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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