CHAPTER 3 OUTLINE. 3.1 Consumer Preferences. 3.2 Budget Constraints. 3.3 Consumer Choice. 3.4 Revealed Preference

Transcription

1 Chapter 3: Consumer Behavior CHAPTER 3 OUTLINE 3.1 Consumer Preferences 3.2 Budget Constraints 3.3 Consumer Choice 3.4 Revealed Preference 3.5 Marginal Utility and Consumer Choice Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 1 of 37

2 Chapter 3: Consumer Behavior 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 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 2 of 37

3 Chapter 3: Consumer Behavior CONSUMER PREFERENCES How might a consumer compare different groups of items available for purchase? A market basket is a collection of one or more commodities Individuals can choose between market baskets containing different goods 2005 Pearson Education, Inc. Chapter 3 3 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 3 of 37

4 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES Market Baskets market basket (or bundle) of one or more goods. List with specific quantities TABLE 3.1 Alternative Market Baskets Market Basket Units of Food Units of Clothing A B D E G H To explain the theory of consumer behavior, we will ask whether consumers prefer one market basket to another. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 4 of 37

5 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES 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. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 5 of 37

6 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES 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. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 6 of 37

7 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES Figure 3.1 Describing Individual Preferences Because more of each good is preferred to less, we can compare market baskets in the shaded areas. Basket A is clearly preferred to basket G, while E is clearly preferred to A. However, A cannot be compared with B, D, or H without additional information. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 7 of 37

8 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES 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. Figure 3.2 An Indifference Curve The indifference curve U 1 that passes through market basket A shows all baskets that give the consumer the same level of satisfaction as does market basket A; these include baskets B and D. Our consumer prefers basket E, which lies above U 1, to A, but prefers A to H or G, which lie below U 1. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 8 of 37

9 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES Indifference Maps indifference map Graph containing a set of indifference curves showing the market baskets among which a consumer is indifferent. Figure 3.3 An Indifference Map An indifference map is a set of indifference curves that describes a person's preferences. 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. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 9 of 37

10 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES Indifference Maps Figure 3.4 Indifference Curves Cannot Intersect If indifference curves U 1 and U 2 intersect, one of the assumptions of consumer theory is violated. According to this diagram, the consumer should be indifferent among market baskets A, B, and D. Yet B should be preferred to D because B has more of both goods. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 10 of 37

11 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES Indifference Curves Indifference Curves Slope Downward 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 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 11 of 37

12 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES Indifference Curves The shapes of indifference curves describe how a consumer is willing to substitute one good for another Clothing A A to B, give up 6 clothing to get 1 food D to E, give up 2 clothing to get 1 food B The more clothing and less food a person has, the more clothing they will give up to get more food D E G Food Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 12 of 37

13 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES The Marginal Rate of Substitution 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. Figure 3.5 The Marginal Rate of Substitution The slope of an indifference curve measures the consumer s marginal rate of substitution (MRS) between two goods. In this figure, the MRS between clothing (C) and food (F) falls from 6 (between A and B) to 4 (between B and D) to 2 (between D and E) to 1 (between E and G). Convexity The decline in the MRS reflects a diminishing marginal rate of substitution. When the MRS diminishes along an indifference curve, the curve is convex. MRS C F Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 13 of 37

14 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES 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 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 14 of 37

15 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES Perfect Substitutes and Perfect Complements Figure 3.6 Perfect Substitutes and Perfect Complements 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. 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. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 15 of 37

16 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES 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 Bads Good for which less is preferred rather than more. How do we account for bads in our preference analysis? We redefine the commodity Clean air Pollution reduction Asbestos removal Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 16 of 37

17 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES Figure 3.7 Preferences for Automobile Attributes 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. Owners of Ford Mustang coupes (a) are willing to give up considerable interior space for additional acceleration. The opposite is true for owners of Ford Explorers (b). They prefer interior space to acceleration. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 17 of 37

18 Chapter 3: Consumer Behavior 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 2005 Pearson Education, Inc. Chapter 3 18 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 18 of 37

19 Chapter 3: Consumer Behavior 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 2005 Pearson Education, Inc. Chapter 3 19 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 19 of 37

20 Chapter 3: Consumer Behavior Consumer Preferences: An Application Styling These consumers place a greater value on performance than styling Performance 2005 Pearson Education, Inc. Chapter 3 20 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 20 of 37

21 Chapter 3: Consumer Behavior Consumer Preferences: An Application Styling These consumers place a greater value on styling than performance Performance 2005 Pearson Education, Inc. Chapter 3 21 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 21 of 37

22 Chapter 3: Consumer Behavior Consumer Preferences: An Application Knowing which group dominates the market will help decide where redesigning dollars should go 2005 Pearson Education, Inc. Chapter 3 22 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 22 of 37

23 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES Utility and Utility Functions utility Numerical score representing the satisfaction from a given market basket. utility function Figure 3.8 market baskets. Utility Functions and Indifference Curves 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. Formula that assigns a level of utility to individual Basket U = FC C 25 = 2.5(10) A 25 = 5(5) B 25 = 10(2.5) Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 23 of 37

24 Chapter 3: Consumer Behavior Utility Example U(F,C) = F + 2C Market Basket Food Clothing Utility A (3) = 14 B (4) = 14 C (4) = 12 Consumer is indifferent between A & B and prefers both to C 2005 Pearson Education, Inc. Chapter 3 24 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 24 of 37

25 Chapter 3: Consumer Behavior 3.1 CONSUMER PREFERENCES 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! Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 25 of 37

26 Chapter 3: Consumer Behavior 3.2 BUDGET CONSTRAINTS budget constraints Constraints that consumers face as a result of limited incomes. The Budget Line budget line All combinations of 2 goods for which total money spent equals to income. P F P C I (3.1) F C TABLE 3.2 Market Baskets and the Budget Line Market Basket Food (F) Clothing (C) Total Spending A 0 40 $80 B $80 D $80 E $80 G 80 0 $80 Example: Assume income of $80/week, P F = $1 and P C = $2 Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 26 of 37

27 Chapter 3: Consumer Behavior 3.2 BUDGET CONSTRAINTS The Budget Line Figure 3.10 A Budget Line 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 B and D) is P F /P C = 10/20 = 1/2. C ( I / P ) ( P / P ) F (3.2) C F C Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 27 of 37

28 Chapter 3: Consumer Behavior 3.2 BUDGET CONSTRAINTS The Effects of Changes in Income and Prices Figure 3.11 Effects of a Change in Income on the Budget Line Income Changes A change in income (with prices unchanged) causes the budget line to shift parallel to the original line (L 1 ). When the income of $80 (on L 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. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 28 of 37

29 Chapter 3: Consumer Behavior 3.2 BUDGET CONSTRAINTS The Effects of Changes in Income and Prices Figure 3.12 Effects of a Change in Price on the Budget Line Price Changes A 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 1 to L 2. However, when the price increases from $1.00 to $2.00, the line rotates inward from L 1 to L 3. Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e. 29 of 37

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 2005 Pearson 3 Education, Inc. 30

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 2005 Pearson 3 Education, Inc. 31

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 1 for our indifference curves Consumer wants to choose highest utility within their budget Chapter 2005 Pearson 3 Education, Inc. 32

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

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: MRS C F Further, the slope of the budget line is: Slope P P F C Chapter 3 35

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

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 C then 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 Clothing (units per week) B Point B does not maximize satisfaction because the MRS = -10/10 = 1 is greater than the price ratio = 1/2-10C F U 1 Chapter Food (units per week) 40

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 2005 Pearson 3 Education, Inc. 42

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

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

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 2005 Pearson 3 Education, Inc. 45

46 Consumer Choice A corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another MRS is not necessarily equal to P A /P B Chapter 2005 Pearson 3 Education, Inc. 46

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

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: MRS P P IceCream FrozenYogurt Chapter 2005 Pearson 3 Education, Inc. 49

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 2005 Pearson 3 Education, Inc. 50

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 2005 Pearson 3 Education, Inc. 51

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 2005 Pearson 3 Education, Inc. 52

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

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

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 2005 Pearson 3 Education, Inc. 55

56 Revealed Preferences Two Budget Lines Clothing (units per month) l 2 l 1 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 B D Chapter 2005 Pearson 3 Education, Inc. Food (units per month) 56

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

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 2005 Pearson 3 Education, Inc. 58

59 Marginal Utility and Consumer Choice Marginal utility measures 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 2005 Pearson 3 Education, Inc. 59

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 2005 Pearson 3 Education, Inc. 60

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 2005 Pearson 3 Education, Inc. 61

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 2005 Pearson 3 Education, Inc. 62

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. MU F U / F Chapter 3 63

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. MU C U / C 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

65 Marginal Utility and Consumer Choice Rearranging: MU F Since C C MRS * F / F / F We can say Chapter 2005 Pearson 3 Education, Inc. 65 MU MU F MRS MU F/MUC C / of * C MU C F for C

66 Marginal Utility and Consumer Choice When consumers maximize satisfaction: MRS P F /P C Since the MRS is also equal to the ratio of the marginal utility of consuming F and C MU /MU P /P F C F C Chapter 2005 Pearson 3 Education, Inc. 66

67 Marginal Utility and Consumer Choice Rearranging, gives the equation for utility maximization: MU / P MU / F F C P C Chapter 2005 Pearson 3 Education, Inc. 67

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 2005 Pearson 3 Education, Inc. 68