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Chapter 3

Chapter 3. Consumer Behavior. Consumer Behavior. Theory of consumer behavior The explanation of how consumers allocate income to the purchase of different goods and services. Consumer Behavior. There are three steps involved in the study of consumer behavior Consumer Preferences

odette-albert
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Chapter 3

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  1. Chapter 3 Consumer Behavior

  2. Consumer Behavior • Theory of consumer behavior • The explanation of howconsumers allocate incometo the purchase of different goods and services Chapter 3

  3. Consumer Behavior • There are three steps involved in the study of consumer behavior • Consumer Preferences • To describe how and why people prefer one good to another • Budget Constraints • People have limited incomes Chapter 3

  4. Consumer Behavior • Given preferences and limited incomes, what amount and type of goods will be purchased? • What combination of goods will consumers buy to maximizetheir satisfaction? Chapter 3

  5. Consumer Preferences • How might a consumer compare different groups of items available for purchase? • A market basket is a collection of one or more commodities • Individuals can choose between market baskets containing different goods Chapter 3

  6. Consumer Preferences – Basic Assumptions • Preferences are complete • Consumers can rank market baskets • Preferences are transitive • If they prefer A to B, and B to C, they must prefer A to C • Consumers always prefer more of any good to less • More is better Chapter 3

  7. Consumer Preferences • Consumer preferences can be represented graphically using indifference curves • Indifference curves represent all combinations of market baskets that the person is indifferent to • A person will be equally satisfied with either choice Chapter 3

  8. Indifference Curves: An Example Chapter 3

  9. Indifference Curves: An Example • Graph the points with one good on the x-axis and one good on the y-axis • Plotting the points, we can make some immediate observations about preferences • More is better Chapter 3

  10. B 50 Clothing H E 40 A 30 D G 20 10 Food 10 20 30 40 Indifference Curves: An Example The consumer prefers A to all combinations in the yellow box, while all those in the pink box are preferred to A. Chapter 3

  11. B 50 Clothing H E 40 A 30 D 20 G U1 10 Food 10 20 30 40 Indifference Curves: An Example • Indifferent between points B, A, & D • E is preferred to points on U1 • Points on U1are preferred to H & G Chapter 3

  12. Indifference Curves • Indifference curves slope downward to the right • If they sloped upward, they would violate the assumption that more is preferred to less Chapter 3

  13. Indifference Curves • To describe preferences for all combinations of goods/services, we have a set of indifference curves – an indifference map • Each indifference curve in the map shows the market baskets among which the person is indifferent Chapter 3

  14. Clothing D B A U3 U2 U1 Food Indifference Map Market basket A is preferred to B. Market basket B is preferred to D. Chapter 3

  15. Indifference Maps • Indifference maps give more information about shapes of indifference curves • Indifference curves cannot cross • Violates assumption that more is better Chapter 3

  16. Indifference Curves • The shapes of indifference curves describe how a consumer is willing to substitute one good for another • A to B, give up 6 clothing to get 1 food • D to E, give up 2 clothing to get 1 food • The more clothing and less food a person has, the more clothing they will give up to get more food Chapter 3

  17. A 16 Clothing 14 12 -6 B 10 1 8 -4 D 6 E 1 G -2 4 1 -1 1 2 Food 1 2 3 4 5 Indifference Curves Observation: The amount of clothing given up for 1 unit of food decreases from 6 to 1 Chapter 3

  18. Indifference Curves • We measure how a person trades one good for another using the marginal rate of substitution (MRS) • 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 Chapter 3

  19. A Clothing 16 14 -6 12 B 10 1 -4 8 D 1 6 E -2 G 4 1 -1 1 2 Food 1 2 3 4 5 Marginal Rate of Substitution MRS = 6 MRS = 2 Chapter 3

  20. Marginal Rate of Substitution • 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 Chapter 3

  21. Marginal Rate of Substitution • The MRS decreases as we move down the indifference curve • Along an indifference curve there is a diminishing marginal rate of substitution. • The MRS went from 6 to 4 to 1 ………….END OF L1!!!!!!!!!! Chapter 3

  22. Marginal Rate of Substitution • Indifference curves with different shapes imply a different willingness to substitute • Two polar cases are of interest • Perfect substitutes • Perfect complements Chapter 3

  23. Marginal Rate of Substitution • Perfect Substitutes • Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant • Example: a person might consider apple juice and orange juice perfect substitutes • They would always trade 1 glass of OJ for 1 glass of Apple Juice Chapter 3

  24. Apple Juice (glasses) 4 3 2 1 Orange Juice (glasses) 0 1 2 3 4 Consumer Preferences Perfect Substitutes Chapter 3

  25. Consumer Preferences • Perfect Complements • Two goods are perfect complements when the indifference curves for the goods are shaped as rightangles • Example: If you have 1 left shoe and 1 right shoe, you are indifferent between having more left shoes only • Must have one right for one left Chapter 3

  26. Left Shoes 4 3 2 1 0 1 2 3 4 Right Shoes Consumer Preferences Perfect Complements Chapter 3

  27. Consumer Preferences • We have assumed all our commodities are “goods” • There are commodities we don’t want more of - bads • Things for which less is preferred to more • Examples • Air pollution • Asbestos Chapter 3

  28. Consumer Preferences • How do we account for bads in our preference analysis? • We redefine the commodity • Clean air • Pollution reduction • Asbestos removal Chapter 3

  29. Consumer Preferences • Utility • A 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

  30. Utility • Utility function • Formula that assigns a level of utility to individual market baskets • If the utility function is U(F,C) = F + 2C A market basket with 8 units of food and 3 units of clothing gives a utility of 14 = 8 + 2(3) Chapter 3

  31. Utility - Example Consumer is indifferent between A & B and prefers both to C…..WHY???? Chapter 3

  32. Clothing 15 C 10 U3 = 100 A 5 B U2 = 50 U1 = 25 Food 0 5 10 15 Utility - Example Basket U = FC C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5) Chapter 3

  33. Utility • Although we numerically rank baskets and indifference curves, numbers are ONLY for ranking • There are two types of rankings • Ordinal ranking • Cardinal ranking Chapter 3

  34. Utility • Ordinal Utility Function • Places market baskets in the order of most preferred to least preferred • Cardinal Utility Function • Utility function describing the extent to which one market basket is preferred to another Chapter 3

  35. Budget Constraints • Budget constraints also limit an individual’s ability to consume in light of the prices they must pay for various goods and services Chapter 3

  36. Budget Constraints • The Budget Line • Indicates all combinations of two commodities for which total money spent equals totalincome • We assume only 2 goods are consumed, so we do not consider savings Chapter 3

  37. The Budget Line • Let F equal the amount of food purchased, and C is the amount of clothing • Price of food = PF and price of clothing = PC • Then PFF is the amount of money spent on food, and PCC is the amount of money spent on clothing Chapter 3

  38. The Budget Line • The budget line then can be written: All income is allocated to food (F) and/or clothing (C) Chapter 3

  39. The Budget Line • Different choices of food and clothing can be calculated that use all income • These choices can be graphed as the budget line • Example: • Assume income of $80/week, PF = $1 and PC = $2 Chapter 3

  40. Budget Constraints Chapter 3

  41. Clothing (I/PC) = 40 A B 30 10 D 20 20 E 10 G Food 0 20 40 60 80 = (I/PF) The Budget Line Chapter 3

  42. 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 slope is the negative of the ratio of the prices of the two goods Chapter 3

  43. The Budget Line • The slope indicates the rate at which the two goods can be substitutedwithout changing the amount of money spent • We can rearrange the budget line equation to make this more clear Chapter 3

  44. The Budget Line Chapter 3

  45. Budget Constraints • The Budget Line • The vertical intercept, I/PC, illustrates the maximum amount of C that can be purchased with income I • The horizontal intercept, I/PF, illustrates the maximum amount of F that can be purchased with income I Chapter 3

  46. 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)….WHY????? • Can buy more of both goods with more income • A decrease in income will have the opposite effect….. Chapter 3

  47. Clothing (units per week) 80 60 L2 (I = $160) 40 20 L3 L1 (I = $40) Food (units per week) (I = $80) 0 40 80 120 160 The Budget Line - Changes An increase in income shifts the budget line outward A decrease in income shifts the budget line inward Chapter 3

  48. The Budget Line - Changes • The Effects of Changes in Prices • Can be illustrated as follows: Chapter 3

  49. Clothing (units per week) 40 L2 L1 L3 (PF = 1/2) (PF = 1) Food (units per week) (PF = 2) 80 160 120 40 The Budget Line - Changes A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward. An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward. Chapter 3

  50. The Budget Line - Changes • The Effects of Changes in Prices • 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 parallel to the original budget line END OF L2!!!!!!!!!!!!!!! Chapter 3

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