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CONSUMER BEHAVIOR
Preferences.
The conflict between
opportunities and desires.
Utility maximizing behavior.
Consumer behavior
slide 1
Preferences or Tastes
All consumers are endowed with a set of
“preferences” among all of the goods and
services from which they can choose.
These preferences are embodied in a "utility
function."
Consumer behavior
slide 2
Economists impose 4 assumptions on the preferences
in the “standard” case of the utility function:
1. A consumer can decide for any pair of “bundles” of goods
which bundle is preferred, or whether he/she is indifferent.
2. Preferences are transitive (consistent).
3. More is better.
4. Indifference curves are “convex”. (See below for a
discussion of indifference curves.)
Consumer behavior
slide 3
A utility function for two goods.
UTILITY FUNCTION
140
120
100
80
U
60
40
20
S
Consumer behavior
24
20
0
16
24 26
12
18 20 22
8
12 14 16
4 0 2 4 6 8 10
T
0
slide 4
Indifference curve
Definition: All combinations of goods among
which the consumer is indifferent.
That is, all the combinations of goods that
give the consumer a particular level of
utility or satisfaction.
Consumer behavior
slide 5
The previous graph can be rotated to show
indifference curves:
UTILITY FUNCTION
26
24
22
20
18
16
14
S
12
10
8
6
4
2
0
U
0
2
4
6
8
10 12 14 16 18 20 22 24 26
T
Consumer behavior
slide 6
Marginal Rate of Substitution
Definition: The Marginal Rate of Substitution
of X for Y is the amount of Y it takes to
make up for the loss of one unit of X.
(It’s minus the slope of an indifference curve.)
Consumer behavior
slide 7
Some indifference curves: U1 < U2 < U3
TACOS
U3
U2
U1
SPAGHETTI
Consumer behavior
slide 8
MRS is minus the slope of an indifference curve.
TACOS
MRSS for T = -(T/S)
U3
T
U2
S
SPAGHETTI
Consumer behavior
slide 9
Characteristics of indifference curves in the
“standard” case:
1) They “fill” the goods space.
2) They cannot intersect.
3) Higher curves lie above and to the right
of others.
4) They are “convex”. (There is increasing
marginal rate of substitution.)
Consumer behavior
slide 10
Woeful tales of preferences
Nickels and dimes.
Right shoes and left shoes.
"I wouldn't eat acorns even if you paid me."
"I would eat acorns only if you paid me."
Consumer behavior
slide 11
Budget Constraints
Definition: The consumer’s budget constraint
shows all of the combinations of goods and
services the consumer is able to buy, given
income and prices.
Consumer behavior
slide 12
Standard case assumptions:
1. The consumer has a fixed, known
money income in each time period.
2. The consumer pays a fixed price (in
terms of dollars) for each good.
Consumer behavior
slide 13
Two good case
Consumer’s income is I dollars per period.
There are two goods, S and T, that have prices
PS and PT.
The consumer’s spending on the two goods
together must be less than or equal to total
income in each time period.
Consumer behavior
slide 14
The Budget Constraint is
PS S + PTT I
This can be written as
T I/PT - (PS /PT)S
Consumer behavior
slide 15
Remember that income and prices are “givens” here,
so the last equation is a linear relationship between
T and S.
T
slope = - PS / PT
I/PT
I/PS
Consumer behavior
S
slide 16
Where are feasible and non-feasible
consumption bundles?
T
I/PT
I/PS
Consumer behavior
S
slide 17
Changing income and prices
What’s the effect on the consumer’s
opportunities if income increases?
I* > I’
PS S + PTT = I’
PS S + PTT = I*
Consumer behavior
slide 18
Where’s the new budget constraint when I
increases to I*?
T
I’/PT
I’/PS
Consumer behavior
S
hidden slide
slide 19
Changing prices
What’s the effect on the consumer’s
opportunities if the price of spaghetti falls?
PS' > P*S
PS' S + PTT = I
P*S S + PTT = I
Consumer behavior
slide 21
Where’s the new budget constraint when the
price of spaghetti falls?
T
I/PT
I/P'S
Consumer behavior
S
hidden
slide
slide 22
Choice
If a consumer wants to choose S and T so as
to maximize total utility, what should he/she
do?
hidden slide
Consumer behavior
slide 24
Maximizing total utility
TACOS
T* and S* are best.
T*
U3
U*
U2
U1
S*
Consumer behavior
SPAGHETTI
slide 26
To maximize utility:
1)
2)
Spend all of your income.
Choose a point on the budget constraint
where:
(a)
an indifference curve is tangent to the
constraint, or
(b)
the MRS is equal to the ratio of the
prices of the goods. (MRSS for T =PS/PT)
Consumer behavior
slide 27
More woeful tales
Nickels & dimes.
Left shoes and right shoes.
Work for pay.
Two part pricing.
Consumer behavior
slide 28
Changes in prices and income
1)
2)
Price changes and price consumption curves.
Income changes and income consumption
curves.
3)
Income and substitution effects.
4)
Consumer Surplus.
Consumer behavior
slide 29
Effects of a price change
If the price of a good declines, consumers will
change the amount they want to buy
(demand), in general.
Consumer behavior
slide 30
Price consumption curve
Locus of utility maximizing amounts of goods at
different prices for one of the goods.
Information from the PCC can be used to derive the
consumer's demand curve for a good.
Consumer behavior
slide 32
Finding the consumer's demand curve
for spaghetti.
T
PS
I/PT
P'S
U*
U'
S'
S*
Consumer behavior
I/P'S
P*S
DS
S
I/P*S
S'
S
S*
slide 33
Income increases
Are the goods normal or
inferior here?
T
I*/PT
I’/PT
U*
U'
S' S*
Consumer behavior
I’/PS
S
slide 34
Choice and inferior goods
Income increases here.
Which good is inferior?
T
I*/PT
I’/PT
U*
U'
S* S'
Consumer behavior
I’/PS
S
slide 35
Income consumption curve
Locus of utility maximizing amounts of goods at
different income levels for the goods.
Information from the ICC can be used to derive what
is called the Engel Curve (or income demand
curve) for a good.
Consumer behavior
slide 36
Income and Substitution Effects
The consumer is maximizing utility.
The price of one good falls.
The change in the demand for the good can be
thought of as having two parts:
A substitution effect, and
An income effect.
Consumer behavior
slide 37
Substitution Effect: The change in demand (due to a
decrease in price) holding the consumer's real
income constant.
Income Effect: The change in demand (due to a
decrease in price) because of the increase in real
income the consumer receives.
Consumer behavior
slide 38
Start with the consumer maximizing utility by
choosing amount S0 of good S.
T
I/PT
U'
S0
Consumer behavior
I/P'S
I/P*S
S
slide 39
The price of good S falls to P*S.
The consumer then chooses S2 of good S.
T
I/PT
U*
U'
S0
Consumer behavior
S2
I/P'S
I/P*S
S
slide 40
To find the substitution effect, we must see what the
consumer will choose at the lower price of S, but
forcing the consumer to have the same real income
(i.e., utility) as at S0.
The substitution effect is a "pure price effect" on
demand.
Consumer behavior
slide 41
Isolating the substitution effect is accomplished by
reducing the consumer's money income after the
price change until the best he or she can do is get
to indifference curve U'.
Consumer behavior
slide 42
The substitution effect always works in the
direction of increasing the demand for a
good whose price has fallen.
The income effect can work in either
direction, depending on whether the good is
normal or inferior.
Consumer behavior
slide 44
Income and substitution effects are used to
show (among other things) the conditions
under which the Law of Demand is “true”.
Consumer behavior
slide 45
Note that for normal goods, the Law of
Demand must hold.
For inferior goods, it may hold.
But if the income effect is of opposite sign
from the substitution effect, and is larger in
magnitude, a decrease in price will lead to
lower demand. (A Giffen Good.)
Consumer behavior
slide 46
THE CARDINAL UTILITY APPROACH
TO CHOICE
Each person has a utility function which is a rule or
equation that determines the consumer’s utility
(satisfaction) for any amounts of goods and
services consumed.
Utility here is assumed to be cardinal, rather than
ordinal. (Measured in "utils"??)
Consumer behavior
slide 47
The dependent variable in the utility function is
utility or satisfaction.
The independent variables are the amounts of the
goods and services an individual consumes.
Consumer behavior
slide 48
LIKE THIS:
UBROWN = f(beer, bicycles, pizza,
spaghetti, tacos, ...)
“Brown’s utility depends on the number of beers he
consumes, the number of bikes he consumes, etc.”
Consumer behavior
slide 49
Brown’s total utility from pizzas.
PIZZA
0
1
2
3
4
5
6
7
8
Consumer behavior
TOTAL UTILITY
0
5
13
22
29
35
40
44
47
slide 50
You can graph the total utility this way.
TOTAL
UTILITY
60
50
40
30
20
10
PIZZAS
0
0 1 2 3 4 5 6 7 8 9 10
Consumer behavior
slide 51
MARGINAL UTILITY:
The marginal utility is the increase in utility you get
from consuming one more unit of the good,
holding the consumption of all other goods
constant.
Consumer behavior
slide 53
The marginal utility of pizza is the change in
utility per unit change in pizza consumption
(holding the consumption of all other goods
constant, of course).
MUPIZZA = the change in U / the change in pizza
= U /  (PIZZA)
Consumer behavior
slide 54
You can compute marginal utility from the total
utility curve.
PIZZA
0
1
2
3
4
5
6
7
8
Consumer behavior
TOTAL UTILITY
(13-5)/(2-1)
0
5
13
22
29
35
40
44
47
MU
5
8
9
7
slide 55
Law of Diminishing Marginal Utility
The marginal utility of a good will eventually
decline as more is consumed.
Consumer behavior
slide 57
Marginal utility begins to decline here with the
consumption of the 4th pizza.
PIZZA
0
1
2
3
4
5
6
7
8
Consumer behavior
TOTAL UTILITY
0
5
(29-22)/(4-3)
13
22
29
35
40
44
47
MU
5
8
9
7
slide 58
Marginal utility is the slope of the total
utility curve.
MU = U / P
TOTAL
UTILITY
60
50
40
30
20
10
0
U
P
0 1 2 3 4 5 6 7 8 9 10
PIZZAS
Consumer behavior
slide 59
Draw the marginal utility curve here. Be sure
to label the axes correctly. Some points are
already shown.
12 marginal utility
The marginal
utility of the 4th
pizza is 7 utils.
10
8
6
4
2
0
0
1
2
3
4
5
6
7
8
9
10
pizzas
Consumer behavior
slide 60
The Law of Diminishing Marginal Utility is assumed
to be true for all consumers, and for all of the
goods a person consumes.
Consumer behavior
slide 62
The standard problem
(same as in ordinal approach)
Suppose a person consumes two goods, say,
tacos and spaghetti.
The person has a fixed money income of I
dollars per time period, say a week.
Tacos and spaghetti can be bought at fixed,
known prices, say PT and PS.
What amounts of spaghetti and tacos will
maximize utility?
Consumer behavior
slide 63
In the earlier solution to this problem, the marginal
rule was to make the MRS equal to the price ratio
of the goods. (MRSS for T =PS/PT)
It's easy to show that the MRS can be expressed as a
ratio of marginal utilities, land the rule rewritten
as:
Consumer behavior
slide 64
Choose S and T so that:
MUS / PS = MUT / PT.
MUS / PS is the marginal utility per $ spent on S.
It is the extra utility you can get from spending
another $ on S.
Consumer behavior
slide 65
WHY THE RULE WORKS
Suppose the rule were not true, but instead we had:
MUS / PS < MUT / PT.
or
12
< 20
Spending $1 less on S would lower your utility by 12
utils.
Respending that $1 on T would raise your utility by
20 utils.
This will give you a net gain of 8 (=20-12) utils.
Consumer behavior
slide 66
So if the MU's per $ spent on two goods are not not
equal, then a gain in total utility is possible by
reallocating your spending.
You should spend more on the good whose MU per $
is the highest. In the example on the last slide, this
was tacos, T.
Consumer behavior
slide 67
Note that as you allocate your $ from the good whose
MU per $ is lower, the MU of that good will rise
(remember the Law of Diminishing MU).
And the MU of the good with the higher MU per $
will fall for the same reason.
Thus, as you reallocate spending, the degree of
inequality between MU’s per $ will diminish.
Consumer behavior
slide 68
Only when the MU per $ spent on S is equal to the
MU per $ spent on T will you be unable to make
utility larger by reallocating you spending, and
total utility will be maximized.
MUS / PS = MUT / PT
Consumer behavior
slide 69
Consumer Surplus
At the level of the individual consumer, CS is the
difference between what the consumer is willing
to pay for a good, and the amount the consumer
actually pays.
It's a measure of the welfare to the consumer of
being able to buy the good in a market.
Consumer behavior
slide 70
Consumer surplus can be measured using
the demand curve for a product.
P
Demand for tacos
P*
D
Q*
Consumer behavior
Q
slide 71
When Q* is sold, willingness to pay is the
shaded area.
P
Demand for tacos
P*
D
Q*
Consumer behavior
Q
slide 72
When Q* is sold at a price P*, consumers pay P*
times Q*. Click to see the cost to consumers.
Click again to see the shaded area that is
consumer surplus.
P
Consumer surplus
P*
Demand for tacos
Cost to
consumers
D
Q*
Consumer behavior
Q
slide 73