumer Behavior

Theory of consumer behavior: how consumers allocate incomes among different goods and services to maximize their well-being.
Consumer behavior is best understood in three distinct steps:

1. Consumer preferences
2. Budget constraints 3. Consumer choices

3.1

CONSUMER PREFERENCES

Market Baskets: List with specific quantities of one or more goods.

TABLE 3.1 Alternative Market Baskets Market Basket A B D E G H Units of Food 20 10 40 30 10 10 Units of Clothing 30 50 20 40 20 40

To explain the theory of consumer behavior, we will ask whether consumers prefer one market basket to another.
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3.1

CONSUMER PREFERENCES Some Basic Assumptions about Preferences

1.Completeness: Preferences are assumed to be complete.

Means 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.
By indifferent we mean that a person will be equally satisfied with either basket.

3.1

CONSUMER PREFERENCES Some Basic Assumptions about Preferences

2.Transitivity: Preferences are assumed to be transitive.

Means if a consumer prefers basket A to basket B and basket B to basket C, then the consumer also prefers A to C. Transitivity is normally regarded as necessary for consumer consistency.

3.More is better than less: Goods are assumed to be desirable.

Means consumers always prefer more of any good to less and are never satisfied or satiated - more is always better.

3.1

CONSUMER PREFERENCES

Indifference Curves

Compare market basket A with those in shaded areas, for example baskets E & G Basket A is clearly preferred to basket G, while E is clearly preferred to A. Why? A cannot be compared with B, D, or H without additional information. Why?

Figure 3.1 Describing Individual Preferences

3.1

CONSUMER PREFERENCES

Indifference Curves

Indifference curve: all combinations of market baskets that provide a consumer with the same level of satisfaction.

Indifference curve U1 shows all baskets that give the consumer the same level of satisfaction as does market basket A; include B and D. This consumer prefers basket E to A, but prefers A to H or G. Why?
Figure 3.2 An Indifference Curve 8

3.1

CONSUMER PREFERENCES

Indifference Maps

Indifference map: A set of indifference curves showing the market baskets among which a consumer is indifferent.
Any market basket on indifference curve U3 is preferred to any basket on curve U2 which in turn is preferred to any on U1. A is preferred to B B is preferred to D A is preferred to D
Figure 3.3 An Indifference Map 9

3.1

CONSUMER PREFERENCES

Indifference Maps

If U1 and U2 intersect, then one of the assumptions of consumer theory is violated. The consumer should be indifferent among market baskets A, B, and D. Why? A = B, A = D, then B = D However B should be preferred to D. Why? B has more of both goods.
Figure 3.4 Indifference Curves Cannot Intersect

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3.1

CONSUMER PREFERENCES The Marginal Rate of Substitution

Marginal rate of substitution (MRS): Maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good.
Slope of an indifference curve measures the marginal rate of substitution (MRS) .

Diminishing marginal rate of substitution. MRS between clothing and food falls from 6 (between A and B) to 1 ( between E and G).
Convexity When the MRS diminishes along an indifference curve, the curve is convex.

Figure 3.5 The Marginal Rate of Substitution 11

3.1

CONSUMER PREFERENCES Perfect Substitutes and Perfect Complements Perfect substitutes: Two goods for which the

marginal rate of substitution of one for the other is a constant.

The indifference curves are shaped as straight lines

Perfect complements: Two goods for which

the MRS is zero or infinite.

The indifference curves are shaped as right angles.

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3.1

CONSUMER PREFERENCES Perfect Substitutes and Perfect Complements

Figure 3.6 Perfect Substitutes and Perfect Complements

(a) Consumer is always indifferent between a glass of apple juice and and a glass of orange juice.

(b) An additional left shoe gives consumer no extra satisfaction unless she also obtains the matching right shoe.
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3.1

CONSUMER PREFERENCES In designing telecom networks trade off between ??

Figure 3.7 Preferences for Automobile Attributes

Preferences for automobile attributes: acceleration and interior space that give the same satisfaction.

Speed vs Security

Owners of Ford Mustang prefer acceleration to interior space .

Owners of Ford Explorers prefer interior space to acceleration.

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3.1

CONSUMER PREFERENCES

Utility and Utility Functions

Utility: Numerical score representing satisfaction from a given market basket.

Utility function: Formula that assigns a level of utility to individual market baskets.

Utility function can be represented by a set of indifference curves, each with a numerical indicator. Three indifference curves (utility levels of 25, 50,100) associated with the utility function FC.
Figure 3.8 Utility Functions and Indifference Curves 15

3.1

CONSUMER PREFERENCES

Ordinal versus Cardinal Utility

Ordinal utility function: Utility function that generates a ranking of market baskets in order of most to least preferred.
Used in the analysis

Cardinal utility function: Utility function describing by how much one market basket is preferred to another.
Not practical to measure

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3.2

BUDGET CONSTRAINTS

The Budget Line

Budget line: All combinations of goods for which the total amount of money spent is equal to income.
PF F PC C I
Table below shows market baskets associated with $80 income when price of food is $1 and price of clothing is $2 per unit.
TABLE 3.2 Market Baskets and the Budget Line Market Basket A B D E Food (F) 0 20 40 60 Clothing (C) 40 30 20 10 Total Spending $80 $80 $80 $80

80

$80

The budget line is: F + 2C = $80

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3.2

BUDGET CONSTRAINTS

The Budget Line

The budget line associated with income of $80 price of food PF = $1 per unit price of clothing PC = $2 per unit.

Slope of the budget line:

PF/PC = 10/20 = 1/2. Budget constraint: F + 2C = $80
Figure 3.10 A Budget Line

PF F PC C I C ( I / PC ) ( PF / PC ) F

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3.2

BUDGET CONSTRAINTS
The Effects of Changes in Income and Prices

Income Changes A change in income with prices unchanged causes the budget line to shift parallel to the original line (L1).

When the income of $80 is increased to $160 budget line shifts outward to L2.
If the income falls to $40, the line shifts inward to L3.

Figure 3.11 Effects of a Change in Income on the Budget Line

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3.2

BUDGET CONSTRAINTS
The Effects of Changes in Income and Prices

Price Changes A change in the price of one good with income unchanged causes the budget line to rotate. When the price of food falls from $1.00 to $0.50, the budget line rotates outward from L1 to L2. When the price of food increases from $1.00 to $2.00, the line rotates inward from L1 to L3.

Figure 3.12 Effects of a Change in Price on the Budget Line

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3.3

CONSUMER CHOICE

The maximizing market basket must satisfy two conditions: 1. It must be located on the budget line. 2. It must give consumer the most preferred combination of goods. A consumer maximizes satisfaction by choosing A where budget line and indifference curve U2 are tangent.

MRS PF / PC
No higher level of satisfaction can be attained with the given budget line, e.g. at D Satisfaction is not maximized at on any lower indifference curve, e.g. at B

Figure 3.13 Maximizing Consumer Satisfaction 21

3.3

CONSUMER CHOICE
Figure 3.14 Consumer Choice of Automobile Attributes

For the given budget of $10,000 Consumers in (a) prefer to buy a car whose acceleration is worth $7000 Consumers in (b) prefer to buy a car whose acceleration is worth $2500
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3.3

CONSUMER CHOICE

Corner Solutions

Corner solution: Situation in which the marginal rate of

substitution of one good for another in a chosen market basket is not equal to the slope of the budget line.
If MRS is not equal to price ratio for all levels of consumption, a corner solution arises.

Consumer maximizes satisfaction by consuming only one good.

At B only ice cream is consumed
Figure 3.15 A Corner Solution 23

3.5

MARGINAL UTILITY AND CONSUMER CHOICE

Marginal utility (MU): Additional satisfaction obtained

from consuming one additional unit of a good.

Distinction between the total utility obtained by consumption and satisfaction obtained from last unit consumed

Diminishing marginal utility: Principle that as more of a good is consumed, the consumption of additional amounts will yield smaller additions to utility.
Satisfaction from additional unit of food (Marginal utility of Food or MUF ) will decline as total amount of food consumed increase.

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3.5

MARGINAL UTILITY AND CONSUMER CHOICE

Equal marginal principle: Utility is maximized when the

consumer has equalized the marginal utility per dollar of expenditure across all goods.
Try to understand this intuitively and then see the formal proof later. Consider consuming telecom / computing services with a fixed budget and trade off between network Speed and Security Utility is maximized when a dollar spend on Speed provides the same utility as a dollar spend on Security. Why? Other wise consumer will buy more of one and less of the other service until marginal utility per dollar of expenditure becomes equal.

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3.5

MARGINAL UTILITY AND CONSUMER CHOICE

Equal marginal principle: Utility is maximized when the

consumer has equalized the marginal utility per dollar of expenditure across all goods.
The formal proof is given bellow

Assume moving along an indifference curve incrementally by F and C . Total utility remains the same and we have U = 0
0 =U Utility maximization requires

0 MU (F ) MU (C) F C (C / F ) MU /MU F C By definition (C/ F) is MRS MRS MU /MU F C

MRS P / P F C MU / MU P / P F C F C MU / P MU / P F F C C

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3.5
Figure 3.20

MARGINAL UTILITY AND CONSUMER CHOICE

Does money bring happiness? No ? Yes ? Depends. Economics Philosophy Religion Psychology Telecom !!? Goolge the question

Marginal Utility and Happiness

Demonstrates diminishing marginal utility of income

A comparison of mean levels of satisfaction with life across income classes in the United States shows that happiness increases with income, but at a diminishing rate.
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