CHAPTER 7

CONSUMER BEHAVIOR
INTRODUCTION

 How are consumer preferences used to determine demand?

 How do consumers allocate income to the purchase of different goods?
 How do consumers with limited income decide what to buy?

2
INTRODUCTION

 How can we determine the nature of consumer preferences for observations of

consumer behavior?
 How can cost of living indexes measure the well-being of consumers?

3
CONSUMER BEHAVIOR - APPLICATIONS

1. How would General Mills determine the price to charge for a new cereal
before it went to the market?
2. To what extent did the food stamp program provide individuals with more
food versus merely subsidizing food they bought anyway?

4
CONSUMER BEHAVIOR

 The theory of consumer behavior can be used to help answer these and many
more questions
 Theory of consumer behavior
 The explanation of how consumers allocate income to the purchase of different goods
and services

5
CONSUMER BEHAVIOR

 There are three steps involved in the study of consumer behavior

1. Consumer Preferences
 To describe how and why people prefer one good to another
2. Budget Constraints
 People have limited incomes

6
CONSUMER BEHAVIOR

3. Given preferences and limited incomes, what amount and type of goods will
be purchased?
 What combination of goods will consumers buy to maximize their satisfaction?

7
CONSUMER PREFERENCES

 How might a consumer compare different groups of items available for

purchase?
 A market basket is a collection of one or more commodities
 Individuals can choose between market baskets containing different goods

8
CONSUMER PREFERENCES – BASIC
ASSUMPTIONS

1. Preferences are complete

 Consumers can rank market baskets
2. Preferences are transitive
 If they prefer A to B, and B to C, they must prefer A to C
3. Consumers always prefer more of any good to less
 More is better

9
CONSUMER PREFERENCES

 Consumer preferences can be represented graphically using indifference curves

 An indifference curve is a graph showing combination of two goods that give
the consumer equal satisfaction and utility. Each point on an indifference
curve indicates that a consumer is indifferent between the two and all points
give him the same utility.
 Indifference curves represent all combinations of market baskets that the person
is indifferent to
 A person will be equally satisfied with either choice

10
INDIFFERENCE CURVES:
AN EXAMPLE
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

11
INDIFFERENCE CURVES:
AN EXAMPLE

 Graph the points with one good on the x-axis and one good on the y-axis
 Plotting the points, we can make some immediate observations about preferences
 More is better

12
INDIFFERENCE CURVES:
AN EXAMPLE

The consumer prefers

Clothing 50 B A to all combinations
in the yellow box, while
40 all those in the pink
H E box are preferred to A.

30 A

20 D
G
10

Food
10 20 30 40
13
INDIFFERENCE CURVES:
AN EXAMPLE

 Points such as B & D have more of one good but less of another compared to A
 Need more information about consumer ranking
 Consumer may decide they are indifferent between B, A and D
 We can then connect those points with an indifference curve

14
INDIFFERENCE CURVES:
AN EXAMPLE
•Indifferent
50 B between points B,
Clothing A, & D
H •E is preferred to
40 E points on U1
•Points on U1 are
A
30 preferred to H &
G
D
20
G U1
10

Food
10 20 30 40 15
INDIFFERENCE CURVES

 Any market basket lying northeast of an indifference curve is preferred to any

market basket that lies on the indifference curve
 Points on the curve are preferred to points southwest of the curve

16
INDIFFERENCE CURVES

 Indifference curves slope downward to the right

 If they sloped upward, they would violate the assumption that more is preferred to less
 Some points that had more of both goods would be indifferent to a basket with less of both
goods

17
 INDIFFERENCE CURVES

 To describe preferences for all combinations of goods/services, we have a set of

indifference curves – an indifference map
 Each indifference curve in the map shows the market baskets among which the person
is indifferent

18
 INDIFFERENCE MAP

Clothing
Market basket A
is preferred to B.
Market basket B is
D preferred to D.
B A
U3

U2

U1

Food

19
 INDIFFERENCE MAPS

 Indifference maps give more information about shapes of indifference curves

 Indifference curves cannot cross
 Violates assumption that more is better

 Why? What if we assume they can cross?

20
INDIFFERENCE MAPS
U1
U •B is preferred to D
Clothing
2 •A is indifferent to B & D
•B must be indifferent to D
but that can’t be if B is
preferred to D
A

B
U2
D
U1
Food

21
INDIFFERENCE CURVES

 The shapes of indifference curves describe how a consumer is willing to

substitute one good for another
 A to B, give up 6 clothing to get 1 food
 D to E, give up 2 clothing to get 1 food

 The more clothing and less food a person has, the more clothing they will give up
to get more food

22
INDIFFERENCE CURVES
A
Clothing 16

14 Observation: The amount

-6 of clothing given up for
12 1 unit of food decreases
from 6 to 1
10 B
1
8 -4
D
6 1
-2 E
4 1 -1
G
1
2
Food
1 2 3 4 5
23
INDIFFERENCE CURVES

 We measure how a person trades one good for another using the marginal rate of
substitution (MRS)
 It 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

24
MARGINAL RATE OF SUBSTITUTION
Clothing 16 A
MRS = 6
MRS   C
14 F
12
-6
10 B
1
8 -4 MRS = 2
D
6
1
-2 E
4 G
1 -1
2 1
Food
1 2 3 4 5
25
MARGINAL RATE OF SUBSTITUTION

 Indifference curves are convex

 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 generally prefer a balanced market basket

26
MARGINAL RATE OF SUBSTITUTION

 The MRS decreases as we move down the indifference curve

 Along an indifference curve there is a diminishing marginal rate of substitution.
 The MRS went from 6 to 4 to 2 to 1

27
MARGINAL RATE OF SUBSTITUTION

 Indifference curves with different shapes imply a different willingness to

substitute
 Two polar cases are of interest
 Perfect substitutes
 Perfect complements

28
MARGINAL RATE OF SUBSTITUTION

 Perfect Substitutes
 Two goods are perfect substitutes when the marginal rate of substitution of one good for
the other is constant
 Example: a person might consider apple juice and orange juice perfect substitutes
 They would always trade 1 glass of OJ for 1 glass of Apple Juice

29
CONSUMER PREFERENCES
Apple
4
Juice
(glasses)
Perfect
3 Substitutes

Orange Juice
0 1 2 3 4 (glasses)
30
CONSUMER PREFERENCES

 Perfect Complements
 Two goods are perfect complements when the indifference curves for the goods are
shaped as right angles
 Example: If you have 1 left shoe and 1 right shoe, you are indifferent between having
more left shoes only
 Must have one right for one left

31
CONSUMER PREFERENCES
Left
Shoes Perfect
4 Complements

0 1 2 3 4 Right Shoes
32
CONSUMER PREFERENCES

 We have assumed all our commodities are “goods”

 There are commodities we don’t want more of - bads
 Things for which less is preferred to more

 Examples
 Air pollution
 Asbestos

33
CONSUMER PREFERENCES

 How do we account for bads in our preference analysis?

 We redefine the commodity
 Clean air

 Pollution reduction

 Asbestos removal

34
CONSUMER PREFERENCES:
AN APPLICATION

 In designing new cars, automobile executives must determine how much time
and money to invest in restyling versus increased performance
 Higher demand for car with better styling and performance
 Both cost more to improve

35
CONSUMER PREFERENCES:
AN APPLICATION

 An analysis of consumer preferences would help to determine where to spend

more on change: performance or styling
 Some consumers will prefer better styling and some will prefer better
performance

36
CONSUMER PREFERENCES:
AN APPLICATION
Styling
These consumers
place a greater
value on
performance than
styling

Performance
37
CONSUMER PREFERENCES:
AN APPLICATION
Styling
These consumers place
a greater value on
styling than
performance

Performance
38
CONSUMER PREFERENCES:
AN APPLICATION

 Knowing which group dominates the market will help decide where redesigning
dollars should go
 A recent study in the US shows that over the past two decades, most consumers
have preferred styling over performance

39
CONSUMER PREFERENCES

 The theory of consumer behavior does not required assigning a numerical value
to the level of satisfaction
 Although ranking of market baskets is good, sometimes numerical value is useful

40
CONSUMER PREFERENCES

 Utility
 A numerical score representing the satisfaction that a consumer gets from a given
market basket
 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

41
UTILITY

 Utility function
 Formula that assigns a level of utility to individual market baskets
 If the utility function is

U(F,C) = F + 2C
A market basket with 8 units of food and 3 units of clothing gives a utility of

14 = 8 + 2(3)

42
UTILITY - EXAMPLE

Market Food Clothing Utility

Basket

A 8 3 8 + 2(3) = 14

B 6 4 6 + 2(4) = 14

C 4 4 4 + 2(4) = 12

Consumer is indifferent between A & B and

prefers both to C

43
UTILITY - EXAMPLE

 Baskets for each level of utility can be plotted to get an indifference curve
 To find the indifference curve for a utility of 14, we can change the combinations of
food and clothing that give us a utility of 14

44
UTILITY - EXAMPLE
Clothing Basket U = FC
C 25 = 2.5(10)
15 A 25 = 5(5)
B 25 = 10(2.5)

C
10

A U3 = 100
5
B U2 = 50
U1 = 25
Food
0 5 10 15
45
UTILITY

 Although we numerically rank baskets and indifference curves, numbers are

ONLY for ranking
 A utility of 4 is not necessarily twice as good as a utility of 2
 There are two types of rankings
 Ordinal ranking
 Cardinal ranking

46
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

47
UTILITY

 The actual unit of measurement for utility is not important

 An ordinal ranking is sufficient to explain how most individual decisions are
made

48
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

49
BUDGET CONSTRAINTS

 The Budget Line

 Indicates all combinations of two commodities for which total money spent equals total
income
 We assume only 2 goods are consumed, so we do not consider savings

50
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 PFF is the amount of money spent on food, and PCC is the amount of money
spent on clothing

51
THE BUDGET LINE
 The budget line then can be written:

PF F  PC C  I

All income is allocated to food (F) and/or clothing (C)

52
 THE BUDGET LINE

 Different choices of food and clothing can be calculated that use all income
 These choices can be graphed as the budget line

 Example:
 Assume income of $80/week, PF = $1 and PC = $2

53
BUDGET CONSTRAINTS

Market Food Clothing Income

Basket PF = $1 PC = $2 I = PFF + PCC

A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80

54
THE BUDGET LINE
Clothing
A
(I/PC) = 40 C 1 PF
Slope   - -
B F 2 PC
30
10 D
20
20
E
10
G
Food
0 20 40 60 80 = (I/PF)
55
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

56
THE BUDGET LINE

 The slope indicates the rate at which the two goods can be substituted without
changing the amount of money spent
 We can rearrange the budget line equation to make this more clear

57
THE BUDGET LINE

I  PX X  PY Y
I  PX X  PY Y
I PX
 X Y
PY PY
58
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

59
THE BUDGET LINE

 As we know, income and prices can change

 As incomes and prices change, there are changes in budget lines
 We can show the effects of these changes on budget lines and consumer choices

60
THE BUDGET LINE - CHANGES

 The Effects of Changes in Income

 An increase in income causes the budget line to shift outward, parallel to the original
line (holding prices constant).
 Can buy more of both goods with more income

61
THE BUDGET LINE - CHANGES

 The Effects of Changes in Income

 A decrease in income causes the budget line to shift inward, parallel to the original line
(holding prices constant)
 Can buy less of both goods with less income

62
THE BUDGET LINE - CHANGES
Clothing
(units
per week) An increase in
income shifts
80 the budget line
outward

60

A decrease in
40 income shifts
the budget line
inward
20 L3
(I = L1 L2
$40) (I = $80) (I = $160)
Food
0 40 80 120 160 (units per week)
63
THE BUDGET LINE - CHANGES

 The Effects of Changes in Prices

 If the price of one good increases, the budget line shifts inward, pivoting from the other
good’s intercept.
 If the price of food increases and you buy only food (x-intercept), then you can’t buy as
much clothing. The x-intercept shifts in.
 If you buy only clothing (y-intercept), you can buy the same amount. No change in y-
intercept.

64
THE BUDGET LINE - CHANGES

 The Effects of Changes in Prices

 If the price of one good decreases, the budget line shifts outward, pivoting from the
other good’s intercept.
 If the price of food decreases and you buy only food (x-intercept), then you can buy
more food. The x-intercept shifts out.
 If you buy only clothing (y-intercept), you can buy the same amount. No change in y-
intercept.

65
THE BUDGET LINE - CHANGES
Clothing
(units
A decrease in the
per week)
price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.
An increase in the
40 price of food to
$2.00 changes
the slope of the
budget line and
rotates it inward.
L3 L1 L2
(PF = 1) (PF = 1/2)
(PF = 2) Food
40 80 120 160 (units per week)
66
THE BUDGET LINE - CHANGES

 The Effects of Changes in Prices

 If the two goods increase in price, but the ratio of the two prices is unchanged, the slope
will not change
 However, the budget line will shift inward parallel to the original budget line

67
THE BUDGET LINE - CHANGES

 The Effects of Changes in Prices

 If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope
will not change
 However, the budget line will shift outward parallel to the original budget line

68
CONSUMER CHOICE

 Given preferences and budget constraints, how do consumers choose what to

buy?
 Consumers choose a combination of goods that will maximize their satisfaction,
given the limited budget available to them

69
CONSUMER CHOICE

 The maximizing market basket must satisfy two conditions:

1. It must be located on the budget line
 They spend all their income – more is better
2. It must give the consumer the most preferred combination of goods and
services

70
CONSUMER CHOICE

 Graphically, we can see different indifference curves of a consumer choosing

between clothing and food
 Remember that U3 > U2 > U1 for our indifference curves
 Consumer wants to choose highest utility within their budget

71
CONSUMER CHOICE
Clothing
(units per
week)
•A, B, C on budget line
40 •D highest utility but not
affordable
A •C highest affordable utility
•Consumer chooses C
30 D

20 C

U3
U2
U1
B
0 20 40 80 Food (units per week) 72
CONSUMER CHOICE

 Consumer will choose highest indifference curve on budget line

 In previous graph, point C is where the indifference curve is just tangent to the
budget line
 Slope of the budget line equals the slope of the indifference curve at this point

73
CONSUMER CHOICE

C
MRS  
F
 Recall, the slope of an indifference curve is:
Further, the slope of the budget line is:

PF
Slope  
PC

74
CONSUMER CHOICE

 Therefore, it can be said at consumer’s optimal consumption point,

PF
MRS 
PC

75
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)
 Note this is ONLY true at the optimal consumption point

76
CONSUMER CHOICE

 Optimal consumption point is where marginal benefits equal marginal costs

 MB = MRS = benefit associated with consumption of 1 more unit of food
 MC = cost of additional unit of food
 1 unit food = ½ unit clothing

 PF/PC

77
CONSUMER CHOICE

 If MRS ≠ PF/PC then individuals can reallocate basket to increase utility

 If MRS > PF/PC

 Will increase food and decrease clothing until MRS = P F/PC

 If MRS < PF/PC

 Will increase clothing and decrease food until MRS = P F/PC

78
CONSUMER CHOICE
Clothing
(units per
week) Point B does not
maximize satisfaction
40 because the
MRS = -10/10 = 1
is greater than the
B
30 price ratio = 1/2

-10C
20

+10F U1
0 20 40 80 Food (units per week) 79
CONSUMER CHOICE:
AN APPLICATION REVISITED

 Consider two groups of consumers, each wishing to spend $10,000 on the styling
and performance of a car
 Each group has different preferences

80
CONSUMER CHOICE:
AN APPLICATION REVISITED

 By finding the point of tangency between a group’s indifference curve and the
budget constraint, auto companies can see how much consumers value each
attribute

81
CONSUMER CHOICE:
AN APPLICATION REVISITED
Styling

$10,000 These consumers

want performance worth
$7000 and styling worth
$3000

$3,000

$7,000 $10,000 Performance

82
CONSUMER CHOICE:
AN APPLICATION REVISITED
Styling
These consumers want
$10,000 styling worth $7000
and performance
worth $3000
$7,000

$3,000 $10,000 Performance

83
CONSUMER CHOICE:
AN APPLICATION REVISITED

 Once a company knows preferences, it can design a production and marketing

plan
 Company can then make a sensible strategic business decision on how to allocate
performance and styling on new cars

84
CONSUMER CHOICE

 A corner solution exists if a consumer buys in extremes, and buys all of one
category of good and none of another
 MRS is not necessarily equal to PA/PB

85
A CORNER SOLUTION
Frozen
Yogurt
(cups
monthly) A A corner solution
exists at point B.
U1 U2 U3

B Ice Cream (cup/month)

86
A CORNER SOLUTION

 At point B, the MRS of ice cream for frozen yogurt is

greater than the slope of the budget line
 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
 Opposite is true if corner solution was at point A

87
A CORNER SOLUTION

 When a corner solution arises, the consumer’s MRS does not necessarily equal
the price ratio
 In this instance it can be said that:

PIceCream
MRS 
PFrozen Yogurt
88
A CORNER SOLUTION

 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

89
A CORNER SOLUTION - EXAMPLE

 Suppose Jane Doe’s parents set up a trust fund for her college education
 The money must be used only for education
 Although a welcome gift, an unrestricted gift might be better

90
A CORNER SOLUTION - EXAMPLE

 Original budget line, PQ, with a market basket, A, of education and other goods
 Trust fund shifts out the budget line as long as trust fund, PB, is spent on
education
 Jane increases satisfaction, moving to higher indifference curve, U 2

91
A CORNER SOLUTION - EXAMPLE
Other
Consumption
($) •Jane better off
on U2
•B is corner
solution
P
B •MRS ≠ PE/POG
U2
A

U1

Q Education ($)
92
A CORNER SOLUTION - EXAMPLE
Other
Consumption
($) •If gift is
unrestricted, Jane
C can be at point C on
U3
U3 •Better off than
P
with restricted gift
B U2
A

U1

Q Education ($)
93
REVEALED PREFERENCES

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

94
REVEALED PREFERENCES –
TWO BUDGET LINES
Clothing l1
(units per •I1: Choose A over B
month) •A is revealed
preferred to B
l2 •l2: Choose B over D
A •B is revealed
preferred to D

B
D

Food (units per month) 95

 REVEALED PREFERENCES –
TWO BUDGET LINES
Clothing l1
(units per
month) All market baskets
in the pink
l2 shaded area are
preferred to A.

A
B is preferred
B
to
all market D
baskets
in the yellow
area
Food (units per month)
96
REVEALED PREFERENCE

 As you continue to change the budget line, individuals can tell you which basket
they prefer to others
 The more the individual reveals, the more you can discern about their preferences
 Eventually you can map out an indifference curve

97
REVEALED PREFERENCES –
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 yellow area
Food (units per month) 98
MARGINAL UTILITY AND CONSUMER CHOICE

 Marginal utility measures the additional satisfaction obtained from consuming

one additional unit of a good
 How much happier is the individual from consuming one more unit of food?

99
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 as consumption increases

100
MARGINAL UTILITY

 The principle of diminishing marginal utility states that as more of a good is

consumed, the additional utility the consumer gains will be smaller and smaller
 Note that total utility will continue to increase since consumer makes choices that
make them happier

101
MARGINAL UTILITY AND INDIFFERENCE
CURVES

 As consumption moves along an indifference curve:

 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)

102
MARGINAL UTILITY AND CONSUMER CHOICE

0  MUF(F)  MUC(C)
 Formally:

No change in total utility along an indifference curve.

Trade off of one good to the other leaves the consumer
just as well off.

103
MARGINAL UTILITY AND CONSUMER CHOICE

  C / F   MU F / MU C
Since
 Rearranging:

  C / F   MRS of F for C
We can say
MRS  MUF/MUC
104
MARGINAL UTILITY AND CONSUMER CHOICE

MRS  PF /PC
 When consumers maximize satisfaction:
Since the MRS is also equal to the ratio of the
marginal utility of consuming F and C

MU F /MU C  PF /PC
105
MARGINAL UTILITY AND CONSUMER CHOICE

MU F / PF  MU C / PC
 Rearranging, gives the equation for utility maximization:

106
MARGINAL UTILITY AND 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.

107