consumer behavior lecture outline - viadrina … claudia vogel euv winter ermt 2009/2010 claudia...

Microeconomics

Claudia Vogel

EUV

Winter Term 2009/2010

Claudia Vogel (EUV) Microeconomics Winter Term 2009/2010 1 / 37

Consumer Behavior

Lecture Outline

Part II Producers, Consumers, and Competitive Markets

3 Consumer BehaviorConsumer PreferencesBudget ConstraintsConsumer ChoiceMarginal Utility and Consumer ChoiceSummary


Consumer Behavior Consumer Preferences

Consumer Behavior

theory of consumer behavior: Description of how consumers allocateincomes among di�erent goods and services to maximize their well-being.

Consumer behavior is best understood in three distict steps:

1 Consumer preferences

2 Budget constraints

3 Consumer choices



Market Baskets

market basket (or bundle): List speci�c quantities of one or more goods.

Example: Alternative Market Baskets

Market Basket Units of Food Units of ClothingA 20 30B 10 50D 40 20E 30 40G 10 20H 10 40

To explain the theory of consumer behavior, we will ask, whether consumers preferone basket to another



Basic Assumptions about Preferences

1 Completeness: Preferences are assumed to be complete. In other words,consumers can compare and rank all possible baskets.

2 Transitivity: Preferences are transitive. Transitivity means that if aconsumer prefers basket A to basket B and basket B to basket C, then theconsumer also prefers A to C. Transitivity is normally regarded as necessaryfor consumer consistency.

3 More is better is less: Goods are assumed to be desirable - i.e. to be good.Consequently, consumers always prefer more of any good to less. In addition,consumers are never satis�ed or satiated; more is always better, even if just alittle better.



Indi�erence Curves 1/2



Indi�erence Curves 2/2

indi�erence curve: Curve representing all combinations of market basketsthat provide a consumer with the same level of satisfaction.



Indi�erence Maps

indi�erence map: Graph containing a set of indi�erence curves showing themarket baskets among which a consumer is indi�erent



The Marginal Rate of Substitution

marginal rate of substitution (MRS): Maximum amount of a good that aconsumer is willing to give up in order to obtain one additional unit ofanother good.

MRS = −4C4F



Perfect Substitutes and Perfect Complements

perfect substitutes: Two goods forwhich the marginal rate ofsubstitution of one for the other is aconstant.

perfect complements: Two goodsfor which theMRS is zero or in�nite;the indi�erence curves are shaped asright angles.



Utility and Utility Functions

utility: Numerical scorerepresenting the satisfaction that aconsumer gets from a given marketbasket.

utility function: Formula thatassigns a level of utility to individualmarket baskets.

ordinal utility function: Utilityfunction that generates a ranking ofmarket baskets in order of most toleast preferred.

cardinal utility function: Utilityfunction describing by how muchone market basket is preferred toanother.



Example: Can Money buy Happiness?


Consumer Behavior Budget Constraints

The Budget Line 1/2

budget constraint: Constraints that consumers face as a result of limitedincomes.

budget line: All combinations of goods for which the total amount of moneyspent is equal to income.

PFF + PCC = I

Example: Market Baskets and the Budget Line

Market Basket Food (F) Clothing (C) Total SpendingA 0 40 $80B 20 30 $80D 40 20 $80E 60 10 $80G 80 0 $80

The table shows market baskets associated with the budget lineF + 2C = $80



The Budget Line 2/2

C =I

PC− PF

PC· F



The E�ects of Changes in Income and Prices


Consumer Behavior Consumer Choice

Maximizing Consumer Satisfaction

The maximizing market basket must satisfy two conditions:

1 It must be located on the budget line.

2 It must give the consumer the most preferred combination of goods andservices.



Marginal Bene�t and Marginal Cost

Satisfaction is maximized (given the budget constraint) at the point where

MRS =PF

PC

marginal bene�t: Bene�t from the consumption of one additional unit of agood.

marginal cost: Cost of one additional unit of a good.

Satisfaction is maximized when the marginal bene�t is equal to the marginal cost.The marginal bene�t is measured by the MRS.



Example: Designing New Automobiles 1/2



Example: Designing New Automobiles 2/2



Corner Solution

corner solution: Situation in which the marginal rate of substitution of onegood for another in a chosen market basket is not equal to the slope of thebudget line.The consumer maximizes satisfaction by consuming only one of the twogoods.



Example: A College Trust Fund


Consumer Behavior Marginal Utility and Consumer Choice

Marginal Utility and Consumer Choice

marginal utility (MU): Additional satisfaction obtained from consuming oneaddtional unit of a good.

diminishing marginal utility: Principle that as more of a good is consumed,the consumption of additional amount will yield smaller additions to utility.

0 = MUF (4F ) +MUC (4C )

−(4C4F

)= MUF

MUC

MRS = MUF

MUC

MRS = PF

PC

MUF

MUC= PF

PC

MUF

PF= MUC

PC

equal marginal principle: Principle that utility is maximized when theconsumer has equalized the marginal utility per dollar of expenditure acrossall goods.



Mathematical Treatment 1/2

Utility Maximization:

Consumer's Maximization problem: U(X ,Y )→ max

Consumer's constraint: PXX + PYY = I

Solving by Lagrange Multiplier Method:

The Lagrangian:

L (X ,Y , λ) = U(X ,Y )− λ (PXX + PYY − I )

Derivatives of the Lagrangian:∂L(X ,Y ,λ)

∂X= ∂U(X ,Y )

∂X− λPX

∂L(X ,Y ,λ)∂Y

= ∂U(X ,Y )∂Y

− λPY∂L(X ,Y ,λ)

∂λ= PXX + PYY − I

Solving the Resulting Equations:

MUX = λPX

MUY = λPY

PXX + PYY = I



Mathematical Treatment 2/2

The Equal Marginal Principle:

λ =MUX (X ,Y )

PX=MUY (X ,Y )

PY

MUX (X ,Y )

MUY (X ,Y )=PX

PY

Marginal Rate of Substitution:

U (X ,Y ) = U∗

MUX (X ,Y ) dX +MUY (X ,Y ) dY = dU∗ = 0

−dYdX

=MUX (X ,Y )

MUY (X ,Y )= MRSXY



Example: Marginal Utility and Happiness



Example: Gasoline Rationing


Consumer Behavior Summary

Summary 1/3

The theory of consumer choice rests on the assumption that people behaverationally in an attempt to maximize the satisfaction they can obtain bypurchasing a particular combination of goods and services.

Consumer choice has two related parts: the study of the consumer'spreferences and the analysis of the budget line that constrains the choicesthat a person can make.

Consumers make choices by comparing market baskets or bundles ofcommodities. Preferences are assumed to be complete (they can compare allpossible market baskets) and transitive (if they prefer basket A to B, and Bto C, then they prefer A to C). In addition, economists assume that more ofeach good is always preferred to less.

Indi�erence curves, which present all combinations of goods and services thatgive the same level of satisfaction, are downward-sloping and cannot intersectone another.



Summary 2/3

Consumer preferences can be completely described by a set of indi�erencecurves known as an indi�erence map. An indi�erence map provides an ordinalranking of all choices that the consumer might make.

The marginal rate of substitution (MRS) of F for C is the maximum amountof C that a person is willing to give up to obtain 1 additional unit of F. TheMRS diminishes as we move down along an indi�erence curve. When there isa diminishing MRS, preferences are convex.

Budget lines represent all combinations of goods for which consumers expendall their income. Budget lines shift outward in response to an increase inconsumer income. When the price of one good (on the horizontal axis)changes while income and the price of the other good do not, budget linespivot aqnd rotate about a �xed point (on the vertical axis).

Consumers maximize satisfaction subject to budget constraints. when aconsumer maximizes satisfaction by consuming some of each of the twogoods, the marginal rate of substitution is equal to the ratio of the prices ofthe two goods being purchased.



Summary 3/3

Maximization is sometimes achieved at a corner solution in which one good isnot consumed. In such cases, the marginal rate of substitution need not beequal the ratio of prices.

The theory of the consumer can be presented by two di�erent approaches.The indi�erence curve approach uses the ordinal properties of utility (that is,it allows for the ranking of alternatives). The utility function approachobtains a utility function by attaching a number to each market basket; ifbasket A is preferred to basket B, A generates more utility than B.

Usually the utility function will show diminishing marginal utility: As moreand more of a good is consumed, the consumer obtains smaller and smallerincrements of utility.

When the utility function approach is used and both goods are consumed,utility maximization occurs when the ratio of the marginal utilities of the twogoods (which is the marginal rate of substitution) is equal to the ratio of theprices.


Exercises 2

Problem 1

Draw indi�erence curves that represent the following individuals' preferences forhamburgers and soft drinks. Indicate the direction in which the individuals'satisfaction (or utility) is increasing.

1 Mary always gets twice as much satisfaction from an extra hamburger as shedoes from an extra soft drink.

2 Jane loves hamburgers and dislikes soft drinks. If she is served a soft drink,she will pour it down the drain rather than drink it.

3 Molly loves hamburgers and soft drinks, but insists on consuming exactly onesoft drink for every two hamburgers that she eats.

4 Bob loves hamburgers and dislikes soft drinks. If he is served a soft drink, hewill drink it to be polite.

5 Bill likes hamburgers, but neither likes or dislikes soft drinks.

6 Joe has convex preferences and dislikes both hamburgers and soft drinks.


Exercises 2

Problem 2

In the previous lecture, consumer preferences for various commodities did notchange during the analysis. Yet in some situations, preferences do change asconsumption occurs. Discuss why and how preferences might change over timewith consumption of these two commodities:

1 cigarettes

2 dinner for the �rst time at a restaurant with a special cuisine


Exercises 2

Problem 3

Jon is always willing to trade one can of Coke for one can of Sprite, or one can ofSprite for one can of Coke.

1 What can you say about Jon's marginal rate of substitution?

2 Draw a set of indi�erence curves for Jon.

3 Draw two budget lines with di�erent slopes and illustrate thesatisfaction-maximizing choice. What conclusion can you draw?


Exercises 2

Problem 4

Antonio buys �ve new college textbooks during his �rst year at school at a cost of$80 each. Used books cost only $50 each. When the bookstore announces thatthere will be a 10 percent increase in the price of new books and a 5 percentincrease in the price of used books, Antonio's father o�ers him $40 extra.

1 What happens to Antonio's budget line? Illustrate the change with newbooks on the vertical axis.

2 Is Antonio worse or better o� after the price change? Explain.


Exercises 2

Problem 5

Anne has a job that requires her to travel three out of every four weeks. She hasan annual travel budget and can travel either by train or by plane. The airline onwhich she typically �ies has a frequent-traveler program that reduces the cost ofher tickets according to the number of miles she has �own in a given year. Whenshe reaches 25,000 miles, the airline will reduce the price of her tickets by 25percent for the remainder of the year. When she reaches 50,000 miles, the airlinewill reduce the price by 50 percent for the remainder of the year. Graph Anne'sbudget line, with train miles on the vertical axis and plane miles on the horizontalaxis.


Exercises 2

Problem 6

Ben allocates his lunch budget between two goods, pizza and burritos.

1 Illustrate Ben's optimal bundle on a graph with pizza on the horizontal axis.

2 Suppose now that pizza is taxed, causing the price to increase by 20 percent.Illustrate Ben's new optimal bundle.

3 Suppose instead that pizza is rationed at a quantity less than Ben's desiredquantity. Illustrate Ben's new optimal bundle.


Exercises 2

Problem 7

Sharon has the following utility function:

U (X ,Y ) =√X +

√Y

where X is her consumption of candy bars, with price PX = $1, and Y is herconsumption of espressos, with PY = $3.

1 Derive Sharon's demand for candy bars and espressos.

2 Assume that her income I = $100. How many candy bars and how manyespressos will Sharon consume?


Exercises 2

Problem 8

Maurice has the following utility function:

U (X ,Y ) = 20X + 80Y − X 2 − 2Y 2

where X is his consumption of CDs, with a price of $1, and Y is his consumptionof movie videos, with a rental price of $2. He plans to spend $41 on both forms ofentertainment. Determine the number of CDs and video rentals that willmaximize Maurice's utility.


consumer behavior lecture outline - viadrina … claudia vogel euv winter ermt 2009/2010 claudia...

Documents