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Chapter 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?. Consumer Behavior. Theory of consumer behavior

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Chapter 3

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  1. Chapter 3 Consumer Behavior

  2. 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? Chapter 3

  3. Consumer Behavior • Theory of consumer behavior • The explanation of how consumers allocate income to the purchase of different goods and services Chapter 3

  4. Consumer Behavior • There are three steps involved in the study of consumer behavior • Consumer Preferences • To describe how and why people prefer one good to another • Budget Constraints • People have limited incomes Chapter 3

  5. Consumer Behavior • 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? Chapter 3

  6. 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 Chapter 3

  7. Consumer Preferences – Basic Assumptions • Preferences are complete. • Consumers can rank market baskets • Preferences are transitive. • If prefer A to B, and B to C, the must prefer A to C • Consumers always prefer more of any good to less. • More is better Chapter 3

  8. Consumer Preferences • Consumer preferences can be represented graphically using indifference curves • Indifference curves represent all combinations of market baskets that the person is indifferent • A person will be equally satisfied with either choice Chapter 3

  9. Indifference Curves: An Example Chapter 3

  10. Indifference Curves: 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 Chapter 3

  11. B 50 Clothing H E 40 A 30 D G 20 10 Food 10 20 30 40 Indifference Curves: An Example The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A. Chapter 3

  12. Indifference Curves: 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 indifference between B, A and D • We can then connect those points with an indifference curve Chapter 3

  13. B 50 Clothing H E 40 A 30 D 20 G U1 10 Food 10 20 30 40 Indifference Curves: An Example • Indifferent between B, A, & D • E is preferred to U1 • U1is preferred to H & G Chapter 3

  14. 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 Chapter 3

  15. Indifference Curves • Indifference curves slope downward to the right. • If it sloped upward it would violate the assumption that more is preferred to less. Chapter 3

  16. 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. Chapter 3

  17. Clothing D B A U3 U2 U1 Food Indifference Map Market basket A is preferred to B. Market basket B is preferred to D. Chapter 3

  18. Indifference Maps • Indifference maps give more information about shapes of indifference curves • Indifference curves can not cross • Why? What if we assume they can cross. Chapter 3

  19. U1 U2 Clothing A B U2 D U1 Food Indifference Maps • B is preferred to D • A is indifferent to B & D • B must be indifferent to D but that can’t be if B is preferred to D Chapter 3

  20. Indifference Curves • The shapes of indifference curves describes 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 Chapter 3

  21. A 16 Clothing 14 12 -6 B 10 1 8 -4 D 6 E 1 G -2 4 1 -1 1 2 Food 1 2 3 4 5 Indifference Curves Observation: The amount of clothing given up for 1 unit of food decreases from 6 to 1 Chapter 3

  22. 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. Chapter 3

  23. A Clothing 16 14 -6 12 B 10 1 -4 8 D 1 6 E -2 G 4 1 -1 1 2 Food 1 2 3 4 5 Marginal Rate of Substitution MRS = 6 MRS = 2 Chapter 3

  24. Marginal Rate of Substitution • 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 Chapter 3

  25. Marginal Rate of Substitution • 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 Chapter 3

  26. Marginal Rate of Substitution • Indifference curves with different shapes imply a different willingness to substitute • Two polar cases are of interest • Perfect substitutes • Perfect complements Chapter 3

  27. Marginal Rate of Substitution • 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 Chapter 3

  28. Apple Juice (glasses) 4 3 2 1 Orange Juice (glasses) 0 1 2 3 4 Consumer Preferences Perfect Substitutes Chapter 3

  29. Consumer Preferences • Perfect Complements • Two goods are perfect complements when the indifference curves for the goods are shaped as right angles. • Example: If have 1 left shoe and 1 right shoe, you are indifferent between having more left shoes only Chapter 3

  30. Left Shoes 4 3 2 1 0 1 2 3 4 Right Shoes Consumer Preferences Perfect Complements Chapter 3

  31. Consumer Preferences • 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 Chapter 3

  32. Consumer Preferences • How do we account for bads in our preference analysis? • We redefine the commodity • Clean air • Pollution reduction • Asbestos removal Chapter 3

  33. Consumer Preferences • The theory of consumer behavior does not require assigning a numerical value to the level of satisfaction • Although ranking of market baskets are good, sometimes numerical value are useful Chapter 3

  34. 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. Chapter 3

  35. 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) Chapter 3

  36. Utility - Example Consumer is indifferent between A & B and prefers both to C Chapter 3

  37. 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 Chapter 3

  38. Clothing 15 C 10 U3 = 100 A 5 B U2 = 50 U1 = 25 Food 0 5 10 15 Utility - Example Basket U = FC C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5) Chapter 3

  39. 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 utility of 2 Chapter 3

  40. 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. Chapter 3

  41. Utility • The actual unit of measurement for utility is not important. • An ordinal ranking is sufficient to explain how most individual decisions are made. Chapter 3

  42. 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. Chapter 3

  43. 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 Chapter 3

  44. 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 PF F is the amount of money spent on food, and PC C is the amount of money spent on clothing. Chapter 3

  45. The Budget Line • The budget line then can be written: All income is allocated to food (F) and/or clothing (C) Chapter 3

  46. The Budget Line • Different choices of food and clothing can be calculated that use all income • Example: • Assume income of $80/week, PF = $1 and PC = $2 Chapter 3

  47. Budget Constraints Chapter 3

  48. Clothing (I/PC) = 40 A B 30 10 D 20 20 E 10 G Food 0 20 40 60 80 = (I/PF) The Budget Line Chapter 3

  49. 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. Chapter 3

  50. 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 Chapter 3

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