chapter_3 Consumer Behavior Robert Pyndick.pdf

Chapter 3
Consumer
Behavior

Chapter 3: Consumer Behavior Slide 2
Topics to be Discussed
Consumer Preferences
Budget Constraints
Consumer Choice
Revealed Preferences

Chapter 3: Consumer Behavior Slide 3
Topics to be Discussed
Marginal Utility and Consumer Choices
Cost-of-Living Indexes

Chapter 3: Consumer Behavior Slide 4
Consumer Behavior
Two applications that illustrate the
importance of the economic theory of
consumer behavior are:
Apple-Cinnamon Cheerios
The Food Stamp Program.

Chapter 3: Consumer Behavior Slide 5
Consumer Behavior
General Mills had to determine how
high a price to charge for Apple-
Cinnamon Cheerios before it went to
the market.

Chapter 3: Consumer Behavior Slide 6
Consumer Behavior
When the food stamp program was
established in the early 1960s, the
designers had to determine to what
extent the food stamps would provide
people with more food and not just
simply subsidize the food they would
have bought anyway.

Chapter 3: Consumer Behavior Slide 7
Consumer Behavior
These two problems require an
understanding of the economic theory of
consumer behavior.

Chapter 3: Consumer Behavior Slide 8
Consumer Behavior
There are three steps involved in the
study of consumer behavior.
1) We will study consumer preferences.
To describe how and why people prefer
one good to another.

Chapter 3: Consumer Behavior Slide 9
Consumer Behavior
There are three steps involved in the
study of consumer behavior.
2)Then we will turn to budget
constraints.
People have limited incomes.

Chapter 3: Consumer Behavior Slide 10
Consumer Behavior
There are three steps involved in the
study of consumer behavior.
3) Finally, we will combine consumer
preferences and budget constraints
to determine consumer choices.
What combination of goods will
consumers buy to maximize their
satisfaction?

Chapter 3: Consumer Behavior Slide 11
Consumer Preferences
A market basketis 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

Chapter 3: Consumer Behavior Slide 12
Consumer Preferences
Three Basic Assumptions
1) Preferences are complete.
2) Preferences are transitive.
3) Consumers always prefer more of
any good to less.
Market Baskets

Chapter 3: Consumer Behavior Slide 13
Consumer Preferences
A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
Market BasketUnits of FoodUnits of Clothing

Chapter 3: Consumer Behavior Slide 14
Consumer Preferences
Indifference curvesrepresent all
combinations of market baskets that
provide the same level of satisfaction to
a person.
Indifference Curves

Chapter 3: Consumer Behavior Slide 15
The consumer prefers
Ato all combinations
in the blue box, while
all those in the pink
box are preferred to A.
Consumer Preferences
Food
(units per week)
10
20
30
40
10 20 30 40
Clothing
(units per week)
50
G
A
EH
B
D

Chapter 3: Consumer Behavior Slide 16
U
1
Combination B,A, & D
yield the same satisfaction
•E is preferred to U
1
•U
1is preferred to H & G
Consumer Preferences
Food
(units per week)
10
20
30
40
10 20 30 40
Clothing
(units per week)
50
G
D
A
E
H
B

Chapter 3: Consumer Behavior Slide 17
Consumer Preferences
Indifference Curves
Indifference curves slope downward to the
right.
If it sloped upward it would violate the
assumption that more of any commodity
is preferred to less.

Chapter 3: Consumer Behavior Slide 18
Consumer Preferences
Indifference Curves
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.

Chapter 3: Consumer Behavior Slide 19
Consumer Preferences
An indifference mapis a set of
indifference curves that describes a
person’s preferences for all
combinations of two commodities.
Each indifference curve in the map shows
the market baskets among which the
person is indifferent.
Indifference Maps

Chapter 3: Consumer Behavior Slide 20
Consumer Preferences
Indifference Curves
Finally, indifference curves cannot cross.
This would violate the assumption that
more is preferred to less.

Chapter 3: Consumer Behavior Slide 21
U
2
U
3
Consumer Preferences
Food
(units per week)
Clothing
(units per week)
U
1
A
B
D
Market basket A
is preferred to B.
Market basket Bis
preferred to D.

Chapter 3: Consumer Behavior Slide 22
U
1
U
2
Consumer Preferences
Food
(units per week)
Clothing
(units per week)
A
D
B
The consumer should
be indifferent between
A, Band D. However,
Bcontains more of
both goods than D.
Indifference Curves
Cannot Cross

Chapter 3: Consumer Behavior Slide 23
A
B
D
E
G
-1
-6
1
1
-4
-2
1
1
Observation: The amount
of clothing given up for
a unit of food decreases
from 6 to 1
Consumer Preferences
Food
(units per week)
Clothing
(units
per week)
2 3 4 51
2
4
6
8
10
12
14
16
Question: Does this
relation hold for giving
up food to get clothing?

Chapter 3: Consumer Behavior Slide 24
Consumer Preferences
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.
Marginal Rate of Substitution

Chapter 3: Consumer Behavior Slide 25
Consumer Preferences
Food
(units per week)
Clothing
(units
per week)
2 3 4 51
2
4
6
8
10
12
14
16
A
B
D
E
G
-6
1
1
1
1
-4
-2
-1
MRS= 6
MRS= 2F
C
MRS




Chapter 3: Consumer Behavior Slide 26
Consumer Preferences
We will now add a fourth assumption
regarding consumer preference:
Along an indifference curve there is a
diminishing marginal rate of substitution.
Note the MRSfor ABwas 6, while that
for DEwas 2.
Marginal Rate of Substitution

Chapter 3: Consumer Behavior Slide 27
Consumer Preferences
Question
What are the first three assumptions?
Marginal Rate of Substitution

Chapter 3: Consumer Behavior Slide 28
Consumer Preferences
Indifference curves are convex because
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.
Consumers prefer a balanced market
basket
Marginal Rate of Substitution

Chapter 3: Consumer Behavior Slide 29
Consumer Preferences
Perfect Substitutes and Perfect
Complements
Two goods are perfect substitutes when
the marginal rate of substitution of one
good for the other is constant.
Marginal Rate of Substitution

Chapter 3: Consumer Behavior Slide 30
Consumer Preferences
Perfect Substitutes and Perfect
Complements
Two goods are perfect complements when
the indifference curves for the goods are
shaped as right angles.
Marginal Rate of Substitution

Chapter 3: Consumer Behavior Slide 31
Consumer Preferences
Orange Juice
(glasses)
Apple
Juice
(glasses)
2 3 41
1
2
3
4
0
Perfect
Substitutes

Chapter 3: Consumer Behavior Slide 32
Consumer Preferences
Right Shoes
Left
Shoes
2 3 41
1
2
3
4
0
Perfect
Complements

Chapter 3: Consumer Behavior Slide 33
Consumer Preferences
BADS
Things for which less is preferred to more
Examples
Air pollution
Asbestos

Chapter 3: Consumer Behavior Slide 34
Consumer Preferences
What Do You Think?
How can we account for Bads in the
analysis of consumer preferences?

Chapter 3: Consumer Behavior Slide 35
Consumer Preferences
Automobile executives must regularly
decide when to introduce new models
and how much money to invest in
restyling.
Designing New Automobiles (I)

Chapter 3: Consumer Behavior Slide 36
Consumer Preferences
An analysis of consumer preferences
would help to determine when and if car
companies should change the styling of
their cars.
Designing New Automobiles (I)

Chapter 3: Consumer Behavior Slide 37
Consumer Preferences
These consumers are
willing to give up
considerable
styling for additional
performance
Styling
Performance
Consumer
Preference A:
High MRS

Chapter 3: Consumer Behavior Slide 38
Consumer Preferences
These consumers are
willing to give up
considerable
performance for
additional styling
Styling
Performance
Consumer
Preference B:
Low MRS

Chapter 3: Consumer Behavior Slide 39
Consumer Preferences
What Do You Think?
How can we determine the consumers
preference?
Designing New Automobiles (I)

Chapter 3: Consumer Behavior Slide 40
Consumer Preferences
A recent study of automobile demand in
the United States shows that over the
past two decades most consumers have
preferred styling over performance.
Designing New Automobiles (I)

Chapter 3: Consumer Behavior Slide 41
Consumer Preferences
Growth of Japanese Imports
1970’s and 1980’s
15% of domestic cars underwent a style
change each year
This compares to 23% for imports
Designing New Automobiles (I)

Chapter 3: Consumer Behavior Slide 42
Consumer Preferences
Utility
Utility: Numerical score representing the
satisfaction that a consumer gets from a
given market basket.

Chapter 3: Consumer Behavior Slide 43
Consumer Preferences
Utility
If buying 3 copies of Microeconomics
makes you happier than buying one shirt,
then we say that the books give you more
utility than the shirt.

Chapter 3: Consumer Behavior Slide 44
Consumer Preferences
Utility Functions
Assume:
The utility function for food (F) and clothing (C)
U(F,C) = F + 2C
Market Baskets: F units C units U(F,C) = F + 2C
A 8 3 8 + 2(3) = 14
B 6 4 6 + 2(4) = 14
C 4 4 4 + 2(4) = 12
The consumer is indifferent to A & B
The consumer prefers A & B to C

Chapter 3: Consumer Behavior Slide 45
Consumer Preferences
Food
(units per week)10 155
5
10
15
0
Clothing
(units
per week)
U
1= 25
U
2= 50 (Preferred to U
1)
U
3= 100 (Preferred to U
2)
A
B
C
Assume: U = FC
Market Basket U = FC
C 25 = 2.5(10)
A 25 = 5(5)
B 25 = 10(2.5)
Utility Functions & Indifference Curves

Chapter 3: Consumer Behavior Slide 46
Consumer Preferences
Ordinal Versus Cardinal Utility
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.
Cardinal Utility Function: utility function
describing the extent to which one market
basket is preferred to another.

Chapter 3: Consumer Behavior Slide 47
Consumer Preferences
Ordinal Versus Cardinal Rankings
The actual unit of measurement for utility is
not important.
Therefore, an ordinal ranking is sufficient to
explain how most individual decisions are
made.

Chapter 3: Consumer Behavior Slide 48
Budget Constraints
Preferences do not explain all of
consumer behavior.
Budget constraintsalso limit an
individual’s ability to consume in light of
the prices they must pay for various
goods and services.

Chapter 3: Consumer Behavior Slide 49
Budget Constraints
The Budget Line
The budget lineindicates all combinations
of two commodities for which total money
spent equals total income.

Chapter 3: Consumer Behavior Slide 50
Budget Constraints
The Budget Line
Let F equal the amount of food purchased,
and C is the amount of clothing.
Price of food = P
fand price of
clothing = P
c
Then P
fFis the amount of money spent on
food, and P
cCis the amount of money
spent on clothing.

Chapter 3: Consumer Behavior Slide 51
Budget Constraints
The budget line then can be written:ICPFP CF 

Chapter 3: Consumer Behavior Slide 52
Budget Constraints
A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
Market BasketFood (F)Clothing (C)Total Spending
P
f = ($1)P
c= ($2) P
fF + P
cC = I

Chapter 3: Consumer Behavior Slide 53
Budget Line F + 2C = $80CF/PPFC -
2
1
- /  Slope
10
20
(I/P
C) = 40
Budget Constraints
Food
(units per week)40 60 80 = (I/P
F)20
10
20
30
0
A
B
D
E
G
Clothing
(units
per week)
Pc= $2 P
f= $1 I = $80

Chapter 3: Consumer Behavior Slide 54
Budget Constraints
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.

Chapter 3: Consumer Behavior Slide 55
Budget Constraints
The Budget Line
The slope indicates the rate at which the
two goods can be substituted without
changing the amount of money spent.

Chapter 3: Consumer Behavior Slide 56
Budget Constraints
The Budget Line
The vertical intercept (I/P
C), illustrates the
maximum amount of C that can be
purchased with income I.
The horizontal intercept (I/P
F), illustrates
the maximum amount of F that can be
purchased with income I.

Chapter 3: Consumer Behavior Slide 57
Budget Constraints
The Effects of Changes in Income and
Prices
Income Changes
An increase in income causes the
budget line to shift outward, parallel to
the original line (holding prices
constant).

Chapter 3: Consumer Behavior Slide 58
Budget Constraints
The Effects of Changes in Income and
Prices
Income Changes
A decrease in income causes the budget
line to shift inward, parallel to the original
line (holding prices constant).

Chapter 3: Consumer Behavior Slide 59
Budget Constraints
Food
(units per week)
Clothing
(units
per week)
80 120 16040
20
40
60
80
0
A increase in
income shifts
the budget line
outward
(I= $160)
L
2
(I= $80)
L
1
L
3
(I=
$40)
A decrease in
income shifts
the budget line
inward

Chapter 3: Consumer Behavior Slide 60
Budget Constraints
The Effects of Changes in Income and
Prices
Price Changes
If the price of one good increases, the
budget line shifts inward, pivoting from
the other good’s intercept.

Chapter 3: Consumer Behavior Slide 61
Budget Constraints
The Effects of Changes in Income and
Prices
Price Changes
If the price of one good decreases, the
budget line shifts outward, pivoting from
the other good’s intercept.

Chapter 3: Consumer Behavior Slide 62
Budget Constraints
Food
(units per week)
Clothing
(units
per week)
80 120 16040
40
(P
F= 1)
L
1
An increase in the
price of food to
$2.00 changes
the slope of the
budget line and
rotates it inward.
L
3
(P
F = 2)
(P
F= 1/2)
L
2
A decrease in the
price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.

Chapter 3: Consumer Behavior Slide 63
Budget Constraints
The Effects of Changes in Income and
Prices
Price Changes
If the two goods increase in price, but
the ratio of the two prices is unchanged,
the slope will not change.

Chapter 3: Consumer Behavior Slide 64
Budget Constraints
The Effects of Changes in Income and
Prices
Price Changes
However, the budget line will shift inward
to a point parallel to the original budget
line.

Chapter 3: Consumer Behavior Slide 65
Budget Constraints
The Effects of Changes in Income and
Prices
Price Changes
If the two goods decrease in price, but
the ratio of the two prices is unchanged,
the slope will not change.

Chapter 3: Consumer Behavior Slide 66
Budget Constraints
The Effects of Changes in Income and
Prices
Price Changes
However, the budget line will shift
outward to a point parallel to the original
budget line.

Chapter 3: Consumer Behavior Slide 67
Consumer Choice
Consumers choose a combination of
goods that will maximize the satisfaction
they can achieve, given the limited
budget available to them.

Chapter 3: Consumer Behavior Slide 68
Consumer Choice
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.

Chapter 3: Consumer Behavior Slide 69
Recall, the slope of an indifference curve is:
Consumer ChoiceF
C
MRS


 C
F
P
P
Slope
Further, the slope of the budget line is:

Chapter 3: Consumer Behavior Slide 70
Consumer Choice
Therefore, it can be said that
satisfaction is maximized where: C
F
P
P
MRS

Chapter 3: Consumer Behavior Slide 71
Consumer Choice
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).

Chapter 3: Consumer Behavior Slide 72
Consumer Choice
Food (units per week)
Clothing
(units per
week)
40 8020
20
30
40
0
U
1
B
Budget Line
Pc= $2 P
f= $1 I = $80
Point Bdoes not
maximize satisfaction
because the
MRS (-(-10/10) = 1
is greater than the
price ratio (1/2).
-10C
+10F

Chapter 3: Consumer Behavior Slide 73
Consumer Choice
Budget Line
U
3
D Market basket D
cannot be attained
given the current
budget constraint.
Pc= $2 P
f= $1 I = $80
Food (units per week)
Clothing
(units per
week)
40 8020
20
30
40
0

Chapter 3: Consumer Behavior Slide 74
U
2
Consumer Choice
Pc= $2 P
f= $1 I = $80
Budget Line
A
At market basket A
the budget line and the
indifference curve are
tangent and no higher
level of satisfaction
can be attained.
At A:
MRS =P
f/P
c= .5
Food (units per week)
Clothing
(units per
week)
40 8020
20
30
40
0

Chapter 3: Consumer Behavior Slide 75
Consumer Choice
Consider two groups of consumers,
each wishing to spend $10,000 on the
styling and performance of cars.
Each group has different preferences.
Designing New Automobiles (II)

Chapter 3: Consumer Behavior Slide 76
Consumer Choice
By finding the point of tangency
between a group’s indifference curve
and the budget constraint auto
companies can design a production and
marketing plan.
Designing New Automobiles (II)

Chapter 3: Consumer Behavior Slide 77
Designing New Automobiles (II)
Styling
Performance$10,000
$10,000
$3,000
These consumers
are willing to trade
off a considerable
amount of styling
for some additional
performance
$7,000

Chapter 3: Consumer Behavior Slide 78
Designing New Automobiles (II)
Styling
$10,000
$10,000
$3,000
These consumers
are willing to trade
off a considerable
amount of
performance for
some additional
styling
$7,000
Performance

Chapter 3: Consumer Behavior Slide 79
Consumer Choice
Choosing between a non-matching and
matching grant to fund police
expenditures
Decision Making & Public Policy

Chapter 3: Consumer Behavior Slide 80
Consumer Choice
Non-matching Grant
Police
Expenditures ($)
Private
Expenditures ($)
O
P
Q
U
1
A
Before Grant
•Budget line: PQ
•A: Preference maximizing
market basket
•Expenditure
•OR: Private
•OS: Police
R
S

Chapter 3: Consumer Behavior Slide 81
V
T
U
3
U
1
After Grant
•Budget line: TV
•B: Preference maximizing
market basket
•Expenditure
•OU: Private
•OZ: Police
B
U
Z
R
Consumer Choice
Non-matching Grant
P
Police
Expenditures ($)
Private
Expenditures ($)
O S Q
A

Chapter 3: Consumer Behavior Slide 82
P
R
U
2
T
U
1
Consumer Choice
Matching Grant
Police ($)
Private
Expenditures ($)
O QS
R
Before Grant
•Budget line: PQ
•A: Preference maximizing
market basket
After Grant
•C: Preference maximizing
market basket
Expenditures
•OW: Private
•OX: Police
C
X
W A

Chapter 3: Consumer Behavior Slide 83
T
U
3
U
1
Nonmatching Grant
•Point B
•OU: Private expenditure
•OZ: Police expenditure
Matching Grant
•Point C
•OW: Private expenditure
•OX: Police expenditure
W
X
Consumer Choice
Matching Grant
P
Police ($)
Private
Expenditures ($)
O Q
A
U
2
C
R
BU
Z

Chapter 3: Consumer Behavior Slide 84
Consumer Choice
A corner solution exists if a consumer
buys in extremes, and buys all of one
category of good and none of another.
This exists where the indifference curves
are tangent to the horizontal and vertical
axis.
MRS is notequal to P
A/P
B
A Corner Solution

Chapter 3: Consumer Behavior Slide 85
A Corner Solution
Ice Cream (cup/month)
Frozen
Yogurt
(cups
monthly)
B
A
U
2U
3U
1
A corner solution
exists at point B.

Chapter 3: Consumer Behavior Slide 86
Consumer Choice
A Corner Solution
At point B, the MRSof ice cream for frozen
yogurt is greater than the slope of the
budget line.
This suggests that if the consumer could
give up more frozen yogurt for ice cream
he would do so.
However, there is no more frozen yogurt to
give up!

Chapter 3: Consumer Behavior Slide 87
Consumer Choice
A Corner Solution
When a corner solution arises, the
consumer’s MRS does not necessarily
equal the price ratio.
In this instance it can be said that:YogurtFrozenIceCreamPPMRS /

Chapter 3: Consumer Behavior Slide 88
Consumer Choice
A Corner Solution
If the MRS is, in fact, significantly greater
than the price ratio, then a small decrease
in the price of frozen yogurt will notalter
the consumer’s market basket.

Chapter 3: Consumer Behavior Slide 89
Consumer Choice
Suppose Jane Doe’s parents set up a
trust fund for her college education.
Originally, the money must be used for
education.
A College Trust Fund

Chapter 3: Consumer Behavior Slide 90
Consumer Choice
If part of the money could be used for
the purchase of other goods, her
consumption preferences change.
A College Trust Fund

Chapter 3: Consumer Behavior Slide 91
The trust fund shifts the budget line
Consumer Choice
P
Q Education ($)
Other
Consumption
($)
U
2
A College Trust Fund
A
U
1
A: Consumption before the trust fund
B
B: Requirement that the trust fund
must be spent on education
C
U
3C: If the trust could be spent on
other goods

Chapter 3: Consumer Behavior Slide 92
Revealed Preferences
If we know the choices a consumer has
made, we can determine what her
preferences are if we have information
about a sufficient number of choices
that are made when prices and incomes
vary.

Chapter 3: Consumer Behavior Slide 93
D
Revealed Preferences--
Two Budget Lines
l
1
l
2
B
A
I
1: Chose A over B
A is revealed preferred to B
l
2: Choose B over D
B is revealed preferred to D
Food (units per month)
Clothing
(units per
month)

Chapter 3: Consumer Behavior Slide 94
B is preferred to
all market baskets
in the green area
Revealed Preferences--
Two Budget Lines
l
2
B
l
1
D
A
All market baskets
in the pink
shaded area are
preferred to A.
Food (units per month)
Clothing
(units per
month)

Chapter 3: Consumer Behavior Slide 95
All market baskets in the
pink area preferred to A
Food (units per month)
Revealed Preferences--
Four Budget Lines
Clothing
(units per
month)
l
1
l
2
l
3
l
4
A: preferred to all
market baskets in
the green area
E
B
A
G
I
3: E revealed preferred to A
I
4: G revealed preferred to A

Chapter 3: Consumer Behavior Slide 96
Amount of Exercise
(hours)
Revealed Preferences for Recreation
Other
Recreational
Activities
($)
0 25 50 75
20
40
60
80
100
l
1
C
l
2
U
2
B
•The rate changes to $1/hr + $30/wk
•New budget line I
2& combination B
•Reveal preference of B to A
U
1
A
Scenario
•Roberta’s recreation budget = $100/wk
•Price of exercise = $4/hr/week
•Exercises 10 hrs/wk at Agiven U
1& I
1
Would the Club’s
profits increase?

Chapter 3: Consumer Behavior Slide 97
Marginal utility measures the additional
satisfaction obtained from consuming
one additional unit of a good.
Marginal Utility and
Consumer Choice
Marginal Utility

Chapter 3: Consumer Behavior Slide 98
Example
The marginal utility derived from increasing
from 0 to 1 units of food might be 9
Increasing from 1 to 2 might be 7
Increasing from 2 to 3 might be 5
Observation: Marginal utility is
diminishing
Marginal Utility
Marginal Utility and
Consumer Choice

Chapter 3: Consumer Behavior Slide 99
The principle of diminishing marginal
utilitystates that as more and more of a
good is consumed, consuming
additional amounts will yield smaller and
smaller additions to utility.
Diminishing Marginal Utility
Marginal Utility and
Consumer Choice

Chapter 3: Consumer Behavior Slide 100
Marginal Utility and the Indifference
Curve
If consumption moves along an
indifference curve, the additional utility
derived from an increase in the
consumption one good, food (F), must
balance the loss of utility from the
decrease in the consumption in the other
good, clothing (C).
Marginal Utility and
Consumer Choice

Chapter 3: Consumer Behavior Slide 101
Formally:C)( MUF) (MU CF 0
Marginal Utility and
Consumer Choice

Chapter 3: Consumer Behavior Slide 102
Rearranging:
Marginal Utility and
Consumer Choice 
CF
MUMUFC //

Chapter 3: Consumer Behavior Slide 103
Because:CF/MU MUMRS 
Marginal Utility and
Consumer Choice 
CF
MUMUFC //   C for F of MRSFC /

Chapter 3: Consumer Behavior Slide 104
When consumers maximize satisfaction
the:CF/P PMRS  CFC F /P P /MUMU 
Marginal Utility and
Consumer Choice
Since the MRS is also equal to the ratio
of the marginal utilities of consuming F
and C, it follows that:

Chapter 3: Consumer Behavior Slide 105
Which gives the equation for utility
maximization:CCFF
PMUPMU //
Marginal Utility and
Consumer Choice

Chapter 3: Consumer Behavior Slide 106
Total utility is maximized when the
budget is allocated so that the marginal
utility per dollar of expenditure is the
same for each good.
This is referred to as the equal marginal
principle.
Marginal Utility and
Consumer Choice

Chapter 3: Consumer Behavior Slide 107
In 1974 and again in 1979, the
government imposed price controls on
gasoline.
This resulted in shortages and gasoline
was rationed.
Gasoline Rationing
Marginal Utility and
Consumer Choice

Chapter 3: Consumer Behavior Slide 108
Nonprice rationing is an alternative to
market rationing.
Under one form everyone has an equal
chance to purchase a rationed good.
Gasoline is rationed by long lines at the
gas pumps.
Gasoline Rationing
Marginal Utility and
Consumer Choice

Chapter 3: Consumer Behavior Slide 109
Rationing hurts some by limiting the
amount of gasoline they can buy.
This can be seen in the following model.
It applies to a woman with an annual
income of $20,000.
Marginal Utility and
Consumer Choice

Chapter 3: Consumer Behavior Slide 110
The horizontal axis shows her annual
consumption of gasoline at $1/gallon.
The vertical axis shows her remaining
income after purchasing gasoline.
Marginal Utility and
Consumer Choice

Chapter 3: Consumer Behavior Slide 111
B
20,000
A
Gasoline
(gallons per year)
Spending
on other
goods ($)20,000
5,000
U
1
C
15,000
2,000
D
With a limit of
2,000 gallons,
the consumer moves
to a lower
indifference curve
(lower level of utility).
18,000
U
2
Marginal Utility and
Consumer Choice

Chapter 3: Consumer Behavior Slide 112
Cost-of-Living Indexes
The CPI is calculated each year as the
ratio of the cost of a typical bundle of
consumer goods and services today in
comparison to the cost during a base
period.

Chapter 3: Consumer Behavior Slide 113
Cost-of-Living Indexes
What Do You Think?
Does the CPI accurately reflect the cost of
living for retirees?
Is it appropriate to use the CPI as a cost-
of-living index for other government
programs, for private union pensions, and
for other private wage agreements?

Chapter 3: Consumer Behavior Slide 114
Cost-of-Living Indexes
Example
Two sisters, Rachel and Sarah, have
identical preferences.
Sarah began college in 1987 with a $500
discretionary budget.
In 1997, Rachel started college and her
parents promised her a budget that was
equivalent in purchasing power.

Chapter 3: Consumer Behavior Slide 115
Cost-of-Living Indexes
Price of books $20/book $100/book
Number of books 15 6
Price of food $2.00/lb. $2.20/lb
Pounds of food 100 300
Expenditure $500 $1,260
1987 (Sarah) 1997
(Rachel)

Chapter 3: Consumer Behavior Slide 116
Cost-of-Living Indexes
Rachel’ Expenditure for Equal Utility
$1,260 = 300 lbs. of food x $2.20/lb. + 6 books x $100/book
Sarah’ Expenditure
$500 = 100 lbs. of food x $2.00/lb. + 15 books x $20/book

Chapter 3: Consumer Behavior Slide 117
Cost-of-Living Indexes
The ideal cost-of-living adjustmentfor
Rachel is $760.
The ideal cost-of-living indexis
$1,260/$500 = 2.52 or 252.
This implies a 152% increase in the cost
of living.

Chapter 3: Consumer Behavior Slide 118
For Rachel to achieve
the same level of utility as
Sarah, with the higher
prices, her budget must
be sufficient to allow her
to consume the bundle
shown by point B.
l
2
B
l
1
U
1
A
Cost-of-Living Indexes
Food
(lb./quarter)
Books
(per quarter)
450
25
20
15
10
5
0 60050100200250300350400 550500

Chapter 3: Consumer Behavior Slide 119
Cost-of-Living Indexes
The ideal cost of living index represents
the cost of attaining a given level of utility
at current (1997) prices relative to the
cost of attaining the same utility at base
(1987) prices.

Chapter 3: Consumer Behavior Slide 120
Cost-of-Living Indexes
To do this on an economy-wide basis
would entail large amounts of information.
Price indexes, like the CPI, use a fixed
consumption bundle in the base period.
Called a Laspeyres price index

Chapter 3: Consumer Behavior Slide 121
Cost-of-Living Indexes
The Laspeyres index tells us:
The amount of money at current year prices
that an individual requires to purchase the
bundle of goods and services that was
chosen in the base year divided by the cost
of purchasing the same bundle at base
year prices.
Laspeyres Index

Chapter 3: Consumer Behavior Slide 122
Cost-of-Living Indexes
Calculating Rachel’s Laspeyres cost
of living index
Setting the quantities of goods in 1997
equal to what were bought by her sister,
but setting their prices at their 1997
levels result in an expenditure of $1,720
(100 x 2.20 + 15 x $100)

Chapter 3: Consumer Behavior Slide 123
Cost-of-Living Indexes
Her cost of living adjustment would now
be $1,220.
The Laspeyres index is:
$1,720/$500 = 344.
This overstates the true cost-of-living
increase.

Chapter 3: Consumer Behavior Slide 124
l
2
Using the Laspeyres
index results in the
budget line shifting
up from I
2to I
3.
l
3
B
l
1
U
1
A
Cost-of-Living Indexes
Food
(lb./quarter)
Books
(per quarter)
450
25
20
15
10
5
0 60050100200250300350400 550500

Chapter 3: Consumer Behavior Slide 125
Cost-of-Living Indexes
What Do You Think?
Does the Laspeyres index always overstate
the true cost-of-living index?

Chapter 3: Consumer Behavior Slide 126
Cost-of-Living Indexes
Yes!
The Laspeyres index assumes that
consumers do not alter their consumption
patterns as prices change.

Chapter 3: Consumer Behavior Slide 127
Cost-of-Living Indexes
Yes!
By increasing purchases of those items that
have become relatively cheaper, and
decreasing purchases of the relatively more
expensive items consumers can achieve the
same level of utility without having to
consume the same bundle of goods.

Chapter 3: Consumer Behavior Slide 128
Cost-of-Living Indexes
The Paasche Index
Calculates the amount of money at current-
year prices that an individual requires to
purchase a current bundle of goods and
services divided by the cost of purchasing the
same bundle in the base year.

Chapter 3: Consumer Behavior Slide 129
Cost-of-Living Indexes
Both indexes involve ratios that involve
today’s current year prices, P
Ftand P
Ct.
However, the Laspeyres index relies on
base year consumption, F
band C
b.
Whereas, the Paasche index relies on
today’s current consumption, F
tand C
t.
Comparing the Two Indexes

Chapter 3: Consumer Behavior Slide 130
Cost-of-Living Indexes
Then a comparison of the Laspeyres and
Paasche indexes gives the following
equations:tCttFt
tCttFt
CPFP
CPFP
LI


 tCttFb
tCttFb
CPFP
CPFP
PI




Chapter 3: Consumer Behavior Slide 131
Cost-of-Living Indexes
Suppose:
Two goods: Food (F) and Clothing (C)
Comparing the Two Indexes

Chapter 3: Consumer Behavior Slide 132
Cost-of-Living Indexes
Let:
P
Ft & P
Ctbe current year prices
P
Fb & P
Cbbe base year prices
F
t & C
tbe current year quantities
F
b & C
bbe base year quantities
Comparing the Two Indexes

Chapter 3: Consumer Behavior Slide 133
Cost-of-Living Indexes
Sarah (1990)
Cost of base-year bundle at current prices
equals $1,720 (100 lbs x $2.20/lb + 15 books
x $100/book)
Cost of same bundle at base year prices is
$500 (100 lbs x $2.00/lb + 15 books x
$20/book)
Comparing the Two Indexes

Chapter 3: Consumer Behavior Slide 134
Cost-of-Living Indexes
Sarah (1990)
Comparing the Two Indexes344
500
7201

$
,$
LI

Chapter 3: Consumer Behavior Slide 135
Cost-of-Living Indexes
Sarah (1990)
Cost of buying current year bundle at current
year prices is $1,260 (300 lbs x $2.20/lb + 6
books x $100/book)
Cost of the same bundle at base year prices
is $720 (300 lbs x $2/lb + 6 books x
$20/book)
Comparing the Two Indexes

Chapter 3: Consumer Behavior Slide 136
Cost-of-Living Indexes
Sarah (1990)
Comparing the Two Indexes175
720
2601

$
,$
PI

Chapter 3: Consumer Behavior Slide 137
Cost-of-Living Indexes
The Paasche index will understate the
cost of living because it assumes that the
individual will buy the current year bundle
in the base year.
The Paasche Index

Chapter 3: Consumer Behavior Slide 138
Cost-of-Living Indexes
In 1995, the government adopted the
chain-weightedprice index to deflate its
measure of real GDP.
Developed to overcome problems that arose
when long-term comparisons of GDP were
made using fixed-weight price indexes and
prices were rapidly changing.

Chapter 3: Consumer Behavior Slide 139
Cost-of-Living Indexes
What Do You Think?
What is the impact on the Federal budget of
using the CPI (a Laspeyres index) to adjust
social security and other programs for
changes in the cost of living?
The Bias of the CPI

Chapter 3: Consumer Behavior Slide 140
Summary
People behave rationally in an attempt
to maximize satisfaction from a
particular combination of goods and
services.
Consumer choice has two related parts:
the consumer’s preferences and the
budget line.

Chapter 3: Consumer Behavior Slide 141
Summary
Consumers make choices by comparing
market baskets or bundles of
commodities.
Indifference curves are downward
sloping and cannot intersect one
another.
Consumer preferences can be
completely described by an indifference
map.

Chapter 3: Consumer Behavior Slide 142
Summary
The marginal rate of substitution of F for
C is the maximum amount of Cthat a
person is willing to give up to obtain one
additional unit of F.
Budget lines represent all combinations
of goods for which consumers expend
all their income.

Chapter 3: Consumer Behavior Slide 143
Summary
Consumers maximize satisfaction
subject to budget constraints.
The theory of revealed preference
shows how the choices that individuals
make when prices and income vary can
be used to determine their preferences.

End of Chapter 3
Consumer
Behavior

chapter_3 Consumer Behavior Robert Pyndick.pdf

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