McGraw-Hill/I rwin

Copyright 2013 by The McGraw-Hill Companies, I nc. All rights reserved.

LECTURE 5
Theory of Consumer Behavior
5-2
Learning Objectives
Explain the concept of utility and basic assumptions
underlying consumer preferences
Define the concept of indifference curves and explain
the properties of indifference curves and maps
Construct a consumers budget line and explain how to
rotate or shift the line when prices or income change
Derive/interpret equilibrium conditions for a consumer to
be maximizing utility subject to a budget constraint
Use indifference curves to derive a demand curve for an
individual consumer and construct a market demand
curve by horizontally summing individual demands
Define a corner solution and explain the condition that
creates a corner solution
5-3
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
5-4
Consumer Theory
Assumes buyers are completely informed
about:
~ Range of products available
~ Prices of all products
~ Capacity of products to satisfy
~ Their incomes
Requires that consumers can rank all
consumption bundles based on the level of
satisfaction they would receive from
consuming the various bundles
5-5
Typical Consumption Bundles for
Two Goods, X & Y (Figure 5.1)
5-6
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
Nonsatiation
~ More of a good is always preferred to less
5-7
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
U = f(X, Y)
5-8
Indifference Curves
Set of points representing different
bundles of goods & services, each of
which yields the same level of total utility
Downward-sloping & convex

5-9
Typical Indifference Curve
(Figure 5.2)
5-10
Marginal Rate of Substitution
MRS measures the number of units of Y
that must be given up per unit of X added
so as to keep 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

X
Y
MU Y
MRS
X MU

5-11
Slope of an Indifference Curve &
the MRS (Figure 5.3)
Quantity of good X
Q
u
a
n
t
i
t
y

o
f

g
o
o
d

Y

0
I
C (360,320)
600
800
A
B
T
T
360
320
5-12
Indifference Maps
An indifference map consists of several
indifference curves
The higher (or further to the right) an
indifference curve, the greater the level
of utility associated with the curve
Combinations of goods on higher
indifference curves are preferred to
combinations on lower curves

5-13
Indifference Map (Figure 5.4)
Q
u
a
n
t
i
t
y

o
f

Y

Quantity of X
I
II
III
IV
5-14
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
MU U X

X
Y
MU Y
MRS
X MU

5-15
Consumers Budget Line
Shows all possible bundles of goods that
can be purchased at given prices if the
entire income is spent

X Y
M P X P Y
X
Y Y
P M
Y X
P P

or
5-16
Consumers Budget Constraint
(Figure 5.5)
5-17
Typical Budget Line (Figure 5.6)
Q
u
a
n
t
i
t
y

o
f

Y

Quantity of X

X
Y Y
P M
Y X
P P


A
B
Y
M
P
X
M
P
5-18
Shifting Budget Lines (Figure 5.7)
Panel B Changes in price of X
200
100
A
B
250
D
R
N
120
240
Q
u
a
n
t
i
t
y

o
f

Y

Quantity of X
Panel A Changes in money income
Q
u
a
n
t
i
t
y

o
f

Y

Quantity of X
A
B
100
F
Z
80
160 200 125
C
5-19
Utility Maximization
Utility maximization subject to a limited
income occurs at the combination of
goods for which the indifference curve is
just tangent to the budget line

X
Y
P Y
MRS
X P

5-20
Utility Maximization
Consumer allocates income so that the
marginal utility per dollar spent on each
good is the same for all commodities
purchased

X Y
X Y
MU MU
P P

X X
Y Y
MU P
MRS
MU P

5-21
Constrained Utility Maximization
(Figure 5.8)
A


I

C



B

II

R

T

Quantity of burgers
Q
u
a
n
t
i
t
y

o
f

p
i
z
z
a
s

0 80 20 100 40 60
10
20
30
40
50
70 10 90 30 50

E

III


D

IV

45
15
5-22
Utility Maximization, N Goods
The utility maximization principle is
easily extended to cover any number of
goods

3 1 2
1 2 3
...
N
N
MU MU MU MU
P P P P

j
i
j i
P
X
MRS
X P

5-23
Individual Consumer Demand
An individuals demand curve for a
specific commodity relates utility-
maximizing quantities purchased to
market prices
~ Income & prices held constant
~ Slope of demand curve illustrates law of
demandquantity demanded varies
inversely with price
5-24
Deriving a Demand Curve
(Figure 5.9)
Q
u
a
n
t
i
t
y

o
f

Y

P
r
i
c
e

o
f

X

(
$
)

Quantity of X
Quantity of X
100
200 125 100
0
0
Px=$10
Px=$5
Px=$8
90 65 50
90 65 50
5
8
10
Demand for X
5-25
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
5-26
Derivation of Market Demand
(Table 5.1)
Quantity demanded
Price Consumer 1 Consumer 2 Consumer 3
Market
demand
$6
2

1
5
4

3

3
12

13
5
8

10

0
7

10
1
3

5

0
6

8
0
1

4

3
25

31
6
12

19

5-27
Derivation of Market Demand
Figure (5.10)
5-28
Corner Solution
In many cases consumers spend their
entire budget and choose to purchase
none of some specific good
A corner solution exists when the utility
maximizing bundle lies at one of the
endpoints of the budget line and the
consumer chooses to consume zero
units of a good
5-29
Corner Solution: X* = 0
Figure (5.11)
5-30
Corner Solution
For goods X and Y, a corner solution, in which
the consumer purchases none of good X, results
when
In general, a corner solution, in which the
consumer purchases none of good X, results
when
X Y
X Y
MU MU
P P

...
j
i X
X i j
MU
MU MU
P P P

5-31
Summary
Basic premise for analyzing consumer behavior
~ Individuals make consumption decisions with the goal of
maximizing their total satisfaction from consuming various
goods and services, subject to the constraint that their spending
on goods exactly equals their incomes
The benefit consumers obtain from the goods and
services they consume is called utility
~ The utility function shows an individual's perception of the level
of utility from consuming each conceivable bundle of goods
~ Marginal utility is the addition to total utility attributable to adding
one unit of a good, holding constant the amounts of all other
goods consumed
~ The marginal rate of substitution (MRS) shows the rate at which
one good can be substituted for another while keeping utility
constant
5-32
Summary
An indifference curve is a set of points representing
different bundles of goods and services, each of which
yields the same level of total utility
The consumers budget line shows the set of all
consumption bundles that can be purchased at given
prices and income if the entire income is spent
A consumer maximizes utility subject to a limited
income at the combination of goods for which the
indifference curve is just tangent to the budget line
~ At this combination, the MRS is equal to the price ratio


5-33
Summary
An individual consumers demand curve relates utility-
maximizing quantities to market prices, holding
constant income and prices of all other goods
~ The slope of the demand curve illustrates the law of demand:
quantity demanded varies inversely with price
Market demand is derived by horizontally summing the
demand curves for all individuals in the market
When a consumer spends the entire budget and
chooses to purchase none of a specific good, this
outcome is called a corner solution