Transcript Managerial Economics: An Analysis of Business Issues

MANAGERIAL ECONOMICS
An Analysis of Business Issues
Howard Davies
and Pun-Lee Lam
Published by FT Prentice Hall
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Chapter 6:
Consumer Behaviour
Objectives:
After studying the chapter, you should
understand:
1. The purpose of the economic theory of
consumer behaviour
2. The difference between that theory and
Consumer Behaviour in Marketing
3. The main approaches to consumer behaviour in
Economics
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Economic Theories
of Consumer Behaviour

ARE NOT rich and highly descriptive analyses of the
links between consumers’ personal, social and
psychological characteristics and their purchasing
behaviour
– look for that in the Marketing treatment of the issue

They ARE abstract and logical analyses of what is
meant by ‘rational choice behaviour’ and the
implications of rational behaviour
– for instance, is it necessarily true that a rational consumer
will buy more of a product as its price falls?
– begin by defining ‘rational choice’ and then follow through
the consequences
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The Main Approaches Are:

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Utility Theory
Indifference Analysis
Revealed Preference
The Characteristics Approach
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Utility Theory

Consumers seek to maximise their UTILITY, which increases as
they consumer more ‘goods’ and decreases as they consumer
more ‘bads’

As a consumer has more of a ‘good’, the extra (marginal) utility
they enjoy from each successive extra unit of the good declines
– the principle of diminishing marginal utiity

A utility-maximising consumer will purchase a combination of
goods such that the extra utility acquired per $ or cent, £ or
penny, is the same for every good OR:

the ratio of the marginal utilities is equal to the ratio of the prices
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Utility Theory and Falling Prices

If a consumer has a fixed income and begins in
equilibrium:
– MUapples/Papples = MUpears/Ppears
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Then the price of apples falls
Left-hand side of the equation> Right-hand side
There is an opportunity to increase UTILITY- how
to do it?
Shift spending from pears to apples - WHY DOES
THIS WORK?
Because each extra penny spent on apples gives
more additional utility than each extra penny
spent on pears
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Indifference Analysis

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UTILITY theory requires us to think in
terms of a cardinally measurable
unobservable concept, which is rather
‘heroic’
INDIFFERENCE ANALYSIS explains
consumer behaviour on the basis of
less restrictive assumptions (tho’ the
logic is very similar)
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Indifference Analysis

The following assumptions are made about ‘rational’
consumers
– they know when they prefer one bundle of goods to another
or are indifferent between them - their preferences are
complete
– Preferences are symmetric. If I prefer A to B, I cannot prefer
B to A.
– Preferences are transitive. If I prefer A to B and B to C I must
prefer A to C.

(These are not as unproblematic as they may
seem)
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Indifference Analysis

Good A
All combinations of A and B
for which the consumer is
indifferent
AN INDIFFERENCE
CURVE
Good B
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Indifference Analysis

Good A
Slopes show relative
preferences for A and B
Good B
An A-lover
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An Indifference Map

Good A
The preferred direction if
A and B are both‘goods
Good B
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
The Optimal Combination of A
and B
Good A
Budget
Line
Good B
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If the Price of B Falls

Good A
More B is bought and (in
this example only) the
same amount of A
Budget
Line
Good B
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What Can We Say In General About
the Consequences of a Price Fall?

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The overall move from one equilibrium to
another is the PRICE EFFECT
PRICE EFFECT can be divided into
SUBSTITUTION EFFECT and INCOME
EFFECT
SUBSTITUTION EFFECT is the result of
changing prices
INCOME EFFECT is the result of changing
real incomes
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How to Find the Substitution and Income
Effects?

Good A
More B is bought (and in
this example only) the
same amount of A
Budget
Line
Good B
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Substitution Effect

Good A
If the consumer was on the
same I-curve as before (same
real income) but prices moved
to their new level, (budget
line has the new slope) more
B must be bought
Good B
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Income Effect

Good A
If relative prices don’t change
but real income rises
Good B
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Income Effect

The substitution effect MUST lead more B to be
bought if the relative price of B falls

The Income effect could work in either direction or be
neutral
– for inferior goods, income effect is negative
– for normal goods it is positive
A GIFFEN good is one where the income effect is
negative and powerful enough to outweigh the
substitution effect

– lower prices, less is bought
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Other Approaches

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Indifference analysis, and its
mathematical version, is the standard
approach
Revealed Preference and the
Characteristics Approach merit brief
consideration
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Revealed Preference
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Less restrictive assumptions - consumers are
consistent in their choices
A budget line is constructed and the
consumer’s choice observed
When price of one good falls, a new choice is
made
The new choice cannot involve less of the
good whose price has fallen
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Revealed Preference

Why?
Apples
Z
X
If combination X is the original choice and
Z is the new choice (after the price of
oranges falls), X to Z is the price effect.
The broken line shows the goods which
could be bought if income remained at the
level requiredto buy the original basket of
goods, but the new price ratio held. We
don’t know exactly where the consumer
would choose to be, but they cannot be to
the left of X because they have already
rejected superior combinations in favour
of X
Oranges
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The Characteristics Approach

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Lancaster 1966
Consumers do not desire ‘goods’ but bundles of
‘characteristics’
– not a computer but
•
•
•
•

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processing speed
memory
storage
functions
Different brands offer different combinations of
characteristics. Combining brands may allow other
combinations to be achieved
Desirable mixes of characteristics might be identified
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Practical Applications of Demand Theory?
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LIMITED. The purpose is to examine the meaning
and consequences of rational behaviour
Forms the theoretical foundation for statistical
analyses of demand
The ‘characteristics’ concept is a useful starting point
in Marketing and has led to ideas like ‘hedonic price’
models.
– Take many different examples or brands of a good. Regress the
price on the characteristics to see how the market prices them
– In Hong Kong, residential property prices are determined by net
floor area, but age, a view of water, pollution and family density
also had significant (but small) effects
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