1MANAGERIAL ECONOMICS

Session 4a

Prof. Dr. Ferdinand D. Saragih, MA

Consumer Behaviour

2Objectives:After studying the chapter, you should understand:1. The purpose of the economic theory of consumer behavior

2. The difference between that theory and consumer behavior in marketing

3. The main approaches to consumer behaviour in economics

Consumer Behaviour

3Economic Theories of Consumer Behavior

ARE NOT rich and highly descriptive analyses of the links between consumers personal, social and psychological characteristics and their purchasing behavior

look for that in the Marketing treatment of the issue They ARE abstract and logical analyses of what is meant by

rational choice behavior and the implications of rational behavior

for instance, is it necessarily true that a rational consumer will buy more of a product as its price falls?

begin by defining rational choice and then follow through the consequences

4The Main Approaches

Utility Theory Indifference Analysis Revealed Preference The Characteristics Approach

5Utility Theory Consumers seek to maximize their UTILITY, which increases as they

consume more goods and decreases as they consume more bads

As a consumer has more of a good, the extra (marginal) utility they enjoy from each successive extra unit of the good declines

the principle of diminishing marginal utility

A utility-maximizing consumer will purchase a combination of goods such that the extra utility acquired per $ or cent, or penny, is the same for every good OR:

the ratio of the marginal utilities is equal to the ratio of the prices

6Utility Theory and Falling Prices If a consumer has a fixed income and begins in

equilibrium: MUapples/Papples = MUpears/Ppears

Suppose, the price of apples falls Left-hand side of the equation> Right-hand side There is an opportunity to increase UTILITY- how to do

it? Shift spending from pears to apples - WHY DOES THIS

WORK? Because each extra penny spent on apples gives more

additional utility than each extra penny spent on pears

7Indifference Analysis UTILITY theory requires us to think in terms of

a cardinally measurable unobservable concept, which is rather heroic

INDIFFERENCE ANALYSIS explains consumer behavior on the basis of less restrictive assumptions (although the logic is very similar)

8Indifference Analysis The following assumptions are made about rational

consumers they know when they prefer one bundle of goods to another or are

indifferent between them - their preferences are complete Preferences are symmetric. If I prefer A to B, I cannot prefer B to A. Preferences are transitive. If I prefer A to B and B to C I must prefer

A to C.

(These are not as unproblematic as they may seem)

9Indifference Analysis Good A

Good B

All combinations of A and B for which the consumer is indifferent

AN INDIFFERENCE CURVE

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Indifference Analysis Good A

Good B

Slopes show relative preferences for A and B

An A-lover

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An Indifference Map Good A

Good B

The preferred direction if A and B are both goods

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The Optimal Combination of A and B Good A

Good BBudget Line

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If the Price of B Falls Good A

Good BBudget Line

More B is bought and (in this example only) the same amount of A

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What Can We Say In General About the Consequences of a Price Fall?

The overall move from one equilibrium to another is the PRICE EFFECT

PRICE EFFECT can be divided into SUBSTITUTION EFFECT and INCOME EFFECT

SUBSTITUTION EFFECT is the result of changing prices

INCOME EFFECT is the result of changing real incomes

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How to Find the Substitution and Income Effects?

Good A

Good BBudget Line

More B is bought (and in this example only) the same amount of A

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Substitution Effect Good A

Good B

If the consumer was on the same I-curve as before (same real income) but prices moved to their new level, (budget line has the new slope) more B must be bought

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Income Effect

Good A

Good B

If relative prices dont change but real income rises

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Income Effect

The substitution effect MUST lead more B to be bought if the relative price of B falls

The Income effect could work in either direction or be neutral

for inferior goods, income effect is negative for normal goods it is positive

A GIFFEN good is one where the income effect is negative and powerful enough to outweigh the substitution effect

lower prices, less is bought

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A decrease in price of food has an income effect and a substitution effect. The consumer is initially at A on budget line RS. When the price of food falls, consumption increase by F1F2 as the consumer moves to B. The substitution effect, F1E (associated with a move from A to D) changes the relative prices of food and clothing but keeps real income (satisfaction) constant. The income effect EF2 (associated with a move from D to B) keeps relative prices constant but increases purchasing power. Food is a normal good because the income effect , EF2 is positive)

A

DB

U1

U2

0 F1 F2E S T

Clothing (units Per Month)

Food (units Per Month)

R

SubstitutionEffect

IncomeEffect

Total Effect

Income Effect and Substitution Effect Normal Good

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AB

D

0 F1 F2

U1

U2

E S

R

T

Total Effect Income EffectSubstitution Effect

Income Effect and Substitution Effect Inferior Good

The effect of a decrease in the price of food is broken down into asubstitution effect F1E and an income effect EF2. In this case, food is an inferior good, because the income effect is negative.However, the substitution effect exceeds the income effect, so thedecrease in the price of food leads to an increase in the quantity offood demanded.

Food(units per month)

Clothing(unit per month)

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A

B

D

0 F1 F2

U2

U1

E S

R

T

Total Effect

Substitution EffectIncome Effect

When food is a giffen good, and the income effect is large enough to dominate the substitution effect, the demand curve will be upward-sloping. The consumer is initially at point A. But after the price of food falls, the consumer moves to B and consumers less food. The income effect, F2F1, is larger than the substitution effect EF2, so that the decrease in the price of food leads to a lower quantity of food demanded.

Food(units per month)

Clothing(unit per month)

Income Effect and Substitution Effect The Giffen Good

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Inferior Good

Steak (units per month)

Hamburger (units per month)

5

10

15

A

B

C

U1

U2

U3

5 10 20 30

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Engel Curves

Inferior

Normal

Income ($ per month) Income ($ per month)

0

10

20

30

4 8 12 16Food (Units per month)

Hamburger (Units per month)5 10

30

20

10

(a) Food is a normal good, and the engel curve is upward

(b) Hamburger is normal good for income less than $ 20 per month and inferior good for income greater than $30 engel curve is upward

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Other Approaches

Indifference analysis, and its mathematical version, is the standard approach

Revealed Preference and the Characteristics Approach merit brief consideration

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Revealed Preference Less restrictive assumptions - consumers are

consistent in their choices A budget line is constructed and the consumers

choice observed When price of one good falls, a new choice is made The new choice cannot involve less of the good

whose price has fallen Why?

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Revealed Preference

Apples

Oranges

XZ

If combination X is the original choice and Z is the new choice (after the price of oranges falls), X to Z is the price effect. The broken line shows the goods which could be bought if income remained at the level required to buy the original basket of goods, but the new price ratio held. We dont know exactly where the consumer would choose to be, but they cannot be to the left of X because they have already rejected superior combinations in favor of X

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The Characteristics Approach Lancaster 1966 Consumers do not desire goods but bundles of

characteristics not a computer but

processing speed memory storage functions

Different brands offer different combinations of characteristics. Combining brands may allow other combinations to be achieved

Desirable mixes of characteristics might be identified

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Practical Applications of Demand Theory?

LIMITED. The purpose is to examine the meaning and consequences of rational behavior

Forms the theoretical foundation for statistical analyses of demand

The characteristics concept is a useful starting point in Marketing and has led to ideas like hedonic price models.

Take many different examples or brands of a good. Regress the price on the characteristics to see how the market prices them

In Hong Kong, residential property prices are determined by net floor area, but age, a view of water, pollution and family density also had significant (but small) effects