Consumer Behavior

Topics to be Discussed
 Consumer Preferences
 Budget Constraints
 Consumer Choice
 Revealed Preferences

Chapter 3: Consumer Behavior Slide 2

Topics to be Discussed
 Marginal Utility and Consumer Choices
 Cost-of-Living Indexes

Chapter 3: Consumer Behavior Slide 3

Consumer Behavior
 There are three steps involved in the
study of consumer behavior.
1) We will study consumer
preferences.
 To describe how and why people prefer
one good to another.

Chapter 3: Consumer Behavior Slide 4

Consumer Behavior
 There are three steps involved in the
study of consumer behavior.
2) Then we will turn to budget
constraints.
 People have limited incomes.

Chapter 3: Consumer Behavior Slide 5

Consumer Behavior
 There are three steps involved in the
study of consumer behavior.
3) Finally, we will combine consumer
preferences and budget
constraints to determine consumer
choices.
 What combination of goods will
consumers buy to maximize their
satisfaction?
Chapter 3: Consumer Behavior Slide 6
 Consumer Preferences
Market Baskets

 A market basket is a collection of one or

more commodities.
 One market basket may be preferred
over another market basket containing a
different combination of goods.

Chapter 3: Consumer Behavior Slide 7

 Consumer Preferences
Market Baskets
 Three Basic Assumptions
1) Preferences are complete: bisa menyatakan
pilihan jika dihadapkan pada pilihan 2 kelompok
barang.
2) Preferences are transitive: pilihannya konsisten
dan tidak “plin-plan” (circle).
3) Consumers always prefer more of any good to
less.
4) Reflective and Continue

Chapter 3: Consumer Behavior Slide 8

Consumer Preferences
Market Basket Units of Food Units of Clothing

A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40

Chapter 3: Consumer Behavior Slide 9

Consumer Preferences
Indifference Curves

 Indifference curves represent all

combinations of market baskets that
provide the same level of satisfaction to
a person.

Chapter 3: Consumer Behavior Slide 10

 Consumer Preferences
Clothing The consumer prefers
(units per week) A to all combinations
50 B in the blue box, while
all those in the pink
box are preferred to A.
40 H E

A
30

D
20 G

10

Food
10 20 30 40 (units per week)
Chapter 3: Consumer Behavior Slide 11
 Consumer Preferences
Clothing Combination B,A, & D
(units per week) yield the same satisfaction
50 B E is preferred to U1
U1 is preferred to H & G
H
40 E

A
30

D
20 U1
G

10

Food
10 20 30 40 (units per week)
Chapter 3: Consumer Behavior Slide 12
Consumer Preferences
 Indifference Curves
 Indifference curves slope downward to the
right.
If it sloped upward it would violate the
assumption that more of any commodity
is preferred to less.

Chapter 3: Consumer Behavior Slide 13

Consumer Preferences
 Indifference Curves
 Any market basket lying above and to the
right of an indifference curve is preferred to
any market basket that lies on the
indifference curve.

Chapter 3: Consumer Behavior Slide 14

Consumer Preferences
Indifference Maps

 An indifference map is a set of

indifference curves that describes a
person’s preferences for all
combinations of two commodities.
 Each indifference curve in the map shows
the market baskets among which the
person is indifferent.

Chapter 3: Consumer Behavior Slide 15

Consumer Preferences
 Indifference Curves
 Finally, indifference curves cannot cross.
Thiswould violate the assumption that
more is preferred to less.

Chapter 3: Consumer Behavior Slide 16

 Consumer Preferences
Clothing
(units per week) Market basket A
is preferred to B.
Market basket B is
D preferred to D.

B A
U3

U2

U1

Food
(units per week)
Chapter 3: Consumer Behavior Slide 17
 Consumer Preferences
Clothing Indifference Curves
(units per week) U1 Cannot Cross
U2

The consumer should

be indifferent between
A, B and D. However,
A B contains more of
both goods than D.

B
D

Food
(units per week)
Chapter 3: Consumer Behavior Slide 18
Consumer Preferences

Clothing 16 A Observation: The amount

(units of clothing given up for
per week) 14 a unit of food decreases
from 6 to 1
12 -6

10 B
1 Question: Does this
8 -4 relation hold for giving
D up food to get clothing?
6 1
-2 E
4 G
1 -1
2 1
Food
1 2 3 4 5 (units per week)
Chapter 3: Consumer Behavior Slide 19
 Consumer Preferences
Marginal Rate of Substitution

 The marginal rate of substitution (MRS)

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: Consumer Behavior Slide 20

Consumer Preferences

Clothing 16 A
(units
per week) 14 MRS = 6
12 -6

10 B
1
8 -4
D MRS = 2
6 1
-2 E
4 G
1 -1
2 1
Food
1 2 3 4 5 (units per week)
Chapter 3: Consumer Behavior Slide 21
 Consumer Preferences
Marginal Rate of Substitution

 We will now add a fourth assumption

regarding consumer preference:
 Along an indifference curve there is a
diminishing marginal rate of substitution.
 Note the MRS for AB was 6, while that
for DE was 2.

Chapter 3: Consumer Behavior Slide 22

 Consumer Preferences
Marginal Rate of Substitution

 Indifference curves are convex because

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 prefer a balanced market
basket

Chapter 3: Consumer Behavior Slide 23

 Consumer Preferences
Marginal Rate of Substitution

 Perfect Substitutes and Perfect

Complements
 Two goods are perfect substitutes when
the marginal rate of substitution of one
good for the other is constant.

Chapter 3: Consumer Behavior Slide 24

 Consumer Preferences
Marginal Rate of Substitution

 Perfect Substitutes and Perfect

Complements
 Two goods are perfect complements when
the indifference curves for the goods are
shaped as right angles.

Chapter 3: Consumer Behavior Slide 25

Consumer Preferences
Apple
Juice
(glasses) 4
Perfect
Substitutes
3

Orange Juice
0 1 2 3 4 (glasses)

Chapter 3: Consumer Behavior Slide 26

Consumer Preferences
Left
Shoes
4

Perfect
3
Complements

0 1 2 3 4 Right Shoes

Chapter 3: Consumer Behavior Slide 27

 Consumer Preferences
Designing New Automobiles (I)

 Automobile executives must regularly

decide when to introduce new models
and how much money to invest in
restyling.

Chapter 3: Consumer Behavior Slide 28

 Consumer Preferences
Designing New Automobiles (I)

 An analysis of consumer preferences

would help to determine when and if car
companies should change the styling of
their cars.

Chapter 3: Consumer Behavior Slide 29

Consumer Preferences

Styling Consumer
Preference A:
High MRS

These consumers are

willing to give up
considerable
styling for additional
performance

Performance

Chapter 3: Consumer Behavior Slide 30

Consumer Preferences
Consumer
Styling
Preference B:
Low MRS
These consumers are
willing to give up
considerable
performance for
additional styling

Performance

Chapter 3: Consumer Behavior Slide 31

 Consumer Preferences
Designing New Automobiles (I)

 What Do You Think?

 How can we determine the consumers
preference?

Chapter 3: Consumer Behavior Slide 32

 Consumer Preferences
Designing New Automobiles (I)

 A recent study of automobile demand in

the United States shows that over the
past two decades most consumers
have preferred styling over
performance.

Chapter 3: Consumer Behavior Slide 33

Consumer Preferences
 Utility
 Utility: Numerical score representing the
satisfaction that a consumer gets from a
given market basket.

Chapter 3: Consumer Behavior Slide 34

Consumer Preferences
 Utility
 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.

Chapter 3: Consumer Behavior Slide 35

Consumer Preferences
 Utility Functions
 Assume: The utility function for
food (F) and clothing (C) U(F,C) = F +
2C
Market Baskets: F units C units U(F,C) = F + 2C
A 8 3 8 + 2(3) =
14 B 6 4 6 + 2(4) =
14 C 4 4 4 + 2(4) = 12
The consumer is indifferent to A & B The
consumer prefers A & B to C

Chapter 3: Consumer Behavior Slide 36

Consumer Preferences
Clothing Utility Functions & Indifference Curves
(units
per week) Assume: U = FC
Market Basket U = FC
15 C 25 = 2.5(10)
A 25 = 5(5)
C B 25 = 10(2.5)
10

A U3 = 100 (Preferred to U2)

5
B
U2 = 50 (Preferred to U1)
U1 = 25
Food
0 5 10 15 (units per week)

Chapter 3: Consumer Behavior Slide 37

Consumer Preferences
 Ordinal Versus Cardinal 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.

Chapter 3: Consumer Behavior Slide 38

Consumer Preferences
 Ordinal Versus Cardinal Rankings
 The actual unit of measurement for utility is
not important.
 Therefore, an ordinal ranking is sufficient to
explain how most individual decisions are
made.

Chapter 3: Consumer Behavior Slide 39

Budget Constraints
 Preferences do not explain all of
consumer behavior.
 Budget constraints also limit an
individual’s ability to consume in light of
the prices they must pay for various
goods and services.

Chapter 3: Consumer Behavior Slide 40

Budget Constraints
 The Budget Line
 The budget line indicates all combinations
of two commodities for which total money
spent equals total income.

Chapter 3: Consumer Behavior Slide 41

Budget Constraints
 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 Pf F is the amount of money spent on
food, and Pc C is the amount of money
spent on clothing.

Chapter 3: Consumer Behavior Slide 42

Budget Constraints
 The budget line then can be written:

Chapter 3: Consumer Behavior Slide 43

Budget Constraints
Market Basket Food (F) Clothing (C) Total Spending
Pf = ($1) Pc = ($2) PfF + PcC = I

A 0 40$80
B 2030$80
D 4020$80
E 6010$80
G 800 $80

Chapter 3: Consumer Behavior Slide 44

Budget Constraints
Clothing
Pc = $2 Pf = $1 I = $80
(units
per week)
A Budget Line F + 2C = $80
(I/PC) = 40

B
30
10
D
20
20
E
10
G Food
0 20 40 60 80 = (I/PF) (units per week)

Chapter 3: Consumer Behavior Slide 45

Budget Constraints
 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: Consumer Behavior Slide 46

Budget Constraints
 The Budget Line
 The slope indicates the rate at which the
two goods can be substituted without
changing the amount of money spent.

Chapter 3: Consumer Behavior Slide 47

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: Consumer Behavior Slide 48

Budget Constraints
 The Effects of Changes in Income and
Prices
 Income Changes
 An increase in income causes the
budget line to shift outward, parallel to
the original line (holding prices
constant).

Chapter 3: Consumer Behavior Slide 49

Budget Constraints
 The Effects of Changes in Income and
Prices
 Income Changes
 A decrease in income causes the budget
line to shift inward, parallel to the original
line (holding prices constant).

Chapter 3: Consumer Behavior Slide 50

Budget Constraints
Clothing
(units A increase in
per week) income shifts
80 the budget line
outward

60
A decrease in
income shifts
40 the budget line
inward

20 L3
(I = L1 L2
$40) (I = $80) (I = $160)
Food
0 40 80 120 160 (units per week)

Chapter 3: Consumer Behavior Slide 51

Budget Constraints
 The Effects of Changes in Income and
Prices
 Price Changes
 If the price of one good increases, the
budget line shifts inward, pivoting from
the other good’s intercept.

Chapter 3: Consumer Behavior Slide 52

Budget Constraints
 The Effects of Changes in Income and
Prices
 Price Changes
 If the price of one good decreases, the
budget line shifts outward, pivoting from
the other good’s intercept.

Chapter 3: Consumer Behavior Slide 53

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

Chapter 3: Consumer Behavior Slide 54

Budget Constraints
 The Effects of Changes in Income and
Prices
 Price Changes
 If the two goods increase in price, but
the ratio of the two prices is unchanged,
the slope will not change.

Chapter 3: Consumer Behavior Slide 55

Budget Constraints
 The Effects of Changes in Income and
Prices
 Price Changes
 However, the budget line will shift inward
to a point parallel to the original budget
line.

Chapter 3: Consumer Behavior Slide 56

Budget Constraints
 The Effects of Changes in Income and
Prices
 Price Changes
 If the two goods decrease in price, but
the ratio of the two prices is unchanged,
the slope will not change.

Chapter 3: Consumer Behavior Slide 57

Budget Constraints
 The Effects of Changes in Income and
Prices
 Price Changes
 However, the budget line will shift
outward to a point parallel to the original
budget line.

Chapter 3: Consumer Behavior Slide 58

Consumer Choice
 Consumers choose a combination of
goods that will maximize the satisfaction
they can achieve, given the limited
budget available to them.

Chapter 3: Consumer Behavior Slide 59

Consumer Choice
 The maximizing market basket must
satisfy two conditions:
1) It must be located on the budget
line.
2) Must give the consumer the most
preferred combination of goods
and services.

Chapter 3: Consumer Behavior Slide 60

Consumer Choice

Recall, the slope of an indifference curve is:

Further, the slope of the budget line is:

Chapter 3: Consumer Behavior Slide 61

Consumer Choice
 Therefore, it can be said that
satisfaction is maximized where:

Chapter 3: Consumer Behavior Slide 62

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).

Chapter 3: Consumer Behavior Slide 63

Consumer Choice
Clothing Pc = $2 Pf = $1 I = $80
(units per
week) Point B does not
maximize satisfaction
40 because the
MRS (-(-10/10) = 1
is greater than the
B price ratio (1/2).
30
-10C
Budget Line
20

U1
+10F

0 20 40 80 Food (units per week)

Chapter 3: Consumer Behavior Slide 64

Consumer Choice
Clothing Pc = $2 Pf = $1 I = $80
(units per
week)

40

D Market basket D
30 cannot be attained
given the current
budget constraint.
20
U3

Budget Line

0 20 40 80 Food (units per week)

Chapter 3: Consumer Behavior Slide 65

Consumer Choice
Clothing Pc = $2 Pf = $1 I = $80
(units per
week) At market basket A
the budget line and the
40 indifference curve are
tangent and no higher
level of satisfaction
can be attained.
30

A
20 At A:
MRS =Pf/Pc = .5

U2
Budget Line
0 20 40 80 Food (units per week)

Chapter 3: Consumer Behavior Slide 66

 Consumer Choice
Designing New Automobiles (II)

 Consider two groups of consumers,

each wishing to spend $10,000 on the
styling and performance of cars.
 Each group has different preferences.

Chapter 3: Consumer Behavior Slide 67

 Consumer Choice
Designing New Automobiles (II)

 By finding the point of tangency

between a group’s indifference curve
and the budget constraint auto
companies can design a production and
marketing plan.

Chapter 3: Consumer Behavior Slide 68

Designing New Automobiles (II)

Styling

$10,000 These consumers

are willing to trade
off a considerable
amount of styling
for some additional
performance

$3,000

$7,000 $10,000 Performance

Chapter 3: Consumer Behavior Slide 69

Designing New Automobiles (II)

Styling

$10,000 These consumers

are willing to trade
off a considerable
$7,000 amount of
performance for
some additional
styling

$3,000 $10,000 Performance

Chapter 3: Consumer Behavior Slide 70

 Consumer Choice
Decision Making & Public Policy

 Choosing between a non-matching and

matching grant to fund police
expenditures

Chapter 3: Consumer Behavior Slide 71

 Consumer Choice
Private Non-matching Grant
Expenditures ($)

Before Grant
 Budget line: PQ
P A: Preference maximizing
market basket
Expenditure
 OR: Private
A  OS: Police
R

U1

Police
O S Q Expenditures ($)
Chapter 3: Consumer Behavior Slide 72
 Consumer Choice
Private Non-matching Grant
Expenditures ($)

T
After Grant
 Budget line: TV
P B: Preference maximizing
market basket
Expenditure
U B OU: Private
A OZ: Police
R U3

U1

Police
O S Z Q V Expenditures ($)
Chapter 3: Consumer Behavior Slide 73
 Consumer Choice
Private Matching Grant
Expenditures ($)

T Before Grant
 Budget line: PQ
 A: Preference maximizing
P market basket
After Grant
C: Preference maximizing
market basket
W A Expenditures
R C OW: Private
U2 OX: Police

U1

O S X Q R Police ($)

Chapter 3: Consumer Behavior Slide 74

 Consumer Choice
Private Matching Grant
Expenditures ($)

T
Nonmatching Grant
Point B
P OU: Private expenditure
OZ: Police expenditure
Matching Grant
U B Point C
W A OW: Private expenditure
C U OX: Police expenditure
U2 3

U1

O Z X Q R Police ($)

Chapter 3: Consumer Behavior Slide 75

Consumer Choice
A Corner Solution

 A corner solution exists if a consumer

buys in extremes, and buys all of one
category of good and none of another.
 This exists where the indifference curves
are tangent to the horizontal and vertical
axis.
 MRS is not equal to PA/PB

Chapter 3: Consumer Behavior Slide 76

A Corner Solution
Frozen
Yogurt
(cups
monthly) A A corner solution
exists at point B.
U1 U2 U3

B Ice Cream (cup/month)

Chapter 3: Consumer Behavior Slide 77

Consumer Choice
 A Corner Solution
 At point B, the MRS of ice cream for frozen
yogurt is greater than the slope of the
budget line.
 This suggests that 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!

Chapter 3: Consumer Behavior Slide 78

Consumer Choice
 A Corner Solution
 When a corner solution arises, the
consumer’s MRS does not necessarily
equal the price ratio.
 In this instance it can be said that:

Chapter 3: Consumer Behavior Slide 79

Consumer Choice
 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 consumer’s market basket.

Chapter 3: Consumer Behavior Slide 80

Revealed Preferences
 If we know the choices a consumer has
made, we can determine what her
preferences are if we have information
about a sufficient number of choices
that are made when prices and incomes
vary.

Chapter 3: Consumer Behavior Slide 81

Revealed Preferences--
Two Budget Lines

Clothing l1 I1: Chose A over B

(units per A is revealed preferred to B
month)
l2: Choose B over D
l2 B is revealed preferred to D

B
D

Food (units per month)

Chapter 3: Consumer Behavior Slide 82

Revealed Preferences--
Two Budget Lines

Clothing l1
(units per All market baskets
month) in the pink
shaded area are
l2 preferred to A.

B
D
B is preferred to
all market baskets
in the green area

Food (units per month)

Chapter 3: Consumer Behavior Slide 83

Revealed Preferences--
Four Budget Lines
I3: E revealed preferred to A
Clothing
l3
(units per
month) All market baskets in the
pink area preferred to A
E
l1

l4
A
l2
B G
A: preferred to all I4: G revealed preferred to A
market baskets in
the green area
Food (units per month)

Chapter 3: Consumer Behavior Slide 84

Marginal Utility and
Consumer Choice
Marginal Utility

 Marginal utility measures the additional

satisfaction obtained from consuming
one additional unit of a good.

Chapter 3: Consumer Behavior Slide 85

Marginal Utility and
Consumer Choice
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

Chapter 3: Consumer Behavior Slide 86

 Marginal Utility and
Consumer Choice
Diminishing Marginal Utility

 The principle of diminishing marginal

utility states that as more and more of a
good is consumed, consuming
additional amounts will yield smaller and
smaller additions to utility.

Chapter 3: Consumer Behavior Slide 87

Marginal Utility and
Consumer Choice

 Marginal Utility and the Indifference

Curve
 If consumption moves along an
indifference curve, the 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: Consumer Behavior Slide 88

Marginal Utility and
Consumer Choice

 Formally:

Chapter 3: Consumer Behavior Slide 89

Marginal Utility and
Consumer Choice

 Rearranging:

Chapter 3: Consumer Behavior Slide 90

Marginal Utility and
Consumer Choice

 Because:

Chapter 3: Consumer Behavior Slide 91

Marginal Utility and
Consumer Choice

 When consumers maximize satisfaction the:

 Since the MRS is also equal to the ratio

of the marginal utilities of consuming F
and C, it follows that:

Chapter 3: Consumer Behavior Slide 92

Marginal Utility and
Consumer Choice

 Which gives the equation for utility

maximization:

Chapter 3: Consumer Behavior Slide 93

Marginal Utility and
Consumer 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: Consumer Behavior Slide 94

Summary
 People behave rationally in an attempt
to maximize satisfaction from a
particular combination of goods and
services.
 Consumer choice has two related parts:
the consumer’s preferences and the
budget line.

Chapter 3: Consumer Behavior Slide 95

Summary
 Consumers make choices by comparing
market baskets or bundles of
commodities.
 Indifference curves are downward
sloping and cannot intersect one
another.
 Consumer preferences can be
completely described by an indifference
map.
Chapter 3: Consumer Behavior Slide 96
Summary
 The marginal rate of substitution of F for
C is the maximum amount of C that a
person is willing to give up to obtain one
additional unit of F.
 Budget lines represent all combinations
of goods for which consumers expend
all their income.

Chapter 3: Consumer Behavior Slide 97

Summary
 Consumers maximize satisfaction
subject to budget constraints.
 The theory of revealed preference
shows how the choices that individuals
make when prices and income vary can
be used to determine their preferences.

Chapter 3: Consumer Behavior Slide 98

End of Chapter 3
Consumer Behavior