Ch03 Pindyck

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 Education, Inc.
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?
Chapter 3
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?
Chapter 3
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
Chapter 3
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
Chapter 3
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?
Chapter 3
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
Chapter 3
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
Chapter 3
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
Chapter 3
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
Chapter 3
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
Chapter 3
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
Chapter 3
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
Chapter 3
14
An Example
Clothin
g
50
40
E
A
30
20
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
Chapter 3
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
Chapter 3
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
Chapter 3
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
Chapter 3
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
Chapter 3
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?
Chapter 3
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
Chapter 3
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
Chapter 3
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
4
Chapter 3
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
Chapter 3
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
1
4
Chapter 3
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
Chapter 3
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
Chapter 3
27
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
Chapter 3
28
How do we account for bads in our
preference analysis?
We redefine the commodity
Clean
air
Pollution reduction
Asbestos removal
Chapter 3
29
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
Chapter 3
30
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
Chapter 3
31
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
Chapter 3
32
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)
Chapter 3
33
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
Chapter 3
34
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
Chapter 3
Income
35
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
Chapter 3
80 = (I/PF)
Food
36
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
37
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
Chapter 3
38
The Budget Line
I PX X PY Y
I PX X PY Y
I PX
X Y
PY PY
Chapter 3
39
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
40
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
Chapter 3
41
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
Chapter 3
42

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
Chapter 3
43

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
Chapter 3
L2
(I = $160)
160
Food
(units per week)
44

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.
Chapter 3
45

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.
Chapter 3
46

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
Chapter 3
160
Food
(units per week)
47

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
Chapter 3
48

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
Chapter 3
49
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 3
50
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 3
51
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
Chapter 3
52
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
Chapter 3
80
U2
Food (units per week)
53
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
54
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
55
Consumer Choice
Therefore, it can be said at consumers
optimal consumption point,
PF
MRS
PC
Chapter 3
56
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
57
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
Chapter 3
58
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
Chapter 3
59
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
B
30
-10C
20
+10F
20
40
U1
Chapter 3
80
Food (units per week)
60
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 3
61
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 3
62
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 3
63
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 3
64

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.
Chapter 3
65

Choice
Rearranging:
C / F MU F / MU C
Since
C / F MRS of F for C
We can say
MRS MUF/MUC
Chapter 3
66

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
Chapter 3
67

Choice
Rearranging, gives the equation for utility
maximization:
MU F / PF MU C / PC
Chapter 3
68

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
69

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Chapter 3

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Consumer Behavior Applications

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Consumer Preferences Basic

2. Preferences are transitive

3. Consumers always prefer more of any

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

The consumer prefers

Consumer may decide they are

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

points that had more of both goods would

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

assumption that more is better

Why? What if we assume they can cross?

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

The more clothing and less food a

Observation: The amount

2005 Pearson Education, Inc.

Marginal Rate of Substitution

Marginal Rate of Substitution

Consumers generally prefer a balanced

2005 Pearson Education, Inc.

Marginal Rate of Substitution

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

The Budget Line

2005 Pearson Education, Inc.

The Budget Line

2005 Pearson Education, Inc.

The Budget Line

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

The Budget Line

2005 Pearson Education, Inc.

The Budget Line

2005 Pearson Education, Inc.

The Budget Line

2005 Pearson Education, Inc.

The Budget Line

2005 Pearson Education, Inc.

The Budget Line

2005 Pearson Education, Inc.

The Budget Line - Changes

2005 Pearson Education, Inc.

The Budget Line - Changes

2005 Pearson Education, Inc.

The Budget Line - Changes