Consumer Behavior

1
 Contents
A. Consumer Preferences
B. Budget Constraints
C. Consumer Choice
D. Revealed Preference
E. Marginal Utility and Consumer
Choice
•
Consumer Behavior
Consumer behavior is best understood in three
distinct steps:

1) We will study consumer preferences

• A description of why and how people prefer one good to another.

2) Then we will turn to the budget constraints

• Consumers have a limited income.

3) Finally we combine consumer preferences and

budget constraints to determine consumer choice.
• Which combination of goods will consumers buy to maximize their
satisfaction?
 A Consumer Preferences
• A market basket is a list with specific
quantities of one or more commodities. It
might also refer to the quantities of food,
clothing etc that a consumer buys each
month. Many economist also use the
word bundle to mean the same as
market basket.
 Assumptions
• Three basic assumptions of consumer theory.
1. Preferences are assumed to be complete. In other
words consumers can compare and rank all possible
baskets.
2) Preferences are transitive. Transitivity means that if a
consumer prefers basket A to basket B and basket B to
basket C, then the consumers also prefers A to C.
3) More is better than less- Consumers always prefer
more of any good to less. Here goods are assumed to be
desirable. (ignore the “bads” such as air pollution).
 Consumer Preferences
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
Source: Pindyck (2004)
 Consumer Preferences
• An indifference curve represents all
combinations of market baskets that
provide a consumer with the same level of
satisfaction.
 Consumer Preferences
Clothing
(units per week)

50 B The consumer prefers

A to all combinations
in the blue box, while
40 H E all those in the yellow
box are preferred to A.
A
30

D
20 G

10

Food
10 20 30 40 (units per week)
Source: Pindyck (2004)
 Consumer Preferences
Clothing
The combinations B,A & D yield
(units per week)
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
10 20 30 40 (units per week)
Source: Pindyck (2004)
 Consumer Preferences
• Indifference Curves
– Indifference curves slope downward from left
to right.
• An upward sloping curve would violate the
assumption that more of any commodity is
preferred to less.
– Any market basket lying above and to the
right of the indifference curve is preferred to
any market basket on the indifference curve.
 Consumer Preferences
• An indifference map is a set of
indifference curves that describes a
person’s preferences.
– Any indifference curve represents the amount
of consumption bundles between which a
consumer is indifferent.
 Consumer Preferences
Clothing
(units per week)
Market basket A is
preferred to
market basket B.
D Market basket B is
preferred to D.

B A
U3

U2 Exercise: Draw
your own
U1
indifference curve!
Food
(units per week)
Source: Pindyck (2004)
 Consumer preferences
• Indifference curves cannot intersect.
Clothing Units

B U2
A

C
U1

Food Units
Shape of the Indifference Curve
• Downward sloping from the left. More of
any good is preferred to less. In other
words it also shows the substitution (or
trade offs) between two market baskets.
• How much of one’s quantity is willing to
give up for another.
 Consumer Preferences
Clothing
(units per week) A
16 Observation: The amount
of clothing given up for
14 one unit of food reduces
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)
Source: Pindyck (2004)
 Consumer Preferences
• The marginal rate of substitution (MRS)
measures the maximum amount of a good
a consumer is willing to give up in order to
obtain one additional unit of another good.
– The MRS is equal in magnitude to the slope of
the indifference curve.
 Consumer Preferences
Clothing
(units per week) A
16 MRS   C
F
14 MRS = 6 C  Clothing

12 -6
F  Food

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)
Source: Pindyck (2004)
 Consumer Preferences
• We will now add a fourth assumption
regarding consumer preference:
– Diminishing marginal rate of
substitution: The MRS decreases along
the indifference curve.
• Notice: The MRS for AB was 6 as the MRS for
DE was 2.
 Consumer Preferences
• Indifference curves are usually convex. As
more and more of one good is consumed,
we can expect that a consumer will prefer
to give up fewer and fewer units of a
second good to get additional units of the
first one.

• Consumers prefer a balanced

consumption bundle.