CONSUMER BEHAVIOR

1
CONSUMER BEHAVIOR

• Preferences.
• The conflict between opportunities and desires.
• Utility maximizing behavior.

2
Preferences or Tastes

• All consumers are endowed with a set of
  preferences among all of the goods and services
  from which they can choose.
• These preferences are embodied in a "utility
  function."

3

• Economists impose 4 assumptions on the
  preferences in the standard case of the utility
  function
• 1. A consumer can decide for any pair of
  bundles of goods which bundle is preferred, or
  whether he/she is indifferent.
• 2. Preferences are transitive (consistent).
• 3. More is better.
• 4. Indifference curves are convex. (See
  below for a discussion of indifference curves.)

4
A utility function for two goods.
5
Indifference curve

• Definition All combinations of goods among
  which the consumer is indifferent.
• That is, all the combinations of goods that give
  the consumer a particular level of utility or
  satisfaction.

6

• The previous graph can be rotated to show
  indifference curves

7
Marginal Rate of Substitution

• Definition The Marginal Rate of Substitution of
  X for Y is the amount of Y it takes to make up
  for the loss of one unit of X.
• (Its minus the slope of an indifference curve.)

8
Some indifference curves U1 lt U2 lt U3
TACOS
SPAGHETTI
9
MRS is minus the slope of an indifference curve.
TACOS
MRSS for T -(?T/?S)
U3
?T
U2
?S
SPAGHETTI
10

• Characteristics of indifference curves in the
  standard case
• 1) They fill the goods space.
• 2) They cannot intersect.
• 3) Higher curves lie above and to the right of
  others.
• 4) They are convex. (There is increasing
  marginal rate of substitution.)

11
Woeful tales of preferences

• Nickels and dimes.
• Right shoes and left shoes.
• "I wouldn't eat acorns even if you paid me."
• "I would eat acorns only if you paid me."

12
Budget Constraints

• Definition The consumers budget constraint
  shows all of the combinations of goods and
  services the consumer is able to buy, given
  income and prices.

13

• Standard case assumptions
• 1. The consumer has a fixed, known money income
  in each time period.
• 2. The consumer pays a fixed price (in terms of
  dollars) for each good.

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Two good case

• Consumers income is I dollars per period.
• There are two goods, S and T, that have prices PS
  and PT.
• The consumers spending on the two goods together
  must be less than or equal to total income in
  each time period.

15
The Budget Constraint is

• PS S PTT ??I
• This can be written as
• T ??I/PT - (PS /PT)S

16

• Remember that income and prices are givens
  here, so the last equation is a linear
  relationship between T and S.

slope - PS / PT
17

• Where are feasible and non-feasible consumption
  bundles?

T
I/PT
S
I/PS
18
Changing income and prices

• Whats the effect on the consumers opportunities
  if income increases?
• I gt I
• PS S PTT I
• PS S PTT I

19

• Wheres the new budget constraint when I
  increases to I?

T
I/PT
S
hidden slide
I/PS
20
An increase in income expands the consumer's
opportunities.
T
I/PT
S
I/PS
21
Changing prices

• Whats the effect on the consumers opportunities
  if the price of spaghetti falls?
• PS' gt PS
• PS' S PTT I
• PS S PTT I

22

• Wheres the new budget constraint when the price
  of spaghetti falls?

T
I/PT
S
hidden slide
I/P'S
23

• Wheres the budget constraint when the price of
  spaghetti falls?

A fall in the price of spaghetti also expands the
consumer's opportunities, but in a different way.
T
I/PT
S
I/P'S
I/PS
24
Choice

• If a consumer wants to choose S and T so as to
  maximize total utility, what should he/she do?

hidden slide
25
Constraints and choices
TACOS
What to choose??
SPAGHETTI
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Maximizing total utility
TACOS
T and S are best.
T
U3
U
U2
U1
S
SPAGHETTI
27
To maximize utility

• 1) Spend all of your income.
• 2) Choose a point on the budget constraint
  where
• (a) an indifference curve is tangent to the
  constraint, or
• (b) the MRS is equal to the ratio of the prices
  of the goods. (MRSS for T PS/PT)

28
More woeful tales

• Nickels dimes.
• Left shoes and right shoes.
• Work for pay.
• Two part pricing.

29
Changes in prices and income

• 1) Price changes and price consumption curves.
• 2) Income changes and income consumption curves.
• 3) Income and substitution effects.
• 4) Consumer Surplus.

30
Effects of a price change

• If the price of a good declines, consumers will
  change the amount they want to buy (demand), in
  general.

31

• Here the price of spaghetti falls. The consumer
  changes the amounts chosen.

T
I/PT
U'
S
I/P'S
S'
32
Price consumption curve

• Locus of utility maximizing amounts of goods at
  different prices for one of the goods.
• Information from the PCC can be used to derive
  the consumer's demand curve for a good.

33
Finding the consumer's demand curve for spaghetti.
T
PS
I/PT
P'S
U'
S
S
I/P'S
S'
S'
34
Income increases
Are the goods normal or inferior here?
T
I/PT
U'
I/PS
S'
S
35
Choice and inferior goods
Income increases here. Which good is inferior?
T
I/PT
U'
S'
I/PS
S
36
Income consumption curve

• Locus of utility maximizing amounts of goods at
  different income levels for the goods.
• Information from the ICC can be used to derive
  what is called the Engel Curve (or income demand
  curve) for a good.

37
Income and Substitution Effects

• The consumer is maximizing utility.
• The price of one good falls.
• The change in the demand for the good can be
  thought of as having two parts
• A substitution effect, and
• An income effect.

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• Substitution Effect The change in demand (due
  to a decrease in price) holding the consumer's
  real income constant.
• Income Effect The change in demand (due to a
  decrease in price) because of the increase in
  real income the consumer receives.

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• Start with the consumer maximizing utility by
  choosing amount S0 of good S.

T
I/PT
U'
S
I/P'S
S0
I/PS
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• The price of good S falls to PS.
• The consumer then chooses S2 of good S.

T
I/PT
U'
S
I/P'S
S0
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• To find the substitution effect, we must see what
  the consumer will choose at the lower price of S,
  but forcing the consumer to have the same real
  income (i.e., utility) as at S0.
• The substitution effect is a "pure price effect"
  on demand.

42

• Isolating the substitution effect is accomplished
  by reducing the consumer's money income after the
  price change until the best he or she can do is
  get to indifference curve U'.

43

• S1 - S0 is the substitution effect.
• S2 - S1 is the income effect.

T
I/PT
U'
S
I/P'S
S0
44

• The substitution effect always works in the
  direction of increasing the demand for a good
  whose price has fallen.
• The income effect can work in either direction,
  depending on whether the good is normal or
  inferior.

45

• Income and substitution effects are used to show
  (among other things) the conditions under which
  the Law of Demand is true.

46

• Note that for normal goods, the Law of Demand
  must hold.
• For inferior goods, it may hold.
• But if the income effect is of opposite sign from
  the substitution effect, and is larger in
  magnitude, a decrease in price will lead to lower
  demand. (A Giffen Good.)

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THE CARDINAL UTILITY APPROACH TO CHOICE

• Each person has a utility function which is a
  rule or equation that determines the consumers
  utility (satisfaction) for any amounts of goods
  and services consumed.
• Utility here is assumed to be cardinal, rather
  than ordinal. (Measured in "utils"??)

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• The dependent variable in the utility function is
  utility or satisfaction.
• The independent variables are the amounts of the
  goods and services an individual consumes.

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LIKE THIS

• UBROWN f(beer, bicycles, pizza,
• spaghetti, tacos,
  ...)
• Browns utility depends on the number of beers
  he consumes, the number of bikes he consumes,
  etc.

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Browns total utility from pizzas.
PIZZA
TOTAL UTILITY
0
0
1
5
2
13
3
22
4
29
5
35
6
40
7
44
8
47
51

• You can graph the total utility this way.

TOTAL UTILITY
60
50
40
30
20
10
PIZZAS
0
0
1
2
3
4
5
6
7
8
9
10
52

• You can graph the total utility this way.

TOTAL UTILITY
PIZZAS
53

• MARGINAL UTILITY
• The marginal utility is the increase in utility
  you get from consuming one more unit of the good,
  holding the consumption of all other goods
  constant.

54

• The marginal utility of pizza is the change in
  utility per unit change in pizza consumption
  (holding the consumption of all other goods
  constant, of course).
• MUPIZZA the change in U / the change in pizza
• ??U / ? (PIZZA)

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• You can compute marginal utility from the total
  utility curve.

PIZZA
TOTAL UTILITY
MU
0
0
(13-5)/(2-1)
1
5
5
2
13
8
3
22
9
4
29
7
5
35
6
40
7
44
8
47
56

• You can compute marginal utility from the total
  utility curve.

PIZZA
TOTAL UTILITY
MU
0
0
(13-5)/(2-1)
1
5
5
2
13
8
3
22
9
4
29
7
5
35
6
6
40
5
7
44
4
8
47
3
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• Law of Diminishing Marginal Utility
• The marginal utility of a good will eventually
  decline as more is consumed.

58

• Marginal utility begins to decline here with the
  consumption of the 4th pizza.

PIZZA
TOTAL UTILITY
MU
0
0
1
5
5
2
13
8
(29-22)/(4-3)
3
22
9
4
29
7
5
35
6
40
7
44
8
47
59

• Marginal utility is the slope of the total
  utility curve.

MU ?U / ?P
TOTAL UTILITY
60
50
40
30
? U
20
? P
10
0
0
1
2
3
4
5
6
7
8
9
10
PIZZAS
60

• Draw the marginal utility curve here. Be sure to
  label the axes correctly. Some points are
  already shown.

marginal utility
12
The marginal utility of the 4th pizza is 7 utils.
10
8
6
4
2
0
0
1
2
3
4
5
6
7
8
9
10
pizzas
61

• The 5th pizza is worth less than the 4th pizza.

marginal utility
And the marginal utility of the 5th pizza is 6.
pizzas
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• The Law of Diminishing Marginal Utility is
  assumed to be true for all consumers, and for all
  of the goods a person consumes.

63
The standard problem(same as in ordinal approach)

• Suppose a person consumes two goods, say, tacos
  and spaghetti.
• The person has a fixed money income of I dollars
  per time period, say a week.
• Tacos and spaghetti can be bought at fixed, known
  prices, say PT and PS.
• What amounts of spaghetti and tacos will maximize
  utility?

64

• In the earlier solution to this problem, the
  marginal rule was to make the MRS equal to the
  price ratio of the goods. (MRSS for T PS/PT)
• It's easy to show that the MRS can be expressed
  as a ratio of marginal utilities, land the rule
  rewritten as

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• Choose S and T so that
• MUS / PS MUT / PT.
• MUS / PS is the marginal utility per spent on
  S.
• It is the extra utility you can get from spending
  another on S.

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WHY THE RULE WORKS

• Suppose the rule were not true, but instead we
  had MUS / PS lt MUT / PT.
• or 12 lt 20
• Spending 1 less on S would lower your utility by
  12 utils.
• Respending that 1 on T would raise your utility
  by 20 utils.
• This will give you a net gain of 8 (20-12)
  utils.

67

• So if the MU's per spent on two goods are not
  not equal, then a gain in total utility is
  possible by reallocating your spending.
• You should spend more on the good whose MU per
  is the highest. In the example on the last
  slide, this was tacos, T.

68

• Note that as you allocate your from the good
  whose MU per is lower, the MU of that good will
  rise (remember the Law of Diminishing MU).
• And the MU of the good with the higher MU per
  will fall for the same reason.
• Thus, as you reallocate spending, the degree of
  inequality between MUs per will diminish.

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• Only when the MU per spent on S is equal to the
  MU per spent on T will you be unable to make
  utility larger by reallocating you spending, and
  total utility will be maximized.
• MUS / PS MUT / PT

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Consumer Surplus

• At the level of the individual consumer, CS is
  the difference between what the consumer is
  willing to pay for a good, and the amount the
  consumer actually pays.
• It's a measure of the welfare to the consumer of
  being able to buy the good in a market.

71

• Consumer surplus can be measured using the demand
  curve for a product.

P
Demand for tacos
P
D
Q
Q
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• When Q is sold, willingness to pay is the shaded
  area.

P
Demand for tacos
P
D
Q
Q
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• When Q is sold at a price P, consumers pay P
  times Q. Click to see the cost to consumers.
  Click again to see the shaded area that is
  consumer surplus.

P
P
Demand for tacos
D
Q
Q