MANAGERIAL

ECONOMICS
ANALYSIS AND STRATEGY
Evan J. Douglas
CHAPTER 3

CONSUMER BEHAVIOR
 Executive Summary
In the first two chapters we spoke in general terms of costs, revenues, and profits. We now
examine the principles underlying consumer demand and, hence, the firm’s revenues. By
understanding consumer behaviour, we can predict consumers’ responses to changes in
variables that the firm can control, such as prices, product design, and promotional
expenditures. We also examine the probable response of consumers to changes in
variables that the firm cannot control, such as consumer incomes and the prices (and other
competitive strategies) of other sellers. With this understanding, the manager is better able
to explain and predict the behaviour of the firm’s revenues.
The first section of this chapter examines the traditional approach to consumer
behaviour, known as indifferent-curve analysis of consumer choice between and among
products. Consumers derive utility from products, and this utility, relative to the prices of
these goods and services, determines which products are chosen within the consumer’s
income constraint.
We next examine the attribute approach to consumer choice, which assumes that
consumers buy products because they like the benefits that the product delivers. Using a car
as an example, the traditional view is that the consumer derives utility from the automobile
itself, while the attribute approach is that utility is obtained from the benefits provided by the
automobile, such as transportation, comfort, prestige, power, and fuel economy. The
attribute approach has important implications for managers and, moreover, provides the
bridge that links the economic analysis of consumer behaviour with the marketing strategies
of business firms. Since attributes generate value for consumers, the prices of products
should be chosen with reference to the attributes embodied in the product. Similarly,
products should be designed to include attributes that potential buyers want, and
subsequently advertised to draw attention to the presence of desirable attributes.
Indifference-Curve Analysis of
Consumer Behavior
 Utility is the psychic satisfaction, or feeling of well-being,
that a consumer derives from the consumption of goods
and services. Total utility is the sum of all utility received
from all goods and services consumed. The marginal
utility of a good is equal to the change in total utility when
the consumption of that good is changed by one unit.
Indifference Curves between Products
 An indifference curve is a line on a graph representing
combinations of two products (or any two variables, such as risk
and return) that give the same total utility to a particular person.
The four properties of
indifference curves:
 Higher curves are preferred to lower curves
 Negatively sloped throughout
 Neither meet nor intersect
 Convex from below
 The marginal rate of substitution (MRS) is defined as the
amount of one product that the consumer will be willing to
give up for an additional unit of another product, while
remaining at the same level of utility.

MRS = MUc/MUh
 The budget constraint is defined as the total income or wealth
the consumer is able to spend on goods and services per
period. In the simple two-commodity situation we can write
the budget constraint as

B = PhH + PcC
where,
B = the total dollar budget available to the consumer
Ph and Pc = the prices per physical unit of hamburgers and
cokes respectively
H and C = the number of hamburgers and cokes purchased
The Rule of Utility Maximization
 Utility maximization requires that the consumer choose the
combination on the budget constraint line where this line is tangent
to an indifference curve. Tangency between the budget line and an
indifference curve means that their slopes must be equal. Since the
slope of an indifference curve is the marginal rate of substitution and
the slope of the budget line is the price ratio, we can express the
condition for utility maximization as
MRS = –Pc / Ph
given that all available income is spent. We may alternatively
express the maximizing condition as
MUc / MUh = –Pc / Ph
Rearranging terms, we have
MUc / –Pc = MUh / Ph
The Budget Constraint between Products
Maximization of Utility from Products
The Price Effect and the Law of Demand

 The price effect is defined as the change in the quantity

demanded of a particular product that is due to a change
in the price of that product, ceteris paribus.
 The law of demand states that as the price is raised the
consumer demands progressively less of the product,
and, conversely, as the price is reduced the consumer
demands progressively more of the product, ceteris
paribus. The law of demand is an empirical law, meaning
that it is commonly observed in practice. It is expressed
graphically as a negatively sloping line relating price to
units of quantity demanded; this line is the demand
curve.
The Price Consumption Curve and the Demand Curve
Income Consumption Curve for Normal Goods
Income Consumption Curve Where X is an
Inferior Good
A Change in Tastes and Preferences in Favor
of Product X
The Attribute Approach to
Consumer Choice
 Kelvin Lancaster introduced the attribute analysis of
consumer behavior in 1966 and expanded it substantially
in 1971. This new theory of demand departed from the
traditional approach by asserting that consumers derive
utility not from the products themselves but from the
characteristics or attributes provided by the products.
Depicting Products in Attribute Space

Restaurant D

Restaurant F
The Budget Constraint and the Efficiency
Frontier
The efficiency frontier is the outer boundary of the attainable
combinations of the desired attributes, given the budget constraint.
Maximizing Utility from Attributes
 The Mixability of Products
 Indivisibility of Products

Maximization of Utility from Indivisibility of Products Necessitating a

Attributes Suboptimal Combination of Attributes
Pricing a Product Out of the Market
Changes in Income for Superior and
Inferior Goods

The Income Effect where Product B Is a The Income Effect where Product B Is an
Normal Good Inferior Good
Changed Consumer Perception of a
Product