Bab 3

Chapter 3
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?
©2005 Pearson Education, Inc. Chapter 3 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?

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?

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

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

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?

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

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

 Consumer preferences can be
represented graphically using
indifference curves
 Indifference curves represent all
combinations of market baskets that the
person is indifferent to
A person will be equally satisfied with either
choice

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

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

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
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

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
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

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

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

Indifference Map
Clothing
Market basket A
is preferred to B.
Market basket B is
D preferred to D.
B A
U3
U2
U1
Food

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?

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

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

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
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

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
 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

 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 1

 Indifference curves with different shapes
imply a different willingness to substitute
 Two polar cases are of interest
Perfect substitutes
Perfect complements

 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

Apple
4
Juice
(glasses)
Perfect
3 Substitutes
Orange Juice
0 1 2 3 4 (glasses)
 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

Left
Shoes Perfect
4 Complements
0 1 2 3 4 Right Shoes

 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

 How do we account for bads in our
preference analysis?
We redefine the commodity
 Clean air
 Pollution reduction
 Asbestos removal

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

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

An Application
Styling
These consumers
place a greater
value on
performance than
styling
Performance
An Application
Styling
These consumers place
a greater value on
styling than
performance
Performance
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

 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

 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

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)

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

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

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
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

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

Utility
 The actual unit of measurement for utility
is not important
 An ordinal ranking is sufficient to explain
how most individual decisions are made

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

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

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

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)

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

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

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)

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

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

The Budget Line
I  PX X  PY Y
I  PX X  PY Y
I PX
 X Y
PY PY
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

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

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

 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

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)
 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 food. The x-intercept shifts in.
If you buy only clothing (y-intercept), you can
buy the same amount. No change in y-
intercept.

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.

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)
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

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

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

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

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

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)
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

Consumer Choice
 Recall, the slope of an indifference curve
is:
C
MRS  
F
Further, the slope of the budget line is:
PF
Slope  
PC

Consumer Choice
 Therefore, it can be said at consumer’s
optimal consumption point,
PF
MRS 
PC

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

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

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 = PF/PC
 If MRS < PF/PC
Will increase clothing and decrease food until
MRS = PF/PC

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)
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

Consumer Choice:
 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

Consumer Choice:
Styling
$10,000 These consumers

want performance worth
$7000 and styling worth
$3000
$3,000
$7,000 $10,000 Performance

Consumer Choice:
Styling
These consumers want
$10,000 styling worth $7000
and performance
worth $3000
$7,000
$3,000 $10,000 Performance

Consumer Choice:
 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

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

A Corner Solution
Frozen
Yogurt
(cups
monthly) A A corner solution
exists at point B.
U1 U2 U3
B Ice Cream (cup/month)

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

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
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

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

 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, U2

Other
Consumption
($) •Jane better off
on U2
•B is corner
solution
P
B •MRS ≠ PE/POG
U2
A
U1
Q Education ($)
Other
Consumption
($) •If gift is
unrestricted, Jane
C can be at point C on
U3
U3 •Better off than
P
with restricted gift
B U2
A
U1
Q Education ($)
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.

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)

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

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

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
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?

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

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

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)

Choice
 Formally:
0  MUF(F)  MUC(C)
No change in total utility along an indifference curve.
Trade off of one good to the other leaves the consumer
just as well off.

Choice
 Rearranging:
 C / F   MU F / MU C
Since
 C / F   MRS of F for C
We can say
MRS  MUF/MUC
Choice
 When consumers maximize satisfaction:
MRS  PF /PC
Since the MRS is also equal to the ratio of the
marginal utility of consuming F and C
MU F /MU C  PF /PC
Choice
 Rearranging, gives the equation for utility
maximization:
MU F / PF  MU C / PC

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.

Cost-of-Living Indexes
 Social Security payments are given to
qualifying individuals
 Each year the benefit increases equal to
the rate of increase of the Consumer
Price Index (CPI)
Ratio of the present cost of typical bundle of
goods/services in comparison to the cost
during a base period

 Does the CPI give a good measure of
inflation and therefore a measure of the
cost of living changes?
 Should the CPI be used to measure how
much cost of living has increased,
determining increases in government
payment programs?

 The ideal cost of living index represents
the cost of attaining a given level of utility
at current prices relative to the cost of
attaining the same utility at base prices

 To obtain the ideal cost of living index
would require too much information, such
as consumer preferences as well as
prices and expenditures
 Actual price indexes are based on
consumer purchases, not preferences

 Laspeyres price index
Amount of money at current year prices that
an individual requires to purchase a bundle
of goods/services chosen in a base year
divided by the cost of purchasing the same
bundle at base-year prices
Ex: CPI

 The Laspeyres price index assumes that
consumers do not alter their consumption
patterns as prices change
 Tends to overstate the true cost of living
index
 Using the CPI to adjust retirement
benefits will tend to overcompensate
most recipients, requiring greater
government expenditure

 Paasche index
Focuses on the cost of buying the current
year’s bundle
Amount of money at current-year prices that
an individual requires to purchase a current
bundle of goods/services divided by the cost
of purchasing the same bundle in a base
year

 Comparison of indexes
Both are fixed weight indexes
Quantities of various goods and services in
each index remain unchanged
Laspeyres index keeps quantities at base
year levels
Paasche index keeps unchanged quantities
at current year levels

 Chain-Weighted Indexes
Cost-of-living index that accounts for
changes in quantities of goods and services
Introduced to overcome problems that arose
when long-term comparisons were made
using fixed weight price indexes

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Chapter 3

©2005 Pearson Education, Inc. Chapter 3 2

©2005 Pearson Education, Inc. Chapter 3 3

1. How would General Mills determine the

©2005 Pearson Education, Inc. Chapter 3 4

©2005 Pearson Education, Inc. Chapter 3 5

©2005 Pearson Education, Inc. Chapter 3 6

3. Given preferences and limited incomes,

©2005 Pearson Education, Inc. Chapter 3 7

©2005 Pearson Education, Inc. Chapter 3 8

©2005 Pearson Education, Inc. Chapter 3 9

©2005 Pearson Education, Inc. Chapter 3 10

©2005 Pearson Education, Inc. Chapter 3 11

©2005 Pearson Education, Inc. Chapter 3 12

The consumer prefers

©2005 Pearson Education, Inc. Chapter 3 14

©2005 Pearson Education, Inc. Chapter 3 16

©2005 Pearson Education, Inc. Chapter 3 17

 To describe preferences for all

©2005 Pearson Education, Inc. Chapter 3 18

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 Indifference maps give more information

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14 Observation: The amount

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Consumer is indifferent between A & B and

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

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 Different choices of food and clothing can

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Market Food Clothing Income

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