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Understanding Consumer Preferences and Choices

This chapter explores consumer behavior, focusing on consumer preferences, budget constraints, and consumer choices. It also discusses the importance of economic theory in understanding consumer behavior through real-world applications such as Apple-Cinnamon Cheerios and the Food Stamp program.

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Understanding Consumer Preferences and Choices

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  1. Chapter 3 Consumer Behavior

  2. Topics to be Discussed • Consumer Preferences • Budget Constraints • Consumer Choice • Revealed Preferences Chapter 3: Consumer Behavior

  3. Topics to be Discussed • Marginal Utility and Consumer Choices • Cost-of-Living Indexes Chapter 3: Consumer Behavior

  4. Consumer Behavior • Two applications that illustrate the importance of the economic theory of consumer behavior are: • Apple-Cinnamon Cheerios • The Food Stamp Program. Chapter 3: Consumer Behavior

  5. Consumer Behavior • General Mills had to determine how high a price to charge for Apple-Cinnamon Cheerios before it went to the market. Chapter 3: Consumer Behavior

  6. Consumer Behavior • When the food stamp program was established in the early 1960s, the designers had to determine to what extent the food stamps would provide people with more food and not just simply subsidize the food they would have bought anyway. Chapter 3: Consumer Behavior

  7. Consumer Behavior • These two problems require an understanding of the economic theory of consumer behavior. Chapter 3: Consumer Behavior

  8. Consumer Behavior • There are three steps involved in the study of consumer behavior. 1) We will study consumer preferences. • To describe how and why people prefer one good to another. Chapter 3: Consumer Behavior

  9. Consumer Behavior • There are three steps involved in the study of consumer behavior. 2) Then we will turn to budget constraints. • People have limited incomes. Chapter 3: Consumer Behavior

  10. Consumer Behavior • There are three steps involved in the study of consumer behavior. 3) Finally, we will combine consumer preferences and budget constraints to determine consumer choices. • What combination of goods will consumers buy to maximize their satisfaction? Chapter 3: Consumer Behavior

  11. Consumer Preferences Market Baskets • A market basket is a collection of one or more commodities. • One market basket may be preferred over another market basket containing a different combination of goods. Chapter 3: Consumer Behavior

  12. Consumer Preferences Market Baskets • Three Basic Assumptions 1) Preferences are complete. 2) Preferences are transitive. 3) Consumers always prefer more of any good to less. Chapter 3: Consumer Behavior

  13. Consumer Preferences Market Basket Units of Food Units of Clothing A 20 30 B 10 50 D 40 20 E 30 40 G 10 20 H 10 40 Chapter 3: Consumer Behavior

  14. Consumer Preferences Indifference Curves • Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person. Chapter 3: Consumer Behavior

  15. The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A. B H E A D G Consumer Preferences Clothing (units per week) 50 40 30 20 10 Food (units per week) 10 20 30 40 Chapter 3: Consumer Behavior

  16. Combination B,A, & D • yield the same satisfaction • E is preferred to U1 • U1is preferred to H & G B H E A D U1 G Consumer Preferences Clothing (units per week) 50 40 30 20 10 Food (units per week) 10 20 30 40 Chapter 3: Consumer Behavior

  17. Consumer Preferences • Indifference Curves • Indifference curves slope downward to the right. • If it sloped upward it would violate the assumption that more of any commodity is preferred to less. Chapter 3: Consumer Behavior

  18. Consumer Preferences • Indifference Curves • Any market basket lying above and to the right of an indifference curve is preferred to any market basket that lies on the indifference curve. Chapter 3: Consumer Behavior

  19. Consumer Preferences Indifference Maps • An indifference map is a set of indifference curves that describes a person’s preferences for all combinations of two commodities. • Each indifference curve in the map shows the market baskets among which the person is indifferent. Chapter 3: Consumer Behavior

  20. Consumer Preferences • Indifference Curves • Finally, indifference curves cannot cross. • This would violate the assumption that more is preferred to less. Chapter 3: Consumer Behavior

  21. Market basket A is preferred to B. Market basket B is preferred to D. D B A U3 U2 U1 Consumer Preferences Clothing (units per week) Food (units per week) Chapter 3: Consumer Behavior

  22. U1 U2 The consumer should be indifferent between A, B and D. However, B contains more of both goods than D. A B D Consumer Preferences Indifference Curves Cannot Cross Clothing (units per week) Food (units per week) Chapter 3: Consumer Behavior

  23. A Observation: The amount of clothing given up for a unit of food decreases from 6 to 1 -6 B 1 -4 D 1 E -2 G 1 -1 1 Consumer Preferences Clothing (units per week) 16 14 12 10 Question: Does this relation hold for giving up food to get clothing? 8 6 4 2 Food (units per week) 1 2 3 4 5 Chapter 3: Consumer Behavior

  24. Consumer Preferences Marginal Rate of Substitution • The marginal rate of substitution (MRS) 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: Consumer Behavior

  25. Consumer Preferences A Clothing (units per week) 16 14 MRS = 6 -6 12 10 B 1 8 -4 D MRS = 2 6 1 E -2 G 4 1 -1 1 2 Food (units per week) 1 2 3 4 5 Chapter 3: Consumer Behavior

  26. Consumer Preferences Marginal Rate of Substitution • We will now add a fourth assumption regarding consumer preference: • Along an indifference curve there is a diminishing marginal rate of substitution. • Note the MRS for AB was 6, while that for DE was 2. Chapter 3: Consumer Behavior

  27. Consumer Preferences Marginal Rate of Substitution • Question • What are the first three assumptions? Chapter 3: Consumer Behavior

  28. Consumer Preferences Marginal Rate of Substitution • Indifference curves are convex because 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. • Consumers prefer a balanced market basket Chapter 3: Consumer Behavior

  29. Consumer Preferences Marginal Rate of Substitution • Perfect Substitutes and Perfect Complements • Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant. Chapter 3: Consumer Behavior

  30. Consumer Preferences Marginal Rate of Substitution • Perfect Substitutes and Perfect Complements • Two goods are perfect complements when the indifference curves for the goods are shaped as right angles. Chapter 3: Consumer Behavior

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

  32. Consumer Preferences Left Shoes 4 Perfect Complements 3 2 1 0 1 2 3 4 Right Shoes Chapter 3: Consumer Behavior

  33. Consumer Preferences • BADS • Things for which less is preferred to more • Examples • Air pollution • Asbestos Chapter 3: Consumer Behavior

  34. Consumer Preferences • What Do You Think? • How can we account for Bads in the analysis of consumer preferences? Chapter 3: Consumer Behavior

  35. Consumer Preferences Designing New Automobiles (I) • Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling. Chapter 3: Consumer Behavior

  36. Consumer Preferences Designing New Automobiles (I) • An analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars. Chapter 3: Consumer Behavior

  37. These consumers are willing to give up considerable styling for additional performance Consumer Preferences Consumer Preference A: High MRS Styling Performance Chapter 3: Consumer Behavior

  38. These consumers are willing to give up considerable performance for additional styling Consumer Preferences Consumer Preference B: Low MRS Styling Performance Chapter 3: Consumer Behavior

  39. Consumer Preferences Designing New Automobiles (I) • What Do You Think? • How can we determine the consumers preference? Chapter 3: Consumer Behavior

  40. Consumer Preferences Designing New Automobiles (I) • A recent study of automobile demand in the United States shows that over the past two decades most consumers have preferred styling over performance. Chapter 3: Consumer Behavior

  41. Consumer Preferences Designing New Automobiles (I) • Growth of Japanese Imports • 1970’s and 1980’s • 15% of domestic cars underwent a style change each year • This compares to 23% for imports Chapter 3: Consumer Behavior

  42. Consumer Preferences • Utility • Utility: Numerical score representing the satisfaction that a consumer gets from a given market basket. Chapter 3: Consumer Behavior

  43. Consumer Preferences • Utility • 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: Consumer Behavior

  44. Consumer Preferences • Utility Functions • Assume: The utility function for food (F) and clothing (C) U(F,C) = F + 2C Market Baskets: F units C units U(F,C) = F + 2C A 8 3 8 + 2(3) = 14 B 6 4 6 + 2(4) = 14 C 4 4 4 + 2(4) = 12 The consumer is indifferent to A & B The consumer prefers A & B to C Chapter 3: Consumer Behavior

  45. Assume: U = FC Market Basket U = FC C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5) C U3 = 100 (Preferred to U2) A B U2 = 50 (Preferred to U1) U1 = 25 Consumer Preferences Utility Functions & Indifference Curves Clothing (units per week) 15 10 5 Food (units per week) 0 5 10 15 Chapter 3: Consumer Behavior

  46. Consumer Preferences • Ordinal Versus Cardinal Utility • 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. • Cardinal Utility Function: utility function describing the extent to which one market basket is preferred to another. Chapter 3: Consumer Behavior

  47. Consumer Preferences • Ordinal Versus Cardinal Rankings • The actual unit of measurement for utility is not important. • Therefore, an ordinal ranking is sufficient to explain how most individual decisions are made. Chapter 3: Consumer Behavior

  48. Budget Constraints • Preferences do not explain all of consumer behavior. • 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: Consumer Behavior

  49. Budget Constraints • The Budget Line • The budget lineindicates all combinations of two commodities for which total money spent equals total income. Chapter 3: Consumer Behavior

  50. Budget Constraints • 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 Pf F is the amount of money spent on food, and PcC is the amount of money spent on clothing. Chapter 3: Consumer Behavior

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