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

Chapter 3
Consumer
Behavior
Topics to be Discussed

Consumer Preferences

Budget Constraints

Consumer Choice

Revealed Preferences
Chapter 3: Consumer Behavior
Slide 2
Topics to be Discussed

Marginal Utility and Consumer Choices

Cost-of-Living Indexes
Chapter 3: Consumer Behavior
Slide 3
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 4
Consumer Behavior

General Mills had to determine how
high a price to charge for AppleCinnamon Cheerios before it went to
the market.
Chapter 3: Consumer Behavior
Slide 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.
Chapter 3: Consumer Behavior
Slide 6
Consumer Behavior

These two problems require an
understanding of the economic theory of
consumer behavior.
Chapter 3: Consumer Behavior
Slide 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.
Chapter 3: Consumer Behavior
Slide 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.
Chapter 3: Consumer Behavior
Slide 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?
Chapter 3: Consumer Behavior
Slide 10
Consumer Preferences
Market Baskets

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.
Chapter 3: Consumer Behavior
Slide 11
Consumer Preferences
Market Baskets

Three Basic Assumptions
1) Preferences are complete.
2) Preferences are transitive.
3) Consumers always prefer more of
any good to less.
Chapter 3: Consumer Behavior
Slide 12
Consumer Preferences
Market Basket Units of Food Units of Clothing
A
20
30
B
10
50
D
40
20
E
30
40
G
10
20
H
10
40
Chapter 3: Consumer Behavior
Slide 13
Consumer Preferences
Indifference Curves

Indifference curves represent all
combinations of market baskets that
provide the same level of satisfaction to
a person.
Chapter 3: Consumer Behavior
Slide 14
Consumer Preferences
Clothing
(units per week)
50
B
40
H
The consumer prefers
A to all combinations
in the blue box, while
all those in the pink
box are preferred to A.
E
A
30
D
G
20
10
10
20
Chapter 3: Consumer Behavior
30
40
Food
(units per week)
Slide 15
Consumer Preferences
Clothing
(units per week)
Combination B,A, & D
yield the same satisfaction
•E is preferred to U1
•U1 is preferred to H & G
B
50
H
E
40
A
30
D
20
U1
G
10
10
20
Chapter 3: Consumer Behavior
30
40
Food
(units per week)
Slide 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.
Chapter 3: Consumer Behavior
Slide 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.
Chapter 3: Consumer Behavior
Slide 18
Consumer Preferences
Indifference Maps

An indifference map is 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.
Chapter 3: Consumer Behavior
Slide 19
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 20
Consumer Preferences
Clothing
(units per week)
Market basket A
is preferred to B.
Market basket B is
preferred to D.
D
B
A
U3
U2
U1
Food
(units per week)
Chapter 3: Consumer Behavior
Slide 21
Consumer Preferences
Clothing
(units per week)
U2
Indifference Curves
Cannot Cross
U1
The consumer should
be indifferent between
A, B and D. However,
B contains more of
both goods than D.
A
B
D
Food
(units per week)
Chapter 3: Consumer Behavior
Slide 22
Consumer Preferences
A
Clothing 16
(units
per week) 14
12
Observation: The amount
of clothing given up for
a unit of food decreases
from 6 to 1
-6
10
B
1
8
Question: Does this
relation hold for giving
up food to get clothing?
-4
D
6
1
-2
4
E
G
1 -1
1
2
1
2
Chapter 3: Consumer Behavior
3
4
5
Food
(units per week)
Slide 23
Consumer Preferences
Marginal Rate of Substitution

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.
Chapter 3: Consumer Behavior
Slide 24
Consumer Preferences
A
Clothing 16
(units
per week) 14
12
MRS   C
MRS = 6
F
-6
10
B
1
8
-4
D
6
MRS = 2
1
-2
4
E
G
1 -1
1
2
1
2
Chapter 3: Consumer Behavior
3
4
5
Food
(units per week)
Slide 25
Consumer Preferences
Marginal Rate of Substitution

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.
Chapter 3: Consumer Behavior
Slide 26
Consumer Preferences
Marginal Rate of Substitution

Question
 What
are the first three assumptions?
Chapter 3: Consumer Behavior
Slide 27
Consumer Preferences
Marginal Rate of Substitution

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
Chapter 3: Consumer Behavior
Slide 28
Consumer Preferences
Marginal Rate of Substitution

Perfect Substitutes and Perfect
Complements

Two goods are perfect substitutes when
the marginal rate of substitution of one
good for the other is constant.
Chapter 3: Consumer Behavior
Slide 29
Consumer Preferences
Marginal Rate of Substitution

Perfect Substitutes and Perfect
Complements

Two goods are perfect complements when
the indifference curves for the goods are
shaped as right angles.
Chapter 3: Consumer Behavior
Slide 30
Consumer Preferences
Apple
Juice
(glasses) 4
Perfect
Substitutes
3
2
1
0
1
Chapter 3: Consumer Behavior
2
3
4
Orange Juice
(glasses)
Slide 31
Consumer Preferences
Left
Shoes
4
Perfect
Complements
3
2
1
0
1
Chapter 3: Consumer Behavior
2
3
4
Right Shoes
Slide 32
Consumer Preferences

BADS
 Things

for which less is preferred to more
Examples
 Air
pollution
 Asbestos
Chapter 3: Consumer Behavior
Slide 33
Consumer Preferences

What Do You Think?
 How
can we account for Bads in the
analysis of consumer preferences?
Chapter 3: Consumer Behavior
Slide 34
Consumer Preferences
Designing New Automobiles (I)

Automobile executives must regularly
decide when to introduce new models
and how much money to invest in
restyling.
Chapter 3: Consumer Behavior
Slide 35
Consumer Preferences
Designing New Automobiles (I)

An analysis of consumer preferences
would help to determine when and if car
companies should change the styling of
their cars.
Chapter 3: Consumer Behavior
Slide 36
Consumer Preferences
Styling
Consumer
Preference A:
High MRS
These consumers are
willing to give up
considerable
styling for additional
performance
Performance
Chapter 3: Consumer Behavior
Slide 37
Consumer Preferences
Styling
Consumer
Preference B:
Low MRS
These consumers are
willing to give up
considerable
performance for
additional styling
Performance
Chapter 3: Consumer Behavior
Slide 38
Consumer Preferences
Designing New Automobiles (I)

What Do You Think?
 How
can we determine the consumers
preference?
Chapter 3: Consumer Behavior
Slide 39
Consumer Preferences
Designing New Automobiles (I)

A recent study of automobile demand in
the United States shows that over the
past two decades most consumers have
preferred styling over performance.
Chapter 3: Consumer Behavior
Slide 40
Consumer Preferences
Designing New Automobiles (I)

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
Chapter 3: Consumer Behavior
Slide 41
Consumer Preferences

Utility

Utility: Numerical score representing the
satisfaction that a consumer gets from a
given market basket.
Chapter 3: Consumer Behavior
Slide 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.
Chapter 3: Consumer Behavior
Slide 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
Chapter 3: Consumer Behavior
Slide 44
Consumer Preferences
Utility Functions & Indifference Curves
Clothing
(units
per week)
Assume: U = FC
Market Basket
U = FC
C
25 = 2.5(10)
A
25 = 5(5)
B
25 = 10(2.5)
15
C
10
U3 = 100 (Preferred to U2)
A
5
B
0
5
Chapter 3: Consumer Behavior
10
U2 = 50 (Preferred to U1)
U1 = 25
Food
15
(units per week)
Slide 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.
Chapter 3: Consumer Behavior
Slide 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.
Chapter 3: Consumer Behavior
Slide 47
Budget Constraints

Preferences do not explain all of
consumer behavior.

Budget constraints also 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 48
Budget Constraints

The Budget Line

The budget line indicates all combinations
of two commodities for which total money
spent equals total income.
Chapter 3: Consumer Behavior
Slide 49
Budget Constraints

The Budget Line

Let F equal the amount of food purchased,
and C is the amount of clothing.

Price of food = Pf and price of
clothing = Pc

Then Pf F is the amount of money spent on
food, and Pc C is the amount of money
spent on clothing.
Chapter 3: Consumer Behavior
Slide 50
Budget Constraints

The budget line then can be written:
PFF  PCC  I
Chapter 3: Consumer Behavior
Slide 51
Budget Constraints
Market Basket Food (F) Clothing (C) Total Spending
Pf = ($1) Pc = ($2)
PfF + PcC = I
A
0
40
$80
B
20
30
$80
D
40
20
$80
E
60
10
$80
G
80
0
$80
Chapter 3: Consumer Behavior
Slide 52
Budget Constraints
Clothing
(units
per week)
(I/PC) = 40
Pc = $2
Pf = $1
I = $80
Budget Line F + 2C = $80
A
1
Slope  C/F  -  - PF/PC
2
B
30
10
D
20
20
E
10
G
0
20
40
Chapter 3: Consumer Behavior
60
80 = (I/PF)
Food
(units per week)
Slide 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.
Chapter 3: Consumer Behavior
Slide 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.
Chapter 3: Consumer Behavior
Slide 55
Budget Constraints

The Budget Line

The vertical intercept (I/PC), illustrates the
maximum amount of C that can be
purchased with income I.

The horizontal intercept (I/PF), illustrates
the maximum amount of F that can be
purchased with income I.
Chapter 3: Consumer Behavior
Slide 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).
Chapter 3: Consumer Behavior
Slide 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).
Chapter 3: Consumer Behavior
Slide 58
Budget Constraints
Clothing
(units
per week)
A increase in
income shifts
the budget line
outward
80
60
A decrease in
income shifts
the budget line
inward
40
20
L3
(I =
$40)
0
40
L2
L1
(I = $80)
80
Chapter 3: Consumer Behavior
120
(I = $160)
160
Food
(units per week)
Slide 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 good’s intercept.
Chapter 3: Consumer Behavior
Slide 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 good’s intercept.
Chapter 3: Consumer Behavior
Slide 61
Budget Constraints
Clothing
(units
per week)
An increase in the
price of food to
$2.00 changes
the slope of the
budget line and
rotates it inward.
A decrease in the
price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.
40
L3
L1
L2
(PF = 1)
(PF = 2)
40
80
Chapter 3: Consumer Behavior
(PF = 1/2)
120
160
Food
(units per week)
Slide 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.
Chapter 3: Consumer Behavior
Slide 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.
Chapter 3: Consumer Behavior
Slide 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.
Chapter 3: Consumer Behavior
Slide 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.
Chapter 3: Consumer Behavior
Slide 66
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 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.
Chapter 3: Consumer Behavior
Slide 68
Consumer Choice
Recall, the slope of an indifference curve is:
C
MRS  
F
Further, the slope of the budget line is:
PF
Slope  
PC
Chapter 3: Consumer Behavior
Slide 69
Consumer Choice

Therefore, it can be said that
satisfaction is maximized where:
PF
MRS 
PC
Chapter 3: Consumer Behavior
Slide 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).
Chapter 3: Consumer Behavior
Slide 71
Consumer Choice
Clothing
(units per
week)
Pc = $2
Pf = $1
I = $80
Point B does not
maximize satisfaction
because the
MRS (-(-10/10) = 1
is greater than the
price ratio (1/2).
40
30
B
-10C
Budget Line
20
U1
+10F
0
20
40
Chapter 3: Consumer Behavior
80
Food (units per week)
Slide 72
Consumer Choice
Clothing
(units per
week)
Pc = $2
Pf = $1
I = $80
40
Market basket D
cannot be attained
given the current
budget constraint.
D
30
20
U3
Budget Line
0
20
40
Chapter 3: Consumer Behavior
80
Food (units per week)
Slide 73
Consumer Choice
Clothing
(units per
week)
Pc = $2
Pf = $1
I = $80
At market basket A
the budget line and the
indifference curve are
tangent and no higher
level of satisfaction
can be attained.
40
30
A
At A:
MRS =Pf/Pc = .5
20
U2
Budget Line
0
20
40
Chapter 3: Consumer Behavior
80
Food (units per week)
Slide 74
Consumer Choice
Designing New Automobiles (II)

Consider two groups of consumers,
each wishing to spend $10,000 on the
styling and performance of cars.

Each group has different preferences.
Chapter 3: Consumer Behavior
Slide 75
Consumer Choice
Designing New Automobiles (II)

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.
Chapter 3: Consumer Behavior
Slide 76
Designing New Automobiles (II)
Styling
These consumers
are willing to trade
off a considerable
amount of styling
for some additional
performance
$10,000
$3,000
$7,000
Chapter 3: Consumer Behavior
$10,000 Performance
Slide 77
Designing New Automobiles (II)
Styling
These consumers
are willing to trade
off a considerable
amount of
performance for
some additional
styling
$10,000
$7,000
$3,000
Chapter 3: Consumer Behavior
$10,000 Performance
Slide 78
Consumer Choice
Decision Making & Public Policy

Choosing between a non-matching and
matching grant to fund police
expenditures
Chapter 3: Consumer Behavior
Slide 79
Consumer Choice
Non-matching Grant
Private
Expenditures ($)
Before Grant
• Budget line: PQ
•A: Preference maximizing
market basket
•Expenditure
•OR: Private
•OS: Police
P
A
R
U1
O
S
Chapter 3: Consumer Behavior
Q
Police
Expenditures ($)
Slide 80
Consumer Choice
Non-matching Grant
Private
Expenditures ($)
T
After Grant
• Budget line: TV
•B: Preference maximizing
market basket
•Expenditure
•OU: Private
•OZ: Police
P
B
U
A
R
U3
U1
O
S
Z
Chapter 3: Consumer Behavior
Q
V
Police
Expenditures ($)
Slide 81
Consumer Choice
Matching Grant
Private
Expenditures ($)
Before Grant
• Budget line: PQ
• A: Preference maximizing
market basket
After Grant
•C: Preference maximizing
market basket
Expenditures
•OW: Private
•OX: Police
T
P
W
R
A
C
U2
U1
O
S
X
Chapter 3: Consumer Behavior
Q
R
Police ($)
Slide 82
Consumer Choice
Matching Grant
Private
Expenditures ($)
T
Nonmatching Grant
•Point B
•OU: Private expenditure
•OZ: Police expenditure
Matching Grant
•Point C
•OW: Private expenditure
•OX: Police expenditure
P
U
W
B
A
C
U
U2 3
U1
O
Z X
Chapter 3: Consumer Behavior
Q
R
Police ($)
Slide 83
Consumer Choice
A Corner Solution

A corner solution exists if a consumer
buys in extremes, and buys all of one
category of good and none of another.

This exists where the indifference curves
are tangent to the horizontal and vertical
axis.

MRS is not equal to PA/PB
Chapter 3: Consumer Behavior
Slide 84
A Corner Solution
Frozen
Yogurt
(cups
monthly)
A
U1
U2
U3
B
Chapter 3: Consumer Behavior
A corner solution
exists at point B.
Ice Cream (cup/month)
Slide 85
Consumer Choice

A Corner Solution

At point B, the MRS of ice cream for frozen
yogurt is greater than the slope of the
budget line.

This suggests that if the consumer could
give up more frozen yogurt for ice cream
he would do so.

However, there is no more frozen yogurt to
give up!
Chapter 3: Consumer Behavior
Slide 86
Consumer Choice

A Corner Solution


When a corner solution arises, the
consumer’s MRS does not necessarily
equal the price ratio.
In this instance it can be said that:
MRS  PIceCream / PFrozen Yogurt
Chapter 3: Consumer Behavior
Slide 87
Consumer Choice

A Corner Solution

If the MRS is, in fact, significantly greater
than the price ratio, then a small decrease
in the price of frozen yogurt will not alter
the consumer’s market basket.
Chapter 3: Consumer Behavior
Slide 88
Consumer Choice
A College Trust Fund

Suppose Jane Doe’s parents set up a
trust fund for her college education.

Originally, the money must be used for
education.
Chapter 3: Consumer Behavior
Slide 89
Consumer Choice
A College Trust Fund

If part of the money could be used for
the purchase of other goods, her
consumption preferences change.
Chapter 3: Consumer Behavior
Slide 90
Consumer Choice
Other
Consumption
($)
A College Trust Fund
A: Consumption before the trust fund
The trust fund shifts the budget line
B: Requirement that the trust fund
must be spent on education
U3
C: If the trust could be spent on
other goods
C
P
A
B
U2
U1
Q
Chapter 3: Consumer Behavior
Education ($)
Slide 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.
Chapter 3: Consumer Behavior
Slide 92
Revealed Preferences-Two Budget Lines
Clothing
(units per
month)
I1: Chose A over B
A is revealed preferred to B
l2: Choose B over D
B is revealed preferred to D
l1
l2
A
B
D
Food (units per month)
Chapter 3: Consumer Behavior
Slide 93
Revealed Preferences-Two Budget Lines
Clothing
(units per
month)
l1
All market baskets
in the pink
shaded area are
preferred to A.
l2
A
B
B is preferred to
all market baskets
in the green area
D
Food (units per month)
Chapter 3: Consumer Behavior
Slide 94
Revealed Preferences-Four Budget Lines
I3: E revealed preferred to A
Clothing
(units per
month)
l3
All market baskets in the
pink area preferred to A
l1
E
l4
A
l2
B
A: preferred to all
market baskets in
the green area
Chapter 3: Consumer Behavior
G
I4: G revealed preferred to A
Food (units per month)
Slide 95
Revealed Preferences for Recreation
Scenario
•Roberta’s recreation budget = $100/wk
•Price of exercise = $4/hr/week
•Exercises 10 hrs/wk at A given U1 & I1
Other
Recreational
Activities
($)
100 C
80
60
40
A
•The rate changes to $1/hr + $30/wk
•New budget line I2 & combination B
•Reveal preference of B to A
B
U1
U2
Would the Club’s
profits increase?
20
l1
0
25
Chapter 3: Consumer Behavior
l2
50
75
Amount of Exercise
(hours)
Slide 96
Marginal Utility and
Consumer Choice
Marginal Utility

Marginal utility measures the additional
satisfaction obtained from consuming
one additional unit of a good.
Chapter 3: Consumer Behavior
Slide 97
Marginal Utility and
Consumer Choice
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
Chapter 3: Consumer Behavior
Slide 98
Marginal Utility and
Consumer Choice
Diminishing Marginal Utility

The principle of diminishing marginal
utility states that as more and more of a
good is consumed, consuming
additional amounts will yield smaller and
smaller additions to utility.
Chapter 3: Consumer Behavior
Slide 99
Marginal Utility and
Consumer Choice

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).
Chapter 3: Consumer Behavior
Slide 100
Marginal Utility and
Consumer Choice

Formally:
0  MUF(F)  MUC(C)
Chapter 3: Consumer Behavior
Slide 101
Marginal Utility and
Consumer Choice

Rearranging:
 C / F   MU F / MUC
Chapter 3: Consumer Behavior
Slide 102
Marginal Utility and
Consumer Choice
 C / F   MU F / MUC

Because:
 C / F   MRS of F for C
MRS  MU F/MU C
Chapter 3: Consumer Behavior
Slide 103
Marginal Utility and
Consumer Choice

When consumers maximize satisfaction
the:
MRS  PF/PC

Since the MRS is also equal to the ratio
of the marginal utilities of consuming F
and C, it follows that:
MU F/MU C  PF/PC
Chapter 3: Consumer Behavior
Slide 104
Marginal Utility and
Consumer Choice

Which gives the equation for utility
maximization:
MUF / PF  MUC / PC
Chapter 3: Consumer Behavior
Slide 105
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: Consumer Behavior
Slide 106
Marginal Utility and
Consumer Choice
Gasoline Rationing

In 1974 and again in 1979, the
government imposed price controls on
gasoline.

This resulted in shortages and gasoline
was rationed.
Chapter 3: Consumer Behavior
Slide 107
Marginal Utility and
Consumer Choice
Gasoline Rationing

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.
Chapter 3: Consumer Behavior
Slide 108
Marginal Utility and
Consumer Choice

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.
Chapter 3: Consumer Behavior
Slide 109
Marginal Utility and
Consumer Choice

The horizontal axis shows her annual
consumption of gasoline at $1/gallon.

The vertical axis shows her remaining
income after purchasing gasoline.
Chapter 3: Consumer Behavior
Slide 110
Marginal Utility and
Consumer Choice
Spending
on other
goods ($)
A
20,000
18,000
15,000
With a limit of
2,000 gallons,
the consumer moves
to a lower
indifference curve
(lower level of utility).
D
C
U1
U2
B
2,000 5,000
Chapter 3: Consumer Behavior
20,000
Gasoline
(gallons per year)
Slide 111
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 112
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 costof-living index for other government
programs, for private union pensions, and
for other private wage agreements?
Chapter 3: Consumer Behavior
Slide 113
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 114
Cost-of-Living Indexes
1987 (Sarah) 1997
Price of books (Rachel)
$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
Chapter 3: Consumer Behavior
Slide 115
Cost-of-Living Indexes
Sarah’ Expenditure
$500 = 100 lbs. of food x $2.00/lb. + 15 books x $20/book
Rachel’ Expenditure for Equal Utility
$1,260 = 300 lbs. of food x $2.20/lb. + 6 books x $100/book
Chapter 3: Consumer Behavior
Slide 116
Cost-of-Living Indexes

The ideal cost-of-living adjustment for
Rachel is $760.

The ideal cost-of-living index is
$1,260/$500 = 2.52 or 252.

This implies a 152% increase in the cost
of living.
Chapter 3: Consumer Behavior
Slide 117
Cost-of-Living Indexes
Books
(per quarter)
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.
U1
25
20
15
A
10
B
5
l1
l2
0 50 100 200 250 300 350 400 450 500 550 600
Chapter 3: Consumer Behavior
Food
(lb./quarter)
Slide 118
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 119
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 120
Cost-of-Living Indexes
Laspeyres Index

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.
Chapter 3: Consumer Behavior
Slide 121
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 122
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 123
Cost-of-Living Indexes
Books
(per quarter)
Using the Laspeyres
index results in the
budget line shifting
up from I2 to I3.
U1
25
20
15
A
10
B
l3
5
l1
l2
0 50 100 200 250 300 350 400 450 500 550 600
Chapter 3: Consumer Behavior
Food
(lb./quarter)
Slide 124
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 125
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 126
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 127
Cost-of-Living Indexes

The Paasche Index

Calculates the amount of money at currentyear 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 128
Cost-of-Living Indexes
Comparing the Two Indexes

Both indexes involve ratios that involve
today’s current year prices, PFt and PCt.

However, the Laspeyres index relies on
base year consumption, Fb and Cb.

Whereas, the Paasche index relies on
today’s current consumption, Ft and Ct .
Chapter 3: Consumer Behavior
Slide 129
Cost-of-Living Indexes

Then a comparison of the Laspeyres and
Paasche indexes gives the following
equations:
PFt Ft  PCt Ct
LI 
PFt Ft  PCt Ct
PFb Ft  PCt Ct
PI 
PFb Ft  PCt Ct
Chapter 3: Consumer Behavior
Slide 130
Cost-of-Living Indexes
Comparing the Two Indexes

Suppose:
 Two
goods: Food (F) and Clothing (C)
Chapter 3: Consumer Behavior
Slide 131
Cost-of-Living Indexes
Comparing the Two Indexes

Let:
 PFt &
PCt be current year prices
 PFb &
PCb be base year prices
 Ft &

Ct be current year quantities
Fb & Cb be base year quantities
Chapter 3: Consumer Behavior
Slide 132
Cost-of-Living Indexes
Comparing the Two 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)
Chapter 3: Consumer Behavior
Slide 133
Cost-of-Living Indexes
Comparing the Two Indexes

Sarah (1990)
$1,720
LI 
 344
$500
Chapter 3: Consumer Behavior
Slide 134
Cost-of-Living Indexes
Comparing the Two 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)
Chapter 3: Consumer Behavior
Slide 135
Cost-of-Living Indexes
Comparing the Two Indexes

Sarah (1990)
$1,260
PI 
 175
$720
Chapter 3: Consumer Behavior
Slide 136
Cost-of-Living Indexes
The Paasche Index

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.
Chapter 3: Consumer Behavior
Slide 137
Cost-of-Living Indexes

In 1995, the government adopted the
chain-weighted price 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 138
Cost-of-Living Indexes
The Bias of the CPI

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?
Chapter 3: Consumer Behavior
Slide 139
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 140
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 141
Summary

The marginal rate of substitution of F for
C is the maximum amount of C that 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 142
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.
Chapter 3: Consumer Behavior
Slide 143
End of Chapter 3
Consumer
Behavior