ME 08-11 Consumer Behaviour

Analysis of Consumer Behavior

T.J. Joseph

Factors affecting choice:

• Limited income necessitates choice.

• Consumers make choices purposefully.

• One good can be substituted for another.

• Consumers must make decisions without perfect information, but knowledge and past experience will help.

Fundamentals of Consumer Choice

Utility Utility: The extent of satisfaction obtained from the

consumption of the goods and services preferred by consumers

– If buying a copy of Microeconomics book makes you happier than buying one T-shirt, then we say that the book gives you more utility than the T-shirt.

Utility Utility is affected by the consumption of physical

commodities, psychological attitudes, peer group pressures, personal experiences, and the general cultural environment

Economists generally devote attention to quantifiable options while holding constant the other things that affect utility

– ceteris paribus assumption

Cardinal Versus Ordinal Utility Cardinal Utility Function: utility function describing

the extent to which one market basket is preferred to another.

Cardinal Utility: Gives a numerical score representing the satisfaction that a consumer gets from a given market basket.

Cardinal Versus Ordinal Rankings 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.– The actual unit of measurement for utility is not

important.

– Therefore, an ordinal ranking is sufficient to explain how most individual decisions are made.

Cardinal Versus Ordinal Rankings Given the assumptions, it is possible to show that people are

able to rank in order all possible situations from least desirable to most– if A is preferred to B, then the utility assigned to A exceeds

the utility assigned to B

U(A) > U(B) Utility rankings are ordinal in nature

– they record the relative desirability of commodity bundles It is also impossible to compare utilities between people

Cardinal Utility AnalysisTotal Utility (TU)

The total satisfaction that a person gains from all units of a commodity consumed within a given time period

Marginal utility (MU)

The additional satisfaction gained from consuming one extra unit within a given period of time

Diminishing Marginal Utility

As the rate of consumption increases, the marginal utility derived from consuming additional units of a good will decline.

• Law of diminishing marginal utility:

• A consumer's willingness to pay for a unit of a good is directly related to the utility derived from consumption of the unit.

The Demand Curve

• The law of diminishing marginal utility implies that a consumer's marginal benefit, and thus the height of their demand curve, falls with the rate of consumption

$2.50

$2.00

Price

Frozen pizzasper week

$3.00

$3.50

MB4 MB3 MB2 MB1<<<

MU4 MU3 MU2 MU1<<<because

d MB=

• Jones’s demand for frozen pizzas, (given by the demand curve), reflects the law of diminishing marginal utility.

• Because marginal utility (MU) falls with increased consumption, so does a consumer’s maximum willingness to pay -- marginal benefit (MB).

• A consumer will purchase until MB = Price . . . so at $2.50 Jones would purchase 3 frozen pizzas and receive a consumer surplus shown by the shaded area (above the price line and below the demand curve).

Price =$2.50

The Demand CurveJones’s demand curvefor frozen pizza

421 3

MB4

MB3

MB2

MB1

Consumer Equilibrium With Many Goods Each consumer will maximize his/her satisfaction by

ensuring that the last dollar spent on each commodity yields an equal degree of marginal utility.

MUAPA

=MUBPB

= . . . =MUNPN

The Equilibrium Condition or the Utility Maximising Condition for a Consumer when he picks up a basket of commodities is:

Equal marginal utilities per rupee for every good

1. A consumer is currently purchasing 3 pairs of jeans and 5 t-shirts per year. The price of jeans is $30, and t-shirts cost $10. At the current rate of consumption, the marginal utility of jeans is 60 and the marginal utility of t-shirts is 30. Is this consumer maximizing his utility? Would you suggest he buy more jeans and fewer t-shirts, or more t-shirts and fewer jeans?

2. “If the price of gasoline goes up and Dan now buys fewer candy bars because he has to spend more on gas, this would best be explained by the substitution effect.” -- Is this statement true or false?

Questions for Thought

Decision Making Process of a Consumer

Preferences vs. Choices Preference Set – a set of goods and services he/she

wants (likes or dislikes)

Opportunity Set (choices) – a set of goods and services he/she can buy with the limited income (budget)

Given these two sets the consumer can list out the feasible set of wants, which can be satisfied and also arrive at a combination that maximizes his satisfaction/benefits.

Model of Rational Choice There are three steps involved in the study of consumer

behavior.1) Consumer preferences.

What the consumer wants to doHow and why people prefer one good to another.

2) Budget constraints.What the consumer can afford to doPeople have limited incomes.

3) Rational DecisionWhat combination of goods will consumers buy to maximize

their satisfaction?Combine consumer preferences and budget constraints to

determine consumer choices (optimal decision).

Axioms of Rational Choice Given an individual’s preferences, economics provides

an optimal and rational solution to the problem of choice, under certain assumptions:

Assumption of Completeness:– if A and B are any two commodities, an individual can

always specify exactly one of these possibilities:

I prefer A to B

I prefer B to A

I am indifferent between A and B

Axioms of Rational Choice Assumption of Transitivity (Consistency):

– if A is preferred to B, and B is preferred to C, then A is preferred to C

– assumes that the individual’s choices are internally consistent

Assumption of Non-Satiation:– A rational consumer prefers more of a good to less of a

good

Consumer Preferences

Market Baskets

A 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

A 2 10

B 1 16

C 1 12

D 3 06

E 4 04

F 3 14

G 5 01

H 2 04

Market Basket Units of Food Units of Clothing (in ‘000 calories)

Indifference Curves Indifference curves represent all combinations of

market baskets that provide the same level of satisfaction to a person.

B

A

DE

G

Indifference Curves

Food(‘000 calories per week)

Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16

U1

C

F

H

More preferred

Less preferred

Combinations of B, A, D, E and G give same level of utility

F is more preferred

C is less preferred

Indifference Curves - Properties(1) Indifference curves slope downward to the right

(negative MRS)– If it sloped upward it would violate the assumption

that more of any commodity is preferred to less.

(2) Indifference curves are convex to the origin – 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 (diminishing MRS)

A

B

D

EG-1

-6

1

1

-4

-21

1

Observation: The amountof clothing given up for a unit of food decreasesfrom 6 to 1

Indifference Curves - Properties

Food(units per week)

Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16

Question: Does thisrelation hold for givingup food to get clothing?


(3) Indifference curves cannot cross.

– This would violate the assumption that more is preferred to less.

(4) Any market basket lying above and to the right of an indifference curve is preferred to any market basket that lies on the indifference curve.

U1U2



Clothing(units per week)

A

D

B

The consumer shouldbe indifferent betweenA, B and D. However,B contains more ofboth goods than D.

Indifference CurvesCannot Cross

U2

U3



Clothing(units per week)

U1

AB

D

Market basket Ais preferred to B.Market basket B ispreferred to D.

Marginal Rate of Substitution The 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.

– 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.

Marginal Rate of Substitution


Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16 A

B

D

EG

-6

1

1

11

-4

-2-1

MRS = 6

MRS = 2

FCMRS

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.

Perfect Complements– Two goods are perfect complements when the

indifference curves for the goods are shaped as right angles.


Orange Juice(glasses)

Apple Juice

(glasses)

2 3 41

1

2

3

4

0

PerfectSubstitutes


Right Shoes

LeftShoes

2 3 41

1

2

3

4

0

PerfectComplements

Budget Constraints

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.

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

The budget line depends on three parameters– price of good X– price of good Y– income of consumer

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.

The budget line then can be written:

ICPFP CF

The Budget Line

A 0 12 120

B 1 10 120

C 2 8 120

D 3 6 120

E 4 4 120

F 5 2 120

G 6 0 120

Market Basket Food (F) Clothing (C) Total SpendingPf = (Rs.20) Pc = (Rs.10) PfF + PcC = I

The Budget Line


Clothing(units

per week)

2 3 4 51

2

4

6

8

10

(I/Pc ) 12

14

16

B

D

E

F

6 (I/Pf )

A

C

G

PC = Rs.10 Pf = Rs.20 I = Rs.120

Budget Line 20F + 10C = 120

CF/PPFC - 12- / Slope

2

1

Affordable

Not affordable

11

Slope of the Budget Line Equals the relative price of food F to clothing C

It’s the amount of clothing C that has to be given up to purchase one more unit of food F

C

F

PPSlope

C

F

PP

FCSlope

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.

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

The Budget Line

The 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.

12

Shifts in the Budget Line Changes in the prices of the goods or income shift the

budget line

A change in income (holding prices constant) causes a parallel shift the budget line

A change in the price of one good swivels the budget line (i.e. the slope changes)

The Effect of Income Changes


Clothing(units

per week)

6 9 123

6

12

18

24

0

A increase inincome shifts

the budget lineoutward

(I = 240)L2

(I = 120)L1

L3 (I =60)

A decrease inincome shifts

the budget lineinward

Effects of Changes in Income and Prices

Effects of Price Changes

– If the price of one good increases, the budget line shifts inward, pivoting from the other good’s intercept.

– If the price of one good decreases, the budget line shifts outward, pivoting from the other good’s intercept.

The Effect of Price Changes


Clothing(units

per week)

6 9 123

12

(PF = 20)

L1

An increase in theprice of food toRs.40 changesthe slope of thebudget line and

rotates it inward.

L3

(PF = 40)(PF = 10)

L2

A decrease in theprice of food toRs.10changes

the slope of thebudget line and

rotates it outward.

Effects of Changes in Prices If the two goods increase in price, but the ratio of the two

prices is unchanged, the slope will not change.

– The budget line will shift inward to a point parallel to the original budget line.

If the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change.

– The budget line will shift outward to a point parallel to the original budget line.

Consumer Choice(Rational or Optimal

Decision)

16

Equilibrium Conditions

All income is spent (point E is on the budget line)

The slope of the indifference curve equals the slope of the budget line

Marginal rate of substitution = the relative price ratio

Consumer Choice (Utility Maximization) Consumers choose a combination of goods that will

maximize the satisfaction they can achieve, given the limited budget available to them.

The 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.

Recall, the slope of an indifference curve is:

Consumer Choice (Equilibrium)

FCMRS

C

F

PPSlope

Further, the slope of the budget line is:

Therefore, it can be said that satisfaction is maximized where:

C

F

PPMRS

It 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).

Consumer Choice

Food (units per week)

Clothing(units per

week)

4 82

4

8

12

0

U1

B

Budget Line

Pc = 10 Pf = 20 I = 120

Point B does not maximize satisfaction

because theMRS

is greater than the price ratio

6

Consumer Choice

Budget Line

U3

D Market basket D cannot be attainedgiven the current

budget constraint.

Pc = 10 Pf = 20 I = 120


Clothing(units per

week)

4 82

4

8

12

0 6

U2

Consumer Choice (Equilibrium)Pc = 10 Pf = 20 I = 120

Budget Line

A

At market basket A the budget line and theindifference curve aretangent and no higherlevel of satisfaction

can be attained.

At A:MRS = Pf/Pc = -2


Clothing(units per

week)

4 82

4

8

12

0 6

6

3

From Cardinal Approach we know that the consumer will be in equilibrium when:

Consumer Choice (Equilibrium)

F

F

C

C

PMU

PMU

C

F

C

F

PP

MUMU

That is,

Therefore, we can say that satisfaction is maximized where:

C

F

C

FFC MU

MUPPMRS

Income Consumption Curve (ICC) When income of the consumer increases, keeping the

prices of commodities the same, the budget line shifts to the right

The shift in budget line shifts the equilibrium position of the consumer at a higher indifference curve

Income Consumption Curve (ICC) is the locus of all such tangency points between the budget lines and the indifference curves

ICC shows the effect of the change in income on the equilibrium quantities purchased of the two

commodities

Income Consumption Curve (ICC)Good Y

Good XU1

U2

X1 X3

E1

E3

E2

X2

U3

Income Consumption Curve

Price Consumption Curve (PCC) PCC represents the successive points of tangency

between the different budget lines and indifference curves because of changes in the price of one of the commodity, ceteris paribus

(Consumer income and prices of other commodities remain the same)

The demand curve of the consumer for a commodity can be derived from the PCC (Explain).

Price Consumption Curve (PCC)

Good Y

Good X

U1

U3

X1 X3

E1

E3

E2

X2

U2

A

B C D

Price Consumption Curve

Income & Substitution Effects Substitution Effect

– the effect on consumption of a good resulting only from the change in its relative pricerelative price (i.e. the slopeslope of the budget line)

Income Effect

– the effect on consumption of a good resulting only from the change in realreal income (i.e. the positionposition of the budget line)

Price Effect = Income Effect + Substitution Effect

A Fall in Price of Good X

All other goods (Y)

Good X

U1

U2

X1 X3

E1 E3

E2

X2

Substitution effect:E1 to E2

Income effect:E2 to E3

References

1. Chapter 3 & 4 in Dominick Salvatore (2009) “Principles of Microeconomics”, 5th edition, Oxford Higher Education.

2. Chapters 21 in William Boyes and Michael Melvin (2009), ‘Textbook of Economics’, 6th edition, Biztantra publications.

Documents

ME 08-11 Consumer Behaviour