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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?
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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?
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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
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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
1. Budget Constraints
People have limited incomes
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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?
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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
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Consumer Preferences
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
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B H A D E
40 30 20 10 10
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The consumer prefers A to all combinations in the yellow box, while all those in the pink box are preferred to A.
20
30
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Food
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Clothin g
B H A D G E
Indifferent between points B, A, & D E is preferred to points on U1 Points on U1 are preferred to H & G
U1
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30
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Food
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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
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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
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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
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Indifference Map
Clothing Market basket A is preferred to B. Market basket B is preferred to D.
D B A
U3 U2 U1
Food
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Indifference Maps
Indifference maps give more information about shapes of indifference curves
Indifference curves cannot cross
Violates
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Indifference Maps
Clothing
U
2
U1
A B D
U2 U1
Food
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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
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Indifference Curves
Clothing 16
A
Observation: The amount of clothing given up for 1 unit of food decreases from 6 to 1
14 12 10 8 6 4 2 1
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-6 1 -4 1 -2 1 -1
B D E
1
G
Food
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4
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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
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A MRS = 6
-6 1 -4 1 -2 1 -1 1
14 12 10 8 6 4 2 1
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MRS = C
B D MRS = 2 E
G
Food
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4
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Consumer Preferences
Apple 4 Juice (glasses)
Perfect Substitutes
1 0 1 2 3
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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
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Consumer Preferences
Left Shoes
4 3 2 1 0 1 2 3
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Perfect Complements
Right Shoes
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Consumer Preferences
We have assumed all our commodities are goods There are commodities we dont want more of - bads
Things for which less is preferred to more
Examples
Air pollution Asbestos
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Consumer Preferences
How do we account for bads in our preference analysis?
We redefine the commodity
Clean
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Performance
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Performance
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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
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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
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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)
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Utility - Example
Market Basket A B C Food Clothing Utility
8 6 4
3 4 4
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
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Utility - Example
Clothing
15
C
10
U = FC 25 = 25 = 5(5) 25 =
A B
U3 = 100 U2 = 50 U1 = 25 Food
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0
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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
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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
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Utility
The actual unit of measurement for utility is not important An ordinal ranking is sufficient to explain how most individual decisions are made
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Budget Constraints
Preferences do not explain all of consumer behavior Budget constraints also limit an individuals ability to consume in light of the prices they must pay for various goods and services
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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
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PF F + PC C = I
All income is allocated to food (F) and/or clothing (C)
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Example:
Assume income of $80/week, PF = $1 and PC = $2
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Budget Constraints
Market Basket A B D E G Food PF = $1 0 20 40 60 80 Clothing PC = $2 40 30 20 10 0 Income
I = PFF + PCC
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(I/PC) = 40 30
A B 10 D 20 E
C 1 PF Slope = = - =F 2 PC
20 10
G
0 20 40 60
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80 = (I/PF)
Food
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I = PX X + PY Y I PX X = PY Y I PX X =Y PY PY
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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
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80 60 40 20
0
L3 (I = $40)
40
80
120
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Food
(units per week)
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40
L3
(PF = 2)
40
L1
(PF = 1)
80
L2
120
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An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward.
(PF = 1/2)
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Food
(units per week)
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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
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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
1. It must give the consumer the most preferred combination of goods and services
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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
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Consumer Choice
Clothing (units per week)
40 A 30 20 C D
A, B, C on budget line D highest utility but not affordable C highest affordable utility Consumer chooses C
U3 B
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U1
80
U2
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20
40
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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
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Consumer Choice
Recall, the slope of an indifference curve is:
C MRS = F
Further, the slope of the budget line is:
PF Slope = PC
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Consumer Choice
Therefore, it can be said at consumers optimal consumption point,
PF MS = R PC
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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
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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 = unit clothing PF/PC
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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
Consumer Choice
Clothing (units per week)
40 30
-10C
Point B does not maximize satisfaction because the MRS = -10/10 = 1 is greater than the price ratio = 1/2
20
+10F
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U1
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40
80
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$3,000
$7,000
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$10,000 Performance
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$3,000
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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
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A Corner Solution
Frozen Yogurt (cups monthly)
A U1 U2 U3
B
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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
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A Corner Solution
When a corner solution arises, the consumers MRS does not necessarily equal the price ratio In this instance it can be said that:
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 consumers market basket
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B A
U2
U1
Q
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C
P
U3
B A
U2
If gift is unrestricted, Jane can be at point C on U3 Better off than with restricted gift
U1
Q
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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.
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l1
l2 A B D
I1: Choose A over B A is revealed preferred to B l2: Choose B over D B is revealed preferred to D
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l1
All market baskets in the pink shaded area are preferred to A.
l2 A
B is preferred to all market baskets in the yellow area
B D
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
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l1 l4
l2
B G
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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
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0 = MU F(F) + MU C(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.
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MRS = PF /PC
Since the MRS is also equal to the ratio of the marginal utility of consuming F and C
MU F /MUC = PF /PC
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MUF / PF = M UC / PC
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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
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Cost-of-Living Indexes
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?
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Cost-of-Living Indexes
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
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Cost-of-Living Indexes
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
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Cost-of-Living Indexes
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
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Cost-of-Living Indexes
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
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Cost-of-Living Indexes
Paasche index
Focuses on the cost of buying the current years 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
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Cost-of-Living Indexes
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
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Cost-of-Living Indexes
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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