Theory of Consumer Behavior: Ninth Edition Ninth Edition

Managerial Economics
ninth edition
Thomas Maurice
Chapter 5
Theory of Consumer Behavior
McGraw-Hill/Irwin McGraw-Hill/Irwin Managerial Economics, 9e Managerial Economics, 9e
Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
The Consumers Optimization Problem

Individual consumption decisions are made with the goal of maximizing total satisfaction from consuming various goods and services
Subject to the constraint that spending on goods exactly equals the individuals money income
5-2
Consumer Theory
Assumes buyers are completely informed about:
Range of products available Prices of all products Capacity of products to satisfy Their income
Requires that consumers can rank all consumption bundles based on the level of satisfaction they would receive from consuming the various bundles
5-3
Typical Consumption Bundles for Two Goods, X & Y (Figure 5.1)
5-4
Properties of Consumer Preferences

Completeness

For every pair of consumption bundles, A and B, the consumer can say one of the following:
A is preferred to B B is preferred to A
The consumer is indifferent between A and B
Transitivity
If A is preferred to B, and B is preferred to C, then A must be preferred to C More of a good is always preferred to less
Nonsatiation
5-5
Utility
Benefits consumers obtain from goods & services they consume is utility A utility function shows an individuals perception of the utility level attained from consuming each conceivable bundle of goods
5-6
Indifference Curves
Locus of points representing different bundles of goods, each of which yields the same level of total utility Negatively sloped & convex
5-7
Typical Indifference Curve

(Figure 5.2)
5-8
Marginal Rate of Substitution

MRS shows the rate at which one good can be substituted for another while keeping utility constant
Negative of the slope of the indifference curve Diminishes along the indifference curve as X increases & Y decreases Ratio of the marginal utilities of the goods
Y MU X MRS X MUY
5-9
Slope of an Indifference Curve & the MRS (Figure 5.3)
600 Quantity of good Y
T 320 C (360,320) I
B 0 360 Quantity of good X 800
5-10
Indifference Map
(Figure 5.4)
Quantity of Y
IV III II I
Quantity of X
5-11
Marginal Utility
Addition to total utility attributable to the addition of one unit of a good to the current rate of consumption, holding constant the amounts of all other goods consumed
5-12
Consumers Budget Line

Shows all possible commodity bundles that can be purchased at given prices with a fixed money income
M PX X PY Y
or
M PX Y X PY PY
5-13
Consumers Budget Constraint

(Figure 5.5)
5-14
Typical Budget Line

M P Y
(Figure 5.6)
A
M PX X P P Y Y
Quantity of Y
Quantity of X 5-15
M PX
Shifting Budget Lines (Figure 5.7)

120 R
Quantity of Y
Quantity of Y
100 80
A F
100
N 240
C 125
B 200
D 250
160 200
Quantity of X
Quantity of X
Panel A Changes in money income
Panel B Changes in price of X
5-16
Utility Maximization
Utility maximization subject to a limited money income occurs at the combination of goods for which the indifference curve is just tangent to the budget line
Y MU X PX MRS X MUY PY
5-17
Utility Maximization
Consumer allocates income so that the marginal utility per dollar spent on each good is the same for all commodities purchased
MU X MUY PX PY
5-18
Constrained Utility Maximization

(Figure 5.8)
50 45
Quantity of pizzas
40
B
R
D
E IV III
30
20 15 10
10 20 30 40 50 60
II T I
70
80
90
100
Quantity of burgers
5-19
Individual Consumer Demand

An individuals demand curve for a specific commodity relates utilitymaximizing quantities purchased to market prices
Money income & prices held constant Slope of demand curve illustrates law of demandquantity demanded varies inversely with price
5-20
Deriving a Demand Curve

(Figure 5.9)
100
Quantity of Y
Px=$10 Px=$8 Px=$5
50 65
90 100
125
200
Quantity of X
Price of X ($)
10 8
5 Demand for X 0 50 65 90
Quantity of X
5-21
Market Demand & Marginal Benefit

List of prices & quantities consumers are willing & able to purchase at each price, all else constant Derived by horizontally summing demand curves for all individuals in market Because prices along market demand measure the economic value of each unit of the good, it can be interpreted as the marginal benefit curve for a good
5-22
Derivation of Market Demand

(Table 5.1)
Quantity demanded Price Consumer 1 Consumer 2 Consumer 3
Market demand
$6
3 5 8 10 12 13
0 1 3 5 7 10
0 0 1 4
3 6 12 19 25 31
5
4
3
2 1
6
8
5-23
Derivation of Market Demand

Figure (5.10)
5-24
Substitution & Income Effects

When price changes, total change in quantity demanded is composed of two parts
Substitution effect Income effect
5-25

Substitution effect
Change in consumption of a good after a change in its price, when the consumer is forced by a change in money income to consume at some point on the original indifference curve Change in consumption of a good resulting strictly from a change in purchasing power
Income effect
5-26
Income & Substitution Effects: A Decrease in Px (Figure 5.12)

Total effect of = Substitution + Income price effect effect decrease 9 = 5 + 4 Total effect of = Substitution + Income price effect effect decrease 3 = 5 + (-2)
5-27

Consider the substitution effect alone:
Amount of good consumed must vary inversely with price
Income effect reinforces the substitution effect for a normal good & offsets it for an inferior good
5-28
Summary of Substitution & Income Effects (Table 5.2)

Substitution Effect
Price of X decreases: Normal Good Inferior Good Price of X increases: Normal Good Inferior Good
Income Effect
X rises X rises X falls X falls
X rises
X falls
X falls X rises
5-29

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Managerial Economics

The Consumers Optimization Problem

Typical Consumption Bundles for Two Goods, X & Y (Figure 5.1)

Properties of Consumer Preferences

Typical Indifference Curve

Marginal Rate of Substitution

Slope of an Indifference Curve & the MRS (Figure 5.3)

600 Quantity of good Y

B 0 360 Quantity of good X 800

Consumers Budget Line

Consumers Budget Constraint

Typical Budget Line

Shifting Budget Lines (Figure 5.7)

Panel A Changes in money income

Panel B Changes in price of X

Constrained Utility Maximization

Individual Consumer Demand

Deriving a Demand Curve

Px=$10 Px=$8 Px=$5

Market Demand & Marginal Benefit

Derivation of Market Demand

Derivation of Market Demand

Substitution & Income Effects

Substitution & Income Effects

Income & Substitution Effects: A Decrease in Px (Figure 5.12)

Substitution & Income Effects

Summary of Substitution & Income Effects (Table 5.2)

X rises X rises X falls X falls

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