Session 2

Consumer behavior
 Posing the issue …
• Neoclassical utility theory (main focus of the session) is a
mental model of consumer’s decision making process
– Preferences are given
– Goods are given
• An alternate model of decision making process
– Preferences over attributes / characteristics are given
– Goods attributes / characteristics (including prices) are given
– We will study this later
• Advertising can take things further by playing with
consumer preferences!
• Consumer financing can take things further by playing with
the consumer’s budget
– Example GM Financial, Tata Motors Finance
2
 Market basket
• Market basket is a combination of goods and
services that an individual might consume
• Baskets (or bundles) consist of some amount of
each good
– Bundle x has 2 orange and 1 banana
– Bundle y has 1 orange and 2 banana
– Bundle z has 3 orange and 0 banana
• Consumers have preferences over bundles of
goods
Example of market baskets
 Consumer preferences
• Consumer
  preferences tell us how an individual
would rank (i.e., compare the desirability of) any two
baskets, assuming the baskets were available at no
cost.
• Weak preference relation
– Bundle x at least as good as y
– Bundle y at least as good as x
– Consumer indifferent between x and y
• Strong preference relation
– Bundle x at least as good as y but not equal to y
 Cardinal vs ordinal ranking
• Ordinal ranking indicates whether a consumer prefers
one basket to another, but does not contain quantitative
information about the intensity of that preference
– We know consumer prefers A to D but not how much more he
prefers A to D
• Cardinal ranking gives a quantitative measure of the
intensity of a preference for one basket over another
– Consumer like A two times as much as D
• Easier to elicit ordinal info than cardinal info
– Eliciting preferences from customers using surveys
 Consumer preferences
• Preferences
  are assumed to satisfy the
following properties
– Preferences are complete (either , or , or )
– Preferences are transitive (if , and , then )
– More is better (, , etc)
• Preferences that satisfy these properties are
said to be rational, and can be represented by
a utility function
 Operational relevance
• Producers want to learn about consumers’
preferences to exploit them better
• One way they do this is to conduct surveys on
consumers asking them to rank products on
desirability
• These surveys are meaningful only if
preferences are rational
– Suitable target group
– Transitivity checks
 Utility function
• Utility
  function assigns a number to each
bundle, thus ranking the bundles according to
preferences
• Thus, x at least as good as y iff
 Preferences with a single good
• Sarah,
  purchases only one good, burgers.
• Let y denote the number of burgers she
purchases each week, and let U(y) measure
the level of satisfaction (or utility) that Sarah
derives from purchasing y burgers
• Let
• Does Sara’s preferences satisfy the three
assumptions made earlier?
 Marginal utility
• Marginal utility is the rate at which total utility
changes as the level of consumption rises

• What is Sara’s marginal utility for burgers at y=4?

• Graphically, the marginal utility at a particular
point is represented by the slope of a line that is
tangent to the utility function at that point.
 Diminishing marginal utility
• Principle
  of diminishing marginal utility: After
some point, as consumption of a good
increases, the marginal utility of that good will
begin to fall
• More is better means that marginal utility is
always positive
– Is this true for
 Why assert DMU?
• DMU of income provided a historically import
ant rationale for progressive taxation
– If each additional dollar of income provided less
and less additional utility, then the wealthy would
sacrifice less utility than the poor would when
taxed
 Sometimes more is not always better

• But, reasonable to assume that more is better

for amounts of a good that a consumer might
actually purchase (why buy more than 7?)
Preferences with multiple goods
 Marginal utility with multiple goods

• The marginal utility of any one good is the rate

at which total utility changes as the level of
consumption of that good rises, holding
constant the levels of consumption of all other
goods
Practice problem
 Example of preference ordering and utility
function
•• Consider three bundles of three types of goods
 
– x is (3,3,3) of apple, orange, banana
– y is (4,2,3) of apple, orange, banana
– z is (5,1,3) of apple, orange, banana
• x at least as good as y, y at least as good as z, x at least as good as z
• Consider utility function

• What is the utility level of each bundle?

• Is the preference ordering of bundles same under the utility
function?
• Is this the only utility function that can represent these preferences?

19
 Indifference map
• Indifference curve: A curve connecting a set of
consumption baskets that yield the same level of
satisfaction to the consumer.
 Properties of indifference curves
• 1. When the consumer likes both goods (i.e.,
when MUx and MUy are both positive), all the
indifference curves have a negative slope,
otherwise it will contradict more is better
 Properties of indifference curves
• 2. Indifference curves cannot intersect
 Properties of indifference curves
• 3. Every consumption basket lies on one and
only one indifference curve
– Bundle A can lie on two indifference curves only if
they intersect (not allowed)
 Properties of indifference curves
•  4. Indifference curves are not “thick.”
– Since B lies to the northeast of A, , so A and B
cannot be on the same indifference curve
Marginal rate of substitution
Marginal rate of substitution
(MRS) of food for clothing
is the rate at which
consumers will give up
clothing for one more unit
of food, keeping utility
constant

From A to B, he gives up 6
units of C for 1 unit of F,
so MRS of F for C at A is
6
 Marginal rate of substitution
• MRSxy
  at any point is the negative of the slope of
the indifference curve at that point, and is equal to
the ratio of marginal utilities of x and y

• So,
 Diminishing MRS
• MRSxy (amount of y
you are willing to give
up for an additional
unit of x) diminishes
as the consumption of
x increases along an IC
– As you have more
food, you are less
willing to give up
clothing for an
additional unit of food
 Examples of preferences
• Perfect substitutes (MRS is constant)
• U = P + 2W
 Examples of preferences
• Perfect complements (MRS is 0 or infinity)
• U(R,L) = 10min(R,L)
Examples of preferences
Cobb Douglas indifference curves
 Practice problem 1
• Draw indifference curves to represent the
following types of consumer preferences
– I like both peanut butter and jelly, and always get
the same additional satisfaction from an ounce of
peanut butter as I do from 2 ounces of jelly
– I like peanut butter, but neither like nor dislike jelly
– I like peanut butter, but dislike jelly
– I like peanut butter and jelly, but I only want 2
ounces of peanut butter for every ounce of jelly
 Practice problem 2
• Daniel and Will each consume two goods.
When they consume the same basket, Daniel’s
marginal utility of each good is higher than
Will’s. But at any basket they both have the
same marginal rate of substitution of one good
for the other.
• Do they have the same ordinal ranking of
different baskets?
• UD=xy, UW=x+y
 Practice problem 3
• Claire consumes three goods out of her
income: food (F), shelter (S), and clothing (C).
At her current levels of consumption, her
marginal utility of food is 3 and her marginal
utility of shelter is 6. Her marginal rate of
substitution of shelter for clothing is 4.
• Do you have enough information to determine
her marginal rate of substitution of food for
clothing? If so, what is it? If not, why not?
 Consumer choice
• How much of what you like should you buy?
• Optimal choice: maximize utility subject to the
budget constraint
– Pick the combination of goods that gives you
maximum utility subject to the total expenditure
on these goods being less than or equal to the
total available income
 ● budget constraints Constraints that consumers face
as a result of limited incomes.

• The Budget Line

● budget line All combinations of goods for which the total
amount of money spent is equal to income.

PF F  PC C  I (3.1)

TABLE 3.2 Market Baskets and the Budget Line

Market Basket Food (F) Clothing (C) Total Spending

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

The table shows market baskets associated with the budget line
F + 2C = $80
A Budget Line

A budget line describes the

combinations of goods that can be
purchased given the consumer’s
income and the prices of the goods.
Line AG (which passes through
points B, D, and E) shows the
budget associated with an income
of $80, a price of food of PF = $1
per unit, and a price of clothing of
PC = $2 per unit.
The slope of the budget line
(measured between points B and D)
is −PF/PC = −10/20 = −1/2.

C  ( I / PC )  ( PF / PC ) F (3.2)
 Effect of changing income and prices

Effects of a Change in Income on the

Budget Line

Income Changes A change in

income (with prices unchanged)
causes the budget line to shift
parallel to the original line (L1).
When the income of $80 (on L1) is
increased to $160, the budget line
shifts outward to L2.
If the income falls to $40, the line
shifts inward to L3.
Effects of a Change in Price on the
Budget Line

Price Changes A change in the

price of one good (with income
unchanged) causes the budget line
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.
Optimal choice
Utility maximization
 Utility maximization
• Utility is maximized when slope of budget line equals
slope of indifference curve i.e. IC and BL are tangent to
each other. Why?
• Slope of IC at B i.e. -MRSxy(B) = -2
– He is willing to give up 2 units of Y per unit of X
• Slope of BL at B i.e. -Px/Py = -0.5
– Market will ask for only 0.5 units of Y per unit of X
• So, he can increase utility by giving up 6 units of Y, offering
to market, getting 12 units of X and increasing utility
– He would only have needed 3 units of X to remain at same level
of utility. Instead, he got 12 from the market. Party time!
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 Utility maximization
• Tangency
  condition:
• Equal bang for buck:
• Last dollar spent on X must increase utility by
the same amount as last dollar spent on Y.
Otherwise, utility can be increased by
reallocation expenditure from X to Y or Y to X
– Let and . What should consumer do?

43
 Expenditure minimization
• What basket should consumer choose to
minimize expenditure while attaining target
level of utility?
Expenditure minimization
 Expenditure minimization
• The basket that maximizes utility with a given
level of income leads the consumer to a level of
utility U2
• That same basket minimizes the level of
expenditure necessary for the consumer to
achieve a level of utility U2
• So, utility maximization and expenditure
minimization problems are dual to one another
 Corner solution
• A solution to the consumer’s optimal choice
problem at which some good is not being
consumed at all, in which case the optimal
basket lies on an axis
– Some consumers do not own an automobile or a
house
– Some students may not spend money on movies
or pizza
 Corner solution
•  Let
Corner solution
 Practice problem 1
• Jane likes hamburgers (H) and milkshakes (M). Her
indifference curves are bowed in toward the origin
and do not intersect the axes.
• The price of a milkshake is $1 and the price of a
hamburger is $3. She is spending all her income at the
basket she is currently consuming, and her marginal
rate of substitution of hamburgers for milkshakes is 2
• Is she at an optimum? If so, show why. If not, should
she buy fewer hamburgers and more milkshakes, or
the reverse?
 Practice problem 2
• Julie consumes two goods, food and clothing, and always
has a positive marginal utility for each good.
• Her income is 24. Initially, the price of food is 2 and the price
of clothing is 2.
• After new government policies are implemented, the price
of food falls to 1 and the price of clothing rises to 4
• Suppose, under the initial budget constraint, her optimal
choice is 10 units of food and 2 units of clothing
• After the prices change, can you predict whether her utility
will be higher, lower, or the same as under the initial prices?
 Practice problem 3
• Justin has the utility function U = xy
• The price of x is 2, the price of y is py , and his
income is 40
• When he maximizes utility subject to his
budget constraint, he purchases 5 units of y
• What must be the price of y and the amount
of x consumed?
Where does demand curve come from?
A closer look – PCC
(I = 40, Py = 4)
At A, MRSxy = 1, so x worth same as y.
Since y worth $4, x also worth $4.
At B, MRSxy = ½, so x worth ½ of y. Since y
worth $4, x worth $2.
At C, MRSxy = ¼, so x worth ¼ of y. Since y
worth $4, x worth $1.
A closer look – demand curve
(willingness to pay curve)

At A, MRSxy = 1, so x worth same as y.

Since y worth $4, x also worth $4.
At B, MRSxy = ½, so x worth ½ of y. Since y
worth $4, x worth $2.
At C, MRSxy = ¼, so x worth ¼ of y. Since y
worth $4, x worth $1.
 Demand curve
• Demand curve for X is derived from the
solving the consumer’s constrained
optimization program for different levels of
price of X, keeping price of Y and income
constant
– Same holds true for Y also
Change in income and optimal choice
Change in income and shift in demand
 Engel curve
• Shows amount of good consumed at each
level of income
• Normal good (consumer buys more as income
increases) has positively sloped Engel curve
 Inferior goods
• Consumer purchases less of it as income
increases (e.g. public transport)
 Negative slope Engel curve
• Inferior good beyond $300 income
 Finding a demand curve
• The utility function is U(x,y) = xy
• The price of x is Px , the price of y is Py , and
income is I
• What is the equation for the demand curve for
x?
• Is x a normal good?
 Finding a demand curve
• Utility function is U(x, y) = xy + 10x
• Income is $100, price of x $1. The price of y is
Py
• What is the demand for y?
 Substitution and Income effect of price
change
• Substitution effect: The change in the amount
of a good that would be consumed as the price
of that good changes, holding constant all other
prices and the level of utility
– Movement along the indifference curve
• Income effect: The change in the amount of a
good that a consumer would buy as purchasing
power changes, holding all prices constant
– Moving to a new indifference curve
 Substitution and Income effect of price
change
• Step 1: Find the original basket A
 Substitution and Income effect of price
change
• Step 2: Find the final basket C after Px reduces
• A to C includes both SE and IE
 Substitution and Income effect of price
change
• Step 3: find the decomposition basket B
IE and SE when good is neither inferior nor
normal
IE and SE when good is inferior with
downward sloping demand curve
IE and SE for Giffen good (upward sloping
demand curve)
 When is a good a Giffen good?
• Households are poor enough that they face
subsistence concerns
• They consume a simple diet including a staple good
(rice) and a fancy good (meat)
• Staple good is cheapest source of calories, comprises
large part of budget, has no close substitute
• Households cannot be so poor that they consume only
the staple good
• Giffen good illustrates importance of income effects of
price changes for poor households
 The Giffen good in history
• As Mr. Giffen has pointed out, a rise in the price of
bread makes so large a drain on the resources of
the poorer labouring families …, that they are
forced to
– curtail their consumption of meat and the more
expensive farinaceous foods, and
– bread being still the cheapest food which they can get
and will take, they consume more, and not less of it
• Alfred Marshall, Principles of Economics (1895 ed.)
 The Giffen good today
• Jensen and Miller (2008) American Economic
Review
– Subsidized purchases of wheat and rice flour for
extremely poor families in Hunan and Gansu
provinces in China
– Purchases of these goods declined
– Subsidy freed up resources to purchase better
(normal) food stuffs
 Consumer surplus
• CS is the difference between the maximum
amount a consumer is willing to pay for a good
and the amount he or she must actually pay
when purchasing it
• For cases where only 1 unit is bought:
– WTP = 15
– P = 12
– CS = WTP – P = 15 – 12 = 3
 CS when many units bought
• CS is area between demand curve and price
line
 Why care about CS?
• For a seller, CS is amount of money that can
potentially be extracted from the consumer
– Firms would love to get their hands on your CS
• Price taking firms (e.g. perfectly competitive firms)
cannot extract your CS
• Firms with price setting power and the ability to price
discriminate (e.g. monopolists) can extract some or all
of your CS
– What tools can such firms use to extract your CS?
– Stay tuned and find out
 Network externalities
• Amount of a good demanded by one consumer depends on
the number of other consumers who purchase the good
• Examples
– WORD more useful as word processor if more people use it since
they can exchange and collaborate on documents
– Complementary goods e.g. WINDOWS and APPS: more people
using an OS leads to more apps, raising the demand for the OS
– Fads
– Social network: more people using it raises its value to everyone
since you can stay in touch with old friends and make new
friends
Positive network externality: bandwagon
effect
Negative network externality: snob effect
 Find the demand curve (interior solution)

•  
• Price of x is Px and price of y is Py
• Income available is I
• Hint: optimal choice must satisfy tangency
condition and lie on budget line
 Find a demand curve (corner solution)

•  
• Price of x is Px and price of y is Py
• Income available is I
• Find demand curve for y
• Hint: at what range of prices will he buy 0
amount of y?
 IE and SE numerical problem
• Utility function U(x, y) = xy
• Income is $72 per week
• Price of y is Py = $1 per unit.
• Price of x is initially $9 per unit and then falls
to $4 per unit
• Find the IE and SE and total change in quantity
demanded of x
 Consumer surplus problem
• Demand curve is Q = 100 – P
• Market price is P = 40
• What is the consumer surplus?
Extra stuff for knowledge sake but not for the
exam
• So far we examined neoclassical utility theory
• A mental model of consumer’s decision making
process
– Preferences are given
– Goods are given
• Now, an alternate model of decision making process
– Preferences over attributes / characteristics are given
– Goods attributes / characteristics (including prices) are
given
 The pioneering work of Lancaster
• Lancaster (1966) said utility derived not from goods
but from characteristics embodied in goods
– Products have objective characteristics
– Consumers can assess the characteristics embedded in
products
– Consumers derive utility from characteristics
– So, utility derived not from car but from engine capacity,
seating capacity, luggage space, fuel economy etc.
• Let us see some examples of this approach in action
in a business / policy setting
 Conjoint analysis
(Marketing technique)
• Method to learn about consumer preferences
– Identify relevant product attributes
– Assign levels to the attributes to capture actual or potential
variation
– Ask consumers to rate products e.g. 0 to 10 scale
• Treat this as utility measure
– Decompose ratings into “part-worth” utilities for each level of
each attribute of the product
• This is done by ordinary least squares regression
• Part worth utility is how much “part” of the product i.e. the
particular attribute is worth in utils
– Whole is worth the sum of the parts
 Example
• Three attributes with different levels

• How many possible product concepts?

• Let respondents rate the concepts on a scale from 0
to 10 with 10 indicating highest degree of preference
Example data from a respondent
Brand (1,2,3) = (A, B, C)
Color (1,2) = (Red, Blue)
EXCEL regression results
Brand A and Color Red are reference
categories. So, coefficient of B is increase in
utility by moving from A to B.
Coefficient of Blue is increase in utility by
moving from Red to Blue
Coefficient of Price is increase in utility
increasing price by $1 (this is marginal
utility of money)
 Part worth utilities
• Regression results give part worth utilities as
– Brand: A = 0, B = 1.67, C = 3.17 utils
– Color: Red = 0, Blue = 1.11 utils
– Price: 1 USD = -0.05 utils
• Recombine part-worth utilities to get
– Predicted customer preferences for combinations of attributes (even new
products)
• (Brand A, Red, 125USD) = 8.11 + 0 + 0 + (125*-0.05) = 1.86 utils
– WTP for configuration changes
• From Red to Blue will increase utility by 1.11 utils. Consumer will be WTP extra (1.11 / 0.05) =
22.2USD for this since utility remains constant after this
– Identify the optimal product concept
• Brand C, Blue, 50 USD
– Likely market share for new products
• Rule 1: maximum utility rule (rarely purchased goods)
– Consumer chooses product that provides the highest utility value from the available alternatives
• Rule 2: share of utility rule (frequently purchased goods)
– Product gets a share of consumers’ purchases in proportion to its share in consumers’ preferences
 Discrete choice experiment
• Draws from random utility theory (RUT) of
Thurstone (1927) and McFadden (1986)
• RUT postulates
– There is a latent construct called utility
– Utility summarized by two components
• Systematic (V)
– Function of product attributes
• Random (e)
– So, Uik = Vik+ eik for individual i and choice k
 RUT
•• Assume
  individual chooses product with highest utility
– We have that probability that individual i chooses alternative k
i.e. P{(Vik+ eik) = max (Vim+ eim)} for all m products

– If e is distributed iid type 1 extreme value, then this probability

is

• Above model is called conditional logit model

– Probabilities are a function of choice attributes
– Model fitted by Maximum Likelihood Estimation
– Inter alia, model produces estimates of
• WTP can be estimated by including price as an attribute
 DCE
• Finkelstein et al (2011): How willing are US
citizens to accept the costs of
counterterrorism policies
– Each participant presented with five trade-off
questions
– Each question describes two hypothetical security
policies that the U.S. government might pursue
– Respondents asked to pick their preferred option
• Helps you to design optimal policies
Example of policy choice presented
Figure 2. Example Counterterrorism Conjoint Question
Option A Option B
Government Strategies to Improve Security
Increase in your taxes to fund $500 over ten years or $50 $7,000 over ten years or
antiterrorism measures over the next 10 per year on average $700 per year on average
years
Government access to personal Allowed but only with a Allowed but only with a
information judge’s permission judge’s permission
Using race, ethnicity, or country of Not allowed Not allowed
citizenship to identify potential terrorists
Jailing suspected terrorists without trial Less than 6 months Less than 6 months
Using harsh methods to question Allowed, but only with Allowed, but only with
suspected terrorists approval from responsible approval from responsible
official to prevent imminent official to prevent imminent
attack attack
National Security Outcomes
Expected deaths from terrorism 30 deaths over the next 500 deaths over the next
on U.S. soil over the next 10 years 10 years 10 years
If these were the only options available,  
which policy would you choose?
Suppose you were asked to vote on the policy option you just selected. Would you vote in favor of this
option being implemented?
 Yes, I would vote for this option
 No, I would not vote for this option

94
Regression results (only betas shown)
• Increase in personal taxes
– -0.00013
• Government access to personal info
– Never (0.123), if judge allows (0.177), if suspected (-0.026), always (-
0.274)
• Profiling
– Never (-0.077), country of origin (0.164), always (-0.086)
• Jailing without trial
– <6mths (0.092), 6mths-2yrs (0.068), 2yrs-7yrs (-0.062), indefinite (-0.098)
• Use of torture to interrogate
– Never (0.039), if judge allows & imminent threat (0.042), if judge allows
& no imminent threat (0.125), always (-0.206)
• Outcomes i.e. expected deaths from terrorism events
– -0.00041
95
 Interpreting results
What is the price of privacy?
• How much extra taxes will citizens be willing to pay
over next 10 years to move from always allow govt
access to personal information to never allow govt
access to personal information?
– Increase in utility is 0.177 – (– 0.274) = 0.451 utils
– One dollar tax is worth -0.00013 utils
– WTP increases by 0.451 / 0.00013 = 3469 USD
• Alternatively, how many extra deaths will citizens
be willing to accept over next 10 years for the same
change?
– One death is worth -0.00041 utils
– WTA deaths increases by 0.451 / 0.00041 = 1100 deaths
 Hedonic price model
•• Hedonic
  price model estimates where we have data on
several brands’ prices (P) and characteristics (z)
– We can thus estimate how brand price is related to brand
characteristics
– Marginal price of the nth characteristic is
• If , then marginal price of the characteristic (hedonic
price) is just the corresponding b
– Roughly speaking, a hedonic price is a measure of the
marginal utility of a particular attribute
– So, ratio of hedonic prices for two different attributes
represents the MRS between them
 Chinese housing market example
• Hai-zhen et al (2005)
• Some house characteristics and their hedonic prices (in
yuan)
– Floor area in sq mtr (0.594)
– Distance to city center (-1.122)
– No of bus routes in vicinity (0.506)
• MRS of floor area for bus routes is 1.17, indicating
willingness to sacrifice 1.17 bus routes for additional sq
mtr of floor area
• Helps you to price your apartment as a builder / landlord