consumer behaviorslide 1 consumer behavior preferences. the conflict between opportunities and...

Consumer behavior slide 1

CONSUMER BEHAVIORCONSUMER BEHAVIOR

Preferences.

The conflict between opportunities and desires.

Utility maximizing behavior.


Preferences or TastesPreferences or Tastes

All consumers are endowed with a set of “preferences” among all of the goods and services from which they can choose.

These preferences are embodied in a "utility function."


Economists impose 4 assumptions on the preferences in the “standard” case of the utility function:

1. A consumer can decide for any pair of “bundles” of goods which bundle is preferred, or whether he/she is indifferent.

2. Preferences are transitive (consistent).

3. More is better.

4. Indifference curves are “convex”. (See below for a discussion of indifference curves.)


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U

T

S

UTILITY FUNCTION

A utility function for two goods.


Definition: All combinations of goods among which the consumer is indifferent.

That is, all the combinations of goods that give the consumer a particular level of utility or satisfaction.

Indifference curveIndifference curve


The previous graph can be rotated to show indifference curves:

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UTILITY FUNCTION


Marginal Rate of SubstitutionMarginal Rate of Substitution

Definition: The Marginal Rate of Substitution of X for Y is the amount of Y it takes to make up for the loss of one unit of X.

(It’s minus the slope of an indifference curve.)


TACOS

SPAGHETTI

U1

U2

U3

Some indifference curves: U1 < U2 < U3


TACOS

SPAGHETTI

U2

U3

MRS is minus the slope of an indifference curve.MRS is minus the slope of an indifference curve.

MRSS for T = -(T/S)

T

S


Characteristics of indifference curves in the “standard” case:

1) They “fill” the goods space.

2) They cannot intersect.

3) Higher curves lie above and to the right of others.

4) They are “convex”. (There is increasing marginal rate of substitution.)


Woeful tales of preferencesWoeful tales of preferences

Nickels and dimes.

Right shoes and left shoes.

"I wouldn't eat acorns even if you paid me."

"I would eat acorns only if you paid me."


Budget ConstraintsBudget Constraints

Definition: The consumer’s budget constraint shows all of the combinations of goods and services the consumer is able to buy, given income and prices.


Standard case assumptions:

1. The consumer has a fixed, known money income in each time period.

2. The consumer pays a fixed price (in terms of dollars) for each good.


Two good caseTwo good case

Consumer’s income is I dollars per period.

There are two goods, S and T, that have prices PS and PT.

The consumer’s spending on the two goods together must be less than or equal to total income in each time period.


The Budget Constraint is

PS S + PTT I

This can be written as

T I/PT - (PS /PT)S


Remember that income and prices are “givens” here, so the last equation is a linear relationship between T and S.

T

S

I/PT

I/PS

slope = - PS / PT


Where are feasible and non-feasible consumption bundles?

T

S

I/PT

I/PS


Changing income and pricesChanging income and prices

What’s the effect on the consumer’s opportunities if income increases?

I* > I’

PS S + PTT = I’

PS S + PTT = I*


Where’s the new budget constraint when I increases to I*?

T

S

I’/PT

I’/PS hidden slide


Changing pricesChanging prices

What’s the effect on the consumer’s opportunities if the price of spaghetti falls?

PS' > P*S

PS' S + PTT = I

P*S S + PTT = I


Where’s the new budget constraint when the price of spaghetti falls?

T

S

I/PT

I/P'Shidden slide


ChoiceChoice

If a consumer wants to choose S and T so as to maximize total utility, what should he/she do?

hidden slide


TACOS

SPAGHETTI

U1

U2

U3

Maximizing total utilityMaximizing total utility

T* and S* are best.

U*

T*

S*


To maximize utility:To maximize utility:

1) Spend all of your income.

2) Choose a point on the budget constraint where:

(a) an indifference curve is tangent to the constraint, or

(b) the MRS is equal to the ratio of the prices of the goods. (MRSS for T =PS/PT)


More woeful talesMore woeful tales

Nickels & dimes.

Left shoes and right shoes.

Work for pay.

Two part pricing.


Changes in prices and incomeChanges in prices and income

1) Price changes and price consumption curves.

2) Income changes and income consumption curves.

3) Income and substitution effects.

4) Consumer Surplus.


Effects of a price changeEffects of a price change

If the price of a good declines, consumers will change the amount they want to buy (demand), in general.


Price consumption curvePrice consumption curve

Locus of utility maximizing amounts of goods at different prices for one of the goods.

Information from the PCC can be used to derive the consumer's demand curve for a good.


Finding the consumer's demand curve Finding the consumer's demand curve for spaghetti.for spaghetti.

T

S

I/PT

I/P'SS'

U'

PS

S

P'S

I/P*S

P*S

S'S*

U*

S*

DS


Income increasesIncome increases

T

S

I’/PT

I’/PS

I*/PT

U'

S'

U*

S*

Are the goods normal or inferior here?


Choice and inferior goods

T

S

I’/PT

I’/PS

I*/PT

U'

S'

U*

S*

Income increases here. Which good is inferior?


Income consumption curve

Locus of utility maximizing amounts of goods at different income levels for the goods.

Information from the ICC can be used to derive what is called the Engel Curve (or income demand curve) for a good.


Income and Substitution Effects

The consumer is maximizing utility.

The price of one good falls.

The change in the demand for the good can be thought of as having two parts:

A substitution effect, and

An income effect.


Substitution Effect: The change in demand (due to a decrease in price) holding the consumer's real income constant.

Income Effect: The change in demand (due to a decrease in price) because of the increase in real income the consumer receives.


Start with the consumer maximizing utility by choosing amount S0 of good S.

T

S

I/PT

I/P'S I/P*SS0

U'


The price of good S falls to P*S.

The consumer then chooses S2 of good S.

T

S

I/PT

I/P'S I/P*SS0

U'

S2

U*


To find the substitution effect, we must see what the consumer will choose at the lower price of S, but forcing the consumer to have the same real income (i.e., utility) as at S0.

The substitution effect is a "pure price effect" on demand.


Isolating the substitution effect is accomplished by reducing the consumer's money income after the price change until the best he or she can do is get to indifference curve U'.


The substitution effect always works in the direction of increasing the demand for a good whose price has fallen.

The income effect can work in either direction, depending on whether the good is normal or inferior.


Income and substitution effects are used to show (among other things) the conditions under which the Law of Demand is “true”.


Note that for normal goods, the Law of Demand must hold.

For inferior goods, it may hold.

But if the income effect is of opposite sign from the substitution effect, and is larger in magnitude, a decrease in price will lead to lower demand. (A Giffen Good.)


THE CARDINAL UTILITY APPROACH TO CHOICE

Each person has a utility function which is a rule or equation that determines the consumer’s utility (satisfaction) for any amounts of goods and services consumed.

Utility here is assumed to be cardinal, rather than ordinal. (Measured in "utils"??)


The dependent variable in the utility function is utility or satisfaction.

The independent variables are the amounts of the goods and services an individual consumes.


LIKE THIS:

UBROWN = f(beer, bicycles, pizza,

spaghetti, tacos, ...)

“Brown’s utility depends on the number of beers he consumes, the number of bikes he consumes, etc.”


Brown’s total utility from pizzas.

PIZZA TOTAL UTILITY0 01 52 133 224 295 356 407 448 47


You can graph the total utility this way.

PIZZAS

TOTALUTILITY

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MARGINAL UTILITY:MARGINAL UTILITY:

The marginal utility is the increase in utility you get from consuming one more unit of the good, holding the consumption of all other goods constant.


The marginal utility of pizza is the change in utility per unit change in pizza consumption (holding the consumption of all other goods constant, of course).

MUPIZZA = the change in U / the change in pizza

= U / (PIZZA)


You can compute marginal utility from the total utility curve.

(13-5)/(2-1)

PIZZA TOTAL UTILITY MU0 01 5 52 13 83 22 94 29 75 356 407 448 47


Law of Diminishing Marginal UtilityLaw of Diminishing Marginal Utility

The marginal utility of a good will eventually decline as more is consumed.


Marginal utility begins to decline here with the consumption of the 4th pizza.

(29-22)/(4-3)

PIZZA TOTAL UTILITY MU0 01 5 52 13 83 22 94 29 75 356 407 448 47


Marginal utility is the slope of the total utility curve.

PIZZAS

TOTALUTILITY

U

P

MU = U / P

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Draw the marginal utility curve here. Be sure to label the axes correctly. Some points are already shown.

marginal utility

pizzas

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The marginal utility of the 4thpizza is 7 utils.

The marginal utility of the 4thpizza is 7 utils.


The Law of Diminishing Marginal Utility is assumed to be true for all consumers, and for all of the goods a person consumes.


The standard problemThe standard problem(same as in ordinal approach)(same as in ordinal approach)

Suppose a person consumes two goods, say, tacos and spaghetti.

The person has a fixed money income of I dollars per time period, say a week.

Tacos and spaghetti can be bought at fixed, known prices, say PT and PS.

What amounts of spaghetti and tacos will maximize utility?


In the earlier solution to this problem, the marginal rule was to make the MRS equal to the price ratio of the goods. (MRSS for T =PS/PT)

It's easy to show that the MRS can be expressed as a ratio of marginal utilities, land the rule rewritten as:


Choose S and T so that:

MUS / PS = MUT / PT.

MUS / PS is the marginal utility per $ spent on S.

It is the extra utility you can get from spending another $ on S.


WHY THE RULE WORKS

Suppose the rule were not true, but instead we had: MUS / PS < MUT / PT.

or 12 < 20

Spending $1 less on S would lower your utility by 12 utils.

Respending that $1 on T would raise your utility by 20 utils.

This will give you a net gain of 8 (=20-12) utils.


So if the MU's per $ spent on two goods are not not equal, then a gain in total utility is possible by reallocating your spending.

You should spend more on the good whose MU per $ is the highest. In the example on the last slide, this was tacos, T.


Note that as you allocate your $ from the good whose MU per $ is lower, the MU of that good will rise (remember the Law of Diminishing MU).

And the MU of the good with the higher MU per $ will fall for the same reason.

Thus, as you reallocate spending, the degree of inequality between MU’s per $ will diminish.


Only when the MU per $ spent on S is equal to the MU per $ spent on T will you be unable to make utility larger by reallocating you spending, and total utility will be maximized.

MUS / PS = MUT / PT


Consumer Surplus

At the level of the individual consumer, CS is the difference between what the consumer is willing to pay for a good, and the amount the consumer actually pays.

It's a measure of the welfare to the consumer of being able to buy the good in a market.


Consumer surplus can be measured using the demand curve for a product.

Demand for tacos

D

Q* Q

P

P*


When Q* is sold, willingness to pay is the shaded area.

Demand for tacos

D

Q* Q

P

P*


When Q* is sold at a price P*, consumers pay P* times Q*. Click to see the cost to consumers. Click again to see the shaded area that is consumer surplus.

Demand for tacos

D

Q* Q

P

P*

Cost to consumers

Consumer surplus

consumer behaviorslide 1 consumer behavior preferences. the conflict between opportunities and...

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