A Theory of Consumer Behavior Preliminaries

1. Introduction The fundamental question in economics is

2. Consumer Preferences Given limited resources, how are goods and service allocated?
3. Indierence Curves Last class we argued this allocation comes from the interaction of supply
and demand. Today we want to develop the theory of demand.
4. The Marginal Rate of Substitution
Given limited income, how do consumer allocate their income across
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5. Utility
dierent goods and services?
6. Budget Constraints
We focus on three main criteria
7. Consumer Choices
1. Consumer Preferences
8. Revealed Preference 2. Consumer Income
9. Marginal Utility and Consumer Optimization 3. Available choices

Consumer Preferences

The number of dierent goods and services one can purchase is simply Consumer theory is essentially a model of you. It is hard to study
too large to comprehend. So we begin by considering a market basket consumer theory without become introspective.
or bundle of goods. I know what you will be thinking: Oh I never go into a store and think
Usually we just work with two goods. about my purchases this way ...
apples and oranges But keep with me. Economics is like playing pool.
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beans and cornbread but you dont get to drink beer in class
food and clothing Consumers are not explicitly solving complicated mathematical prob-
It is a more general set up than you might think. Consider one good lems, but the solution to the model can accurately describe their be-
to represent everything else. havior.
oranges and everything else
 We begin by considering a market basket or bundle. It is a collection of
goods and services a particular individual might consume. For example,
one basket might be The Three Big Assumptions About Consumer Preferences
two Super Bowl tickets, a hotel room in Detroit, and a six-pack 1. Preferences are complete.
or a basket might be
two tickets to Met, a dinner at a nice restaurant in NYC, and room That is, the consumer is able to rank any two baskets. For bas-
at the Yale Club kets A and B, for example, the consumer can state her preferences
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according to one of the following possibilities
We are going to follow the books example and only think about baskets She prefers basket A to basket B (written A
B).
or bundles of food and clothing
She prefers basket B to basket A (written A B).
six units of food and seven units of clothing She is indierent between, or equally happy with, baskets A and
B (written A B).
and/or
seven units of food and six units of clothing

2. Preferences are transitive

3. More is better than less.
By this we mean that the consumer makes choices that are consistent
with each other. In other words, having more of a good is better for the consumer.
Suppose that a consumer tells us that she prefers basket A to basket Goods are assumed to be desirable. You never get satiated. This
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B, and basket B to basket E. We can then expect her to prefer assumption is made make our life easy for now.
basket A to basket E. Flip bads into goods
We can represent transitivity as follows: If A
B and if B
E, Free disposal
then A
E.
 Indierence Curves
Now suppose I state the individual is equally happy consuming either
Lets consider the books food and clothing example. bundle B or A or D.
Look at table 3.1 and gure 3.1 I can draw an indierence curve through these points.
Using the assumption that more is always preferred to less we state the An indierence curve represents all combinations of market baskets that
following provide a consumer with the same level of satisfaction.

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1. B
H
G Indierence curves that are high and to the right represent higher levels
2. E
A
G of utility, because more consumption is preferred to less.
3. E
H In general, indierence curves are bowed toward the origin. You prefer
4. D
G a little bit of everything to a lot of just one thing.
Not much more we can say at this point.

1. Indierence curves slope downward from left to right

This follows from our assumption that more is preferred to less.
If an indierence curve was upward sloping the individual would
The Four Important Properties of Indierence Curves
have to be indierent between two market baskets even though one
1. When consumers like both goods, indierence curves slope downward would have more of both goods.
from left to right: less consumption of one good requires more con- 2. Indierence curve cannot intersect.
sumption in the other good to keep the consumer equally happy.
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Consider the case of two indierence curve which cross. See gure
2. Indierence curves cannot intersect 3.4.
3. Every consumption basket lies on one and only one indierence curve. The basket represented by point B on U1 is preferred to the basket
4. Indierence curves are not thick. represented by point D on U2. Thus U1 > U2.
Similarly the basket represented by point R on U2 is preferred to
the basket represented by point Q on U1. Thus U2 > U1. But wait
this cant be. There is a logical inconsistency here.
 3. Every consumption basket lies on one and only one indierence
curve. The Marginal Rate of Substitution
This follows from the property that indierence curve cannot inter-
sect. A consumers willingness to substitute one good for another while main-
taining the same level of satisfaction is called the marginal rate of
The basket represented by point A lies on the two intersecting in-
substitution.
dierence curves (U1 and U2); a point can lie on two curves only at
a place where the two curves intersect. For example, a consumers marginal rate of substitution of hamburgers
Since indierence curves cannot intersect, every consumption basket for lemonade is the rate at which the consumer would be willing to give
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must lie on a single indierence curve. up glasses of lemonade to get more hamburgers, with the same overall
satisfaction.
4. Indierence curves are not thick.
See gure 3.5
To see why, consider the gure with the think indierence curve
The MRS can be written mathematically as C
F .
passing through distinct baskets A and B.
If B lies northeast of A, the utility of B must be higher than the When the indierence curves are bowed to the origin, the MRS is di-
utility of A. Therefore A and B cannot be on the same indierence minishing.
curve.

Perfect Substitutes and Perfect Complements

Lets look at two extreme cases Utility

Perfect substitutes are two goods for which the marginal rate of substi-
tution is a constant. The book denes utility as the numerical score representing the satis-
faction that a consumer receives from a market basket.
Hence the indierence curves has a constant slope. Does not have to
be one-for-one. This will allows us to represent consumer preferences with a utility
function. We can then illustrate
These are goods that the consumer doesnt care how she has has of
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one or the other, but only about the total amount of the two goods. Consider a single customer who consumes a single good: cola. Let the

Examples, red pencils and blue pencils. consumers utility function be U (y) = y.

Perfect complements are two goods for which the MRS is innite; the More must be preferred to less, and preferences must be transitive.
indierence curves are shaped as right angles. The rate at which total utility changes as the level of consumption rises
These are goods that are always consumed in xed proportions. Right is call the marginal utility or in short M U .
shoes and left shoes are the classic example. Doesnt have to be one-
for-one.
 Utility and Happiness
Keep in mind
In standard economics we use utility to represent a measure of sat-
Total utility and marginal utility cannot be plotted on the same graph. isfaction or happiness that people receive from consuming a good or
Utility is measured in U , which we often called utils, but is really service.
just a made up unit of account. But do more goods and service really make people happier?
Marginal utility is measured in U
y .
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So one area of research these days is happiness economics.
From the previous point, it may be clear to many that marginal utility
Two examples of trying to directly measuring happiness
is the slope of the utility function. It the rate of change in utility as
one changes consumption. the book
In other words, it is the rise over the run. the reading packet
Price of everything, value of nothing?

In this case, the marginal utility of any good is the rate at which total
utility changes as the consumption of that rises, holding constant the
levels of consumption of all other goods.
The marginal utility of food measures how the level of satisfaction
Utility with more than one good changes (U ) in response to a change in the consumption of food (F )
holding the consumption of clothing constant.
Now lets consider the case when there are two goods, which we call Mathematically,
food and clothing.
U
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Suppose the utility function for these two goods is U (F, C) = F C. M UF = |C is held constant
F
So just to get idea of units, if the consumer consumes
2 units of clothing Similarly, the marginal utility of clothing measures how the level of
and 8 units of food his utility is U (C, F ) = 2 8 = 4. satisfaction changes (U ) in response to a change in the consumption
of clothing (C) holding the consumption of food constant.
Mathematically,
U
M UC = |F is held constant
C
 Back to Indierence Curves Budget Constraint

Recall that all points on an indierence curve generate the same level The budget constraint denes the set of baskets that a consumer can
of utility. purchase with a limited amount of income. Suppose a consumer pur-
chases only two types of goods, food and clothing. Let F denote the
So on an indierence curve it must be the case that amount of food purchased and C denote the amount of clothing.
M UF F = M UC C We denote the prices of the two good PF and PC . Note the units ($
per unit of food and $ per unit of clothing)
That is gain in utility from an increase in food consumption must ex-
actly equal to the loss in utility from a decrease in consumption of The budget line indicates all the combinations of F and C for which to
clothing. total amount of money spend
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Rewriting this expression PF F + PC C = I
C M UF Consider what happens if the consumer spend all his/her money on
=
F M UC clothing (e.g. F = 0).
Note that C
F is the marginal rate of substitution. So we get C = I/PC
M UF Now consider the case if the consumer spends al his/her money on food
M RS =
M UC (e.g. C = 0).
So the marginal rate of substitution is the ratio of the marginal utilities. F = I/PF

We can rewrite the budget constraint as:

Changes in Income
C = I/PC (PF /PC )F
Positive intercept and a negative slope. A change in the income does not change the slope of the budget con-
straint, since the slope is the ratio of the two prices, and prices remain
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The slope of the budget constraint (PF /PC ) is the negative of the ratio unchanged.
of the two prices. Slope of the budget constraint is the opportunity cost.
A change in income causes a parallel shift in the budget constraint (in
Bundles to southwest of the budget constraint are in the feasible set. or out).
Bundles to the northeast of the budget constraint are not feasible.
 Putting Preferences and Constraints Together: Consumer Choice

We want to nd the bundle of goods such that

1. maximize his satisfaction
2. allows him to live within his budget constraint.
Changes in Relative Prices
The maximizing bundle must satisfy two conditions
Consider a decrease in the price of food. 1. It must be on the budget constraint
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If the person consumes no food, nothing changes for him/her. 2. It must give the consumer the most preferred combination.
The budget constraint rotates in. Note that the optimal bundle must be located on the budget line.
Assuming the consumer likes both goods (food and clothing), a bas-
ket on the interior of the budget set cannot be optimal because it
does not require the consumer to spend all his income.
The unspent income could be used to increase satisfaction with the
purchase of additional food or clothing.

Figure 3.13 So lets start at point A and consider moving along the budget con-
To maximize satisfaction while satisfying the budget constraint, the straint. Utility must fall even if we move a little bit because indierence
consumer will choose the bundle that allows him to reach the high curve are bowed to the origin.
indierence curve while being on or inside the budget line. Note an important feature of the optimal bundle: at this choice, the
The optimal bundle is point A. Any other point on or inside the budget indierence curve is tangent to the budget line.
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line will leave the consumer with a lower level of satisfaction. Do you remember from high school math what tangent means?
Bundles outside the budget line, such as D, cannot be optimal because If the indierence curve were not tangent it would cross the budget line,
the consumer cannot aord them. and if it cross the budget line, there would be some nearby point on the
Bundles within the budget set cannot be optimal for reasons we have budget line that lies above the indierence curve which means that
already discussed. we couldnt have started at an optimal bundle.
 Some Applications

When driving, most people like to

get to their destination quickly
Lets stick with cars. When driving, most people like
get to their destination safely
power and performance
There is a tradeo between these two objectives.
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fuel economy
Now lets do some thought experiments
Now what is going to happen with the introduction of hybrid engines?
the introduction of seat belts
buy a really safe car (a SUV?)
we remove all seat belts and place a huge spike on every steering
wheel

Revealed Preference Marginal Utility and Consumer Optimization

We are never going to directly observe someones indierence curves ... Recall
M UF
But we do often get observations about consumer choices with two M RS =
M UC
dierence budget lines. We can use these observation to infer
the key equation:
In other words, we can reverse the process and see what the consumers
behavior reveals about his preferences. M U F PF = M U C PC
If a consumer chooses one market basket over another, and if the cho- or
sen market basket is more expensive than the alternative, then the M UF PF
=
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consumer must prefer the chosen market basket. M U C PC

Figure 3.17. That is the ratio of the marginal utilities is equal to the ratio of prices.
We know the consumer prefers A to B. Since we know
Can we say anything about A and D? M UF
M RS =
Now suppose prices change so the budget constraint mover from l1 M UC
to l2. this means
If the consumer now choose B we know the consumer prefers B to M UF PF
M RS = =
D. We know previously that the consumer chose A to B, so we now M U C PC
know the consumer prefers A to D.
THIS IS BIG!!!!!
 Marginal Utility and Consumer Optimization
People may value their total consumption of the two goods very dier-
In well-organized markets, it is typical that everyone faces roughly the ently. Some people may be consuming a lot of butter and little milk,
same prices for goods. Take, for example, two goods like butter and and some may be doing the reverse. Some wealthy people may be con-
milk. suming a lot of milk and a lot of butter while other people may be
consuming just a little of each good.
If everyone faces the same prices for butter and milk, and everyone
is optimizing ... then everyone must have the same marginal rate of But everyone who is consuming the goods must agree on how much one
is worth in terms of the other; how much of one they would be willing
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substitution for butter and milk.
to sacrice to get some more of the other.
This follows directly from the analysis above. The market is oering
everyone the same rate of exchange for butter and milk, and everyone The fact that
is adjusting consumption of the goods until their internal marginal M UF PF
valuation of the two goods equals the markets external valuation of M RS = =
M U C PC
the two goods.
means that we can value possible changes in consumption bundles.
This statement is independent of income and tastes.

Suppose, for example, that the price of milk is $1 a quart and the price
of butter is $2 per pound. The marginal rate of substitution for all
people who consume both butter and milk must be 2: they have to Suppose the inventor said But I can run this machine in reverse and
have 2 quarts of milk to compensate them for giving up 1 pound of transform 1 pound of butter into 3 quarts of milk
butter. Or conversely, they have to have 1 pound of butter to make it
Then the venture capitalist inside of us should state Sign me up
worth their while to give up 2 quarts of milk.
People are just willing to trade one pound of butter for two quarts of
Suppose an inventor discover a new way of turning milk into butter.
milk. So getting three quarts of milk for one pound of butter is a better
For every 3 quarts of milk poured into this machine, you get 1 pound
deal than is being oered in the marketplace.
of butter and no other useful by-products.
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Market prices tell us the rst machine is unprotable, but the second
OK venture capitalists how much should we invest in this new tech-
machine is more protable because people values the output more than
nology? The answer is nothing.
the input.
Everyone is operating at a point where they are willing to trade o 2
Prices are not arbitrary numbers but reect how people value things on
quarts of milk for 1 pound of butter. They are not going to be willing
the margin. This is one of the most fundamental and important ideas
to tradeo 3 quarts of milk for 1 pound of butter.
in economics.
That is, we know from the relative prices of butter and milk that people
value the inputs more than the outputs.