CH 03

Chapter 3
Consumer Behavior
Introduction
How are consumer preferences used to
determine demand?
How do consumers allocate income to
the purchase of different goods?
How do consumers with limited income
decide what to buy?
2005 Pearson Chapter 3
Introduction
How can we determine the nature of
consumer preferences for observations
of consumer behavior?
How can cost of living indexes measure
the well-being of consumers?
Consumer Behavior Applications

1. How would General Mills determine the
price to charge for a new cereal before
it went to the market?
2. To what extent did the food stamp
program provide individuals with more
food versus merely subsidizing food
they bought anyway?
Consumer Behavior
The theory of consumer behavior can be
used to help answer these and many
more questions
Theory of consumer behavior
The explanation of how consumers allocate

income to the purchase of different goods
and services
Consumer Behavior
There are three steps involved in the
study of consumer behavior
1. Consumer Preferences
To describe how and why people prefer one

good to another
2. Budget Constraints
People have limited incomes
Consumer Behavior
3. Given preferences and limited incomes,
what amount and type of goods will be
purchased?
What combination of goods will consumers

buy to maximize their satisfaction?
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
Consumer Preferences Basic

Assumptions
1. Preferences are complete
Consumers can rank market baskets
2. Preferences are transitive
If they prefer A to B, and B to C, they must

prefer A to C
3. Consumers always prefer more of any

good to less
More is better
Consumer preferences can be
represented graphically using
indifference curves
Indifference curves represent all
combinations of market baskets that the
person is indifferent to
A person will be equally satisfied with either

choice
10
Indifference Curves:
An Example
Market Basket
Units of Food
Units of Clothing
20
30
10
50
40
20
30
40
10
20
10
40
11
An Example
Graph the points with one good on the xaxis and one good on the y-axis
Plotting the points, we can make some
immediate observations about
preferences
More is better
12
An Example
Clothin 50
g
The consumer prefers

A to all combinations
in the yellow box, while
all those in the pink
box are preferred to A.
40
30
E
A
20
10
10
20
30
40
Food
13
An Example
Points such as B & D have more of one
good but less of another compared to A
Need more information about consumer

ranking
Consumer may decide they are

indifferent between B, A and D
We can then connect those points with an

indifference curve
14
An Example
Clothin
g
50
40
E
A
30
20
D
G
10
Indifferent
between
points B, A, &
D
E is
preferred to
points on U1
Points on U1
are preferred
Uto H & G
1
10
20
30
40
Food
15
Indifference Curves
Any market basket lying northeast of an
indifference curve is preferred to any
market basket that lies on the
indifference curve
Points on the curve are preferred to
points southwest of the curve
16
Indifference Curves
Indifference curves slope downward to
the right
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
17
Indifference Curves
To describe preferences for all
combinations of goods/services, we have
a set of indifference curves an
indifference map
Each indifference curve in the map shows

the market baskets among which the person
is indifferent
18
Indifference Map
Clothing
Market basket A
is preferred to B.
Market basket B is
preferred to D.
D
B
A
U3
U2
U1
Food
19
Indifference Maps
Indifference maps give more information
about shapes of indifference curves
Indifference curves cannot cross

Violates
assumption that more is better
Why? What if we assume they can cross?
20
Indifference Maps
Clothing
U1
B is preferred to D
A is indifferent to B
&D
B must be
indifferent to D but
that cant be if B is
preferred to D
A
B
D
U2
U1
Food
21
Indifference Curves
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
22
Indifference Curves
A
Clothing 16
14
12
Observation: The amount

of clothing given up for
1 unit of food decreases
from 6 to 1
-6
10
1
-4
8
6
B
D
1
-2
E
1 -1
2
1
Food
23
Indifference Curves
We measure how a person trades one
good for another using the marginal rate
of substitution (MRS)
It 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
24
Marginal Rate of Substitution

A
Clothing 16
14
12
MRS C
MRS =
6
-6
10
1
-4
8
6
B
D
1
-2
MRS = 2
E
1 -1
G
Food
25

Indifference curves are convex
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 generally prefer a balanced

market basket
26

The MRS decreases as we move down
the indifference curve
Along an indifference curve there is a
diminishing marginal rate of substitution.
The MRS went from 6 to 4 to 1
27

Indifference curves with different shapes
imply a different willingness to substitute
Two polar cases are of interest
Perfect substitutes
Perfect complements
28

Perfect Substitutes
Two goods are perfect substitutes when the
marginal rate of substitution of one good for
the other is 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
29
Apple
4
Juice
(glasses)
Perfect
Substitute
s
1
0
Orange Juice
(glasses)
30
Perfect Complements
Two goods are perfect complements when
the indifference curves for the goods 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
31
Left
Shoes
Perfect
Complements
4
3
2
1
0
Right Shoes
32
We have assumed all our commodities
are goods
There are commodities we dont want
more of - bads
Things for which less is preferred to more
Examples
Air pollution
Asbestos
33
How do we account for bads in our
preference analysis?
We redefine the commodity

Clean
air
Pollution reduction
Asbestos removal
34
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
35
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
36
An Application
Styling
These
consumers
place a
greater value
on
performance
than styling
Performance
37
An Application
Styling
These consumers
place a greater
value on styling
than performance
Performance
38
An Application
Knowing which group dominates the
market will help decide where
redesigning dollars should go
A recent study in the US shows that over
the past two decades, most consumers
have preferred styling over performance
39
The theory of consumer behavior does
not required assigning a numerical value
to the level of satisfaction
Although ranking of market baskets is
good, sometimes numerical value is
useful
40
Utility
A numerical score representing the
satisfaction that a consumer gets from a
given market basket
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
41
Utility
Utility function
Formula that assigns a level of utility to
individual market baskets
If the utility function is
U(F,C) = F + 2C
A market basket with 8 units of food and 3 units of
clothing gives a utility of
14 = 8 + 2(3)
42
Utility - Example
Market
Basket
Food
Clothing
Utility
8 + 2(3) = 14
6 + 2(4) = 14
4 + 2(4) = 12
Consumer is indifferent between A & B and

prefers both to C
43
Utility - Example
Baskets for each level of utility can be
plotted to get an indifference curve
To find the indifference curve for a utility of

14, we can change the combinations of food
and clothing that give us a utility of 14
44
Utility - Example
Clothing
Basket
C
2.5(10)
A
B
10(2.5)
15
10
25 = 5(5)
25 =
U3 = 100
U = FC
25 =
10
U2 = 50
15
U1 = 25
Food
45
Utility
Although we numerically rank baskets
and indifference curves, numbers are
ONLY for ranking
A utility of 4 is not necessarily twice as
good as a utility of 2
There are two types of rankings
Ordinal ranking
Cardinal ranking
46
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
47
Utility
The actual unit of measurement for utility
is not important
An ordinal ranking is sufficient to explain
how most individual decisions are made
48
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
49
Budget Constraints
The Budget Line
Indicates all combinations of two
commodities for which total money spent
equals total income
We assume only 2 goods are consumed, so
we do not consider savings
50
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 PFF is the amount of money spent
on food, and PCC is the amount of money
spent on clothing
51
The Budget Line

The budget line then can be written:
PF F PC C I
All income is allocated to food (F) and/or clothing
(C)
52
The Budget Line

Different choices of food and clothing
can be calculated that use all income
These choices can be graphed as the budget

line
Example:
Assume income of $80/week, PF = $1 and PC

= $2
53
Budget Constraints
Market
Basket
Food
PF = $1
Clothing
PC = $2
I = PFF + PCC
40
$80
20
30
$80
40
20
$80
60
10
$80
80
$80
Income
54
The Budget Line

Clothing
(I/PC) = 40
C
1
PF
Slope
- F
2
PC
30
10
20
D
20
E
10
G
0
20
40
60
80 = (I/PF)
Food
55
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
56
The Budget Line

The slope indicates the rate at which the
two goods can be substituted without
changing the amount of money spent
We can rearrange the budget line
equation to make this more clear
57
The Budget Line
I PX X PY Y
I PX X PY Y
I PX
X Y
PY PY
58
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
59
The Budget Line

As we know, income and prices can
change
As incomes and prices change, there are
changes in budget lines
We can show the effects of these
changes on budget lines and consumer
choices
60
The Budget Line - Changes

The Effects of Changes in Income
An increase in income causes the budget
line to shift outward, parallel to the original
line (holding prices constant).
Can buy more of both goods with more
income
61

The Effects of Changes in Income
A decrease in income causes the budget line
to shift inward, parallel to the original line
(holding prices constant)
Can buy less of both goods with less income
62

Clothing
(units
per week)
An increase in
income shifts
the budget line
outward
80
60
A decrease in
income shifts
the budget line
inward
40
20
0
L3
(I = L1
(I = $80)
$40)
40
80
120
L2
(I = $160)
160
Food
(units per week)
63

The Effects of Changes in Prices
If the price of one good increases, the budget
line shifts inward, pivoting from the other
goods intercept.
If the price of food increases and you buy
only food (x-intercept), then you cant buy as
much food. The x-intercept shifts in.
If you buy only clothing (y-intercept), you can
buy the same amount. No change in yintercept.
64

If the price of one good decreases, the
budget line shifts outward, pivoting from the
other goods intercept.
If the price of food decreases and you buy
only food (x-intercept), then you can buy
more food. The x-intercept shifts out.
If you buy only clothing (y-intercept), you can
buy the same amount. No change in yintercept.
65

Clothing
(units
per week)
A decrease in the
price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.
40
L3
L2
L1
(PF = 1/2)
(PF = 1)
(PF = 2)
40
80
An increase in the
price of food to
$2.00 changes
the slope of the
budget line and
rotates it inward.
120
160
Food
(units per week)
66

If the two goods increase in price, but the
ratio of the two prices is unchanged, the
slope will not change
However, the budget line will shift inward
parallel to the original budget line
67

If the two goods decrease in price, but the
ratio of the two prices is unchanged, the
slope will not change
However, the budget line will shift outward
parallel to the original budget line
68
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
69
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
70
Consumer Choice
Graphically, we can see different
indifference curves of a consumer
choosing between clothing and food
Remember that U3 > U2 > U1 for our
indifference curves
Consumer wants to choose highest utility
within their budget
71
Consumer Choice
Clothing
(units per
week)
A, B, C on budget line
D highest utility but
not affordable
C highest affordable
utility
Consumer chooses C
40
A
30
20
C
U3
U1
B
0
20
40
80
U2
Food (units
72 per week)
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
73
Consumer Choice
Recall, the slope of an indifference curve
is:
C
MRS
F
Further, the slope of the budget line is:
PF
Slope
PC
74
Consumer Choice
Therefore, it can be said at consumers
optimal consumption point,
PF
MRS
PC
75
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
76
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 = unit clothing
PF/PC
77
Consumer Choice
If MRS PF/PC then individuals can
reallocate basket to increase utility
If MRS > PF/PC
Will increase food and decrease clothing until

MRS = PF/PC
If MRS < PF/PC
Will increase clothing and decrease food until

MRS = PF/PC
78
Consumer Choice
Clothing
(units per
week)
Point B does not

maximize satisfaction
because the
MRS = -10/10 = 1
is greater than the
price ratio = 1/2
40
30
-10C
20
+10F
20
40
U1
80
Food (units per week)
79
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
80
Consumer Choice:
By finding the point of tangency between
a groups indifference curve and the
budget constraint, auto companies can
see how much consumers value each
attribute
81
Consumer Choice:
Styling
$10,000
These consumers
want performance
worth $7000 and
styling worth $3000
$3,000
$7,000
$10,000Performance
82
Consumer Choice:
Styling
These
consumers want
styling worth
$7000 and
performance
worth $3000
$10,000
$7,000
$3,000
$10,000Performance
83
Consumer Choice:
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
84
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 PA/PB
85
A Corner Solution
Frozen
Yogurt
(cups
monthly)
A
U1 U2 U3
A corner solution
exists at point B.
Ice Cream (cup/month)
86
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
87
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:
PIceCream
MRS
PFrozen Yogurt
88
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
89
A Corner Solution - Example

Suppose Jane Does 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
90

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, U2
91

Other
Consumption
($)
U2
Jane better off

on U2
B is corner
solution
MRS PE/POG
U1
Q
Education ($)
92

Other
Consumption
($)
C
U3
U2
If gift is
unrestricted,
Jane can be at
point C on U3
Better off
than with
restricted gift
U1
Q
Education ($)
93
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.
94
Two Budget Lines
Clothing
(units per
month)
l1
I1: Choose A over

B
A is revealed
preferred to B
l2: Choose B over
D
B is revealed
preferred to D
l2
A
B
D
Food (units per month)
95
Two Budget Lines
Clothing
(units per
month)
l1
All market baskets

in the pink
shaded area are
preferred to A.
l2
A
B is
preferred
to
all market
baskets
in the
yellow
area
B
D
96
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
97
Four Budget Lines
I3: E revealed preferred to A
Clothing
(units per
month)
l3
l1
All market baskets in the

pink area preferred to A
l4
A
l2
B
A: preferred to all
market baskets in
the yellow area
I4: G revealed preferred to

98
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?
99
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
100
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
101
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)
102

Choice
Formally:
0 MUF(F) MUC(C)
No change in total utility along an indifference curve.
Trade off of one good to the other leaves the consumer
just as well off.
103

Choice
Rearranging:
C / F MU F / MU C
Since
C / F MRS of F for C
We can say
MRS MUF/MUC
104

Choice
When consumers maximize satisfaction:
MRS PF /PC
Since the MRS is also equal to the ratio of
the marginal utility of consuming F and C
MU F /MU C PF /PC
105

Choice
Rearranging, gives the equation for utility
maximization:
MU F / PF MU C / PC
106

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.
107
Cost-of-Living Indexes
Social Security payments are given to
qualifying individuals
Each year the benefit increases equal to
the rate of increase of the Consumer
Price Index (CPI)
Ratio of the present cost of typical bundle of

goods/services in comparison to the cost
during a base period
108
Does the CPI give a good measure of
inflation and therefore a measure of the
cost of living changes?
Should the CPI be used to measure how
much cost of living has increased,
determining increases in government
payment programs?
109
The ideal cost of living index represents
the cost of attaining a given level of utility
at current prices relative to the cost of
attaining the same utility at base prices
110
To obtain the ideal cost of living index
would require too much information, such
as consumer preferences as well as
prices and expenditures
Actual price indexes are based on
consumer purchases, not preferences
111
Laspeyres price index
Amount of money at current year prices that
an individual requires to purchase a bundle
of goods/services chosen in a base year
divided by the cost of purchasing the same
bundle at base-year prices
Ex: CPI
112
The Laspeyres price index assumes that
consumers do not alter their consumption
patterns as prices change
Tends to overstate the true cost of living
index
Using the CPI to adjust retirement
benefits will tend to overcompensate
most recipients, requiring greater
government expenditure
113
Paasche index
Focuses on the cost of buying the current
years bundle
Amount of money at current-year prices that
an individual requires to purchase a current
bundle of goods/services divided by the cost
of purchasing the same bundle in a base
year
114
Comparison of indexes
Both are fixed weight indexes
Quantities of various goods and services in
each index remain unchanged
Laspeyres index keeps quantities at base
year levels
Paasche index keeps unchanged quantities
at current year levels
115
Chain-Weighted Indexes
Cost-of-living index that accounts for
changes in quantities of goods and services
Introduced to overcome problems that arose
when long-term comparisons were made
using fixed weight price indexes
116

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Chapter 3

2005 Pearson Chapter 3

2005 Pearson Chapter 3

Consumer Behavior Applications

2005 Pearson Chapter 3

The explanation of how consumers allocate

2005 Pearson Chapter 3

To describe how and why people prefer one

People have limited incomes

2005 Pearson Chapter 3

What combination of goods will consumers

2005 Pearson Chapter 3

2005 Pearson Chapter 3

Consumer Preferences Basic

Consumers can rank market baskets

2. Preferences are transitive

If they prefer A to B, and B to C, they must

3. Consumers always prefer more of any

2005 Pearson Chapter 3

A person will be equally satisfied with either

2005 Pearson Chapter 3

2005 Pearson Chapter 3

2005 Pearson Chapter 3

The consumer prefers

2005 Pearson Chapter 3

Need more information about consumer

Consumer may decide they are

We can then connect those points with an

2005 Pearson Chapter 3

2005 Pearson Chapter 3

2005 Pearson Chapter 3

If they sloped upward, they would violate the

points that had more of both goods would

2005 Pearson Chapter 3

Each indifference curve in the map shows

2005 Pearson Chapter 3

2005 Pearson Chapter 3

Indifference curves cannot cross

assumption that more is better

Why? What if we assume they can cross?

2005 Pearson Chapter 3

2005 Pearson Chapter 3

The more clothing and less food a

Observation: The amount

2005 Pearson Chapter 3

2005 Pearson Chapter 3

Marginal Rate of Substitution

2005 Pearson Chapter 3

Marginal Rate of Substitution

As more of one good is consumed, a

Consumers generally prefer a balanced

2005 Pearson Chapter 3

Marginal Rate of Substitution

2005 Pearson Chapter 3

Marginal Rate of Substitution

2005 Pearson Chapter 3

Marginal Rate of Substitution

would always trade 1 glass of OJ for 1

2005 Pearson Chapter 3

2005 Pearson Chapter 3

have one right for one left

2005 Pearson Chapter 3

2005 Pearson Chapter 3