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Fernando & Yvonn Quijano

Prepared by:

Consumer

Behavior

3

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TE

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

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2 of 37Copyright 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

3.4 Revealed Preference

3.5 Marginal Utility and Consumer Choice

3.6 Cost-of-Living Indexes

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Consumer Behavior

theory of consumer behavior Description of howconsumers allocate incomes among different goods andservices to maximize their well-being.

Consumer behavior is best understood in three distinct steps:

1. Consumer preferences

2. Budget constraints

3. Consumer choices

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CONSUMER PREFERENCES3.1

Market Baskets

market basket (orbundle) List with specific quantitiesof one or more goods.

TABLE 3.1 Alternative Market Baskets

A 20 30

B 10 50

D 40 20

E 30 40

G 10 20

H 10 40

Market Basket Units of Food Units of Clothing

To explain the theory of consumer behavior, we will askwhether consumersprefer one market basket to another.

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Some Basic Assumptions about Preferences

1. Completeness: Preferences are assumed to be complete. Inother words, consumers can compare and rank all possiblebaskets. Thus, for any two market basketsA and B, a consumerwill preferA to B, will prefer B toA, or will be indifferent between

the two. By indifferent we mean that a person will be equallysatisfied with either basket.

Note that these preferences ignore costs. A consumer mightprefer steak to hamburger but buy hamburger because it ischeaper.

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Some Basic Assumptions about Preferences

2. Transitivity: Preferences are transitive. Transitivity means thatif a consumer prefers basketA to basket B and basket B tobasket C, then the consumer also prefersA to C. Transitivity isnormally regarded as necessary for consumer consistency.

3. More is better than less: Goods are assumed to bedesirablei.e., to be good. Consequently, consumers alwaysprefer more of any good to less. In addition, consumers arenever satisfied or satiated; more is always better, even if just alittle better. This assumption is made for pedagogic reasons;

namely, it simplifies the graphical analysis. Of course, somegoods, such as air pollution, may be undesirable, andconsumers will always prefer less. We ignore these bads in

the context of our immediate discussion.

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Describing Individual Preferences

Because more of each good ispreferred to less, we can

compare market baskets in theshaded areas. BasketAis clearlypreferred to basket G, while Eisclearly preferred toA.

However,Acannot be comparedwith B, D, or Hwithout additionalinformation.


Figure 3.1

Indifference curves

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An indifference map is a set of

indifference curves thatdescribes a person'spreferences.

An Indifference Map


Figure 3.3

Indifference Maps

indifference map Graph containing a set of indifference curvesshowing the market baskets among which a consumer is indifferent.

Any market basket onindifference curve U3, such asbasketA, is preferred to anybasket on curve U2(e.g.,

basket B), which in turn ispreferred to any basket on U1,such as D.

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If indifference curves U1and U2intersect, one of theassumptions of consumertheory is violated.

Indifference Curves Cannot Intersect


Figure 3.4

Indifference Maps

According to this diagram, theconsumer should be indifferentamong market basketsA, B,and D. Yet Bshould bepreferred to Dbecause Bhasmore of both goods

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The magnitude of the slope of an

indifference curve measures theconsumers marginal rate of

substitution (MRS) between two goods.

The Marginal Rate of Substitution


Figure 3.5

The Marginal Rate of Substitution

In this figure, the MRS between clothing(C) and food (F) falls from 6 (betweenAand B) to 4 (between Band D) to 2(between Dand E) to 1 (between Eand

G).Convexity The decline in the MRSreflects a diminishing marginal rate ofsubstitution. When the MRSdiminishes along an indifference curve,the curve is convex.

marginal rate of substitution Maximum amount of a good that aconsumer is willing to give up in order to obtain one additional unit ofanother good.

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Perfect Substitutes and Perfect Complements

perfect substitutes Two goods for which the marginal rateof substitution of one for the other is a constant.

perfect complements Two goods for which the MRS iszero or infinite; the indifference curves are shaped as rightangles.

bad Good for which less is preferred rather than more.

Bads

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In (a), Bob views orange juice andapple juice as perfect substitutes:He is always indifferent between aglass of one and a glass of theother.



Figure 3.6


In (b), Jane views left shoes andright shoes as perfect complements:

An additional left shoe gives her noextra satisfaction unless she also

obtains the matching right shoe.

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Preferences for automobile attributes can be described byindifference curves. Each curve shows the combination ofacceleration and interior space that give the same satisfaction.

Preferences for Automobile Attributes


Owners of Ford Mustang coupes arewilling to give up considerable interiorspace for additional acceleration.

Figure 3.7

The opposite is true for owners ofFord Explorers. They preferinterior space to acceleration.

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A cross-countrycomparison shows thatindividuals living incountries with higher

GDP per capita are onaverage happier thanthose living in countrieswith lower per-capitaGDP.

Ordinal versus Cardinal Utility

ordinal utility function Utility function that generates a rankingof market baskets in order of most to least preferred.

cardinal utility function Utility function describing by how muchone market basket is preferred to another.

Income and Happiness

Figure 3.9

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Clothing (C)

BUDGET CONSTRAINTS3.2

Market baskets associated with the budget lineF+ 2C= $80

The Budget Line

budget constraints Constraints that consumers faceas a result of limited incomes.

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

TABLE 3.2 Market Baskets and the Budget Line

A 0 40 $80

B 20 30 $80

D 40 20 $80

E 60 10 $80

G 80 0 $80

Market Basket Food (F) Total Spending

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A budget line describes thecombinations of goods that can bepurchased given the consumers

income and the prices of the goods.

LineAG(which passes throughpoints B, D, and E) shows thebudget associated with an incomeof $80, a price of food of PF= $1 perunit, and a price of clothing of PC=$2 per unit.

The slope of the budget line

(measured between points Band D)is PF/PC= 10/20 = 1/2.

The Budget Line

A Budget Line

Figure 3.10

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Income changes A change inincome (with prices unchanged)causes the budget line to shift

parallel to the original line (L1).

When the income of $80 (onL1) isincreased to $160, the budget lineshifts outward to L2.

If the income falls to $40, the lineshifts inward to L3.

The Effects of Changes in Income and Prices

Effects of a Change in Income on the

Budget Line

Figure 3.11

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Price changes A change in theprice of one good (with incomeunchanged) causes the budget line

to rotate about one intercept.

When the price of food falls from$1.00 to $0.50, the budget linerotates outward from L1to L2.

However, when the price increasesfrom $1.00 to $2.00, the line rotates

inward from L1 toL3.

The Effects of Changes in Income and Prices

Effects of a Change in Price on the

Budget Line

Figure 3.12

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CONSUMER CHOICE3.3

A consumer maximizes satisfactionby choosing market basketA. Atthis point, the budget line andindifference curve U2are tangent.

No higher level of satisfaction (e.g.,market basket D) can be attained.

AtA, the point of maximization, the

MRS between the two goods equalsthe price ratio. At B, however,because the MRS [ (10/10) = 1] is

greater than the price ratio (1/2),satisfaction is not maximized.

Maximizing Consumer Satisfaction

Figure 3.13

The maximizing market basket must satisfy two conditions:

1. It must be located on the budget line.

2. It must give the consumer the most preferred combination ofgoods and services.

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CONSUMER CHOICE3.3

marginal benefit Benefit from the consumption of oneadditional unit of a good.

marginal cost Cost of one additional unit of a good.Using these definitions, we can then say that satisfaction ismaximized when the marginal benefitthe benefit associatedwith the consumption of one additional unit of foodis equal tothe marginal costthe cost of the additional unit of food. The

marginal benefit is measured by the MRS.

Satisfaction is maximized (given the budget constraint) at thepoint where MRS = PF/PC.

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Consumer Choice of Automobile Attributes

CONSUMER CHOICE3.3

The consumers in (a) are willing to trade off a considerable amount of interior spacefor some additional acceleration. Given a budget constraint, they will choose a carthat emphasizes acceleration. The opposite is true for consumers in (b).

Figure 3.14

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CONSUMER CHOICE3.3

When a corner solution arises,the consumer maximizessatisfaction by consuming onlyone of the two goods.

Given budget lineAB, the highestlevel of satisfaction is achieved atBon indifference curve U1, where

the MRS (of ice cream for frozenyogurt) is greater than the ratio ofthe price of ice cream to the priceof frozen yogurt.

Corner Solutions

A Corner Solution

Figure 3.15

corner solution Situation in which the marginal rate ofsubstitution for one good in a chosen market basket isnot equal to the slope of the budget line.

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A College Trust Fund

CONSUMER CHOICE3.3

When given a collegetrust fund that must bespent on education, thestudent moves fromAto

B, a corner solution.If, however, the trust fundcould be spent on otherconsumption as well aseducation, the studentwould be better off at C.

Figure 3.16

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REVEALED PREFERENCE3.4

If an individual facing budget line l1

chose market basketArather thanmarket basket B,Ais revealed to bepreferred to B.

Likewise, the individual facingbudget line l2chooses marketbasket B, which is then revealed tobe preferred to market basket D.

WhereasAis preferred to all marketbaskets in the green-shaded area,all baskets in the pink-shaded areaare preferred toA.

Revealed Preference:

Two Budget Lines

Figure 3.17

If a consumer chooses one market basket over another, and if

the chosen market basket is more expensive than the alternative,then the consumer must prefer the chosen market basket.

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Facing budget line l3theindividual chooses E, which isrevealed to be preferred toA(becauseA could have beenchosen).

Likewise, facing line l4, theindividual chooses Gwhich isalso revealed to be preferred to

A.

WhereasAis preferred to all

market baskets in the green-shaded area, all market basketsin the pink-shaded area arepreferred toA.

Revealed Preference:

Four Budget Lines

Figure 3.18

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Revealed Preference for Recreation


When facing budget line l1, anindividual chooses to use ahealth club for 10 hours per week

at pointA.When the fees are altered, shefaces budget line l2.

She is then made better offbecause market basketAcanstill be purchased, as can marketbasket B, which lies on a higher

indifference curve.

Figure 3.19

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MARGINAL UTILITY AND CONSUMER CHOICE3.5

marginal utility (MU) Additional satisfaction obtainedfrom consuming one additional unit of a good.

diminishing marginal utility Principle that as more of a good isconsumed, the consumption of additional amounts will yieldsmaller additions to utility.

( / ) MU MU ( )C F CF C

0 MU ( ) MU ( )F CF C

MRS MU /MU (3.5)F C

MRS / (3.6)P PF C

MU /MU /P PF FC C

MU / MU / (3.7)P PF F C C

equal marginal principle Principle that utility is maximizedwhen the consumer has equalized the marginal utility per dollar ofexpenditure across all goods.

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Marginal Utility and Happiness


A comparison of mean levels of satisfaction with life across income classes in theUnited States shows that happiness increases with income, but at a diminishing rate.

Figure 3.20

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Inefficiency of Gasoline Rationing


When a good is rationed, lessis available than consumerswould like to buy. Consumersmay be worse off. Withoutgasoline rationing, up to 20,000gallons of gasoline areavailable for consumption (atpoint B).

The consumer chooses point Con indifference curve U2,consuming 5000 gallons of

gasoline.However, with a limit of 2000gallons of gasoline underrationing (at point E), theconsumer moves to Don thelower indifference curve U1.

Figure 3.21

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Comparing Gasoline Rationing to the

Free Market


If the price of gasoline in a competitivemarket is $2.00 per gallon and themaximum consumption of gasoline is

10,000 gallons per year, the woman isbetter off under rationing (which holdsthe price at $1.00 per gallon), sinceshe chooses the market basket atpoint F, which lies below indifferencecurve U1(the level of utility achievedunder rationing).

However, she would prefer a freemarket if the competitive price were$1.50 per gallon, since she wouldselect market basket G, which liesabove indifference curve U1.

Figure 3.22

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COST-OF-LIVING INDEXES3.6

Ideal Cost-of-Living Index

cost-of-living index Ratio of the present cost of atypical bundle of consumer goods and services comparedwith the cost during a base period.

ideal cost-of-living index Cost of attaining a givenlevel of utility at current prices relative to the cost ofattaining the same utility at base-year prices.

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The initial budget constraintfacing Sarah in 1995 is given byline l1; her utility-maximizingcombination of food and booksis at pointAon indifferencecurve U1.

Rachel requires a budgetsufficient to purchase the food-book consumption bundle givenby point Bon line l2(and tangentto indifference curve U1).


TABLE 3.3 Ideal Cost-of-Living Index

Price of books $20/book $100/bk

Number of books 15 6

Price of food $2.00/lb. $2.20/lb.

Pounds of food 100 300

Expenditure $500 $1260

2005 (Rachel )1995 (Sarah)

Cost-of-Living Indexes

Figure 3.23

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A price index, which representsthe cost of buying bundleAatcurrent prices relative to thecost of bundleAat base-yearprices, overstates the ideal cost-of-living index.


TABLE 3.3 Ideal Cost-of-Living Index

Price of books $20/book $100/bk

Number of books 15 6

Price of food $2.00/lb. $2.20/lb.

Pounds of food 100 300

Expenditure $500 $1260

2005 (Rachel )1995 (Sarah)

Cost-of-Living Indexes

Figure 3.23

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fixed-weight index Cost-of-living index in which thequantities of goods and services remain unchanged.

chain-weighted price index Cost-of-living index thataccounts for changes in quantities of goods and services.

Price Indexes in the United States: Chain Weighting

A commission chaired by Stanford University professor MichaelBoskin concluded that the CPI overstated inflation byapproximately 1.1 percentage pointsa significant amount giventhe relatively low rate of inflation in the United States in recentyears.

Approximately 0.4 percentage points of the 1.1-percentage-pointbias was due to the failure of the Laspeyres price index toaccount for changes in the current year mix of consumption of theproducts in the base-year bundle.

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