Consumer Behaviour

Chapter 3Consumer Behavior

Chapter 11

Topics to be DiscussedConsumer PreferencesBudget ConstraintsConsumer ChoiceRevealed Preferences

Chapter 12

Topics to be DiscussedMarginal Utility and Consumer ChoicesCost-of-Living Indexes

Chapter 13

Consumer BehaviorTwo applications that illustrate the importance of the economic theory of consumer behavior are:Apple-Cinnamon CheeriosThe Food Stamp Program.

Chapter 14

Consumer BehaviorGeneral Mills had to determine how high a price to charge for Apple-Cinnamon Cheerios before it went to the market.

Chapter 15

Consumer BehaviorWhen the food stamp program was established in the early 1960s, the designers had to determine to what extent the food stamps would provide people with more food and not just simply subsidize the food they would have bought anyway.

Chapter 16

Consumer BehaviorThese two problems require an understanding of the economic theory of consumer behavior.

Chapter 17

Consumer BehaviorThere are three steps involved in the study of consumer behavior.

1) We will study consumer preferences.To describe how and why people prefer one good to another.

Chapter 18


2)Then we will turn to budget constraints.People have limited incomes.

Chapter 18


3) Finally, we will combine consumer preferences and budget constraints to determine consumer choices.What combination of goods will consumers buy to maximize their satisfaction?

Chapter 19

Consumer PreferencesA market basket is a collection of one or more commodities.One market basket may be preferred over another market basket containing a different combination of goods.

Market Baskets

Chapter 110

Consumer PreferencesThree Basic Assumptions

1) Preferences are complete.2) Preferences are transitive.3) Consumers always prefer more of any good to less.Market Baskets

Chapter 111

Consumer PreferencesA2030B1050D4020E3040G1020H1040Market BasketUnits of Food Units of Clothing

Chapter 112

Consumer PreferencesIndifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person.

Indifference Curves

Chapter 113

Consumer PreferencesFood(units per week)1020304010203040Clothing(units per week)50

Chapter 115

Consumer PreferencesFood(units per week)1020304010203040Clothing(units per week)50

Chapter 117

Consumer PreferencesIndifference CurvesIndifference curves slope downward to the right.If it sloped upward it would violate the assumption that more of any commodity is preferred to less.

Chapter 118

Consumer PreferencesIndifference CurvesAny market basket lying above and to the right of an indifference curve is preferred to any market basket that lies on the indifference curve.

Chapter 119

Consumer PreferencesAn indifference map is a set of indifference curves that describes a persons preferences for all combinations of two commodities.Each indifference curve in the map shows the market baskets among which the person is indifferent.

Indifference Maps

Chapter 120

Consumer PreferencesIndifference CurvesFinally, indifference curves cannot cross.This would violate the assumption that more is preferred to less.

Chapter 121

Consumer PreferencesFood(units per week)Clothing(units per week)

Chapter 124

Consumer PreferencesFood(units per week)Clothing(units per week)Indifference CurvesCannot Cross

Chapter 126

Consumer PreferencesFood(units per week)Clothing(units per week)23451246810121416Question: Does thisrelation hold for givingup food to get clothing?

Chapter 132

Consumer PreferencesThe marginal rate of substitution (MRS) 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.

Marginal Rate of Substitution

Chapter 129

Consumer PreferencesFood(units per week)Clothing(units per week)23451246810121416ABDEG-61111-4-2-1MRS = 6MRS = 2

Chapter 132

Consumer PreferencesWe will now add a fourth assumption regarding consumer preference:Along an indifference curve there is a diminishing marginal rate of substitution.Note the MRS for AB was 6, while that for DE was 2.


Chapter 133

Consumer PreferencesQuestionWhat are the first three assumptions?


Chapter 133

Consumer PreferencesIndifference curves are convex because 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 prefer a balanced market basket


Chapter 134

Consumer PreferencesPerfect Substitutes and Perfect ComplementsTwo goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant.


Chapter 135

Consumer PreferencesPerfect Substitutes and Perfect ComplementsTwo goods are perfect complements when the indifference curves for the goods are shaped as right angles.


Chapter 136

Consumer PreferencesOrange Juice(glasses)Apple Juice(glasses)234112340PerfectSubstitutes

Chapter 138

Consumer PreferencesRight ShoesLeftShoes234112340PerfectComplements

Chapter 140

Consumer PreferencesBADSThings for which less is preferred to moreExamplesAir pollutionAsbestos

Chapter 1

Consumer PreferencesWhat Do You Think?How can we account for Bads in the analysis of consumer preferences?

Chapter 1

Consumer PreferencesAutomobile executives must regularly decide when to introduce new models and how much money to invest in restyling.

Designing New Automobiles (I)

Chapter 141

Consumer PreferencesAn analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars.


Chapter 141

Consumer Preferences

StylingPerformanceConsumerPreference A:High MRS

Chapter 143


StylingPerformanceConsumerPreference B:Low MRS

Chapter 144

Consumer PreferencesWhat Do You Think?How can we determine the consumers preference?


Chapter 141

Consumer PreferencesA recent study of automobile demand in the United States shows that over the past two decades most consumers have preferred styling over performance.


Chapter 145

Consumer PreferencesGrowth of Japanese Imports1970s and 1980s15% of domestic cars underwent a style change each yearThis compares to 23% for imports


Chapter 145

Consumer PreferencesUtilityUtility: Numerical score representing the satisfaction that a consumer gets from a given market basket.

Chapter 1103

Consumer PreferencesUtilityIf 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 1104

Consumer PreferencesUtility FunctionsAssume:The utility function for food (F) and clothing (C) U(F,C) = F + 2C

Market Baskets: F units C units U(F,C) = F + 2C A 8 3 8 + 2(3) = 14 B 6 4 6 + 2(4) = 14 C 4 4 4 + 2(4) = 12 The consumer is indifferent to A & B The consumer prefers A & B to C

Chapter 1104


Food(units per week)10155510150Clothing(unitsper week)Utility Functions & Indifference Curves

Chapter 15442

Consumer PreferencesOrdinal Versus Cardinal UtilityOrdinal 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 127

Consumer PreferencesOrdinal Versus Cardinal RankingsThe actual unit of measurement for utility is not important.Therefore, an ordinal ranking is sufficient to explain how most individual decisions are made.

Chapter 128

Budget ConstraintsPreferences do not explain all of consumer behavior.Budget constraints also limit an individuals ability to consume in light of the prices they must pay for various goods and services.

Chapter 14642

Budget ConstraintsThe Budget LineThe budget line indicates all combinations of two commodities for which total money spent equals total income.

Chapter 14742

Budget ConstraintsThe Budget LineLet F equal the amount of food purchased, and C is the amount of clothing.Price of food = Pf and price of clothing = PcThen Pf F is the amount of money spent on food, and Pc C is the amount of money spent on clothing.

Chapter 14842

Budget ConstraintsThe budget line then can be written:

Chapter 14942

Budget ConstraintsA040$80B2030$80D4020$80E6010$80G800$80Market BasketFood (F) Clothing (C)Total SpendingPf = ($1)Pc = ($2)PfF + PcC = I

Chapter 15012

Budget Constraints

(I/PC) = 40Food(units per week)406080 = (I/PF)201020300Clothing(unitsper week)Pc = $2 Pf = $1 I = $80

Chapter 15442

Budget ConstraintsThe Budget LineAs 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 15542

Budget ConstraintsThe Budget LineThe slope indicates the rate at which the two goods can be substituted without changing the amount of money spent.

Chapter 15642

Budget ConstraintsThe Budget LineThe vertical intercept (I/PC), illustrates the maximum amount of C that can be purchased with income I.The horizontal intercept (I/PF), illustrates the maximum amount of F that can be purchased with income I.

Chapter 15742

Budget ConstraintsThe Effects of Changes in Income and PricesIncome ChangesAn increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant).

Chapter 15842

Budget ConstraintsThe Effects of Changes in Income and PricesIncome ChangesA decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant).

Chapter 15842

Budget Constraints

Food(units per week)Clothing(unitsper week)8012016040204060800

Chapter 16142

Budget ConstraintsThe Effects of Changes in Income and PricesPrice ChangesIf the price of one good increases, the budget line shifts inward, pivoting from the other goods intercept.

Chapter 16242

Budget ConstraintsThe Effects of Changes in Income and PricesPrice ChangesIf the price of one good decreases, the budget line shifts outward, pivoting from the other goods intercept.

Chapter 16242

Budget Constraints

Food(units per week)Clothing(unitsper week)801201604040

Chapter 16542

Budget ConstraintsThe Effects of Changes in Income and PricesPrice ChangesIf the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change.

Chapter 16642

Budget ConstraintsThe Effects of Changes in Income and PricesPrice ChangesHowever, the budget line will shift inward to a point parallel to the original budget line.

Chapter 16642

Budget ConstraintsThe Effects of Changes in Income and PricesPrice ChangesIf the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change.

Chapter 16742

Budget ConstraintsThe Effects of Changes in Income and PricesPrice ChangesHowever, the budget line will shift outward to a point parallel to the original budget line.

Chapter 16742

Consumer ChoiceConsumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.

Chapter 168

Consumer ChoiceThe maximizing market basket must satisfy two conditions:

1) It must be located on the budget line.2) Must give the consumer the most preferred combination of goods and services.

Chapter 169

Consumer ChoiceRecall, the slope of an indifference curve is:Further, the slope of the budget line is:

Chapter 170

Consumer ChoiceTherefore, it can be said that satisfaction is maximized where:

Chapter 171

Consumer ChoiceIt can be said that satisfaction is maximized when marginal rate of substitution (of F and C) is equal to the ratio of the prices (of F and C).

Chapter 172

Consumer ChoiceFood (units per week)Clothing(units per week)4080202030400

Chapter 176

Consumer ChoicePc = $2 Pf = $1 I = $80Food (units per week)Clothing(units per week)4080202030400

Chapter 177

Consumer ChoicePc = $2 Pf = $1 I = $80Food (units per week)Clothing(units per week)4080202030400

Chapter 178

Consumer ChoiceConsider two groups of consumers, each wishing to spend $10,000 on the styling and performance of cars.Each group has different preferences.

Designing New Automobiles (II)

Chapter 179

Consumer ChoiceBy finding the point of tangency between a groups indifference curve and the budget constraint auto companies can design a production and marketing plan.


Chapter 179


StylingPerformance$10,000$10,000$3,000$7,000

Chapter 181


Styling$10,000$10,000Performance

Chapter 181

Consumer ChoiceChoosing between a non-matching and matching grant to fund police expenditures

Decision Making & Public Policy

Chapter 1

Consumer Choice

Non-matching GrantPoliceExpenditures ($)PrivateExpenditures ($)O

Chapter 1

Consumer Choice

RNon-matching GrantPPoliceExpenditures ($)PrivateExpenditures ($)OSQA

Chapter 1

Consumer Choice

TMatching GrantPolice ($)PrivateExpenditures ($)OQSRA

Chapter 1

Consumer Choice

TNonmatching GrantPoint BOU: Private expenditureOZ: Police expenditure

Matching GrantPoint COW: Private expenditureOX: Police expenditure

WXMatching GrantPPolice ($)PrivateExpenditures ($)OQAU2CR

Chapter 1

Consumer ChoiceA corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another. This exists where the indifference curves are tangent to the horizontal and vertical axis.MRS is not equal to PA/PB

A Corner Solution

Chapter 183

A Corner SolutionIce Cream (cup/month)FrozenYogurt(cupsmonthly)BA

Chapter 184

Consumer ChoiceA Corner SolutionAt point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line.This suggests that if the consumer could give up more frozen yogurt for ice cream he would do so.However, there is no more frozen yogurt to give up!

Chapter 185

Consumer ChoiceA Corner SolutionWhen a corner solution arises, the consumers MRS does not necessarily equal the price ratio.In this instance it can be said that:

Chapter 186

Consumer ChoiceA Corner SolutionIf the MRS is, in fact, significantly greater than the price ratio, then a small decrease in the price of frozen yogurt will not alter the consumers market basket.

Chapter 187

Consumer ChoiceSuppose Jane Does parents set up a trust fund for her college education.Originally, the money must be used for education.

A College Trust Fund

Chapter 188

Consumer ChoiceIf part of the money could be used for the purchase of other goods, her consumption preferences change.

A College Trust Fund

Chapter 188

Consumer ChoiceEducation ($)OtherConsumption($)A College Trust Fund

Chapter 192

Revealed PreferencesIf we know the choices a consumer has made, we can determine what her preferences are if we have information about a sufficient number of choices that are made when prices and incomes vary.

Chapter 193

Revealed Preferences--Two Budget Lines

Dl1AI1: Chose A over B A is revealed preferred to Bl2: Choose B over D B is revealed preferred to DFood (units per month)Clothing(units permonth)

Chapter 197

Revealed Preferences--Two Budget Lines

Food (units per month)Clothing(units permonth)

Chapter 197

Revealed Preferences--Four Budget Lines

Food (units per month)Clothing(units permonth)

Chapter 1102

Revealed Preferences for Recreation

Amount of Exercise (hours)OtherRecreationalActivities($)025507520406080100ScenarioRobertas recreation budget = $100/wkPrice of exercise = $4/hr/weekExercises 10 hrs/wk at A given U1 & I1

Would the Clubs profits increase?

Chapter 1102

Marginal Utility andConsumer ChoiceMarginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.

Marginal Utility

Chapter 1107

Marginal Utility andConsumer ChoiceExampleThe marginal utility derived from increasing from 0 to 1 units of food might be 9Increasing from 1 to 2 might be 7Increasing from 2 to 3 might be 5Observation: Marginal utility is diminishing

Marginal Utility

Chapter 1108

Marginal Utility andConsumer ChoiceThe principle of diminishing marginal utility states that as more and more of a good is consumed, consuming additional amounts will yield smaller and smaller additions to utility.

Diminishing Marginal Utility

Chapter 1109

Marginal Utility andConsumer ChoiceMarginal Utility and the Indifference CurveIf consumption moves along an indifference curve, the additional utility derived from an increase in the consumption one good, food (F), must balance the loss of utility from the decrease in the consumption in the other good, clothing (C).

Chapter 1110

Marginal Utility andConsumer ChoiceFormally:

Chapter 1111

Marginal Utility andConsumer ChoiceRearranging:

Chapter 1112

Marginal Utility andConsumer ChoiceBecause:

Chapter 1

113

Marginal Utility andConsumer ChoiceWhen consumers maximize satisfaction the:

Since the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it follows that:

Chapter 1115

Marginal Utility andConsumer ChoiceWhich gives the equation for utility maximization:

Chapter 1116

Marginal Utility andConsumer ChoiceTotal utility is maximized when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good.This is referred to as the equal marginal principle.

Chapter 1117

Marginal Utility andConsumer ChoiceIn 1974 and again in 1979, the government imposed price controls on gasoline.This resulted in shortages and gasoline was rationed.

Gasoline Rationing

Chapter 1118

Marginal Utility andConsumer ChoiceNonprice rationing is an alternative to market rationing.Under one form everyone has an equal chance to purchase a rationed good.Gasoline is rationed by long lines at the gas pumps.

Gasoline Rationing

Chapter 1118

Marginal Utility andConsumer ChoiceRationing hurts some by limiting the amount of gasoline they can buy.This can be seen in the following model.It applies to a woman with an annual income of $20,000.

Chapter 1119

Marginal Utility andConsumer ChoiceThe horizontal axis shows her annual consumption of gasoline at $1/gallon.The vertical axis shows her remaining income after purchasing gasoline.

Chapter 1120

Marginal Utility andConsumer Choice

Gasoline(gallons per year)Spendingon othergoods ($)20,000

Chapter 1123

Cost-of-Living IndexesThe CPI is calculated each year as the ratio of the cost of a typical bundle of consumer goods and services today in comparison to the cost during a base period.

Chapter 1124

Cost-of-Living IndexesWhat Do You Think?Does the CPI accurately reflect the cost of living for retirees?Is it appropriate to use the CPI as a cost-of-living index for other government programs, for private union pensions, and for other private wage agreements?

Chapter 1125

Cost-of-Living IndexesExampleTwo sisters, Rachel and Sarah, have identical preferences.Sarah began college in 1987 with a $500 discretionary budget. In 1997, Rachel started college and her parents promised her a budget that was equivalent in purchasing power.

Chapter 1126

Cost-of-Living IndexesPrice of books$20/book$100/bookNumber of books156Price of food$2.00/lb.$2.20/lbPounds of food100300Expenditure$500$1,260 1987 (Sarah) 1997 (Rachel)

Chapter 1127

Cost-of-Living Indexes

Chapter 1128

Cost-of-Living IndexesThe ideal cost-of-living adjustment for Rachel is $760.The ideal cost-of-living index is $1,260/$500 = 2.52 or 252.This implies a 152% increase in the cost of living.

Chapter 1129


Food(lb./quarter)Books(per quarter)450252015105060050100200250300350400550500

Chapter 1131

Cost-of-Living IndexesThe ideal cost of living index represents the cost of attaining a given level of utility at current (1997) prices relative to the cost of attaining the same utility at base (1987) prices.

Chapter 1132

Cost-of-Living IndexesTo do this on an economy-wide basis would entail large amounts of information.Price indexes, like the CPI, use a fixed consumption bundle in the base period.Called a Laspeyres price index

Chapter 1133

Cost-of-Living IndexesThe Laspeyres index tells us:The amount of money at current year prices that an individual requires to purchase the bundle of goods and services that was chosen in the base year divided by the cost of purchasing the same bundle at base year prices.

Laspeyres Index

Chapter 1134

Cost-of-Living IndexesCalculating Rachels Laspeyres cost of living index Setting the quantities of goods in 1997 equal to what were bought by her sister, but setting their prices at their 1997 levels result in an expenditure of $1,720 (100 x 2.20 + 15 x $100)

Chapter 1135

Cost-of-Living IndexesHer cost of living adjustment would now be $1,220.The Laspeyres index is: $1,720/$500 = 344.This overstates the true cost-of-living increase.

Chapter 1136


l2Food(lb./quarter)Books(per quarter)450252015105060050100200250300350400550500

Chapter 1131

Cost-of-Living IndexesWhat Do You Think?Does the Laspeyres index always overstate the true cost-of-living index?

Chapter 1138

Cost-of-Living IndexesYes!The Laspeyres index assumes that consumers do not alter their consumption patterns as prices change.

Chapter 1139

Cost-of-Living IndexesYes!By increasing purchases of those items that have become relatively cheaper, and decreasing purchases of the relatively more expensive items consumers can achieve the same level of utility without having to consume the same bundle of goods.

Chapter 1139

Cost-of-Living IndexesThe Paasche IndexCalculates the amount of money at current-year prices that an individual requires to purchase a current bundle of goods and services divided by the cost of purchasing the same bundle in the base year.

Chapter 1140

Cost-of-Living IndexesBoth indexes involve ratios that involve todays current year prices, PFt and PCt.However, the Laspeyres index relies on base year consumption, Fb and Cb.Whereas, the Paasche index relies on todays current consumption, Ft and Ct .

Comparing the Two Indexes

Chapter 1141

Cost-of-Living IndexesThen a comparison of the Laspeyres and Paasche indexes gives the following equations:

Chapter 1142

Cost-of-Living IndexesSuppose:Two goods: Food (F) and Clothing (C)


Chapter 1141

Cost-of-Living IndexesLet:PFt & PCt be current year pricesPFb & PCb be base year pricesFt & Ct be current year quantities Fb & Cb be base year quantities


Chapter 1141

Cost-of-Living IndexesSarah (1990)Cost of base-year bundle at current prices equals $1,720 (100 lbs x $2.20/lb + 15 books x $100/book)Cost of same bundle at base year prices is $500 (100 lbs x $2.00/lb + 15 books x $20/book)


Chapter 1141

Cost-of-Living IndexesSarah (1990)


Chapter 1141

Cost-of-Living IndexesSarah (1990)Cost of buying current year bundle at current year prices is $1,260 (300 lbs x $2.20/lb + 6 books x $100/book)Cost of the same bundle at base year prices is $720 (300 lbs x $2/lb + 6 books x $20/book)


Chapter 1141

Cost-of-Living IndexesSarah (1990)


Chapter 1141

Cost-of-Living IndexesThe Paasche index will understate the cost of living because it assumes that the individual will buy the current year bundle in the base year.

The Paasche Index

Chapter 1143

Cost-of-Living IndexesIn 1995, the government adopted the chain-weighted price index to deflate its measure of real GDP.Developed to overcome problems that arose when long-term comparisons of GDP were made using fixed-weight price indexes and prices were rapidly changing.

Chapter 1144

Cost-of-Living IndexesWhat Do You Think?What is the impact on the Federal budget of using the CPI (a Laspeyres index) to adjust social security and other programs for changes in the cost of living?

The Bias of the CPI

Chapter 1144

SummaryPeople behave rationally in an attempt to maximize satisfaction from a particular combination of goods and services.Consumer choice has two related parts: the consumers preferences and the budget line.

Chapter 1145

SummaryConsumers make choices by comparing market baskets or bundles of commodities.Indifference curves are downward sloping and cannot intersect one another.Consumer preferences can be completely described by an indifference map.

Chapter 1145

SummaryThe marginal rate of substitution of F for C is the maximum amount of C that a person is willing to give up to obtain one additional unit of F.Budget lines represent all combinations of goods for which consumers expend all their income.

Chapter 1146

SummaryConsumers maximize satisfaction subject to budget constraints.The theory of revealed preference shows how the choices that individuals make when prices and income vary can be used to determine their preferences.

Chapter 1148

End of Chapter 3Consumer Behavior

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Consumer Behaviour