CONSUMER BEHAVIOR

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

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." Consumer behavior

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.) Consumer behavior

A utility function for two goods. Consumer behavior

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. Consumer behavior

The previous graph can be rotated to show indifference curves: Consumer behavior

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. • (It’s minus the slope of an indifference curve.) Consumer behavior

U3 U2 U1 Some indifference curves: U1 < U2 < U3 TACOS SPAGHETTI Consumer behavior

MRS is minus the slope of an indifference curve. TACOS MRSS for T = -(T/S) U3 T U2 S SPAGHETTI Consumer behavior

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.) Consumer behavior

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." Consumer behavior

Budget Constraints • Definition: The consumer’s budget constraint shows all of the combinations of goods and services the consumer is able to buy, given income and prices. Consumer behavior

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. Consumer behavior

Two good case • Consumer’s income is I dollars per period. • There are two goods, S and T, that have prices PS and PT. • The consumer’s spending on the two goods together must be less than or equal to total income in each time period. Consumer behavior

The Budget Constraint is • PS S + PTT I • This can be written as • T I/PT - (PS /PT)S Consumer behavior

T I/PT S I/PS • Remember that income and prices are “givens” here, so the last equation is a linear relationship between T and S. slope = - PS / PT Consumer behavior

Where are feasible and non-feasible consumption bundles? T I/PT S I/PS Consumer behavior

Changing income and prices • What’s the effect on the consumer’s opportunities if income increases? • I* > I’ • PS S + PTT = I’ • PS S + PTT = I* Consumer behavior

Where’s the new budget constraint when I increases to I*? T I’/PT S hidden slide I’/PS Consumer behavior

Changing prices • What’s the effect on the consumer’s opportunities if the price of spaghetti falls? • PS' > P*S • PS'S + PTT = I • P*S S + PTT = I Consumer behavior

Where’s the new budget constraint when the price of spaghetti falls? T I/PT hidden slide S I/P'S Consumer behavior

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

Maximizing total utility TACOS T* and S* are best. T* U3 U* U2 U1 S* SPAGHETTI Consumer behavior

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) Consumer behavior

More woeful tales • Nickels & dimes. • Left shoes and right shoes. • Work for pay. • Two part pricing. Consumer behavior

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. Consumer behavior

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

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. Consumer behavior

U* P*S DS I/P*S S* S* Finding the consumer's demand curve for spaghetti. T PS I/PT P'S U' S S I/P'S S' S' Consumer behavior

I*/PT U* S* Income increases Are the goods normal or inferior here? T I’/PT U' I’/PS S' S Consumer behavior

I*/PT U* S* Choice and inferior goods Income increases here. Which good is inferior? T I’/PT U' S' I’/PS S Consumer behavior

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. Consumer behavior

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. Consumer behavior

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. Consumer behavior

Start with the consumer maximizing utility by choosing amount S0 of good S. T I/PT U' S I/P'S S0 I/P*S Consumer behavior

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

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. Consumer behavior

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'. Consumer behavior

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. Consumer behavior

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

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.) Consumer behavior

THE CARDINAL UTILITY APPROACH TO CHOICE • Each person has a utility function which is a rule or equation that determines the consumer’s utility (satisfaction) for any amounts of goods and services consumed. • Utility here is assumed to be cardinal, rather than ordinal. (Measured in "utils"??) Consumer behavior

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. Consumer behavior

LIKE THIS: • UBROWN = f(beer, bicycles, pizza, • spaghetti, tacos, ...) • “Brown’s utility depends on the number of beers he consumes, the number of bikes he consumes, etc.” Consumer behavior

Brown’s 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 Consumer behavior

TOTAL UTILITY 60 • You can graph the total utility this way. 50 40 30 20 10 PIZZAS 0 0 1 2 3 4 5 6 7 8 9 10 Consumer behavior

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. Consumer behavior

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) Consumer behavior

PIZZA TOTAL UTILITY MU 0 0 (13-5)/(2-1) • You can compute marginal utility from the total utility curve. 1 5 5 2 13 8 3 22 9 4 29 7 5 35 6 40 7 44 8 47 Consumer behavior

Law of Diminishing Marginal Utility • The marginal utility of a good will eventually decline as more is consumed. Consumer behavior

CONSUMER BEHAVIOR