Lecture 4 Microeconomics microecon micro

Microeconomics

1. Chapter 3: Consumer Behavior
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CHAPTER 3 OUTLINE
3.1Consumer Preferences
3.2Budget Constraints
3.3Consumer Choice
3.4Revealed Preference
3.5Marginal Utility and Consumer Choice

2. Chapter 3: Consumer Behavior
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Consumer Behavior
●theory of consumer behavior Description of how
consumers allocate incomes among different goods and
services to maximize their well-being.
Consumer behavior is best understood in three distinct steps:
1.Consumer preferences: how and why people prefer one goof to
another
2.Budget constraints: people have limited incomes
3.Consumer choices: what combination of goods consumers buy

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Chapter 3 3©2005 Pearson Education, Inc.
CONSUMER PREFERENCES
•How might a consumer compare different groups of items available
for purchase?
•A market basketis a collection of one or more commodities
•Individuals can choose between market baskets containing different
goods

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CONSUMER PREFERENCES3.1
Market Baskets
●market basket (orbundle)List with specific quantities
of one or more goods.
TABLE 3.1 Alternative Market Baskets
A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
Market Basket Units of Food Units of Clothing
To explain the theory of consumer behavior, we will ask
whether consumers prefer one market basket to another.

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CONSUMER PREFERENCES3.1
Some Basic Assumptions about Preferences
1.Completeness: Preferences are assumed to be complete.
In other words, consumers can compare and rank all possible
baskets. Thus, for any two market baskets A and B, a consumer
will prefer A to B, will prefer B to A, or will be indifferent between
the two.
By indifferent we mean that a person will be equally satisfied
with either basket.
Note that these preferences ignore costs. A consumer might
prefer steak to hamburger but buy hamburger because it is
cheaper.

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CONSUMER PREFERENCES3.1
Some Basic Assumptions about Preferences
2.Transitivity:
if a consumer prefers basket A to basket B and basket B to
basket C, then the consumer also prefers A to C.
Transitivity is normally regarded as necessary for consumer
consistency.
3.More is better than 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 satisfied or satiated;
more is always better, even if just a little better.

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Describing Individual Preferences
Because more of each good is
preferred to less, we can
compare market baskets in the
shaded areas. Basket Ais clearly
preferred to basket G, while Eis
clearly preferred to A.
However, Acannot be compared
with B, D, or Hwithout additional
information.
CONSUMER PREFERENCES3.1
Figure 3.1

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The indifference curve U
1that
passes through market basket
Ashows all baskets that give
the consumer the same level of
satisfaction as does market
basket A; these include
baskets Band D.
An Indifference Curve
CONSUMER PREFERENCES3.1
Figure 3.2
Indifference Curves: Consumer preferences represented graphically
●indifference curve Curve representing all combinations of market
baskets that provide a consumer with the same level of satisfaction.
Our consumer prefers basket
E, which lies above U
1, to A,
but prefers Ato Hor G, which
lie below U
1.

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An indifference map is a set of
indifference curves that
describes a person's
preferences.
An Indifference Map
CONSUMER PREFERENCES3.1
Figure 3.3
Indifference Maps
●indifference map Graph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.
Any market basket on
indifference curve U
3, such as
basket A, is preferred to any
basket on curve U
2(e.g.,
basket B), which in turn is
preferred to any basket on U
1,
such as D.

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If indifference curves U
1and U
2
intersect, one of the
assumptions of consumer
theory is violated.
Indifference Curves Cannot Intersect
CONSUMER PREFERENCES3.1
Figure 3.4
Indifference Maps
According to this diagram, the
consumer should be indifferent
among market baskets A, B,
and D. Yet Bshould be
preferred to Dbecause Bhas
more of both goods.

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If they sloped upward, they would
violate the assumption that more is
preferred to less
Some points that had more of
both goods would be
indifferent to a basket with less
of both goods
Indifference Curves Slope Downward
CONSUMER PREFERENCES3.1
Indifference Curves

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The shapes of indifference curves
describe how a consumer is willing
to substitute one good for another
A to B, give up 6 clothing to get 1 food
D to E, give up 2 clothing to get 1 food
The more clothing and less food a
person has, the more clothing they
will give up to get more food
CONSUMER PREFERENCES3.1
Indifference Curves
A
B
D
E
G
-1
-6
1
1
-4
-2
1
1
Food
Clothing
2 3 4 51
2
4
6
8
10
12
14
16

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The slope of an indifference curve
measures the consumer’s marginal
rate of substitution (MRS) between two
goods.
The Marginal Rate of Substitution
CONSUMER PREFERENCES3.1
Figure 3.5
The Marginal Rate of Substitution
In this figure, the MRS between clothing
(C) and food (F) falls from 6 (between A
and B) to 4 (between Band D) to 2
(between Dand E) to 1 (between Eand
G).
ConvexityThe decline in the MRS
reflects a diminishing marginal rate of
substitution. When the MRS
diminishes along an indifference curve,
the curve is convex.
●marginal rate of substitution (MRS) the amount of a good that a
consumer is willing to give up in order to obtain one additional unit of
another good.F
C
MRS




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CONSUMER PREFERENCES3.1
Perfect Substitutes and Perfect Complements
●perfect substitutes Two goods for which
the marginal rate of substitution of one for the
other is a constant.
Example: a person might consider apple juice
and orange juice perfect substitutes.
They would always trade 1 glass of OJ for 1
glass of Apple Juice

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In (a),Bob views orange juice and
apple juice as perfect substitutes:
He is always indifferent between a
glass of one and a glass of the
other.
Perfect Substitutes and Perfect Complements
CONSUMER PREFERENCES3.1
Figure 3.6
Perfect Substitutes and Perfect Complements
In (b), Jane views left shoes and
right shoes as perfect complements:
An additional left shoe gives her no
extra satisfaction unless she also
obtains the matching right shoe.

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CONSUMER PREFERENCES3.1
Perfect Substitutes and Perfect Complements
●perfect complements Two goods for which the MRS is
zero or infinite; the indifference curves are shaped as right
angles.
Example: If you have 1 left shoe and 1 right shoe, you are
indifferent between having more left shoes only
Must have one right for one left
Good for which less is preferred rather than more.
Bads
How do we account for badsin our preference analysis?
We redefine the commodity
•Clean air
•Pollution reduction
•Asbestos removal

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Preferences for automobile attributes can be described by
indifference curves. Each curve shows the combination of
acceleration and interior space that give the same satisfaction.
Preferences for Automobile Attributes
CONSUMER PREFERENCES3.1
Owners of Ford Mustang coupes (a)are
willing to give up considerable interior
space for additional acceleration.
Figure 3.7
The opposite is true for owners of
Ford Explorers (b). They prefer
interior space to acceleration.

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Chapter 3 18©2005 Pearson Education, Inc.
Consumer Preferences: An Application
•In designing new cars, automobile executives
must determine how much time and money to
invest in restyling versus increased performance
-Higher demand for car with better styling and performance
-Both cost more to improve

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Chapter 3 19©2005 Pearson Education, Inc.
Consumer Preferences: An Application
•An analysis of consumer preferences would help to
determine where to spend more on change: performance
or styling
•Some consumers will prefer better styling and some will
prefer better performance

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Consumer Preferences:
An Application
These consumers
place a greater
value on
performance
than styling
Styling
Performance

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Chapter 3 21©2005 Pearson Education, Inc.
Consumer Preferences:
An Application
These consumers
place a greater
value on styling than
performance
Styling
Performance

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Chapter 3 22©2005 Pearson Education, Inc.
Consumer Preferences: An Application
•Knowing which group dominates the market will help
decide where redesigning dollars should go

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CONSUMER PREFERENCES3.1
A utility function can be
represented by a set of
indifference curves, each
with a numerical
indicator.
This figure shows three
indifference curves (with
utility levels of 25, 50,
and 100, respectively)
associated with the utility
function FC.
Utility and Utility Functions
●utility Numerical score representing the satisfaction from a given
market basket.
●utility function Formula that assigns a level of utility to individual
market baskets.
Utility Functions and Indifference Curves
Figure 3.8
BasketU = FC
C 25 = 2.5(10)
A 25 = 5(5)
B 25 = 10(2.5)

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Chapter 3 24©2005 Pearson Education, Inc.
Utility –Example
U(F,C) = F + 2C
Market
Basket
FoodClothing Utility
A 8 3 8 + 2(3) = 14
B 6 4 6 + 2(4) = 14
C 4 4 4 + 2(4) = 12
Consumer is indifferent between A & B and
prefers both to C

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CONSUMER PREFERENCES3.1
Ordinal versus Cardinal Utility
●ordinal utility function Utility function that generates a
ranking of market baskets in order of most to least
preferred.
●cardinal utility function Utility function describing
by how much one market basket is preferred to
another.
●ordinal ranking is sufficient to explain how
most individuals decisions are made!

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Clothing (C)
BUDGET CONSTRAINTS3.2
Example: Assume income of $80/week, P
F= $1 and P
C= $2
The Budget Line
●budget constraints Constraintsthat consumers face
as a result of limited incomes.
●budget line All combinations of 2 goods for which total
money spent equals to income.
TABLE 3.2 Market Baskets and the Budget Line
A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
Market BasketFood (F) Total SpendingFC
P F P C I
(3.1)

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BUDGET CONSTRAINTS3.2
A budget line describes the
combinations of goods that can be
purchased given the consumer’s
income and the prices of the goods.
Line AG(which passes through
points B, D, and E) shows the
budget associated with an income
of $80, a price of food of P
F= $1 per
unit, and a price of clothing of P
C=
$2 per unit.
The slope of the budget line
(measured between points Band D)
is −P
F/P
C= −10/20 = −1/2.
The Budget Line
A Budget Line
Figure 3.10( / ) ( / )
C F C
C I P P P F
(3.2)

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BUDGET CONSTRAINTS3.2
Income ChangesA change in
income (with prices unchanged)
causes the budget line to shift
parallel to the original line (L
1).
When the income of $80 (onL
1) is
increased to $160, the budget line
shifts outward to L
2.
If the income falls to $40, the line
shifts inward to L
3.
The Effects of Changes in Income and Prices
Effects of a Change in Income on the
Budget Line
Figure 3.11

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BUDGET CONSTRAINTS3.2
Price ChangesA change in the
price of one good (with income
unchanged) causes the budget line
to rotate about one intercept.
When the price of food falls from
$1.00 to $0.50, the budget line
rotates outward from L
1to L
2.
However, when the price increases
from $1.00 to $2.00, the line rotates
inward from L
1toL
3.
The Effects of Changes in Income and Prices
Effects of a Change in Price on the
Budget Line
Figure 3.12

30. Consumer Choice
•Given preferences and budget constraints,
how do consumers choose what to buy?
•Consumers choose a combination of
goods that will maximize their satisfaction,
given the limited budget available to them
Chapter 3 30©2005 Pearson Education, Inc.

31. Consumer Choice
•The maximizing market basket must
satisfy two conditions:
1.It must be located on the budget line
–They spend all their income –more is better
2.It must give the consumer the most
preferred combination of goods and
services
Chapter 3 31©2005 Pearson Education, Inc.

32. Consumer Choice
•Graphically, we can see different
indifference curves of a consumer
choosing between clothing and food
•Remember that U
3> U
2> U
1for our
indifference curves
•Consumer wants to choose highest utility
within their budget
Chapter 3 32©2005 Pearson Education, Inc.

33. Consumer Choice
Chapter 3
U
3
D
C
Food (units per week)
40 8020
Clothing
(units per
week)
20
30
40
0
U
1
A
B
•A, B, C on budget line
•D highest utility but not
affordable
•C highest affordable
utility
•Consumer chooses C

34. Consumer Choice
•Consumer will choose highest indifference
curve on budget line
•In previous graph, point C is where the
indifference curve is just tangent to the
budget line
•Slope of the budget line equals the slope
of the indifference curve at this point
Chapter 3 34

35. Consumer Choice
•Recall, the slope of an indifference curve
is:
Chapter 3 35F
C
MRS


 C
F
P
P
Slope
Further, the slope of the budget line is:

36. Consumer Choice
•Therefore, it can be said at consumer’s
optimal consumption point,
Chapter 3 36C
F
P
P
MRS

37. 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)
•Note this is ONLY true at the optimal
consumption point
Chapter 3 37

38. Consumer Choice
•Optimal consumption point is where
marginal benefits equal marginal costs
•MB = MRS = benefit associated with
consumption of 1 more unit of food
•MC = cost of additional unit of food
–1 unit food = ½ unit clothing
–P
F
/P
C
Chapter 3 38

39. Consumer Choice
•If MRS ≠ P
F/P
Cthen individuals can
reallocate basket to increase utility
•If MRS > P
F/P
C
–Will increase food and decrease clothing until
MRS = P
F
/P
C
•If MRS < P
F/P
C
–Will increase clothing and decrease food until
MRS = P
F
/P
C
Chapter 3 39

40. Consumer Choice
Chapter 3
40
Food (units per week)
Clothing
(units per
week)
40 8020
20
30
40
0
Point Bdoes not
maximize satisfaction
because the
MRS = -10/10 = 1
is greater than the
price ratio = 1/2
+10F
U
1
-10C
B

41. Consumer Choice:
An Application Revisited
•Consider two groups of consumers, each
wishing to spend $10,000 on the styling
and performance of a car
•Each group has different preferences
Chapter 3 41

42. Consumer Choice:
An Application Revisited
•By finding the point of tangency between a
group’s indifference curve and the budget
constraint, auto companies can see how
much consumers value each attribute
Chapter 3 42©2005 Pearson Education, Inc.

43. Consumer Choice:
An Application Revisited
Chapter 3
Styling
Performance$10,000
$10,000 These consumers
want performance
worth $7000 and styling
worth $3000
$3,000
$7,000

44. Consumer Choice:
An Application Revisited
Chapter 3 44©2005 Pearson Education, Inc.
These consumers
want styling worth
$7000 and
performance worth
$3000
$3,000
$7,000
Styling
$10,000
$10,000
Performance

45. Consumer Choice:
An Application Revisited
•Once a company knows preferences, it
can design a production and marketing
plan
•Company can then make a sensible
strategic business decision on how to
allocate performance and styling on new
cars
Chapter 3 45©2005 Pearson Education, Inc.

46. Consumer Choice
•A corner solutionexists if a consumer
buys in extremes, and buys all of one
category of good and none of another
–MRS is notnecessarily equal to P
A
/P
B
Chapter 3 46©2005 Pearson Education, Inc.

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

48. A Corner Solution
•At point B, the MRS of ice cream for frozen yogurt is
greater than the slope of the budget line
•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
•Opposite is true if corner solution was at point A
Chapter 3 48

49. 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:
Chapter 3 49©2005 Pearson Education, Inc.YogurtFrozen
IceCream
P
P
MRS

50. 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 not alter
the consumer’s market basket
Chapter 3 50©2005 Pearson Education, Inc.

51. A Corner Solution -Example
•Suppose Jane Doe’s parents set up a trust
fund for her college education
•The money must be used only for
education
•Although a welcome gift, an unrestricted
gift might be better
Chapter 3 51©2005 Pearson Education, Inc.

52. A Corner Solution -Example
•Original budget line, PQ, with a market
basket, A, of education and other goods
•Trust fund shifts out the budget line as
long as trust fund, PB, is spent on
education
•Jane increases satisfaction, moving to
higher indifference curve, U
2
Chapter 3 52©2005 Pearson Education, Inc.

53. A Corner Solution -Example
Chapter 3©2005 Pearson Education, Inc.
P
Q Education ($)
Other
Consumption
($)
U
2
A
U
1
B
•Jane better off
on U
2
•B is corner
solution
•MRS ≠ P
E/P
OG

54. A Corner Solution -Example
Chapter 3 54
P
Q Education ($)
Other
Consumption
($)
U
2
A
U
1
B
•If gift is
unrestricted, Jane
can be at point C
on U
3
•Better off than
with restricted gift

55. Revealed Preferences
•If we know the choices a consumer has
made, we can determine what their
preferences are if we have information
about a sufficient number of choices that
are made when prices and incomes vary.
Chapter 3 55©2005 Pearson Education, Inc.

56. Revealed Preferences –
Two Budget Lines
Chapter 3 56©2005 Pearson Education, Inc.
l
1
l
2
B
A
•I
1: Choose 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)
D

57. Revealed Preferences –
Two Budget Lines
Chapter 3 57
l
1
l
2
B
A
Food (units per month)
Clothing
(units per
month)
D
All market baskets
in the pink
shaded area are
preferred to A.
B is
preferred to
all market
baskets
in the yellow
area

58. Revealed Preference
•As you continue to change the budget line,
individuals can tell you which basket they
prefer to others
•The more the individual reveals, the more
you can discern about their preferences
•Eventually you can map out an
indifference curve
Chapter 3 58©2005 Pearson Education, Inc.

59. Marginal Utility and
Consumer Choice
•Marginal utilitymeasures the additional
satisfaction obtained from consuming one
additional unit of a good
–How much happier is the individual from
consuming one more unit of food?
Chapter 3 59©2005 Pearson Education, Inc.

60. Marginal Utility -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
as consumption increases
Chapter 3 60©2005 Pearson Education, Inc.

61. Marginal Utility
•The principle of diminishing marginal utility
states that as more of a good is
consumed, the additional utility the
consumer gains will be smaller and
smaller
•Note that total utility will continue to
increase since consumer makes choices
that make them happier
Chapter 3 61©2005 Pearson Education, Inc.

62. Marginal Utility and
Indifference Curves
•As consumption moves along an
indifference curve:
–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)
Chapter 3 62©2005 Pearson Education, Inc.

63. Marginal Utility and
Consumer Choice
•MU of any good is the rate at which total U
changes as the consumption rises, holding
constant the levels of consumption of all
other goods.
•MU of food measures how the level of
satisfaction changes (ΔU) in response to
change in the consumption of food (ΔF)
holding consumption of clothing constant.
Chapter 3 63 FUMU
F
 /

64. Marginal Utility and
Consumer Choice
•Similarly, MU of food measures how the level of
satisfaction changes (ΔU) in response to change in the
consumption of Clothing (ΔC) holding consumption of
Food constant.
•Since all points on IC generate same level of U, the gain
in utility from an increase in Food consumption must
exactly equal to loss in utility from a decrease in
consumption if clothing.
Chapter 3 64 CUMU
C
 /

65. Marginal Utility and
Consumer Choice
•Rearranging:
Chapter 3 65©2005 Pearson Education, Inc. 
 
CF
CF
CF
/MU MUMRS
MRSFC
Since
MUMUFC
CMUFMU




saycan We
Cfor F of /
//
**

66. Marginal Utility and
Consumer Choice
•When consumers maximize satisfaction:
Chapter 3 66©2005 Pearson Education, Inc.CF
/P PMRS  CF

CF
/P P /MUMU 
Since the MRS is also equal to the ratio of the
marginal utility of consuming F and C

67. Marginal Utility and
Consumer Choice
•Rearranging, gives the equation for utility
maximization:
Chapter 3 67©2005 Pearson Education, Inc.CCFF
PMUPMU //

68. Marginal Utility and
Consumer Choice
•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.
Chapter 3 68©2005 Pearson Education, Inc.