Chapter 3 Consumer Behavior. Chapter 3: Consumer BehaviorSlide 2 Consumer Behavior There are three...

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Chapter 3 Consumer Behavior

Transcript of Chapter 3 Consumer Behavior. Chapter 3: Consumer BehaviorSlide 2 Consumer Behavior There are three...

Chapter 3

Consumer Behavior

Consumer Behavior

Chapter 3: Consumer Behavior Slide 2

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 Slide 3

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 Slide 4

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 Slide 5

Consumer Preferences

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.

Market BasketsMarket Baskets

Chapter 3: Consumer Behavior Slide 6

Consumer Preferences

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 Slide 7

Consumer Preferences

A 20 30

B 10 50

D 40 20

E 30 40

G 10 20

H 10 40

Market Basket Units of Food Units of Clothing

Chapter 3: Consumer Behavior Slide 8

Consumer Preferences

Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person.

Indifference CurvesIndifference Curves

Chapter 3: Consumer Behavior Slide 9

The consumer prefersA to all combinationsin the blue box, whileall those in the pink

box are preferred to A.

Consumer Preferences

Food(units per week)

10

20

30

40

10 20 30 40

Clothing(units per week)

50

G

A

EH

B

D

Chapter 3: Consumer Behavior Slide 10

U1

Combination B,A, & Dyield the same satisfaction•E is preferred to U1

•U1 is preferred to H & G

Consumer Preferences

Food(units per week)

10

20

30

40

10 20 30 40

Clothing(units per week)

50

G

D

A

EH

B

Chapter 3: Consumer Behavior Slide 11

U2

U3

Consumer Preferences

Food(units per week)

Clothing(units per week)

U1

AB

D

Market basket Ais preferred to B.Market basket B ispreferred to D.

Chapter 3: Consumer Behavior Slide 12

U1U2

Consumer Preferences

Food(units per week)

Clothing(units per week)

A

D

B

The consumer shouldbe indifferent betweenA, B and D. However,B contains more ofboth goods than D.

Indifference CurvesCannot Cross

Chapter 3: Consumer Behavior Slide 13

A

B

D

EG-1

-6

1

1

-4

-21

1

Observation: The amountof clothing given up for a unit of food decreasesfrom 6 to 1

Consumer Preferences

Food(units per week)

Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16

Question: Does thisrelation hold for givingup food to get clothing?

Chapter 3: Consumer Behavior Slide 14

Consumer Preferences

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.

Marginal Rate of SubstitutionMarginal Rate of Substitution

Chapter 3: Consumer Behavior Slide 15

Consumer Preferences

Food(units per week)

Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16 A

B

D

EG

-6

1

1

11

-4

-2-1

MRS = 6

MRS = 2

FCMRS

Chapter 3: Consumer Behavior Slide 16

Consumer Preferences

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

Marginal Rate of SubstitutionMarginal Rate of Substitution

Chapter 3: Consumer Behavior Slide 17

Consumer Preferences

Perfect Substitutes and Perfect ComplementsTwo goods are perfect substitutes when

the marginal rate of substitution of one good for the other is constant.

Marginal Rate of SubstitutionMarginal Rate of Substitution

Chapter 3: Consumer Behavior Slide 18

Consumer Preferences

Orange Juice(glasses)

Apple Juice

(glasses)

2 3 41

1

2

3

4

0

PerfectSubstitutes

PerfectSubstitutes

Chapter 3: Consumer Behavior Slide 19

Consumer Preferences

Perfect Substitutes and Perfect ComplementsTwo goods are perfect complements when

the indifference curves for the goods are shaped as right angles.

Marginal Rate of SubstitutionMarginal Rate of Substitution

Chapter 3: Consumer Behavior Slide 20

Consumer Preferences

Right Shoes

LeftShoes

2 3 41

1

2

3

4

0

PerfectComplements

PerfectComplements

Chapter 3: Consumer Behavior Slide 21

Consumer Preferences

BADSThings for which less is preferred to more

ExamplesAir pollution

Asbestos

Chapter 3: Consumer Behavior Slide 22

Consumer Preferences

What Do You Think?How can we account for Bads in the

analysis of consumer preferences?

Chapter 3: Consumer Behavior Slide 23

Consumer Preferences

Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling.

Designing New Automobiles (I)Designing New Automobiles (I)

Chapter 3: Consumer Behavior Slide 24

Consumer Preferences

These consumers arewilling to give up

considerablestyling for additional

performance

Styling

Performance

ConsumerPreference A:

High MRS

ConsumerPreference A:

High MRS

Chapter 3: Consumer Behavior Slide 25

Consumer Preferences

These consumers arewilling to give up

considerableperformance for additional styling

Styling

Performance

ConsumerPreference B:

Low MRS

ConsumerPreference B:

Low MRS

Chapter 3: Consumer Behavior Slide 26

Consumer Preferences

What Do You Think?

How can we determine the consumers preference?

Designing New Automobiles (I)Designing New Automobiles (I)

Chapter 3: Consumer Behavior Slide 27

Consumer Preferences

A recent study of automobile demand in the United States shows that over the past two decades most consumers have preferred styling over performance.

Designing New Automobiles (I)Designing New Automobiles (I)

Chapter 3: Consumer Behavior Slide 28

Consumer Preferences

UtilityUtility: Numerical score representing the

satisfaction that a consumer gets from a given market basket.

Chapter 3: Consumer Behavior Slide 29

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 Slide 30

Consumer Preferences

Food(units per week)10 155

5

10

15

0

Clothing(units

per week)

U1 = 25

U2 = 50 (Preferred to U1)

U3 = 100 (Preferred to U2)A

B

C

Assume: U = FCMarket Basket U = FC

C 25 = 2.5(10)A 25 = 5(5)B 25 = 10(2.5)

Utility Functions & Indifference CurvesUtility Functions & Indifference Curves

Chapter 3: Consumer Behavior Slide 31

Consumer Preferences

Ordinal Versus Cardinal UtilityOrdinal 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 Slide 32

Consumer Preferences

Ordinal Versus Cardinal RankingsThe 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 Slide 33

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 Slide 34

Budget Constraints

The Budget LineThe budget line indicates all combinations

of two commodities for which total money spent equals total income.

Chapter 3: Consumer Behavior Slide 35

Budget Constraints

The budget line then can be written:

ICPFP CF

Chapter 3: Consumer Behavior Slide 36

Budget Constraints

A 0 40 $80

B 20 30 $80

D 40 20 $80

E 60 10 $80

G 80 0 $80

Market Basket Food (F) Clothing (C) Total SpendingPf = ($1) Pc = ($2) PfF + PcC = I

Chapter 3: Consumer Behavior Slide 37

Budget Line F + 2C = $80

CF/PPFC - 2

1- / Slope

10

20

(I/PC) = 40

Budget Constraints

Food(units per week)40 60 80 = (I/PF)20

10

20

30

0

A

B

D

E

G

Clothing(units

per week)

Pc = $2 Pf = $1 I = $80

Chapter 3: Consumer Behavior Slide 38

Budget Constraints

Food(units per week)

Clothing(units

per week)

80 120 16040

20

40

60

80

0

A increase inincome shifts

the budget lineoutward

(I = $160)L2

(I = $80)

L1

L3

(I =$40)

A decrease inincome shifts

the budget lineinward

Chapter 3: Consumer Behavior Slide 39

Budget Constraints

Food(units per week)

Clothing(units

per week)

80 120 16040

40

(PF = 1)

L1

An increase in theprice of food to$2.00 changes

the slope of thebudget line and

rotates it inward.

L3

(PF = 2)(PF = 1/2)

L2

A decrease in theprice of food to$.50 changes

the slope of thebudget line and

rotates it outward.

Chapter 3: Consumer Behavior Slide 40

Budget Constraints

The Effects of Changes in Income and PricesPrice Changes

If the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change.

Chapter 3: Consumer Behavior Slide 41

Budget Constraints

The Effects of Changes in Income and PricesPrice Changes

However, the budget line will shift inward to a point parallel to the original budget line.

Chapter 3: Consumer Behavior Slide 42

Budget Constraints

The Effects of Changes in Income and PricesPrice Changes

If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change.

Chapter 3: Consumer Behavior Slide 43

Budget Constraints

The Effects of Changes in Income and PricesPrice Changes

However, the budget line will shift outward to a point parallel to the original budget line.

Chapter 3: Consumer Behavior Slide 44

Consumer Choice

Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.

Chapter 3: Consumer Behavior Slide 45

Consumer Choice

The maximizing market basket must satisfy two conditions:

1) It must be located on the budget line.

2) Must give the consumer the most preferred combination of

goods and services.

Chapter 3: Consumer Behavior Slide 46

Recall, the slope of an indifference curve is:

Consumer Choice

F

CMRS

C

F

P

PSlope

Further, the slope of the budget line is:

Chapter 3: Consumer Behavior Slide 47

Consumer Choice

Therefore, it can be said that satisfaction is maximized where:

C

F

P

PMRS

Chapter 3: Consumer Behavior Slide 48

Consumer Choice

Food (units per week)

Clothing(units per

week)

40 8020

20

30

40

0

U1

B

Budget Line

Pc = $2 Pf = $1 I = $80

Point B does not maximize satisfaction

because theMRS (-(-10/10) = 1 is greater than the

price ratio (1/2).

-10C

+10F

Chapter 3: Consumer Behavior Slide 49

Consumer Choice

Budget Line

U3

D Market basket D cannot be attainedgiven the current

budget constraint.

Pc = $2 Pf = $1 I = $80

Food (units per week)

Clothing(units per

week)

40 8020

20

30

40

0

Chapter 3: Consumer Behavior Slide 50

U2

Consumer Choice

Pc = $2 Pf = $1 I = $80

Budget Line

A

At market basket A the budget line and theindifference curve aretangent and no higherlevel of satisfaction

can be attained.

At A:MRS =Pf/Pc = .5

Food (units per week)

Clothing(units per

week)

40 8020

20

30

40

0

Chapter 3: Consumer Behavior Slide 51

Consumer Choice

Choosing between a non-matching and matching grant to fund police expenditures

Decision Making & Public PolicyDecision Making & Public Policy

Chapter 3: Consumer Behavior Slide 52

Consumer Choice

Non-matching GrantNon-matching Grant

PoliceExpenditures ($)

PrivateExpenditures ($)

O

P

Q

U1

A

Before Grant• Budget line: PQ•A: Preference maximizing market basket •Expenditure

•OR: Private•OS: Police

R

S

Chapter 3: Consumer Behavior Slide 53

V

T

U3

U1

After Grant• Budget line: TV•B: Preference maximizing market basket •Expenditure

•OU: Private•OZ: Police

BU

Z

R

Consumer Choice

Non-matching GrantNon-matching Grant

P

PoliceExpenditures ($)

PrivateExpenditures ($)

O S Q

A

Chapter 3: Consumer Behavior Slide 54

P

R

U2

T

U1

Consumer Choice

Matching GrantMatching Grant

Police ($)

PrivateExpenditures ($)

O QS

R

Before Grant• Budget line: PQ• A: Preference maximizing market basket After Grant•C: Preference maximizing market basketExpenditures

•OW: Private•OX: Police

C

X

W A

Chapter 3: Consumer Behavior Slide 55

T

U3

U1

Nonmatching Grant•Point B

•OU: Private expenditure•OZ: Police expenditure

Matching Grant•Point C

•OW: Private expenditure•OX: Police expenditure

W

X

Consumer Choice

Non-Matching GrantNon-Matching Grant

P

Police ($)

PrivateExpenditures ($)

O Q

A

U2

C

R

BU

Z

Chapter 3: Consumer Behavior Slide 56

Consumer Choice

A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another. This exists where the indifference curves

are tangent to the horizontal and/or vertical axis.

MRS is not equal to PA/PB at the chosen bundle.

A Corner SolutionA Corner Solution

Chapter 3: Consumer Behavior Slide 57

A Corner Solution

Ice Cream (cup/month)

FrozenYogurt

(cupsmonthly)

B

A

U2 U3U1

A corner solutionexists at point B.

Chapter 3: Consumer Behavior Slide 58

Consumer Choice

A Corner SolutionWhen a corner solution arises, the

consumer’s MRS does not necessarily equal the price ratio.

In this instance it can be said that:

YogurtFrozenIceCream PPMRS /

Chapter 3: Consumer Behavior Slide 59

Consumer Choice

A Corner SolutionIf the MRS is, in fact, significantly greater

than the price ratio, then a small decrease in the price of frozen yogurt will not alter the consumer’s market basket.

Chapter 3: Consumer Behavior Slide 60

Revealed Preferences

If we know the choices a consumer has made, we can determine what her preferences are if we have information about a sufficient number of choices that are made when prices and income vary.

Chapter 3: Consumer Behavior Slide 61

D

Revealed Preferences--Two Budget Lines

l1

l2

B

A

I1: Chose A over B A is revealed preferred to Bl2: Choose B over D B is revealed preferred to D

Food (units per month)

Clothing(units per

month)

Chapter 3: Consumer Behavior Slide 62

Revealed Preferences--Two Budget Lines

l2

B

l1

D

A

All market basketsin the pink

shaded area are preferred to A.

Food (units per month)

Clothing(units per

month)

B is preferred toall market baskets in the green area

Chapter 3: Consumer Behavior Slide 63

All market baskets in the pink area preferred to A

Food (units per month)

Revealed Preferences--Four Budget Lines

Clothing(units per

month)

l1

l2

l3

l4

A: preferred to allmarket baskets in the green area

E

B

A

G

I3: E revealed preferred to A

I4: G revealed preferred to A

Chapter 3: Consumer Behavior Slide 64

Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.

Marginal Utility andConsumer Choice

Marginal UtilityMarginal Utility

Chapter 3: Consumer Behavior Slide 65

The principle of diminishing marginal utility states that as more and more of a good is consumed, consuming additional amounts will yield smaller and smaller additions to utility.

Diminishing Marginal UtilityDiminishing Marginal Utility

Marginal Utility andConsumer Choice

Chapter 3: Consumer Behavior Slide 66

Marginal Utility and the Indifference CurveIf consumption moves along an

indifference curve, the additional utility derived from an increase in the consumption of one good, food (F), must balance the loss of utility from the decrease in the consumption in the other good, clothing (C).

Marginal Utility andConsumer Choice

Chapter 3: Consumer Behavior Slide 67

The equation for utility maximization:

CCFF PMUPMU //

Marginal Utility andConsumer Choice

Chapter 3: Consumer Behavior Slide 68

In 1974 and again in 1979, the government imposed price controls on gasoline.

This resulted in shortages and gasoline was rationed.

Gasoline RationingGasoline Rationing

Marginal Utility andConsumer Choice

Chapter 3: Consumer Behavior Slide 69

Nonprice rationing is an alternative to market rationing.

Under one form everyone has an equal chance to purchase a rationed good.

Gasoline is rationed by long lines at the gas pumps.

Gasoline RationingGasoline Rationing

Marginal Utility andConsumer Choice

Chapter 3: Consumer Behavior Slide 70

Rationing hurts some by limiting the amount of gasoline they can buy.

This can be seen in the following model.

It applies to a woman with an annual income of $20,000.

Marginal Utility andConsumer Choice

Chapter 3: Consumer Behavior Slide 71

The horizontal axis shows her annual consumption of gasoline at $1/gallon.

The vertical axis shows her remaining income after purchasing gasoline.

Marginal Utility andConsumer Choice

Chapter 3: Consumer Behavior Slide 72

B

20,000

A

Gasoline(gallons per year)

Spendingon othergoods ($) 20,000

5,000

U1

C15,000

2,000

D

With a limit of2,000 gallons,

the consumer movesto a lower

indifference curve(lower level of utility).

18,000

U2

Marginal Utility andConsumer Choice