Download Chapter 3 Consumer Behaviour I — The

Chapter 3
Consumer Behaviour I --The Indifference Curve
Approach
© Pilot Publishing Company Ltd. 2005
Contents:
• Postulates of Consumer Behaviour
• Good, Bad and Neuter
• Utility
• Indifference Curve
• Properties of Indifference Curves of Two Goods
• Other Shapes of Indifference Curves
• Budget Line
• Consumer Equilibrium
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Contents:
• Changes in Consumer Equilibrium in
Response to Changes in Constraints
• Decomposition of Price Effect into
Substitution Effect and Income Effect
• Advanced Material 3.1: Postulate of utility
maximization
• Advanced Material 3.2: Corner solutions
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Postulates of Consumer
Behaviour
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• A theory has four components definitions;
postulates;
test conditions;
implications
• Chapter one: basic definitions
This chapter: postulates
+ test conditions
+ implications
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What are the basic postulates of consumer behaviour?
A. An economic agent behaves rationally.
• Meaning: Behaviour of an economic agent
has objectives and involves a prudent (審慎的)
choice among alternative means. In other words,
consumer behaviour is not random or arbitrary(隨意的).
It has patterns and can be explained.
• Significance: Thus, economic investigation is
possible and meaningful.
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Then how does an individual make his choice?
B. Postulate of constrained maximization / self-interest / selfishness
• Meaning: An economic agent always chooses the
maximizes the achievement of his goals
option that _________
among the options allowed by existing constraints.
• Significance: Without a postulate on economic choice,
there is no economics. Without a confirmed postulate on
economic choice, economics might not have survived.
Note: This is the most important & most useful postulate in economics.
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C. Each individual has many wants.
•
Significance: Hence choice and exchange may arise.
D. To each individual, some goods are scarce.
•
Significance: Hence competition and choice are
inevitable. They constitute the main content of economics.
Scarcity
Competition
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Choice
E. Scarce goods are substitutable
• Meaning: One is willing to forgo something
to get more of the scarce good — substitution,
provided that the value got is larger than the
cost paid.
•
Significance: Exchange is possible.
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F. The law of diminishing MRS
• Marginal rate of substitution (MRS): is the
maximum amount of good Y that an individual is
willing to forgo for an additional unit of good X.
• It is equal to marginal use value (MUV) of good
X in terms of good Y.
• The law states that MRS or MUV of a good
declines
____________
as more units of the good are
obtained, ceteris paribus.
• Significance: (Both interior and corner solutions are possible.)
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Good, Bad and Neuter
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A good is something desired,
some is preferred to _________.
none
i.e., _________
(Options: more / less / none / some)
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Types of goods:
Goods
Free goods
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Scarce goods
(economic goods)
Free good: Features
something desired
its amount available is ______
more than its
amount desired at zero price,
i.e., ________
no more is preferred.
(Options: more / less / some / no more )
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Scarce good (economic good): Features
something desired
less than its amount
its amount available is _____
desired at zero price,
more is preferred to _____.
less
i.e., ______
(Options: more / less / some / none )
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Distinction between free goods and scarce goods:
• Depends on situations rather than kinds.
• Any examples?
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Distinction between free goods and goods free-of-charge:
A free good must be a good free-of-charge. Why?
• its amount available is more than its amount desired.
• no one desires to have more of it
• no production nor exchange takes place  zero-priced.
 A good free-of-charge may not be a free good. Why?
• a scarce good can also be free-of-charge if someone
pays the cost for you. Any examples?
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A bad is something undesired,
less
more
i.e., _________
is preferred to _________.
(Options: more / less / some / none )
Is sickness a bad ?
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A neuter (中性物品) is something
neither desired nor undesired,
i.e., the quantity does not matter.
Any examples?
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Q3.2:
Which of the following are free goods? Explain.
air
pocket money
sea water
parental care
Q3.3:
Draw a demand and supply diagram to
illustrate a free good and a scarce good
respectively.
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Utility
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What is utility?
Utility (效用) is a number
• arbitrarily assigned to entities to rank them
according to one’s preference.
 the higher the utility, the more one prefers the entity.
 a criterion of maximization to rank options for making
choice.
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What is utility?
Utility reflects preference
 happiness / satisfaction
 social welfare
Why?
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Measurement of utility
Ordinal utility
Cardinal utility
• only reflects an order
• can also reflect an
order
• and the difference
• but the difference
between
between
the numbers assigned
the numbers assigned
is meaningful
is meaningless
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Measurement of utility
Which measurement of utility is used
in the indifference curve approach?
Ordinal measure of utility
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Indifference Curve
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What is an indifference curve?
Good Y
An indifference curve (IC, 等優曲線)
is a line joining all the points
(representing different baskets of goods)
giving the same utility to an individual.
U=10
0
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Good X
What is an indifference map?
Good Y
0
An indifference map (等優曲
線圖) is a set of ICs showing
the preference
_________ of an individual.
U=30
U=20
U=10
Good X
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Properties of Indifference Curves
of Two Goods
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1. ICs of two goods are negatively sloped
Keeping utility constant, along an IC,
a basket with more units of good X
fewer units of good Y.
must have _____
Good Y
• Slope of an IC of two goods (= Δ Y/ Δ X)
+X
negative
must be ________.
-Y
U=10
0
Good X
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(Options: more / fewer /
positive / negative)
2. Indifference curves are continuous
If quantities of good X and good Y can be
increased or decreased by infinitesimal amounts,
the ICs are continuous. Why?
Good Y
U=10
0
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Good X
3. Indifference curves can never intersect
 Along U1: point A = point B = U1

B
 Along U2: point A = point C = U2

C
A

• What is the utility of
point A, = U1 or U2?
U of the intersection point
 logical contradiction
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4. Full coverage
Good Y
• If a consumer knows his preference on every
basket of commodities, the commodity plane
will be fully covered by ICs. Why?
 The higher the IC ,
the higher the utility
(U3 > U2 > U1). Why?
0
U1
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U2
U3
Good X
5. Indifference curves of two goods are
convex to the origin
Good Y
The numerical value of the slope of an IC
(+1X -?Y) is equal to the MRS. Why?
As the consumption of good X rises,
MRS (the slope) falls. Why?
+1X
-Y
U1
0
Good X
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As the IC becomes
flatter & flatter, its shape is
convex
_______ to the origin.
Other Shapes of
Indifference Curves
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1. X is a neuter and Y is a good
Why?
Y (A good)
U3>U2>U1
U3
U2
Any increase or
decrease in the quantity
of X makes no difference
to the consumer.
U1
horizontal
ICs are ___________.
0
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X (A neuter)
What will be the shape of the ICs if
(a) X is a good and Y is a neuter?
(b) both X and Y are neuters?
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2. X is a bad and Y is a good
Why?
U3>U2>U1
Y (A good)
U3
U2
U1
+Y
+X
0
To keep U constant,
in a bad (+X) requires
in a good (+Y) as a compensation.
upward sloping
ICs are _________
with a/an increasing
_________slope.
X (A bad)
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What will be the shape of the ICs if
(a) X is a good and Y is a bad?
(b) both X and Y are bads?
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3. X is a commodity with a satiation threshold
(beyond which X turns from a good to a bad)
Good Y
U3>U2>U1
ICs are __________.
U-shaped
U3
Why?
U2
U1
0
X
X is a good X becomes a bad
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What will be the shape of the ICs if both X and
Y are goods with a satiation threshold?
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4. X and Y are perfect substitutes
Good Y (pack of 8 kg rice)
U3>U2>U1
0
U1
U2
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downward sloping
ICs are _________
straight lines.
_______
Why?
U3 Good X (pack of 5 kg rice)
5. X and Y are perfect complements
Good Y (left shoes)
right-angled
ICs are __________.
U3
Why?
U2
U1
0
45o
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U3>U2>U1
Good X (right shoes)
Q3.7: Study the indifference maps below and
determine if X and Y are goods, bads or neuters.
Y
Y
U1 U2 U3
U3
U2
U1
X
X
(a) U1 < U2 < U3
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(b) U1 > U2 > U3
Budget Line
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What is a budget line?
Budget line (BL) or consumption possibility curve is a
boundary showing the largest possible combinations of
goods that a consumer can buy in a market,
given his money income and market prices of the goods.
It is also called the budget constraint.
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Derivation of a BL:
Given I = $100, PX = $20 & PY = $25
The BL is a downward
The maxi. amount of X one can buy
sloping straight line.
Y
$100/$20 = 5
= ___________
4
The maxi. amount of Y one can buy
+1X
-0.8Y
0
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The
slope of BL
$100/$25
= 4 = cost of
= ___________
consuming an additional unit of
To buy
of X,Y.one
good
X1
inmore
termsunit
of good
$20/$25 = 0.8 unit of Y.
forgoes =____________
5
X
Features:
Point A: Expenditure ____
< Income
Y
Point B: Expenditure ____
= Income
Point C: Expenditure ____
> Income



B
C
(Options: >
A
0
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X
=
< )
Equation of budget line
X  PX + Y  PY = I
Expenditure
on good X
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Expenditure
on good Y
Money income
of the consumer
Changes in budget constraints
1. Changes in income
Y
in income
When one’s income
increases, the budget
outward
line will shift ______
in a parallel manner,
and vice versa. Why?
in income
0
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X
2. Proportionate changes in prices
Y
When prices of both
goods rise by the same
proportion, the budget
inward
line will shift _______
in a parallel manner,
and vice versa. Why?
A proportionate
in all money prices
A proportionate
in all money prices
0
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X
3. Disproportionate changes in prices
When PX , the budget line
tilt inward and become
will _________
steeper. Why?
Y
A rise in Px
When PX  , the budget
outward and
line willtilt
__________
flatter Why?
become _______.
A fall in Px
0
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X
Q3.8:
Under the following situations, what would happen to
the budget line? Explain with the aid of diagrams.
(a) I and PY are constants, but Px increases from P0 to
P1.
(b) I and PY are constants, but PX increases as the
consumer buys more and more units of the good,
i.e., PX and X are positively related.
(c) I and PY are constants, but PX decreases as the
consumer buys more and more units of the good,
i.e., PX and X are negatively related.
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Consumer Equilibrium
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What is a consumer equilibrium?
Optimum (最優點) or equilibrium (均衡) is the
best choice of an economic agent in achieving his
objective.
Optimality conditions (最優性條件) or equilibrium
conditions (均衡條件) are descriptions on the
defining features of the optimum or the equilibrium.
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Interior solution
When a consumer buys both goods X & Y,
i.e., the equilibrium is not one of the _________
intercepts
on the budget line, the equilibrium is called
an interior solution (內解點).
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Equilibrium: From observation
Y
U3>U2>U1
Y*
0
It is the tangency
point, the only point on
the budget line reaching
the highest IC attainable.
E*

U3
U1
X*
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From observation, the
best choice achievable is
E* (X*, Y*)
_____________.
U2
X
Why?
Equilibrium conditions:
Y
Y*
U3>U2>U1
2. The consumer
equilibrium is the
____________
tangency
point at which
the slope of IC equals
the slope of BL.
E*

U3
U2
0
U1
X*
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1. The consumer
equilibrium must
lie ____
on the BL.
X
Meaning of the slopes
Slope of indifference curve
Slope of budget line
1.
=ΔY/ΔX, holding utility
constant
2.
= Marginal rate of substitution = Marginal rate of substitution
in consumption, MRSc
in exchange, MRSe
3.
= The maximum amount of Y = The actual amount of Y one
one is willing to pay for an
is required to pay for an
additional unit of X
additional unit of X in exchange
4. = CostValue
/ Value? of an
additional unit of X in terms
of Y (=MUV)
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=ΔY/ΔX, holding expenditure
or income constant
= CostCost
/ Value? of consuming
an additional unit of X in terms
of Y (= Px/Py)
How is the consumer equilibrium reached?
value of an
At point A, MRSc > MRSe (_______
cost
additional X > its ________),
utility can be
buys more units of X.
raised if the consumer _________
Y

A Buy X

U2
(Options: buys more /
sells some /
value / cost )
U1
0
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X
How is the consumer equilibrium reached?
Y
At point B, MRSc < MRSe (value < cost),
utility can be raised if the consumer
_________
sells some units of X.
(Options: buys some /
sells some )
U2

Sell X

0
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B
U1
X
How is the consumer equilibrium reached?
MRSc = MRSe (value = cost),
utility is maximized &
the equilibrium is attained.
Y
E*

0
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U2
U1
X
Changes in
Consumer Equilibrium
in Response to
Changes in Constraints
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A. Changes in income
When income  with PX and PY unchanged,
the BL will shift outward
/ inward? in a parallel manner.
outward
• The effect of income on the consumption of a
consumer can be shown by 2 curves:
1. Income consumption curve
2. Engel curve
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1. Income consumption curve
Income consumption
curve (所得消費曲線,
ICC) is a line joining all
the equilibrium (X,Y) of
a consumer when one’s
income changes, holding
PX and PY constant.
Y



0
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ICC
X
2. Engel curve
Engel curve
(恩格爾曲線) is
a line showing the
consumption of a
good at different
income levels,
holding PX and PY
constant.
X3
X2
X1
0
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Engel
curve
X
I1
I2
I3
Income
A. Superior good:
Its consumption is positively related to income.
X
Y
ICC
Engel
curve
X3
X2
X1
X1 X2 X3
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X
I1
I2
I3 Income
B. Inferior good:
Its consumption is negatively related to income.
Y
ICC
X
Engel curve
X1
X2
X3
X3X2X1
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X
I1
I2
I3 I
B. Changes in price
The effect of price on the consumption of a
consumer can be shown by 2 curves:
1. Price consumption curve
2. Demand curve
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1. Price consumption curve
Y




0
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PCC
Price consumption
curve (價格消費曲線)
is a line joining all the
equilibrium of
a consumer when PX
changes, holding I & PY
constant.
X
2. Demand curve
Demand curve is a line showing
quantity demanded of a good
the ________________
of a consumer at different prices.
Px
Px1
Demand
Curve
Px2
Px3
0
X1
X2 X3
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X
Y
If price (Px) &
quantity demanded
(X) of the good are
negatively related.
PCC
0
Px
X
Px1
Demand
Curve
Px2
Px3
0
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X1 X2
X3
X4
X
Y
Giffen paradox
If price (Px) &
quantity demanded
(X) of a good are
_________
positively related,
the good is called a
Giffen good.
PCC
0
Px
X
Px1
Demand
Curve
Px2
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0
X2 X1
X
Decomposition of
the Price Effect into
the Substitution Effect &
the Income Effect
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Price effect
Price effect is the overall change
in the quantity demanded of a good
caused by a change in its price,
holding money income constant.
Price effect can be decomposed into
substitution effect and __________
income effect.
___________
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Substitution effect (替代效應) is the change in the
quantity demanded of a good caused by a change in
its price, holding utility or real income constant.
Y
Px One will buy more good X to substitute good Y
So substitution effect must be negative.

E1
E3
New equilibrium

0
L1
X1
X3
S.E.
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L3
X
L2
Income effect (所得效應) is the change in the
quantity demanded of a good as a result of a change
in real income caused by a change in its price.
Y
Using the
saved
income

When Px, income is saved. Income
is further saved by the S.E. as the
consumption of an expensive good is
substituted by the consumption of
E2 a cheaper good.

The saved income will raise
the consumption of good X
if good X is a superior good.
E1
E3

0
L3
L1
X1 X3
S.E.
X2
I.E.
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L2
X
Price effect of different kinds of goods
Y
1. The substitution effect
must be negative.
Positive I.E.

E1

E3
L1
0

E2
L3
S.E.
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2. If good X is a superior
good, what will be the
income effect?
3. And what will be the
price effect?
L2
X
Y
Negative I.E.
2. If X is an inferior good
with its -ve I.E. < S.E.,
E1


E2
what will be the price effect?

0
L1
E3
L3
S.E.
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L2
X
Y Negative I.E.

E2
what will be the price effect?

E1

0
3. If X is an inferior good
with its -ve I.E. > S.E.,
(called Giffen good),
L1
E3
L3
S.E.
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L2
X
Q3.12:
Decompose the price effect into the substitution effect
and the income effect, when the price of good X rises.
(a) If good X is a superior good
(b) If good X is an inferior good with its substitution
effect greater than its income effect
(c) If good X is an inferior good with its substitution
effect smaller than its income effect
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Advanced Material 3.1: Postulate of utility maximization
If the utility and the cost of each option
can be measured or asserted beforehand
• the postulate can generate refutable predictions and
it is useful if it is not refuted.
 cannot be measured or asserted beforehand
• the postulate cannot generate refutable predictions,
then it becomes tautological and useless in explanation
and prediction.
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Advanced Material 3.2: Corner solutions
When a consumer buys one good only, i.e., the
equilibrium is one of the intercepts on the budget line,
the equilibrium is called a corner solution (角隅解).
specialization in consumption.
There is a ___________________
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Advanced Material 3.2: Corner solutions
Possible reasons for a corner solution are:
1. The good is too expensive.
2. The entity is a bad.
3. MRS is not decreasing.
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1. The good is too expensive
Y (A good)
E*
MRSe (= cost) >
MRSc (= value)
U
3
U2
U3>U2>U1
U1
1X
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X (A good but
too expensive)
2. The entity is a bad
Y (A good)
U3
U2
E*
U1
U3>U2>U1
0
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X (A bad)
3. MRS is not decreasing
Y (A good)
Y (A good)
U3>U2>U1
U3>U2>U1
E*
U3
E*
U2
U3
U1
U2
U1
0
X (A good)
Constant MRS
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0
X (A good)
Increasing MRS
Correcting Misconceptions:
1. A free good is a good provided by the government
free of charge.
2. A free good is a good without utility and is
not preferred.
3. Utility is a measure of individual satisfaction
or a measure of social welfare.
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Correcting Misconceptions:
4. Utility of a good must be a positive number
and that of a bad must be negative.
5. Postulate of utility maximization is tautological.
6. A straight-line indifference curve denies
the postulate of substitution.
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Correcting Misconceptions:
7. A concave indifference map cannot have
consumer equilibrium or can have an interior
solution.
8. A good with its price and quantity demanded
negatively related is a normal good.
9. Holding money income constant is the same as
holding real income constant.
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Correcting Misconceptions:
10. Substitution effect is positive for superior good
and negative for inferior good.
11. Giffen good has no relation with inferior good.
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Survival Kit in Exam:
Question 3.1
(a) What is utility? Must the utility of a bad be
a negative number?
(b) Michael says, “Anderson fails in HKCEE and
he commits suicide. Why? He is maximizing utility.
Mary also fails in HKCEE but she does not commit
suicide. Why? She is maximizing utility. So, the
postulate of utility maximization is tautological.”
Do you agree?
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Survival Kit in Exam:
Question 3.2
Being a member of a club, a consumer can
purchase cosmetics at a reduced price. However,
he has to pay a membership fee, and after which
he has just enough income to purchase the original
basket of goods. Does he prefer to be a member?
Use an indifference map to illustrate.
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