MANAGERIAL ECONOMICS

CHAPTER-3+4: CONSUMER
CHOICE
 Topics to discuss
 Consumer Preferences

 Budget Constraints

 Consumer Choice

 Revealed Preference

 Marginal Utility and Consumer Choice

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CONSUMER BEHAVIOR
 theory of consumer behavior: Description of how
consumers allocate incomes among different goods
and services to maximize their well-being or utility or
satisfaction.
 Consumer behavior is best understood in three
distinct steps:
1. Consumer preferences (willingness factor)
2. Budget constraints (ability factor)
3. Consumer choices (demanding for the goods)

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 CONSUMER PREFERENCES

Market Baskets
● market basket (or bundle) List with specific quantities
of one or more goods.

TABLE 3.1 Alternative Market Baskets

Market Basket Units of Food Units of Clothing

A 20 30
B 10 50
Chapter 3: Consumer Behavior

D 40 20
E 30 40
G 10 20
H 10 40

To explain the theory of consumer behavior, we will ask

whether consumers prefer one market basket to another.

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 Consumer Theory
 Assumes buyers are completely informed
about:
 Range of products available
 Prices of all products
 Capacity of products to satisfy
 Their income
 Requires that consumers can rank all
consumption bundles based on the level of
satisfaction they would receive from
consuming the various bundles

5-5
CONSUMER PREFERENCES
 Few assumptions
 Completeness: Preferences are assumed to be
complete. In other words, consumers can compare and
rank all possible baskets. Thus, for any two market
baskets A and B, a consumer will prefer A to B, will
prefer B to A, or will be indifferent between the two.
 Transitivity: Preferences are transitive. Transitivity
means that if a consumer prefers basket A to basket B
and basket B to basket C, then the consumer also prefers
A to C.
 More is better than less: Goods are assumed to be
socially desirable. Consumer would prefer a basket with 6
2X and 2Y over a basket of 4X and 3Y.
 Consumption Choice

Preferences
The choice that Lisa makes depends on her preferences
—her likes and dislikes.
Her benefit or satisfaction from consuming a good or
service is called utility.
Total Utility
Total utility is the total benefit a person gets from the
consumption of goods. Generally, more consumption gives
more total utility.

© 2010 Pearson Addison-Wesley

 Maximizing Utility

Marginal Utility
Marginal utility from a good is the change in total utility
that results from a unit-increase in the quantity of the good
consumed.
As the quantity consumed of a good increases, the
marginal utility from it decreases.
We call this decrease in marginal utility as the quantity of
the good consumed increases the principle of diminishing
marginal utility.

© 2010 Pearson Addison-Wesley

 Utility-Maximizing Choice
Assume Budget = $ 40;
In row C,

MUS/PS = MUM/PM.

Lisa is maximizing utility.

© 2010 Pearson Addison-Wesley

 MARGINAL UTILITY AND CONSUMER CHOICE

● Marginal utility (MU) Additional satisfaction obtained from consuming

one additional unit of a good.
● diminishing marginal utility Principle that as more of a good is
consumed, the consumption of additional amounts will yield smaller
additions to utility.
0  MU (F )  MU (C )
F C
(C / F )  MU  MU (C )
F C
MRS  MU /MU (3.5)
F C
MRS  P / P (3.6)
F C
MU / MU  P / P
F C F C
MU / P  MU / P (3.7)
F F C C
● equal marginal principle: Principle that utility is maximized
when the consumer has equalized the marginal utility per dollar of
expenditure across all goods.
 Utility Maximization

 Consumer allocates income so that the

marginal utility per dollar spent on each good is
the same for all commodities purchased

MU X MUY

PX PY

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 Example

The price of television ads is $400 per ad, the price of Radio Ad. Is $ 300
Example
 Example

a. If the decision maker chooses to use one unit of X, one unit of Y, and one unit of Z,
the total benefit that results is $ .
b. For the fourth unit of activity Y, each dollar spent increases total benefit by
$ . The fourth unit of activity Y increases total benefit by $ .
c . Suppose the decision maker can spend a total of only $18 on the three activities.
What is the optimal level of X, Y, and Z? Why is this combination optimal? Why is
the combination 2X, 2Y, and 4Z not optimal?
d. Now suppose the decision maker has $33 to spend on the three activities. What is
the optimal level of X, Y, and Z?
 3.1 CONSUMER PREFERENCES

Ordinal versus Cardinal Utility

● ordinal utility function Utility function that
generates a ranking of market baskets in order of
most to least preferred.

● cardinal utility function Utility function

Chapter 3: Consumer Behavior

describing by how much one market basket is

preferred to another.

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 CONSUMER PREFERENCES:
MEASURING UTILITY
 Indifference curve (IC):
Curve representing all
combinations of market
baskets that provide a

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consumer with the same
level of satisfaction.

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UTILITY FUNCTION
 Formula that assigns a level of utility to individual
market basket. For example,

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U(F, C) = F + 2C is the utility function
8 units food (F) and 3 units clothing (C) would provide
utility = 8 + 2(3) = 14.
6 unit foods and 4 units clothing will provide the same
utility.
But 4 units of food and 4 units of clothing do not yield the
same utility.

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INDIFFERENCE CURVE (IC)
 Features or characteristics of IC
1. IC is downward slopping (because, with the fixed
income, a consumer has to reduce consumption of a

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product when consumption of another product rises)
2. IC is convex to the origin (because of diminishing
marginal rate of substitution)
3. ICs can’t intersect each other (by doing so, it violates
transitivity rule)
4. Higher the indifference curve more is the satisfaction
(because in a higher IC, consumer gets more products
than a lower IC)
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 Four Properties of Indifference Curves

Cloth
1. Indifference curves
are downward-
sloping.

A
I1

Food

THE THEORY OF CONSUMER CHOICE 21

 Four Properties of Indifference Curves

Cloth
2. Higher indifference
curves are preferred
to lower ones.

C
D
A I2
I1
I0
Food

THE THEORY OF CONSUMER CHOICE 22

 Four Properties of Indifference Curves

Cloth
3. Indifference curves
cannot cross.

C A
I1 I4

Food

THE THEORY OF CONSUMER CHOICE 23

 Four Properties of Indifference Curves

Cloth
4. Indifference curves
are bowed inward.
A

1
B
2
1 I1

Food

THE THEORY OF CONSUMER CHOICE 24

 Marginal Rate of Substitution

 MRS shows the rate at which one good can

be substituted for another while keeping
utility constant
 Negative of the slope of the indifference curve
 Diminishes along the indifference curve as X
increases & Y decreases
 Ratio of the marginal utilities of the goods

Y MU X
MRS   
X MUY
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 3.1 CONSUMER PREFERENCES

Indifference Maps
● indifference map Graph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.

Figure 3.3

An Indifference Map

An indifference map is a set of

indifference curves that
describes a person's
preferences.
Chapter 3: Consumer Behavior

Any market basket on

indifference curve U3, such as
basket A, is preferred to any
basket on curve U2 (e.g.,
basket B), which in turn is
preferred to any basket on U1,
such as D.

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 EXCEPTIONS OF IC
 Substitute products: Two goods for which the marginal
rate of substitution of one for the other is a constant.
 perfect complements Two goods for which the MRS is

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zero or infinite; the indifference curves are shaped as right
angles.

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 MATHEMATICAL EXAMPLES
 Suppose that Rahim and Karim spend their incomes on two
goods, food (F) and clothing (C). Rahim’s preferences are
represented by the utility function U(F,C) = 10FC , while

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Karim’s preferences are represented by the utility function
U(F,C)= 0.20F2C2.
 With food on the horizontal axis and clothing on the vertical
axis, identify on a graph the set of points that give Rahim the
same level of utility as the bundle (10,5). Do the same for
Karim on a separate graph.
 On the same two graphs, identify the set of bundles that give
Rahim and Karim the same level of utility as the bundle (15,8).
 Do you think Rahim and Karim have the same preferences or
different preferences? Explain.
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 BUDGET LINE
 It shows different combinations of goods and services that an individual can
buy with his/her income.
 Show the impact of change in income on budget line

Slope of the budget line is the price

ratio of two goods under
consideration

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 CHANGE IN BUDGET LINE WITH A CHANGE IN PRICE

Price Changes A change

in the
price of one good (with
income unchanged)
causes the budget line

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to rotate about one
intercept.
When the price of food
falls from $1.00 to $0.50,
the budget line
rotates outward from L1
to L2.
However, when the price
increases
from $1.00 to $2.00, the
line rotates
inward from L1 to L3.
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MATHEMATICAL EXAMPLE

Samira buys five new college textbooks during his first

year at school at a cost of $80 each. Used books cost
only $50 each. When the bookstore announces that there

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will be a 10 percent increase in the price of new books
and a 5 percent increase in the price of used books,
Samira’s father offers him $40 extra.
A) What happens to Samira’s budget line? Illustrate
the change with new books on the vertical axis.
B) Is Samira worse or better off after the price change?
Explain.

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MATHEMATICAL EXAMPLE
 Sonia has a monthly income of $200 that she allocates
among two goods: meat and potatoes. Suppose meat
costs $4 per pound and potatoes $2 per pound. Draw her
budget constraint.
 Suppose also that her utility function is given by the
equation U(M, P) = 0.20M2P2. What combination of
meat and potatoes should she buy to maximize her
utility?

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 EXAMPLE

Suppose a consumer has the indifference map shown below. The relevant budget line
is LZ. The price of good Y is $10.
a. What is the consumer’s income?
b. What is the price of X?
c. Write the equation for the budget line LZ.
d. What combination of X and Y will the consumer choose? Why?
e. What is the marginal rate of substitution at this combination?
f. Explain in terms of the MRS why the consumer would not choose combinations
designated by A or B.
g. Suppose the budget line pivots to LM, income remaining constant. What is the new
price of X? What combination of X and Y is now chosen?
h. What is the new MRS?

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INCOME AND SUBSTITUTION EFFECT
 When price of a product declines, it has two important
effects
1) People can get that product at a cheaper price thus the
ability or purchasing power rises
2) People may not increase the consumption of the
product to maximum thus there is an income gain.

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PRICE, INCOME AND SUBSTITUTION
EFFECT: NORMAL GOODS
 Substitution effect: It shows
the change in consumption
of a product (whose price

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has changed) while keeping
the utility constant. For
example, even if the
consumer can consume F1F2
extra, they will actually
consume F2E. Thus EF2 is
income gain.

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 Giffen Goods

THE THEORY OF CONSUMER CHOICE 36

PRICE CHANGE AND
INDIVIDUAL DEMAND CURVE
 Effect of price change:
When price of one
product decreases, that

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will rotate the budget
line, hence the demand
curve of the product can
be drawn.
 Price consumption curve:
curve tracking the utility
maximizing
combinations.
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INCOME CHANGE AND
CONSUMER’S RESPONSE
 If income increases
with price constant,
the consumers will

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demand more of a
normal product

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ENGEL CURVE
 Curve relating the
quantity of a good
consumed to income.

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 In (a), food is a normal
good and the Engel
curve is upward sloping.
In (b), however, rotten
rice is inferior good
after a certain income
level.

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4.5 NETWORK EXTERNALITIES

● network externality When each individual’s

demand depends on the purchases of other
individuals.
A positive network externality exists if the quantity of a
good demanded by a typical consumer increases in
response to the growth in purchases of other
consumers. If the quantity demanded decreases, there
is a negative network externality.
The Bandwagon Effect
● bandwagon effect Positive network externality
in which a consumer wishes to possess a good in
part because others do.