Theory of Consumer Behavior

Theory ofConsumerBehavior Chapter 3

Topics of Discussion Utility Theory Total Utility (Satisfaction) Marginal Utility Meet Carl or Carla Consumer Law of Diminishing Marginal Utility Indifference Curves Concept of Isoutility Marginal Rate of Substitution The Budget Constraint

Utility Function A utility function is an algebraic expression that allows us to rank consumption bundles or combinations of goods. Let’s assume that total utility is given by the product of the quantities of goods available to consumers. For the sake of simplicity, let’s also assume only two commodities are available to consumers, hamburgers and tacos. Total utility = Qhamburgers x Qpizza Pages 39-40

Utility Function This approach assumes that utility is cardinally measurable in the same sense that a ruler measures distance. The unit of measurement is utils, a fictitious metric. We will learn that consumers only need to rank alternative combinations of bundles of goods. Pages 39-40

Ranking Total Utility Rank A and C over B Indifferent between A and C

Marginal Utility Marginal utility is the change in utility derived from an increase in consumption of a particular good. MUhamburgers =  utility ÷  hamburgers Page 40

Marginal Utility Marginal utility is the change in utility derived from an increase in consumption of a particular good. MUhamburgers =  utility ÷  hamburgers This value will fall (rise) as consumption increases (decreases). Page 40

Marginal utility goes to zero at the peak of the total utility curve Page 42

“Law of Diminishing Marginal Utility” -- Marginal utility decreases as more of a good is consumed over a given time period.

Indifference Curves Cardinal measurement of utility is both unreasonable and unnecessary. We can instead use an ordinal measurement of utility, which means all we need to know is that one bundle is preferred over another. Page 43

Indifference Curves Cardinal measurement of utility is both unreasonable and unnecessary. We can instead use an ordinal measurement of utility, which means all we need to know is that one bundle is preferred over another. Modern consumption theory is based upon the notion of isoutility curves, where “iso” is the Greek for “equal”. The consumer is assumed to be indifferent among different combinations of goods along a isoutility curve. Page 43

Increasing utility Page 43

The two indifference curves here can be thought of as providing 200 and 700 utils of utility. Page 43

The two indifference curves here can be thought of as providing 200 and 700 utils of utility. One would normally expect a number of additional isoutility or indifference curves. Page 43

Slope of Indifference Curve The slope of an indifference curve is known as the marginal rate of substitution (MRS). The marginal rate of substitution of hamburgers for tacos is given by: MRS =  tacos ÷ hamburgers Page 43

Slope of Indifference Curve The slope of an indifference curve is known as the marginal rate of substitution (MRS). The marginal rate of substitution of hamburgers for tacos is given by: MRS =  tacos ÷ hamburgers The MRS reflects the number of tacos a consumer is willing to give up for an additional hamburger. Pages 43-44

The MRS between points M and Q is equal to: -2.0 = -2 ÷ 1.0 Page 43

This means the consumer is will to give up 2 tacos in exchange for an additional hamburger! Page 43

IMPORTANT POINT • Along the SAME indifference curve, the decrease in taco consumption from point M to point Q times the accompanying increase in the MU of tacos MUST be identical to the increase in consumption of hamburgers from point M to point Q times the accompanying decrease in the MU of hamburgers.

Δtacos MUhamburgers = Δhamburgers MUtacos (3.4)

Concept of Budget Constraint Weekly budget for fast food: PHAMBURGERS x QHAMBURGERS + PTACOS x QTACOSBUDGET where PHAMBURGERSand PTACOSrepresent the current price of hamburgers and tacos while QHAMBURGERS and QTACOSrepresent the quantities you plan to consume during the week. Page 45

Concept of Budget Constraint Weekly budget for fast food: PHAMBURGERS x QHAMBURGERS + PTACOS x QTACOSBUDGET where PHAMBURGERSand PTACOSrepresent the current price of hamburgers and tacos while QHAMBURGERS and QTACOSrepre- sent the quantities you plan to consume during the week. The budget constraint limits the amount that you can be spent on these items. A graph depicting this constraint is referred to as the budget line. The slope of this line is given by: Slope of budget line = - (PHAMBURGERS÷ PTACOS) Page 45

Example of a Budget Constraint Each of these combinations represent a point on the budget line…. Page 46

Original budget line Change in income or both prices Line BA is the original budget line. It says that Carl can afford either 10 tacos or two hamburgers a week with his $5 weekly budget. Change in taco price Change in hamburger price Page 46

Original budget line Change in income or both prices The original budget line would shift in to line FG if Carl’s available income fell in half (or both prices doubled). It would shift out to line ED if Carl’s income doubled (or both prices fell in half). Change in taco price Change in hamburger price Page 46

Original budget line Change in income or both prices The budget line would shift out to line AE if the price of tacos fell in half or shift in to line AF if taco prices fell in half. Note the price of hamburgers did not change! Change in taco price Change in hamburger price Page 46

Original budget line Change in income or both prices Finally, the budget line would shift out to line BD if the price of hamburgers fell in half, or in to line line BG if the price of hamburgers doubled. Change in taco price Change in hamburger price Page 46

Engel’s Law: The more wealthy a consumer becomes, the percentage of income spent for food decreases. 1857

Chapter 4 unites the conceptsof indifference curves with abudget constraint to determine consumer equilibrium….

Theory of Consumer Behavior