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Click to edit Master title style,Click to edit Master text styles,Second Level,Third Level,Fourth Level,Fifth Level,Slide,*,Chapter 3,Consumer Behavior,1,Topics to be Discussed,Consumer Preferences,Budget Constraints,Consumer Choice,Revealed Preferences,2,Topics to be Discussed,Marginal Utility and Consumer Choices,Cost-of-Living Indexes,3,Consumer Behavior,Two applications that illustrate the importance of the economic theory of consumer behavior are:,Apple-Cinnamon Cheerios,The Food Stamp Program.,4,Consumer Behavior,General Mills had to determine how high a price to charge for Apple-Cinnamon Cheerios before it went to the market.,5,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.,6,Consumer Behavior,These two problems require an understanding of the economic theory of consumer behavior.,7,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.,8,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.,9,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?,10,Consumer Preferences,A,market basket,is 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,11,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,12,Consumer Preferences,A2030,B1050,D4020,E3040,G1020,H1040,Market BasketUnits of Food Units of Clothing,13,Consumer Preferences,Indifference curves,represent all combinations of market baskets that provide the same level of satisfaction to a person.,Indifference Curves,14,The consumer prefers,A,to 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,E,H,B,D,15,U,1,Combination,B,A, & D,yield the same satisfaction,E,is preferred to,U,1,U,1,is 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,16,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.,17,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.,18,Consumer Preferences,An,indifference map,is a set of indifference curves that describes a persons 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,19,Consumer Preferences,Indifference Curves,Finally, indifference curves cannot cross.,This would violate the assumption that more is preferred to less.,20,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,B,is,preferred to,D.,21,U,1,U,2,Consumer Preferences,Food,(units per week),Clothing,(units per week),A,D,B,The consumer should,be indifferent between,A,B,and,D,. However,B,contains more of,both goods than,D,.,Indifference Curves,Cannot Cross,22,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),2,3,4,5,1,2,4,6,8,10,12,14,16,Question,: Does this,relation hold for giving,up food to get clothing?,23,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,24,Consumer Preferences,Food,(units per week),Clothing,(units,per week),2,3,4,5,1,2,4,6,8,10,12,14,16,A,B,D,E,G,-6,1,1,1,1,-4,-2,-1,MRS,= 6,MRS,= 2,25,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,MRS,for,AB,was 6, while that for,DE,was 2.,Marginal Rate of Substitution,26,Consumer Preferences,Question,What are the first three assumptions?,Marginal Rate of Substitution,27,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,28,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,29,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,30,Consumer Preferences,Orange Juice,(glasses),Apple,Juice,(glasses),2,3,4,1,1,2,3,4,0,Perfect,Substitutes,31,Consumer Preferences,Right Shoes,Left,Shoes,2,3,4,1,1,2,3,4,0,Perfect,Complements,32,Consumer Preferences,BADS,Things for which less is preferred to more,Examples,Air pollution,Asbestos,33,Consumer Preferences,What Do You Think?,How can we account for Bads in the analysis of consumer preferences?,34,Consumer Preferences,Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling.,Designing New Automobiles (,I,),35,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,),36,Consumer Preferences,These consumers are,willing to give up,considerable,styling for additional,performance,Styling,Performance,Consumer,Preference,A,:,High,MRS,37,Consumer Preferences,These consumers are,willing to give up,considerable,performance for,additional styling,Styling,Performance,Consumer,Preference B:,Low,MRS,38,Consumer Preferences,What Do You Think?,How can we determine the consumers preference?,Designing New Automobiles (,I,),39,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,),40,Consumer Preferences,Growth of Japanese Imports,1970s and 1980s,15% of domestic cars underwent a style change each year,This compares to 23% for imports,Designing New Automobiles (,I,),41,Consumer Preferences,Utility,Utility:,Numerical score representing the satisfaction that a consumer gets from a given market basket.,42,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.,43,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,44,Consumer Preferences,Food,(units per week),10,15,5,5,10,15,0,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,45,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.,46,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.,47,Budget Constraints,Preferences do not explain all of consumer behavior.,Budget constraints,also limit an individuals ability to consume in light of the prices they must pay for various goods and services.,48,Budget Constraints,The Budget Line,The,budget line,indicates all combinations of two commodities for which total money spent equals total income.,49,Budget Constraints,The Budget Line,Let F equal the amount of food purchased, and C is the amount of clothing.,Price of food =,P,f,and price of clothing =,P,c,Then,P,f,F,is the amount of money spent on food, and,P,c,C,is the amount of money spent on clothing.,50,Budget Constraints,The budget line then can be written:,51,Budget Constraints,A040$80,B2030$80,D4020$80,E6010$80,G800$80,Market BasketFood (F) Clothing (C)Total Spending,P,f,=,($1),P,c,=,($2),P,f,F + P,c,C = I,52,Budget Line,F +,2,C =,$80,10,20,(,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 = $80,53,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.,54,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.,55,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.,56,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).,57,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).,58,Budget Constraints,Food,(units per week),Clothing,(units,per week),80,120,160,40,20,40,60,80,0,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,59,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 goods intercept.,60,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 goods intercept.,61,Budget Constraints,Food,(units per week),Clothing,(units,per week),80,120,160,40,40,(,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.,62,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.,63,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.,64,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.,65,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.,66,Consumer Choice,Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.,67,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.,68,Recall, the slope of an indifference curve is:,Consumer Choice,Further, the slope of the budget line is:,69,Consumer Choice,Therefore, it can be said that satisfaction is maximized where:,70,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).,71,Consumer Choice,Food,(units per week),Clothing,(units per,week),40,80,20,20,30,40,0,U,1,B,Budget Line,Pc,= $2 P,f,= $1 I = $80,Point,B,does not,maximize satisfaction,because the,MRS (-(-10/10) = 1,is greater than the,price ratio (1/2).,-10,C,+10,F,72,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),40,80,20,20,30,40,0,73,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),40,80,20,20,30,40,0,74,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,),75,Consumer Choice,By finding the point of tangency between a groups indifference curve and the budget constraint auto companies can design a production and marketing plan.,Designing New Automobiles (,II,),76,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,$7,000,77,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,$7,000,Performance,78,Consumer Choice,Choosing between a non-matching and matching grant to fund police expenditures,Decision Making & Public Policy,79,Consumer Choice,Non-matching Grant,Police,Expenditures ($),Private,Expenditures ($),O,P,Q,U,1,A,Before Grant,Budget line:,PQ,A,: Preference maximizing,market basket,Expenditure,OR:,Private,OS:,Police,R,S,80,V,T,U,3,U,1,After Grant,Budget line:,TV,B: Preference maximizing,market basket,Expenditure,OU:,Private,OZ:,Police,B,U,Z,R,Consumer Choice,Non-matching Grant,P,Police,Expenditures ($),Private,Expenditures ($),O,S,Q,A,81,P,R,U,2,T,U,1,Consumer Choice,Matching Grant,Police ($),Private,Expenditures ($),O,Q,S,R,Before Grant,Budget line:,PQ,A: Preference maximizing,market basket,After Grant,C: Preference maximizing,market basket,Expenditures,OW: Private,OX: Police,C,X,W,A,82,T,U,3,U,1,Nonmatching Grant,Point B,OU: Private expenditure,OZ: Police expenditure,Matching Grant,Point C,OW: Private expenditure,OX: Police expenditure,W,X,Consumer Choice,Matching Grant,P,Police ($),Private,Expenditures ($),O,Q,A,U,2,C,R,B,U,Z,83,Consumer Choice,A,corner solution,exists if a consumer buys in extremes, and buys all of one category of good and none of another.,This exists where the indifference curves are tangent to the horizontal and vertical axis.,MRS,is,not,equal to,P,A,/P,B,A Corner Solution,84,A Corner Solution,Ice Cream (cup/month),Frozen,Yogurt,(cups,monthly),B,A,U,2,U,3,U,1,A corner solution,exists at point,B.,85,Consumer Choice,A Corner Solution,At point B, the,MRS,of ice cream for frozen yogurt is greater than the slope of the budget line.,This suggests that if the consumer could give up more frozen yogurt for ice cream he would do so.,However, there is no more frozen yogurt to give up!,86,Consumer Choice,A Corner Solution,When a corner solution arises,the consumers MRS does not necessarily equal the price ratio.,In this instance it can be said that:,87,Consumer Choice,A Corner Solution,If the MRS is, in fact, significantly greater than the price ratio, then a small decrease in the price of frozen yogurt,will not,alter the consumers market basket.,88,Consumer Choice,Suppose Jane Does parents set up a trust fund for her college education.,Originally, the money must be used for education.,A College Trust Fund,89,Consumer Choice,If part of the money could be used for the purchase of other goods, her consumption preferences change.,A College Trust Fund,90,The trust fund shifts the budget line,Consumer Choice,P,Q,Education ($),Other,Consumption,($),U,2,A College Trust Fund,A,U,1,A: Consumption before the trust fund,B,B: Requirement that the trust fund,must be spent on education,C,U,3,C: If the trust could be spent on,other goods,91,Revealed Preferences,If we know the choices a consumer has made, we can determine what her preferences are if we have information about a sufficient number of choices that are made when prices and incomes vary.,92,D,Revealed Preferences-Two Budget Lines,l,1,l,2,B,A,I,1,: Chose A over B,A is revealed preferred to B,l,2,: Choose B over D,B is revealed preferred to D,Food (units per month),Clothing,(units per,month),93,B is preferred to,all market baskets,in the green area,Revealed Preferences-Two Budget Lines,l,2,B,l,1,D,A,All market baskets,in the pink,shaded area are,preferred to,A.,Food (units per month),Clothing,(units per,month),94,All market baskets in the,pink area preferred to A,Food (units per month),Revealed Preferences-Four Budget Lines,Clothing,(units per,month),l,1,l,2,l,3,l,4,A: preferred to all,market baskets in,the green area,E,B,A,G,I,3,:,E revealed preferred to A,I,4,:,G revealed preferred to A,95,Amount of Exercise,(hours),Revealed Preferences for Recreation,Other,Recreational,Activities,($),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,Robertas,recreation budget = $100/wk,Price of exercise = $4/hr/week,Exercises 10 hrs/wk at,A,given,U,1,&,I,1,Would the Clubs,profits increase?,96,Marginal utility,measures the additional satisfaction obtained from consuming one additional unit of a good.,Marginal Utility andConsumer Choice,Marginal Utility,97,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 andConsumer Choice,98,The,principle of dimin
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