consumer preferences and the concept of utility consumer preferences. we study consumer preferences

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  • Why Do You Like What You Like? If you are thinking about buying a car, your choices can be overwhelming: Should you buy or lease?

    New car or used? A sport utility vehicle, a sedan, a sports car, or a minivan? Should you get a sun-

    roof or four-wheel drive? How much extra would you pay for a vehicle that will have a high resale

    value in the future? What are the expected operating expenses for each model—insurance, repairs,

    gasoline, and so on? Finally, what opportunities will you forgo if you buy a car? How else could you

    spend your money, either today or in the future?

    Making decisions about a product with many options is not easy. Before buying a car, for exam-

    ple, you might draw on the experiences of friends and family, read advertisements, visit dealers, and

    test-drive vehicles. You might also research different models and financing options on the Web,

    read Consumer Reports, price insurance rates for favorite models, or even visit chat rooms

    frequented by car buffs.

    As a consumer, you make choices every day of your life. Besides choosing among automobiles,

    you must decide what kind of housing to rent or purchase, what food and clothing to buy, how

    much education to acquire, and so on. Consumer choice provides an excellent example of

    constrained optimization, one of the key tools discussed in Chapter 1. People have unlimited

    desires, but limited resources. The theory of consumer choice focuses on how consumers with

    limited resources choose goods and services.

    3.1 R E P R E S E N TAT I O N S O F P R E F E R E N C E S

    3.2 U T I L I T Y F U N C T I O N S APPLICATION 3.1 Influencing Your Preferences

    APPLICATION 3.2 How People Buy Cars: The Importance of Attributes

    APPLICATION 3.3 Taste Tests

    APPLICATION 3.4 Hula Hoops and Pet Rocks

    3C O N S U M E RP R E F E R E N C E S A N D T H EC O N C E P T O F U T I L I T Y C H A P T E R

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  • In the next three chapters, we will learn about consumer choice. In this chapter we will examine

    consumer preferences. We study consumer preferences to understand how a consumer compares

    (or ranks) the desirability of different sets of goods. For this discussion, we ignore the costs of pur-

    chasing the goods. Thus, consumer preferences indicate whether the consumer likes one particular

    set of goods better than another, assuming that all goods can be “purchased” at no cost.

    Of course, in the real world it does cost the consumer something to purchase goods and a con-

    sumer has limited income. This reality leads us to the second part of our discussion of consumer

    choice in Chapter 4. When goods are costly, a consumer’s income limits the sets of goods she can

    purchase. In Chapter 4 we will show how to describe the set of goods that is affordable given a

    consumer’s income and the prices of goods. Then we will use consumer preferences to answer the

    following question: Which goods among those that are affordable will the consumer choose?

    Why should we study consumer choice in such depth? Consumers are not the only parties inter-

    ested in consumer choice, and in Chapter 5 we will use the theory of consumer choice to derive a

    consumer’s demand curve for any good or service. Businesses care about consumer demand curves

    because they reveal how much a consumer is willing to pay for a product. Governments also care

    about consumer preferences and demands. For example, if a government is interested in helping low-

    income families buy food, policy makers must decide how to do it. Should the government simply

    give the families a cash supplement and let them spend the money in any way they wish? Or should

    the aid be in the form of certificates, such as food stamps, which can only be used to buy food?

    As we will see, the effectiveness and costliness of a program depends on consumers’ preferences.

    C H A P T E R P R E V I E W In this chapter, you will

    • Learn how to represent consumer preferences in terms of market baskets of goods and services.

    • Study three basic assumptions about consumer preferences: preferences are complete, prefer-

    ences are transitive, and more is better.

    • Learn the distinction between ordinal and

    cardinal ranking of preferences.

    • Explore utility functions as a tool for repre-

    senting preferences, and analyze the concept of

    marginal utility and the principle of diminishing

    marginal utility.

    • Apply utility functions in the analysis of prefer-

    ences with a single good and with multiple goods.

    • Study indifference curves as a way of repre-

    senting utility functions in simplified form.

    • Analyze the concept of the marginal rate of

    substitution of one good for another.

    • Explore some special utility functions.

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  • In a modern economy, consumers can purchase a vast array of goods and services. We begin by considering a market basket (sometimes called a bundle), defined as a collection of goods and services that an individual might consume. For example, one basket of goods might include a pair of jeans, two pairs of shoes, and 5 pounds of chocolate candy. A second basket might contain two pairs of jeans, one pair of shoes, and 2 pounds of chocolate candy. More generally, a basket may contain specified amounts of not only jeans, shoes, and chocolate candy, but also housing, electronic goods, tickets for theatrical and sporting events, and many other items.

    To illustrate the idea of a basket, consider a simplified example in which a con- sumer can purchase only two goods, food and clothing. Seven possible consumption baskets are illustrated in Figure 3.1. A consumer who buys basket E consumes 20 units of food and 30 units of clothing per week. One who chooses basket B instead consumes 60 units of food and 10 units of clothing weekly. A basket might contain only one good, such as basket J (only food) or basket H (only clothing).

    Consumer preferences tell us how an individual would rank (i.e., compare the desirability of ) any two baskets, assuming the baskets were available at no cost. Of course, a consumer’s actual choice will ultimately depend on a number of factors in addition to preferences, including income and what the baskets cost. But for now we will consider only consumer preferences for different baskets.

    A S S U M P T I O N S A B O U T C O N S U M E R P R E F E R E N C E S Our study of consumer preferences begins with three basic assumptions that underlie the theory of consumer choice. In making these assumptions, we take it for granted that consumers behave rationally under most circumstances. Later we will discuss situations in which these assumptions might not be valid.

    1. Preferences are complete. That is, the consumer is able to rank any two baskets. For baskets A and B, for example, the consumer can state her preferences according

    70 C H A P T E R 3 C O N S U M E R P R E F E R E N C E S A N D T H E C O N C E P T O F U T I L I T Y

    3.1 R E P R E S E N TA - T I O N S O F P R E F E R E N C E S

    basket A combination of goods and services that an individual might consume.

    consumer preferences Indications of how a con- sumer would rank (compare the desirability of) any two possible baskets, assuming the baskets were available to the consumer at no cost.

    U ni

    ts o

    f c lo

    th in

    g

    Units of food

    0

    30

    20

    10

    20 40 60

    D

    G

    H E

    B

    A

    J

    FIGURE 3.1 Weekly Baskets of Food and Clothing Seven possible weekly baskets of food and clothing that consumers might purchase are illustrated by points A, B, D, E, G, H, and J.

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  • to one of the following possibilities: She prefers basket A to basket B (written A � B). She prefers basket B to basket A (written B � A). She is indifferent between, or equally happy with, baskets A and B (written A ≈ B).

    2. Preferences are transitive. By this we mean that the consumer makes choices that are consistent with each other. Suppose that a consumer tells us that she prefers basket A to basket B, and basket B to basket E. We can then expect her to prefer basket A to basket E. Using the notation we have just introduced to describe preferences, we can represent transitivity as follows: If A � B and if B � E , then A � E .

    3. More is better. In other words, having more of a good is better for the consumer. Suppose the consumer is considering the baskets in Figure 3.1. If more is better, she likes more food better than less food and prefers to have more clothing rather than less clothing. In that case, she would prefer basket A to E or H because she receives the same amount of clothing with these three baskets, but more food at A. She would prefer basket A to B or J because she receives the same amount of food in these three baskets, but more clothing at A. She will also prefer A to G or D because she receives more food and more clothing at A than at either of the other two baskets. Therefore, among the seven baskets, her most preferred basket is A. However, without further information about the con- sumer’s preferences, we do not know how she would rank every pair of baskets. For example, without further information we do not know whether she prefers E to G because she would receive more food bu

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