Consumer Behavior Chapter 3 Chapter Outline Preferences Budget Constraints Consumer Choice Consumer Behavior theory of consumer behavior Description of how consumers allocate incomes among different goods and services to maximize their well being Consumer behavior is best understood in 3 steps Consumer preferences Budget constraints Consumer choices Consumer Preferences market basket or bundle of one or more goods List with specific quantities Alternative Market Baskets 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 To explain the theory of consumer behavior we will ask whether consumers prefer one market basket to another Basic Properties of Preferences These properties characterize rational choice Completeness Transitivity Covexivity Continuity More Is Better Basic Properties of Preferences Completeness if A and B are any two situations an individual can always specify exactly one of these possibilities A is preferred to B B is preferred to A A and B are equally attractive Basic Properties of Preferences Transitivity Convexivity if A is preferred to B and B is preferred to C then A is preferred to C assumes that the individual s choices are internally consistent mixtures of goods are preferable to extremes Continuity if A is preferred to B then situations suitably close to A must also be preferred to B Basic Properties of Preferences More is better than less Goods are assumed to be desirable i e to be good Consumers are never satisfied or satiated more is always better even if just a little better Of course some goods such as air pollution may be undesirable and consumers will always prefer less We ignore these bads in the context of our immediate discussion Utility Given these assumptions it is possible to show that people are able to rank in order all possible situations from least desirable to most Economists call this ranking utility if A is preferred to B then the utility assigned to A exceeds the utility assigned to B U A U B Utility rankings are ordinal in nature they record the relative desirability of commodity bundles Generating Equally Preferred Bundles Indifference Curves An indifference curve shows a set of consumption bundles among which the individual is indifferent Quantity of y Combinations x1 y1 and x2 y2 provide the same level of utility y1 y2 U1 Quantity of x x1 x2 Indifference Curve Map a representative sample of the set of a consumer s indifference curves used as a graphical summary of her preference ordering Quantity of y Increasing utility we assume more is preferred to less U3 U1 U2 U3 U2 U1 Quantity of x Transitivity Indifference curves cannot intersect Quantity of y The individual is indifferent between A and C The individual is indifferent between B and C Transitivity suggests that the individual should be indifferent between A and B C B A U2 But B is preferred to A because B contains more x and y than A U1 Quantity of x Convexity If the indifference curve is convex then the combination x1 x2 2 y1 y2 2 will be preferred to either x1 y1 or x2 y2 This implies that well balanced bundles are preferred to bundles that are heavily weighted toward one commodity Quantity of y y1 y1 y2 2 y2 U1 x1 x1 x2 2 Quantity of x x2 Trade offs Between Goods Marginal rate of substitution MRS the rate at which the consumer is willing to exchange the good measured along the vertical axis for the good measured along the horizontal axis Equal to the absolute value of the slope of the indifference curve Equal to the negative of the slope of the indifference curve Marginal Rate of Substitution Quantity of y dy dy MRS dx dx y1 y2 U1 x1 x2 Quantity of x Diminishing MRS Perfect Substitutes and Perfect Complements perfect substitutes Two goods for which the marginal rate of substitution of one for the other is a constant perfect complements Two goods for which the MRS is zero or infinite the indifference curves are shaped as right angles Perfect Substitutes and Perfect Complements In a Bob views orange juice and apple juice as perfect substitutes He is always indifferent between a glass of one and a glass of the other In b Jane views left shoes and right shoes as perfect complements An additional left shoe gives her no extra satisfaction unless she also obtains the matching right shoe Preferences for Automobile Attributes Owners of Ford Mustang coupes a are willing to give up considerable interior space for additional acceleration The opposite is true for owners of Ford Explorers b They prefer interior space to acceleration ACTIVE LEARNING 1 Indifference Curves Draw indifference curves that represent the following individuals preferences Jane loves hamburgers and dislikes soft drinks If she is served a soft drink she will pour it down the drain rather than drink it Assume disposal is free A Bob loves hamburgers and dislikes soft drinks If he is served a soft drink he will drink it to be polite B Mary always gets twice as much satisfaction from an extra hamburger as she does from an extra soft drink C Budget Constraints Budget Constraints Constraints that consumers face as a result of limited incomes The Budget Line All combinations of goods for which the total amount of money spent is equal to income PF F PC C I Market Baskets and the Budget Line Market Basket Food F Total Spending A 0 Clothing C 40 B 20 30 80 D 40 20 80 E 60 10 80 G 80 0 80 80 The table shows market baskets associated with the budget line F 2C 80 Budget Constraints income 80 price of food PF 1 per unit price of clothing PC 2 per unit C I PC PF PC F Effects of a Change in Income on the Budget Line Effects of a Change in Prices on the Budget Line Price Changes A change in the price of one good with income unchanged causes the budget line to rotate about one intercept The Best Feasible Bundle Consumer s Goal to choose the best affordable bundle to reach the highest indifference curve she can given her budget constraint For convex indifference curves the best bundle will always lie at the point of tangency The Best Affordable Bundle dy PF MRS dx PC best affordable bundle Marginal Utility and Consumer Choice marginal utility MU Additional satisfaction obtained from consuming one additional unit of a good diminishing marginal utility 0 MU DF MU DC F C DC DF MU MU F C MRS MU MU F C MU MU P P F C F C MRS P P F C MU P MU P F F C C equal marginal principle Principle that utility is maximized when the consumer has equalized the marginal utility per dollar of expenditure across