CHAPTER

3

Microeconomics Pindyck/Rubinfeld 7e

Consumer Behavior

ENTS630 – Fall 2011

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 7e.

CHAPTER 3 OUTLINE

3.1 Consumer Preferences
3.2 Budget Constraints 3.3 Consumer Choice 3.5 Marginal Utility and Consumer Choice

2

Consumer choices 3 . Consumer preferences 2.Consumer Behavior ● Theory of consumer behavior: how consumers allocate incomes among different goods and services to maximize their well-being. Consumer behavior is best understood in three distinct steps: 1. Budget constraints 3.

we will ask whether consumers prefer one market basket to another.1 CONSUMER PREFERENCES Market Baskets: List with specific quantities of one or more goods.1 Alternative Market Baskets Market Basket A B D E G H Units of Food 20 10 40 30 10 10 Units of Clothing 30 50 20 40 20 40 To explain the theory of consumer behavior. 4 . TABLE 3.3.

Completeness: Preferences are assumed to be complete.  Means consumers can compare and rank all possible baskets.  Thus.1 CONSUMER PREFERENCES Some Basic Assumptions about Preferences 1. 5 .3. or will be indifferent between the two.  By indifferent we mean that a person will be equally satisfied with either basket. will prefer B to A. a consumer will prefer A to B. for any two market baskets A and B.

then the consumer also prefers A to C.3. 6 . Transitivity is normally regarded as necessary for consumer consistency.Transitivity: Preferences are assumed to be transitive.  Means if a consumer prefers basket A to basket B and basket B to basket C.1 CONSUMER PREFERENCES Some Basic Assumptions about Preferences 2.  Means consumers always prefer more of any good to less and are never satisfied or satiated .More is better than less: Goods are assumed to be desirable.more is always better. 3.

– for example baskets E & G Basket A is clearly preferred to basket G. while E is clearly preferred to A. D.3.1 Describing Individual Preferences 7 .1 CONSUMER PREFERENCES Indifference Curves Compare market basket A with those in shaded areas. Why?  A cannot be compared with B. or H without additional information. Why? Figure 3.

Indifference curve U1 shows all baskets that give the consumer the same level of satisfaction as does market basket A. include B and D. but prefers A to H or G.3. Why? Figure 3.1 ● CONSUMER PREFERENCES Indifference Curves Indifference curve: all combinations of market baskets that provide a consumer with the same level of satisfaction.2 An Indifference Curve 8 . This consumer prefers basket E to A.

Any market basket on indifference curve U3 is preferred to any basket on curve U2 which in turn is preferred to any on U1.1 ● CONSUMER PREFERENCES Indifference Maps Indifference map: A set of indifference curves showing the market baskets among which a consumer is indifferent.3. A is preferred to B B is preferred to D A is preferred to D Figure 3.3 An Indifference Map 9 .

Why? B has more of both goods. The consumer should be indifferent among market baskets A.1 CONSUMER PREFERENCES Indifference Maps If U1 and U2 intersect. then one of the assumptions of consumer theory is violated. Why? A = B. and D. Figure 3. then B = D However B should be preferred to D.3. A = D.4 Indifference Curves Cannot Intersect 10 . B.

MRS between clothing and food falls from 6 (between A and B) to 1 ( between E and G). Convexity When the MRS diminishes along an indifference curve.1 ● CONSUMER PREFERENCES The Marginal Rate of Substitution Marginal rate of substitution (MRS): Maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good.5 The Marginal Rate of Substitution 11 . Slope of an indifference curve measures the marginal rate of substitution (MRS) .3. Diminishing marginal rate of substitution. Figure 3. the curve is convex.

• The indifference curves are shaped as right angles.1 CONSUMER PREFERENCES Perfect Substitutes and Perfect Complements ● Perfect substitutes: Two goods for which the marginal rate of substitution of one for the other is a constant.3. 12 . • The indifference curves are shaped as straight lines ● Perfect complements: Two goods for which the MRS is zero or infinite.

(b) An additional left shoe gives consumer no extra satisfaction unless she also obtains the matching right shoe.1 CONSUMER PREFERENCES Perfect Substitutes and Perfect Complements Figure 3.3. 13 .6 Perfect Substitutes and Perfect Complements (a) Consumer is always indifferent between a glass of apple juice and and a glass of orange juice.

Speed vs Security Owners of Ford Mustang prefer acceleration to interior space .7 Preferences for Automobile Attributes Preferences for automobile attributes: acceleration and interior space that give the same satisfaction. Owners of Ford Explorers prefer interior space to acceleration. 14 .1 CONSUMER PREFERENCES In designing telecom networks trade off between ?? Figure 3.3.

Utility function can be represented by a set of indifference curves. 50.3. each with a numerical indicator.8 Utility Functions and Indifference Curves 15 . ● Utility function: Formula that assigns a level of utility to individual market baskets.1 CONSUMER PREFERENCES Utility and Utility Functions ● Utility: Numerical score representing satisfaction from a given market basket. Figure 3. Three indifference curves (utility levels of 25.100) associated with the utility function FC.

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. • Not practical to measure 16 .3. • Used in the analysis ● Cardinal utility function: Utility function describing by how much one market basket is preferred to another.

PF F  PC C  I Table below shows market baskets associated with $80 income when price of food is $1 and price of clothing is $2 per unit.2 Market Baskets and the Budget Line Market Basket A B D E Food (F) 0 20 40 60 Clothing (C) 40 30 20 10 Total Spending $80 $80 $80 $80 G 80 0 $80 The budget line is: F + 2C = $80 17 . TABLE 3.3.2 BUDGET CONSTRAINTS The Budget Line ● Budget line: All combinations of goods for which the total amount of money spent is equal to income.

Slope of the budget line: −PF/PC = −10/20 = −1/2. Budget constraint: F + 2C = $80 Figure 3.3.10 A Budget Line PF F  PC C  I C  ( I / PC )  ( PF / PC ) F 18 .2 BUDGET CONSTRAINTS The Budget Line The budget line associated with •income of $80 •price of food PF = $1 per unit •price of clothing PC = $2 per unit.

If the income falls to $40. Figure 3. the line shifts inward to L3.11 Effects of a Change in Income on the Budget Line 19 .3.2 BUDGET CONSTRAINTS The Effects of Changes in Income and Prices 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 is increased to $160 budget line shifts outward to L2.

50.12 Effects of a Change in Price on the Budget Line 20 . the line rotates inward from L1 to L3.00 to $0. When the price of food increases from $1. When the price of food falls from $1.2 BUDGET CONSTRAINTS The Effects of Changes in Income and Prices Price Changes A change in the price of one good with income unchanged causes the budget line to rotate. Figure 3.3.00.00 to $2. the budget line rotates outward from L1 to L2.

e. 2. A consumer maximizes satisfaction by choosing A where budget line and indifference curve U2 are tangent. e. It must be located on the budget line. MRS  PF / PC  No higher level of satisfaction can be attained with the given budget line.13 Maximizing Consumer Satisfaction 21 .g. at B Figure 3. It must give consumer the most preferred combination of goods.3. at D  Satisfaction is not maximized at on any lower indifference curve.3 CONSUMER CHOICE The maximizing market basket must satisfy two conditions: 1.g.

14 Consumer Choice of Automobile Attributes For the given budget of $10.3 CONSUMER CHOICE Figure 3.3.000 Consumers in (a) prefer to buy a car whose acceleration is worth $7000 Consumers in (b) prefer to buy a car whose acceleration is worth $2500 22 .

3. If MRS is not equal to price ratio for all levels of consumption.15 A Corner Solution 23 .3 CONSUMER CHOICE Corner Solutions ● Corner solution: Situation in which the marginal rate of substitution of one good for another in a chosen market basket is not equal to the slope of the budget line. Consumer maximizes satisfaction by consuming only one good. a corner solution arises. At B only ice cream is consumed Figure 3.

 Satisfaction from additional unit of food (Marginal utility of Food or MUF ) will decline as total amount of food consumed increase. the consumption of additional amounts will yield smaller additions to utility. 24 .5 MARGINAL UTILITY AND CONSUMER CHOICE ● Marginal utility (MU): Additional satisfaction obtained from consuming one additional unit of a good.3.  Distinction between the total utility obtained by consumption and satisfaction obtained from last unit consumed ● Diminishing marginal utility: Principle that as more of a good is consumed.

 Try to understand this intuitively and then see the formal proof later. Why?  Other wise consumer will buy more of one and less of the other service until marginal utility per dollar of expenditure becomes equal.3.5 MARGINAL UTILITY AND CONSUMER CHOICE ● Equal marginal principle: Utility is maximized when the consumer has equalized the marginal utility per dollar of expenditure across all goods.  Consider consuming telecom / computing services with a fixed budget and trade – off between network Speed and Security  Utility is maximized when a dollar spend on Speed provides the same utility as a dollar spend on Security. 25 .

 The formal proof is given bellow Assume moving along an indifference curve incrementally by ∆F and ∆C .5 MARGINAL UTILITY AND CONSUMER CHOICE ● Equal marginal principle: Utility is maximized when the consumer has equalized the marginal utility per dollar of expenditure across all goods. Total utility remains the same and we have ∆U = 0 0 =∆U Utility maximization requires 0  MU (F )  MU (C) F C (C / F )  MU /MU F C By definition (∆C/ ∆F) is MRS MRS  MU /MU F C MRS  P / P F C MU / MU  P / P F C F C MU / P  MU / P F F C C 26 .3.

5 Figure 3.3. 27 . but at a diminishing rate. Economics Philosophy Religion Psychology Telecom !!? Goolge the question Marginal Utility and Happiness Demonstrates diminishing marginal utility of income A comparison of mean levels of satisfaction with life across income classes in the United States shows that happiness increases with income.20 MARGINAL UTILITY AND CONSUMER CHOICE Does money bring happiness? No ? Yes ? Depends.

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