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Chapter 5

Theory of Consumer Behavior


™ When you walk into a store, you are confronted
with thousands of goods that you might buy.

how to choose a bundle of goods


that, given your resources, best
suits your needs and desires.

Discuss how consumers make decisions


about what to buy.
™ How to decide what to buy and how much to buy?

Paying ability (Income)


Price of the product
The satisfaction that the product will bring to

So, we can analyze consumer behavior


from two aspects:

1.The satisfaction that consumer will get from


the product.
2.Payment constrain because of limited income
and product’s price. 5-3
¾ Consumer preferences

¾ Indifference curves

¾ Budget constrains

¾ Utility maximization

Understanding consumer behavior is the first step in


making profitable pricing , advertising, product design,
and production decisions.
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1. Basic assumptions of
consumer theory
™ As with all economic models, the theory of consumer behavior
employs some simplifying assumptions that allow us to focus on
the fundamental determinants of consumer behavior and to
abstract away from the less important aspects of the consumer’s
decision process

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The Consumer’s
Optimization Problem
™ We assume all individual consumption
decisions are made with the goal of
maximizing total satisfaction from
consuming various goods and services
~ Subject to the constraint that spending on
goods exactly equals the individual’s money
income

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The Consumer’s
Optimization Problem
™ The basic model of consumer theory seeks to
explain how consumers make their purchasing
decisions when they are completely informed
about all thing that matter:
~ Range of products available
~ Prices of all products
~ Capacity of products to satisfy
~ Their incomes

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Suppose that B is considered the most
desirable bundle, and C and A are
viewed as providing equal but lesser
Properties of consumer preferences amounts of satisfaction than B
four assumptions form the basis for the theory of consumer choice.

™ Assumption 1: Individuals can rank their


preferences (Completeness)
Consider a world in which only two goods are available:
deodorant and mouthwash. Suppose a consumer is confronted
with the following combination of those two goods.

A B C

5 cans deodorant 2 cans deodorant 4 cans deodorant

2 bottles mouthwash 6 bottles mouthwash 4 bottles mouthwash

Which combination to choose?


The ability to rank means that the individual can assess the relative
amount of satisfaction that would result from each bundle of goods.
Properties of consumer preferences

™ Assumption 2: Transitivity – it can be


thought of as requiring that preferences
be consistent.
If bundle D is preferred
to bundle B
Bundle D is preferred
to both A and C
If bundle B is preferred
to both A and C

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Properties of consumer preferences

™ Assumption 3: Nonsatiation (more is


preferred to less).
This means that individuals consider themselves better off if they
have more of a good or service than if they have less.
Consider a bundle D that consists of:
A B C D

5 cans deodorant 2 cans deodorant 4 cans deodorant 3 cans deodorant

2 bottles 6 bottles 4 bottles 7 bottles


mouthwash mouthwash mouthwash mouthwash

Which bundle will you choose, B or D?

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Utility
™ Benefits consumers obtain from goods &
services they consume is utility.
~ Utility is an abstract measure of the satisfaction or
happiness that a consumer receives from a bundle of
goods. Economists say that a consumer prefers one
bundle of goods to another if one provides more utility
than the other.
~ Utility is a measuring unit to satisfaction, like dollar,
kilometre, kilogram.

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Example: Utility & Use value

Use value of down


jacket: keep warm
Utility of down jacket:
in different season,
the utility of down
jacket is different.

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Example: Utility
Some people prefer
travelling by air to train
To these people, utility of
go travel by air > travel
by train.

Other people prefer


travelling by train to air
To these people, utility of
go travel by train >
travel by air. 5-14
The utility function
™ A utility function shows an individual’s
perception of the utility level attained from
consuming each conceivable bundle of
goods
U = f(X, Y)
If a consumer prefers one combination of goods, say, 20X and
30Y, to some other combination, say, 15X and 32Y, we need only
say: the amount of utility derived from the first bundle is greater
than the amount from the second: U= f(20,30) > U= f(15,32)

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2. Indifference Curves

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A B C

5 cans deodorant 2 cans deodorant 4 cans deodorant

2 bottles mouthwash 6 bottles mouthwash 4 bottles mouthwash

Bundle A and C were viewed as being equally desirable.

An individual would be indifferent to having A rather than C.


If asked to select one over the other, there would be no basis
for choice.

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™ Now suppose that other bundles, designated as E,F,G
and H, are also considered equivalent to A and C.
This bundles are plotted on a graph
Cans of
deodorant
The points can be joined to form an
A indifference curve that represents all
bundles of goods that provide an
C individual with equal levels of
E satisfaction

F
G
H
Bottle of
mouthwash 5-18
Indifference Curves
™ Indifference curve is a set of points
representing different bundles of goods &
services, each of which yields the same
level of total utility

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Indifference Curves
™ (1) Indifference curves are downward-sloping

Quantity of Point 1 denotes a bundle with more


good Y
of both good X and good Y than
point 2. but because of the
nonsatiation assumption, having
more of both goods X and Y implies
1 1 is preferred to 2.
hence, indifference curves must be
downward sloping.

2
Quantity of
good X
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Indifference Curves
™ (2) Indifference curves
are convex
™ consumers will be willing to
give up successively fewer
units of one good in order to
get additional units of
another good assures that
indifference curves will have
the convex shape.

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Two Extreme Examples of Indifference Curves:
Perfect substitutes
™ Suppose that someone offered you bundles of
nickels and dimes. How would you rank the
different bundles?
Two Extreme Examples of Indifference
Curves: Perfect complements
™ Suppose that someone offered you bundles of shoes.
Some of the shoes fit your left foot, others your right foot.
How would you rank these different bundles?
Marginal Rate of Substitution
™ MRS measures the number of units of Y
that must be given up per unit of X added
so as to keep utility constant
The consumer is indifferent between
combination A (10X and 60Y) and B (20X
and 40Y).
Thus the rate at which the consumer is willing
to substitute is :
∆ 60 40
2
∆ 10 20

The MRS is -2, meaning that the


consumer is willing to give up 2 units
of Y for each unit of X added. 5-24
Marginal Rate of Substitution

~ Negative of the slope of the indifference curve


~ Diminishes along the indifference curve as X
increases & Y decreases

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Marginal Rate of Substitution

A
600
Quantity of good Y

C (360,320)
320

I
T’

B
0 360 800
Quantity of good X

Slope of an Indifference Curve & the MRS (Figure 5.3)


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Indifference Maps
™ An indifference map consists of several
indifference curves
9 The higher (or further
to the right) an
indifference curve, the

Quantity of Y
greater the level of IV
utility associated with
the curve III
9 Combinations of goods
on higher indifference II
curves are preferred to
combinations on lower I
curves
Quantity of X 5-27
Indifference Map
Indifference curves do not intersect
The bundle denotes by 4 has
Quantity of more of both goods than 5
good X
4 is preferred to 5
Because 3 and 5 are on the same
4
5 indifference curve

Transitivity requires that 4


3 be preferred to 3
This is not true, because 3 and 4
are on the same indifference
Quantity of
good Y
curve
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A marginal utility interpretation
of MRS
™ Marginal utility is the addition to total utility that
is attributable to consuming one more unit of a
good, holding constant the amount of all other
goods consumed.
~ Marginal utility of good X (MUX )= ∆U/ ∆X
~ The change in total utility that results when both X and
Y change by small amounts is related to the marginal
utilities of X and Y is:
∆U = (MUX*∆X)+ (MUY*∆Y)

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A marginal utility interpretation
of MRS
™ For points on a given indifference curve, all
combinations of goods yield the same level of utility, so
∆U is 0 for all changes in X and Y that would keep the
consumer on the same indifference curve. So, it follows
that:
∆U = (MUX*∆X)+ (MUY*∆Y) = 0

Therefor, solving for ∆Y/ ∆X: ∆

We have known:

ΔY MU X
MRS = − =
ΔX MUY 5-30
3. The consumer’s budget
constraint
™ what the consumer can afford
™ Actual purchases are strongly influenced by income
and prices.

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™ People consume less than they desire because
their spending is constrained. While the
indifference curve only describes the
consumer’s preference. So after discussing
indifference curve, we need to consider the
budget constraint.

Income and Spending

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™ To keep things simple, we examine the
decision facing a consumer who buys
only two goods: pizza and Pepsi.
Income constraints
• Suppose the consumer has an income of $1,000 per
month and he spends his entire income on pizza and
Pepsi.
The price of a pizza is $10
The price of a pint of Pepsi is $2

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™ Find the combination of pizza and pepsi
that the consumer can buy.

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Consumer’s Budget Line
™ A budget line shows all possible bundles
of goods that can be purchased at given
prices if the entire income is spent

M = PX X + PY Y
or
M PX
Y= − X (In the form of a
straight line)
PY PY
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Consumer’s Budget
The term M/PY Gives the amount of Y the
consumer can buy if no X is purchased.
M
PY
•A Line AB shows all combination of X and Y that
can be purchased with the income (M) and
given prices of goods (Px and Py).

M PX
Quantity of Y

Y= − X
PY PY Is the slope of the budget line
and indicates how much Y
must be given up for an
additional unit of X

B M/P is the amount of X the


Quantity of X

M
X
consumer can buy if no Y is
A Typical Budget Line (Figure 5.6) PX purchased.
Consumer’s Budget
Example: • The slope of the budget
constraint measures the
rate at which the consumer
can trade one good for the
other
• slope is 5 (we can ignore the
minus sign)

reflects the trade-off the


market is offering the
consumer: 1 pizza for 5
pints of Pepsi.
Shifting Budget Lines (Figure 5.7)
If income (M) or the price ratio (Px/Py) changes, the budget line must
change.

R
120
A A

Quantity of Y
Quantity of Y

100 100
F
80

Z B N C B D
160 200 240 125 200 250

Quantity of X Quantity of X

Panel A – Changes in money income Panel B – Changes in price of


X
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4. Utility Maximization
™ Now we have all the tolls needed to analyze consumer choice:
~ The budget line shows all bundles of commodities that are
available to the consumer, given the limited income and market-
determined prices
~ The indifference map show the preference ordering all conceivable
bundles of goods.

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Point X
Which point is the Lies on the budget constraint, indicating that
utility maximized it is an affordable bundle.
point? But X is not the bundle that will maximize the
individual’s utility.
Quantity
of pizzas Point Y
Lies at the tangency between the budget
constraint and the indifference curve.
●Z That is, point Y is the only point on the
curve that touches the budget
constraint.

Y Point Z
● A point such as Z on any higher
indifference curve is above
the budget constraint and
hence is not affordable.
X

Quantity
of burgers
Utility Maximization subject to a
limited income
™ Given the individual’s tastes, preference, and
income, and the price of the two goods, there is
no other point that will provide the same level of
utility or satisfaction as point Y.
Quantity
of pepsi

Y is the point of tangency between ●Z


the indifference curve and the
budget constraint, the slope of Y

the two lines is equal at that point.

X

Quantity
of pizza
Utility Maximization subject to a
limited income
™ Utility maximization subject to a limited
income occurs at the combination of
goods for which the indifference curve is
just tangent to the budget line

ΔY PX
− = MRS =
ΔX PY

5-42
Constrained Utility Maximization
(Figure 5.8)

50
45 •A
Quantity of pizzas

40 •B •D
R E IV
30 •
III
20

15 •C II
T
10 I

0 10 20 30 40 50 60 70 80 90 100

Quantity of burgers
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Explain: a consumer maximizes utility when MRS XY =−
PX
PY

PX Here, x is burger
Suppose at point C: | MRS XY |< Y is pizza
PY

∆ The consumer willing to substitute 1


=1/4
∆ burger for 1/4 pizza


∆ In the market, 1 burger can be
= 4/8 1/2 exchanged for 1/2 pizza.

In the market, 2 burgers can be exchanged


How to make a for 1 pizza, but the consumer willing to give
choice? up 4 burger for 1 pizza, this means if the
consumer reduce the consumption of
burger, total utility will increase.
Explain: a consumer maximizes utility when MRS XY =−
PX
PY

PX Here, x is burger
Suppose at point B: | MRS XY |> Y is pizza
PY

∆ The consumer willing to substitute 1


=2
∆ burger for 2 pizzas


∆ In the market, 1 burger can be
= 4/8 1/2 exchanged for 1/2 pizza.

If the consumer give up 1 pizza, he can get 2


How to make a burgers from the market , the total utility
will increase. so the consumer will reduce the
choice? consumption of pizzas and buy more burgers.
ΔY
MRS XY = −
PX Δ Y
=
PY Δ X
is utility maximized?
ΔX
The rate that Permitted rate
consumer desires to of substitute X
substitute X to Y to Y in market
-△Y/ △X < -△Y/ △X No. The consumer will
reduce the consumption
=1/4 =1/2
of burgers (X)
-△Y/ △X > -△Y/ △X No. The consumer will
=2 =1/2 increase the consumption
of burgers (X)
-△Y/ △X = -△Y/ △X
Yes.
=1/2 =1/2

Conclusion: utility is maximized only when MRSxy=PX/PY


Marginal utility interpretation of
consumer optimization
™ Consumer allocates income so that the
marginal utility per dollar spent on each
good is the same for all commodities
purchased
MU X PX
MRS = =
MUY PY

MU X MUY
=
PX PY
5-47
Quantity
of pepsi

●Z
™ the slope of the two lines is I/Py

equal at point Y ●
Y

X

Quantity
According to indifference curve, of pizza
I/Px
the slope of point Y is: MRSxy=△y/ △x

According to budget line, the


slope of point Y is: -(I/Py)/(I/Px)=Px/Py

MRSxy=△y/ △x=MUx/MUy
So, MUx/MUy=Px/Py MUx/Px=MUy/Py
Utility Maximization, N Goods
™ The utility maximization principle is
easily extended to cover any number of
goods
ΔX i Pj
− = MRS =
ΔX j Pi

MU1 MU 2 MU 3 MU N
= = = ... =
P1 P2 P3 PN
5-49
Example: finding the optimal
bundle of hot dogs and cokes
(P180)

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5. Individual demand and
market demand curves

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Individual Consumer Demand
™ An individual’s demand curve for a
specific commodity relates utility-
maximizing quantities purchased to
market prices
~ Income & prices held constant
~ Slope of demand curve illustrates law of
demand—quantity demanded varies
inversely with price

5-52
Deriving a Demand Curve
(Figure 5.9)
100

Quantity of Y Px=$10

Px=$8

Px=$5

0
50 65 90 100 125 200
Quantity of X
Price of X ($)

10

Demand for X

0
50 65 90
Quantity of X 5-53
Market Demand & Marginal Benefit
™ List of prices & quantities consumers are
willing & able to purchase at each price, all
else constant
™ Derived by horizontally summing demand
curves for all individuals in market
™ Because prices along market demand
measure the economic value of each unit of
the good, it can be interpreted as the
marginal benefit curve for a good
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Derivation of Market Demand
(Table 5.1)

Quantity demanded
Market
Price Consumer 1 Consumer 2 Consumer 3
demand

$6 3 0 0 3

5 5 1 0 6

4 8 3 1 12

3 10 5 4 19

2 12 7 6 25

1 13 10 8 31

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Derivation of Market Demand
Figure (5.10)

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6. Corner Solution

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Corner Solution
™ In many cases consumers spend their
entire budget and choose to purchase
none of some specific good

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Corner Solution: X* = 0
Figure (5.11)
This figure shows a corner solution in
which the consumer spends her entire
budget on good Y and buys none of
good X.
In general, a corner solution, in which the
consumer purchases none of some good
X, result when …… for all
goods I, j, etc.
The consumer spends all of her income,
yet the marginal utility per dollar spent on
X is less than the marginal utility per
dollar spent on any other good that is
purchased. This is usually what we mean
when we say we “cannot afford”
something.
™ A corner solution exists when the utility
maximizing bundle lies at one of the
endpoints of the budget line and the
consumer chooses to consume zero units
of a good

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Corner Solution
™ For goods X and Y, a corner solution, in which
the consumer purchases none of good X, results
when
MU X MUY
<
PX PY
™ In general, a corner solution, in which the
consumer purchases none of good X, results
when
MU X MU i MU j
< = ... =
PX Pi Pj 5-61
Summary
™ Basic premise for analyzing consumer behavior
~ Individuals make consumption decisions with the goal of
maximizing their total satisfaction from consuming various
goods and services, subject to the constraint that their spending
on goods exactly equals their incomes
™ The benefit consumers obtain from the goods and
services they consume is called utility
~ The utility function shows an individual's perception of the level
of utility from consuming each conceivable bundle of goods
~ Marginal utility is the addition to total utility attributable to adding
one unit of a good, holding constant the amounts of all other
goods consumed
~ The marginal rate of substitution (MRS) shows the rate at which
one good can be substituted for another while keeping utility
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constant
Summary
™ An indifference curve is a set of points representing
different bundles of goods and services, each of which
yields the same level of total utility
™ The consumer’s budget line shows the set of all
consumption bundles that can be purchased at given
prices and income if the entire income is spent
™ A consumer maximizes utility subject to a limited
income at the combination of goods for which the
indifference curve is just tangent to the budget line
~ At this combination, the MRS is equal to the price ratio

5-63
Summary
™ An individual consumer’s demand curve relates utility-
maximizing quantities to market prices, holding
constant income and prices of all other goods
~ The slope of the demand curve illustrates the law of demand:
quantity demanded varies inversely with price
™ Market demand is derived by horizontally summing the
demand curves for all individuals in the market
™ When a consumer spends the entire budget and
chooses to purchase none of a specific good, this
outcome is called a corner solution

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