5-1

Theory of Consumer Behavior

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

5-2

The Consumer’s Optimization Problem

• Individual consumption decisions are made with the goal of maximizing total satisfaction from consuming various goods and services• Subject to the constraint that spending on

goods exactly equals the individual’s money income

5-3

Consumer Theory

• Assumes buyers are completely informed about:• Range of products available• Prices of all products• Capacity of products to satisfy• Their income

• Requires that consumers can rank all consumption bundles based on the level of satisfaction they would receive from consuming the various bundles

5-4

Typical Consumption Bundles for Two Goods, X & Y (Figure 5.1)

5-5

Properties of Consumer Preferences

• Completeness• For every pair of consumption bundles, A and B,

the consumer can say one of the following: A is preferred to B B is preferred to A The consumer is indifferent between A and B

• Transitivity• If A is preferred to B, and B is preferred to C,

then A must be preferred to C

• Nonsatiation• More of a good is always preferred to less

5-6

Utility

• Benefits consumers obtain from goods & services they consume is utility

• A utility function shows an individual’s perception of the utility level attained from consuming each conceivable bundle of goods

5-7

Indifference Curves

• Locus of points representing different bundles of goods, each of which yields the same level of total utility

• Negatively sloped & convex

5-8

Typical Indifference Curve (Figure 5.2)

5-9

Marginal Rate of Substitution

• MRS shows the rate at which one good can be substituted for another while keeping utility constant• Negative of the slope of the indifference curve

• Diminishes along the indifference curve as X increases & Y decreases

• Ratio of the marginal utilities of the goods

X

Y

MUYMRS

X MU

5-10

Slope of an Indifference Curve & the MRS (Figure 5.3)

Quantity of good X

Qu

an

tity

of

go

od

Y

0

I

C (360,320)

600

800

A

B

T

T’

360

320

5-11

Indifference Map (Figure 5.4)

Quanti

ty o

f Y

Quantity of X

I

II

III

IV

5-12

Marginal Utility

• Addition to total utility attributable to the addition of one unit of a good to the current rate of consumption, holding constant the amounts of all other goods consumed

MU U X

5-13

Consumer’s Budget Line

• Shows all possible commodity bundles that can be purchased at given prices with a fixed money income

X YM P X P Y

X

Y Y

PMY X

P P

or

5-14

Consumer’s Budget Constraint (Figure 5.5)

5-15

Typical Budget Line (Figure 5.6)

Quanti

ty o

f Y

Quantity of X

X

Y Y

PMY X

P P

•

•

A

B

Y

MP

X

MP

5-16

Shifting Budget Lines (Figure 5.7)

Panel B – Changes in price of X

200

100A

B

250

D

R

N

120

240

Qu

anti

ty o

f Y

Quantity of X

Panel A – Changes in money income

Qu

anti

ty o

f Y

Quantity of X

A

B

100F

Z

80

160

200

125

C

5-17

Utility Maximization

• Utility maximization subject to a limited money income occurs at the combination of goods for which the indifference curve is just tangent to the budget line

X X

Y Y

MU PYMRS

X MU P

5-18

Utility Maximization

• Consumer allocates income so that the marginal utility per dollar spent on each good is the same for all commodities purchased

X Y

X Y

MU MU

P P

5-19

Constrained Utility Maximization (Figure 5.8)

A•

I

C•

•B

II

R

T

Quantity of burgers

Qu

anti

ty o

f piz

zas

0 8020 10040 60

10

20

30

40

50

7010 9030 50

•E

III

•DIV

45

15

5-20

Individual Consumer Demand

• An individual’s demand curve for a specific commodity relates utility-maximizing quantities purchased to market prices• Money income & prices held constant• Slope of demand curve illustrates law of

demand—quantity demanded varies inversely with price

5-21

Deriving a Demand Curve (Figure 5.9)

Qu

anti

ty o

f Y

Pri

ce o

f X

($)

Quantity of X

Quantity of X

100

2001251000

0

Px=$10

Px=$5

Px=$8

906550

906550

5

8

10

Demand for X

5-22

Market Demand & Marginal Benefit

• List of prices & quantities consumers are willing & able to purchase at each price, all else constant

• Derived by horizontally summing demand curves for all individuals in market

• Because prices along market demand measure the economic value of each unit of the good, it can be interpreted as the marginal benefit curve for a good

5-23

Derivation of Market Demand (Table 5.1)

Quantity demanded

Price Consumer 1 Consumer 2 Consumer 3Market

demand

$6

2

1

5

4

3

3

1213

5

8

10

0

7

10

1

3

5

0

6

8

0

1

4

3

2531

6

1219

5-24

Derivation of Market Demand Figure (5.10)

5-25

Substitution & Income Effects

• When price changes, total change in quantity demanded is composed of two parts• Substitution effect• Income effect

5-26

Substitution & Income Effects

• Substitution effect• Change in consumption of a good after a

change in its price, when the consumer is forced by a change in money income to consume at some point on the original indifference curve

• Income effect• Change in consumption of a good resulting

strictly from a change in purchasing power

5-27

Income & Substitution Effects: A Decrease in Px (Figure 5.12)

Total effect of price decrease

= Substitution effect

+ Income effect

9= 5 + 4

Total effect of price decrease

= Substitution effect

+ Income effect

3 = 5 + (-2)

5-28

Substitution & Income Effects

• Consider the substitution effect alone:• Amount of good consumed must vary

inversely with price

• Income effect reinforces the substitution effect for a normal good & offsets it for an inferior good

5-29

Summary of Substitution & Income Effects (Table 5.2)

Substitution Effect Income Effect

Price of X decreases:

Normal Good

Inferior Good

Price of X increases:

Normal Good

Inferior Good

X rises

X rises

X rises

X rises

X falls

X falls

X falls

X falls