Economics Chapter - 3 PGF

Chapter 3
Consumer
Behavior
Topics to be Discussed
 Consumer Preferences
 Budget Constraints
 Consumer Choice
 Revealed Preferences
Chapter 3: Consumer Behavior Slide 2

Consumer Behavior
 Where do demand curves come from?
 We want to look at the fundamental cause of any kind

of demand.
 If we know this, then we can predict the effect of:

 A change in the price of the good
 A change in the price of other goods
 A change in income
 Taxes, etc.

Demand

 Normal Good
 Inferior Good
 Substitutes
 Complements

Supply

Equilibrium

Three Steps to Analyzing Changes in
Equilibrium
 1. Decide whether the event shifts the supply

or demand curve (or perhaps both).
 2. Decide in which direction the curve shifts.
 3. Use the supply-and-demand diagram to

see how the shift changes the equilibrium
price and quantity.

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.

Consumer Behavior

2) Then we will turn to budget

constraints.
 People have limited incomes.

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?

Consumer Preferences
Market Baskets
 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.

Consumer Behavior
 The fundamental building block of consumer behavior
is consumer preferences.
 “Consumer preferences” simply means that when

given a choice between two market baskets (that is, a
combination of different goods of different quantities):
 the consumer prefers one bundle to the other,
 or may possibly be indifferent between them.
 Our starting point is to assume that consumer

preferences exist, and satisfy some basic properties
that should be reasonable.

Market Baskets
 Three Basic Assumptions
1) Preferences are complete.

 That is, if given a choice between any two
out of the infinitely many possible market
baskets, the consumer always finds one at
least as preferable as the other.

Market Baskets
2) Preferences are transitive.

 Suppose the consumer can choose from three bundles: X,
Y, and Z.
 If X is preferred to Y, and Y is preferred to Z, then X must be

preferred to Z.
 Otherwise, it would be possible to trap this consumer in a

“money pump” by trading with him over and over again.

Market Baskets
3) Consumers always prefer more of

any good to less.
 If market basket X has 10 food and 5 clothes,
while basket Y has 11 food and 5 clothes, then Y
will always be preferred to X.

Market Basket Units of Food Units of Clothing
A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40

Indifference Curves
 Indifference curves represent all

combinations of market baskets that
provide the same level of satisfaction to
a person.

Clothing The consumer prefers
(units per week) A to all combinations
50 B in the blue box, while
all those in the pink
box are preferred to A.
40 H E
A
30
D
20 G
10
Food
10 20 30 40 (units per week)
Clothing Combination B,A, & D
(units per week) yield the same satisfaction
50 B •E is preferred to U1
•U1 is preferred to H & G
H
40 E
A
30
D
20 U1
G
10
Food
 Indifference Curves
 Indifference curves slope downward to the
right.
If it sloped upward it would violate the
assumption that more of any commodity
is preferred to less.

 Any market basket lying above and to the
right of an indifference curve is preferred to
any market basket that lies on the
indifference curve.

Indifference Maps
 An indifference map is a set of

indifference curves that describes a
person’s preferences for all
combinations of two commodities.
 Each indifference curve in the map shows
the market baskets among which the
person is indifferent.

 Finally, indifference curves cannot cross.
Thiswould violate the assumption that
more is preferred to less.

Clothing
(units per week) Market basket A
is preferred to B.
Market basket B is
D preferred to D.
B A
U3
U2
U1
Food
(units per week)
Clothing Indifference Curves
(units per week) U1 Cannot Cross
U2
The consumer should

be indifferent between
A, B and D. However,
A B contains more of
both goods than D.
B
D
Food
(units per week)
Clothing 16 A Observation: The amount

(units of clothing given up for
per week) 14 a unit of food decreases
from 6 to 1
12 -6
10 B
1 Question: Does this
8 -4 relation hold for giving
D up food to get clothing?
6 1
-2 E
4 G
1 -1
2 1
Food
1 2 3 4 5 (units per week)
Marginal Rate of Substitution
 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.

Clothing 16 A
MRS   C
(units
per week) 14 MRS = 6 F
12 -6
10 B
1
8 -4
D MRS = 2
6 1
-2 E
4 G
1 -1
2 1
Food
1 2 3 4 5 (units per week)
 We will now add a fourth assumption

regarding consumer preference:
 Along an indifference curve there is a
diminishing marginal rate of substitution.
 Note the MRS for AB was 6, while that for DE
was 2.
 Geometrically, this means that indifference
curves are convex.

 What does convexity of indifference curves mean?
 Suppose there are two market baskets, A and B. The

consumer prefers any mixture of A and B to either A or B
alone.
 For example: suppose a consumer can choose between

100 food, 100 clothes, or 50 food + 50 clothes.
 Under this assumption, the consumer will always prefer 50

food + 50 clothes to 100 of only one good.
 The consumer’s increase in satisfaction from going from
99 to 100 food is less than going from 49 to 50 food.

1) Preferences are complete.
2) Preferences are transitive.
3) Consumers always prefer more of any

good to less.
4)Marginal rates of substitution are

diminishing, or: indifference curves are
convex

 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
 Perfect Substitutes and Perfect

Complements
 Two goods are perfect substitutes when
the marginal rate of substitution of one
good for the other is constant.

 Perfect Substitutes and Perfect

Complements
 Two goods are perfect complements when
the indifference curves for the goods are
shaped as right angles.

Apple
Juice
(glasses) 4
Perfect
Substitutes
3
Orange Juice
0 1 2 3 4 (glasses)

Left
Shoes
4
Perfect
3
Complements
0 1 2 3 4 Right Shoes

 BADS
 Things for which less is preferred to more
 Examples
 Air pollution
 Asbestos

 What Do You Think?

 How can we account for Bads in the
analysis of consumer preferences?

Designing New Automobiles (I)
 Automobile executives must regularly

decide when to introduce new models
and how much money to invest in
restyling.

 An analysis of consumer preferences

would help to determine when and if car
companies should change the styling of
their cars.

Styling Consumer
Preference A:
High MRS
These consumers are

willing to give up
considerable
styling for additional
performance
Performance

Consumer
Styling
Preference B:
Low MRS
These consumers are
willing to give up
considerable
performance for
additional styling
Performance

 How can we determine the consumer’s

preference?
 We could ask them (not very reliable),

or…
 We could look at what they actually

choose (more on this later).

 Utility
 Utility: Numerical score representing the
satisfaction that a consumer gets from a
given market basket.

 Utility
 If buying 3 copies of Microeconomics
makes you happier than buying one shirt,
then we say that the books give you more
utility than the shirt.

 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

Clothing Utility Functions & Indifference Curves
(units
per week) Assume: U = FC
Market Basket U = FC
15 C 25 = 2.5(10)
A 25 = 5(5)
C B 25 = 10(2.5)
10
A U3 = 100 (Preferred to U2)

5
B
U2 = 50 (Preferred to U1)
U1 = 25
Food

 Ordinal Versus Cardinal Utility

 Ordinal 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.

 Ordinal Versus Cardinal Rankings

 The actual unit of measurement for utility is
not important.
 Therefore, an ordinal ranking is sufficient to
explain how most individual decisions are
made.

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.

Budget Constraints
 The Budget Line

 The budget line indicates all combinations
of two commodities for which total money
spent equals total income.

Budget Constraints
 The Budget Line

 Let F equal the amount of food purchased,
and C is the amount of clothing.
 Price of food = Pf and price of
clothing = Pc
 Then Pf F is the amount of money spent on
food, and Pc C is the amount of money
spent on clothing.

Budget Constraints
 The budget line then can be written:
PFF  PCC  I

Budget Constraints
Market Basket Food (F) Clothing (C) Total Spending
Pf = ($1) Pc = ($2) PfF + PcC = I
A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
Budget Constraints
Clothing
Pc = $2 Pf = $1 I = $80
(units
per week)
A Budget Line F + 2C = $80
(I/PC) = 40
B 1
30 Slope  C/F  -  - PF/PC
2
10
D
20
20
E
10
G Food
0 20 40 60 80 = (I/PF) (units per week)

Budget Constraints
 The Budget Line

 As consumption moves along a budget line
from the intercept, the consumer spends
less on one item and more on the other.
 The slope of the line measures the relative
cost of food and clothing.
 The slope is the negative of the ratio of the
prices of the two goods.

Budget Constraints
 The Budget Line

 The slope indicates the rate at which the
two goods can be substituted without
changing the amount of money spent.

Budget Constraints
 The Budget Line

 The vertical intercept (I/PC), illustrates the
maximum amount of C that can be
purchased with income I.
 The horizontal intercept (I/PF), illustrates
the maximum amount of F that can be
purchased with income I.

Budget Constraints
 The Effects of Changes in Income and

Prices
 Income Changes
 An increase in income causes the
budget line to shift outward, parallel to
the original line (holding prices
constant).

Budget Constraints

Prices
 Income Changes
 A decrease in income causes the budget
line to shift inward, parallel to the original
line (holding prices constant).

Budget Constraints
Clothing
(units A increase in
per week) income shifts
80 the budget line
outward
60
A decrease in
income shifts
40 the budget line
inward
20 L3
(I = L1 L2
$40) (I = $80) (I = $160)
Food
0 40 80 120 160 (units per week)

Budget Constraints

Prices
 Price Changes
 If the price of one good increases, the
budget line shifts inward, pivoting from
the other good’s intercept.

Budget Constraints

Prices
 Price Changes
 If the price of one good decreases, the
budget line shifts outward, pivoting from
the other good’s intercept.

Budget Constraints
Clothing
(units An increase in the
per week) price of food to
$2.00 changes
the slope of the
budget line and
rotates it inward.
A decrease in the
40 price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.
L3 L1 L2
(PF = 1) (PF = 1/2)
(PF = 2) Food

Budget Constraints

Prices
 Price Changes
 If the two goods increase in price, but
the ratio of the two prices is unchanged,
the slope will not change.

Budget Constraints

Prices
 Price Changes
 However, the budget line will shift inward
to a point parallel to the original budget
line.

Budget Constraints

Prices
 Price Changes
 If the two goods decrease in price, but
the ratio of the two prices is unchanged,
the slope will not change.

Budget Constraints

Prices
 Price Changes
 However, the budget line will shift
outward to a point parallel to the original
budget line.

Consumer Choice
 Consumers choose a combination of goods

that will maximize the satisfaction they can
achieve, given the limited budget available to
them.
 That is, out of all possible market bundles that

they can afford (i.e. on or below the budget
line)…
 The consumer will choose the one that lies on

the highest possible indifference curve.

Consumer Choice
 The maximizing market basket must satisfy two
conditions:
1) It must be located on the budget line

 Because for any bundle below the budget line, there is a
better bundle on the budget line
2) Must give the consumer the most preferred

combination of goods and services
 That is, the highest possible indifference curve.

Consumer Choice
 This is equivalent to finding the indifference curve
that is tangent (that is, touching at only one point) to
the budget line.
 In most cases, we can find this point by finding the

place on the indifference curve where its slope (which
is equal to the MRS) is the same as the slope of the
budget line.
 There are a couple of exceptions, which we will get to

later.

Consumer Choice
Recall, the slope of an indifference curve is:
C
MRS  
F
Further, the slope of the budget line is:
PF
Slope  
PC
Consumer Choice
 Therefore, it can be said that

satisfaction is maximized where:
PF
MRS 
PC

Consumer Choice
 It can be said that satisfaction is

maximized when marginal rate of
substitution (of F and C) is equal to the
ratio of the prices (of F and C).

Consumer Choice
Clothing Pc = $2 Pf = $1 I = $80
(units per
week) Point B does not
maximize satisfaction
40 because the
MRS (-(-10/10) = 1
is greater than the
B
price ratio (1/2).
30
-10C
Budget Line
20
U1
+10F
0 20 40 80 Food (units per week)

Consumer Choice
(units per
week)
40
D Market basket D
30 cannot be attained
given the current
budget constraint.
20
U3
Budget Line

Consumer Choice
(units per
week) At market basket A
the budget line and the
40 indifference curve are
tangent and no higher
level of satisfaction
can be attained.
30
A
20 At A:
MRS =Pf/Pc = .5
U2
Budget Line

Consumer Choice
 Suppose there are two goods (call them good
1 and good 2).
 The quantity of each good in a basket is given

by the variables (x, y).
 Suppose we know the utility function: u(x, y).
 We want to calculate the MRS for any

combination of x, y.

Consumer Choice


Consumer Choice


Consumer Choice


Consumer Choice


Consumer Choice


Consumer Choice
Designing New Automobiles (II)
 Consider two groups of consumers,

each wishing to spend $10,000 on the
styling and performance of cars.
 Each group has different preferences.

Consumer Choice
 By finding the point of tangency

between a group’s indifference curve
and the budget constraint auto
companies can design a production and
marketing plan.

Styling
$10,000 These consumers

are willing to trade
off a considerable
amount of styling
for some additional
performance
$3,000
$7,000 $10,000 Performance

Styling
$10,000 These consumers

are willing to trade
off a considerable
$7,000 amount of
performance for
some additional
styling
$3,000 $10,000 Performance

Consumer Choice
 Now, let’s solve some examples where we are given
the utility function and the budget line.
 This is from Exercise 10 at the end of Ch. 3 in the

textbook.
 Suppose u(F, C) = FC. The consumer’s total income

is 12, the price of food (Pf) is 1, and the price of
clothing (Pc) is 3.
 First, let’s plot some indifference curves and the

budget line.

Consumer Choice
 Indifference curves for u=1, 12, 24

Consumer Choice
 Budget line: PF F + PC C = 12
 F + 3 C = 12

Consumer Choice
 u(F, C) = FC -> MRS = C/F
 Slope of budget line: PF / PC = 1/3
 Set MRS = PF / PC : C/F = 1/3, or 3C = F
 Together with budget equation F + 3 C = 12, we have

two equations in two unknowns.
 Solve for F, C to get F=6, C=2. This is the optimal

(i.e. utility-maximizing) choice for this consumer.
 The MRS at this point is 2/6 = 1/3, which matches the

slope of the budget line.

Consumer Choice
 This is from Exercise 9 at the end of Ch. 3.
 u(M, P) = 2M + P, income = 200, PM = 4, PP = 2.

Consumer Choice
 u(M, P) = 2M + P, income = 200, PM = 4, PP = 2.
 MRS = 2/1 = 2, at any point on the indifference curve
 Slope of budget line = PM / PP = 4/2 = 2
 The MRS = slope condition holds at any point on the

indifference curve.
 Since all points on an indifference curve give the same utility,

then all points on the indifference curve that touches the budget
line are optimal choices.
 In this case, the budget line overlaps an indifference curve. Any

M, P that satisfies 4 M + 2 P = 200 is an optimal choice.

Consumer Choice
 Now, suppose PP increases to 4. What is the new optimal
consumption?
 The new slope of the budget line is 4/4 = 1.
 The MRS = slope condition cannot be used. Instead, find the

highest indifference curve that touches the budget line.
 Since the indifference curves are steeper than the budget line,
the highest indifference curve will touch the budget line at the
lower right corner.
 At the lower right corner, all income is spent on M, zero on P.
 M = 200 / 4 = 50, P = 0.

Consumer Choice
 Not all indifference curves have a MRS
at all points.
 For example, recall the indifference

curve for perfect complements, e.g. left
and right shoes.
 Technically, the MRS does not exist at

the “kink” in the indifference curve.

Left
Shoes
4
Perfect
3
Complements
No matter what the price is,

the tangent point is at the “kink”.
1
0 1 2 3 4 Right Shoes

Consumer Choice
A Corner Solution
 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 vertical
axis.
 MRS is not equal to PA/PB

A Corner Solution
Frozen
Yogurt
(cups
monthly) A A corner solution
exists at point B.
U1 U2 U3
B Ice Cream (cup/month)

Consumer Choice
 A Corner Solution
 At point B, the MRS of ice cream for frozen
yogurt is greater than the slope of the
budget line.
 This suggests that if the consumer could
give up more frozen yogurt for ice cream
he would do so.
 However, there is no more frozen yogurt to
give up!

Consumer Choice
 When a corner solution arises, the
consumer’s MRS does not necessarily
equal the price ratio.
 In this instance it can be said that:
MRS  PIceCream / PFrozen Yogurt

Consumer Choice
 The general principle of consumer choice to
remember is:
 The consumer will choose the affordable point with

the highest indifference curve.
 This will handle all possible cases.
 If the curve is smooth (i.e. has a MRS) at all points,

and you know the solution is not a corner case, then
you can equate MRS with slope of budget line.

Consumer Choice
 If 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.

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 incomes
vary.

Revealed Preferences--
Two Budget Lines
Clothing l1 I1: Chose A over B

(units per A is revealed preferred to B
month)
l2: Choose B over D
B is revealed preferred to D
l2
B
D
Food (units per month)

Two Budget Lines
Clothing l1
(units per All market baskets
month) in the pink
shaded area are
l2 preferred to A.
B
D
B is preferred to
all market baskets
in the green area

Four Budget Lines
I3: E revealed preferred to A
Clothing
l3
(units per
month) All market baskets in the
pink area preferred to A
E
l1
l4
A
l2
B G
A: preferred to all I4: G revealed preferred to A
market baskets in
the green area

Revealed Preferences for Recreation
Other Scenario
Recreational •Roberta’s recreation budget = $100/wk
Activities •Price of exercise = $4/hr/week
($) •Exercises 10 hrs/wk at A given U1 & I1
100 C
80
•The rate changes to $1/hr + $30/wk
60 •New budget line I2 & combination B
A
B •Reveal preference of B to A
40 U1 U2
Would the Club’s
20 profits increase?
l1 l2
Amount of Exercise
0 25 50 75 (hours)

Marginal Utility and
Consumer Choice
Marginal Utility
 Marginal utility measures the additional

satisfaction obtained from consuming
one additional unit of a good.

Consumer Choice
Marginal Utility
 Example
 The marginal utility derived from increasing
from 0 to 1 units of food might be 9
 Increasing from 1 to 2 might be 7
 Increasing from 2 to 3 might be 5
 Observation: Marginal utility is
diminishing
Consumer Choice
Diminishing Marginal Utility
 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.

Consumer Choice
 Marginal Utility and the Indifference

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

Consumer Choice
 Formally:
0  MUF(F)  MUC(C)

Consumer Choice
 Rearranging:
 C / F   MU F / MUC

Consumer Choice
 C / F   MU F / MUC
 Because:
 C / F   MRS of F for C
MRS  MUF/MUC
Consumer Choice
 When consumers maximize satisfaction

the:
MRS  PF/PC
 Since the MRS is also equal to the ratio
of the marginal utilities of consuming F
and C, it follows that:
MUF/MUC  PF/PC
Consumer Choice
 Which gives the equation for utility

maximization:
MU F / PF  MUC / PC

Consumer Choice
 Total utility is maximized when the

budget is allocated so that the marginal
utility per dollar of expenditure is the
same for each good.
 This is referred to as the equal marginal

principle.

Summary
 People behave rationally in an attempt

to maximize satisfaction from a
particular combination of goods and
services.
 Consumer choice has two related parts:

the consumer’s preferences and the
budget line.

Summary
 Consumers make choices by comparing
market baskets or bundles of
commodities.
 Indifference curves are downward
sloping and cannot intersect one
another.
 Consumer preferences can be
completely described by an indifference
map.
Summary
 The marginal rate of substitution of F for
C is the maximum amount of C that a
person is willing to give up to obtain one
additional unit of F.
 Budget lines represent all combinations

of goods for which consumers expend
all their income.

Summary
 Consumers maximize satisfaction

subject to budget constraints.
 The theory of revealed preference

shows how the choices that individuals
make when prices and income vary can
be used to determine their preferences.

End of Chapter 3
Consumer
Behavior

Economics Chapter - 3 PGF

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Chapter 3

Chapter 3: Consumer Behavior Slide 2

 We want to look at the fundamental cause of any kind

 If we know this, then we can predict the effect of:

 A change in the price of other goods

Chapter 3: Consumer Behavior Slide 3

Chapter 3: Consumer Behavior Slide 4

Chapter 3: Consumer Behavior Slide 7

Chapter 3: Consumer Behavior Slide 9

Chapter 3: Consumer Behavior Slide 13

 1. Decide whether the event shifts the supply

 2. Decide in which direction the curve shifts.

 3. Use the supply-and-demand diagram to

Chapter 3: Consumer Behavior Slide 15

 There are three steps involved in the

1) We will study consumer preferences.

Chapter 3: Consumer Behavior Slide 19

 There are three steps involved in the

2) Then we will turn to budget

Chapter 3: Consumer Behavior Slide 20

 There are three steps involved in the

3) Finally, we will combine consumer

Chapter 3: Consumer Behavior Slide 21

 A market basket is a collection of one or

 One market basket may be preferred

Chapter 3: Consumer Behavior Slide 22

 “Consumer preferences” simply means that when

 or may possibly be indifferent between them.

 Our starting point is to assume that consumer

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 Three Basic Assumptions

1) Preferences are complete.

Chapter 3: Consumer Behavior Slide 24

 Three Basic Assumptions

2) Preferences are transitive.

 If X is preferred to Y, and Y is preferred to Z, then X must be

 Otherwise, it would be possible to trap this consumer in a

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 Three Basic Assumptions

3) Consumers always prefer more of

Chapter 3: Consumer Behavior Slide 26

Chapter 3: Consumer Behavior Slide 27

 Indifference curves represent all

Chapter 3: Consumer Behavior Slide 28

Chapter 3: Consumer Behavior Slide 31

Chapter 3: Consumer Behavior Slide 32

 An indifference map is a set of

Chapter 3: Consumer Behavior Slide 33

Chapter 3: Consumer Behavior Slide 34

The consumer should

Clothing 16 A Observation: The amount

 The marginal rate of substitution (MRS)

Chapter 3: Consumer Behavior Slide 38

 We will now add a fourth assumption

Chapter 3: Consumer Behavior Slide 40

 Suppose there are two market baskets, A and B. The

 For example: suppose a consumer can choose between

 Under this assumption, the consumer will always prefer 50

Chapter 3: Consumer Behavior Slide 41

2) Preferences are transitive.

3) Consumers always prefer more of any

4)Marginal rates of substitution are