CHAPTER 3

consumer behavior
Chapter 3: Consumer Behavior

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 CHAPTER 3 consumer behavior

3.1 Consumer Preferences

3.2 Budget Constraints

3.3 Consumer Choice

Chapter 3: Consumer Behavior

3.4 Marginal Utility and Consumer Choice

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 Consumer Behavior

● theory of consumer behavior Description of how

consumers allocate incomes among different goods and
services to maximize their well-being.

Consumer behavior is best understood in three distinct steps:

1. Consumer preferences
Chapter 3: Consumer Behavior

2. Budget constraints

3. Consumer choices

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 3.1 CONSUMER PREFERENCES

Market Baskets
● market basket (or bundle) List with specific quantities
of one or more goods.

TABLE 3.1 Alternative Market Baskets

Market Basket Units of Food Units of Clothing

A 20 30
B 10 50
Chapter 3: Consumer Behavior

D 40 20
E 30 40
G 10 20
H 10 40

To explain the theory of consumer behavior, we will ask

whether consumers prefer one market basket to another.

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 3.1 CONSUMER PREFERENCES

Some Basic Assumptions about Preferences

1. Completeness

Preferences are assumed to be complete. In other words,

consumers can compare and rank all possible baskets. Thus, for
any two market baskets A and B, a consumer will prefer A to B, will
prefer B to A, or will be indifferent between the two. By indifferent
we mean that a person will be equally satisfied with either basket.
Chapter 3: Consumer Behavior

Note that these preferences ignore costs. A consumer might prefer

coffee to tea but buy tea because it is cheaper.

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 3.1 CONSUMER PREFERENCES

Some Basic Assumptions about Preferences

2. Transitivity:

Preferences are transitive. Transitivity means that if a consumer

prefers basket A to basket B and basket B to basket C, then the
consumer also prefers A to C. Transitivity is normally regarded as
necessary for consumer consistency.

3. More is better than less:

Chapter 3: Consumer Behavior

Goods are assumed to be desirable.

Consequently, consumers always prefer more of any good to less.
In addition, consumers are never satisfied or satiated; more is
always better, even if just a little better.

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 3.1 CONSUMER PREFERENCES

Indifference Curves

Figure 3.1

Describing Individual Preferences

Because more of each good is

preferred to less, we can
compare market baskets in the
shaded areas.
Basket A is clearly preferred to
Chapter 3: Consumer Behavior

basket G, while E is clearly

preferred to A.
However, A cannot be compared
with B, D, or H without additional
information.

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 3.1 CONSUMER PREFERENCES

Indifference Curves
● indifference curve Curve representing all combinations of market
baskets that provide a consumer with the same level of satisfaction.

Figure 3.2

An Indifference Curve

The indifference curve U1 that

passes through market basket
A shows all baskets that give
the consumer the same level of
Chapter 3: Consumer Behavior

satisfaction as does market

basket A; these include
baskets B and D.

Our consumer prefers basket

E, which lies above U1, to A,
but prefers A to H or G, which
lie below U1.

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 3.1 CONSUMER PREFERENCES

Indifference Maps
● indifference map Graph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.

Figure 3.3

An Indifference Map

An indifference map is a set of

indifference curves that
describes a person's
preferences.
Chapter 3: Consumer Behavior

Any market basket on

indifference curve U3, such as
basket A, is preferred to any
basket on curve U2 (e.g.,
basket B), which in turn is
preferred to any basket on U1,
such as D.

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 3.1 CONSUMER PREFERENCES

Indifference Curves Cannot Intersect

Figure 3.4

Indifference Curves Cannot Intersect

If indifference curves U1 and U2

intersect, one of the
assumptions of consumer
theory is violated.
According to this diagram, the
consumer should be indifferent
Chapter 3: Consumer Behavior

among market baskets A, B,

and D. Yet B should be
preferred to D because B has
more of both goods.

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 3.1 CONSUMER PREFERENCES

The Marginal Rate of Substitution

● marginal rate of substitution (MRS) Maximum amount of a good
that a consumer is willing to give up in order to obtain one additional
unit of another good.
Figure 3.5
The Marginal Rate of Substitution

The magnitude of the slope of an

indifference curve measures the
consumer’s marginal rate of
substitution (MRS) between two
Chapter 3: Consumer Behavior

goods.
In this figure, the MRS between clothing
(C) and food (F) falls from 6 (between A
and B) to 4 (between B and D) to 2
(between D and E) to 1 (between E and
G).
Convexity IC is convex when the
MRS diminishes along an indifference
curve, the curve is convex.

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 3.1 CONSUMER PREFERENCES

Perfect Substitutes and Perfect Complements

● perfect substitutes Two goods for which the marginal rate

of substitution of one for the other is a constant.

● perfect complements Two goods for which the MRS is

zero or infinite; the indifference curves are shaped as right
Chapter 3: Consumer Behavior

angles.
Bads
● bad Good for which less is preferred rather than more.

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 3.1 CONSUMER PREFERENCES

Perfect Substitutes and Perfect Complements

Figure 3.6
Perfect Substitutes and Perfect Complements
Chapter 3: Consumer Behavior

In (a), zara views orange juice and In (b), sara views left shoes and
apple juice as perfect substitutes: right shoes as perfect complements:
she is always indifferent between a An additional left shoe gives her no
glass of one and a glass of the extra satisfaction unless she also
other. obtains the matching right shoe.

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 3.1 CONSUMER PREFERENCES

Utility and Utility Functions

● utility Numerical score representing the satisfaction that a
consumer gets from a given market basket.

● utility function Formula that assigns a level of utility to individual

market baskets.
Figure 3.8

Utility Functions and Indifference Curves

A utility function can be

represented by a set of
Chapter 3: Consumer Behavior

indifference curves, each

with a numerical
indicator.
This figure shows three
indifference curves (with
utility levels of 25, 50,
and 100, respectively)
associated with the utility
function FC.

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 3.1 CONSUMER PREFERENCES

Ordinal versus Cardinal Utility

● ordinal utility function Utility function that generates a ranking
of market baskets in order of most to least preferred.

● cardinal utility function Utility function describing by how much

one market basket is preferred to another.
Chapter 3: Consumer Behavior

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 3.2 BUDGET CONSTRAINTS
● budget constraints Constraints that consumers face
as a result of limited incomes.
The Budget Line
● budget line All combinations of goods for which the total
amount of money spent is equal to income.

PF F  PC C  I

TABLE 3.2 Market Baskets and the Budget Line

Chapter 3: Consumer Behavior

Market Basket Food (F) Clothing (C) Total Spending

A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
The table shows market baskets associated with the budget line
F + 2C = $80
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 3.2 BUDGET CONSTRAINTS

The Budget Line

Figure 3.10

A Budget Line

A budget line describes the

combinations of goods that can be
purchased given the consumer’s
income and the prices of the goods.
Line AG (which passes through
points B, D, and E) shows the
budget associated with an income
Chapter 3: Consumer Behavior

of $80, a price of food of PF = $1

per unit, and a price of clothing of
PC = $2 per unit.
The slope of the budget line
(measured between points B and D)
is −PF/PC = −10/20 = −1/2.

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 3.2 BUDGET CONSTRAINTS
The Effects of Changes in Income and Prices

Figure 3.11
Effects of a Change in Income on the
Budget Line

Income Changes A change in

income (with prices unchanged)
causes the budget line to shift
parallel to the original line (L1).
When the income of $80 (on L1) is
Chapter 3: Consumer Behavior

increased to $160, the budget line

shifts outward to L2.
If the income falls to $40, the line
shifts inward to L3.

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 3.2 BUDGET CONSTRAINTS
The Effects of Changes in Income and Prices

Figure 3.12
Effects of a Change in Price on the
Budget Line

Price Changes A change in the

price of one good (with income
unchanged) causes the budget line
to rotate about one intercept.
When the price of food falls from
$1.00 to $0.50, the budget line
Chapter 3: Consumer Behavior

rotates outward from L1 to L2.

However, when the price increases
from $1.00 to $2.00, the line rotates
inward from L1 to L3.

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 3.3 CONSUMER CHOICE
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination
of goods and services.
Figure 3.13

Maximizing Consumer Satisfaction

A consumer maximizes satisfaction

by choosing market basket A. At
this point, the budget line and
indifference curve U2 are tangent.
Chapter 3: Consumer Behavior

No higher level of satisfaction (e.g.,

market basket D) can be attained.
At A, the point of maximization, the
MRS between the two goods equals
the price ratio. At B, however,
because the MRS [− (−10/10) = 1]
is greater than the price ratio (1/2),
satisfaction is not maximized.

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 3.3 CONSUMER CHOICE

Satisfaction is maximized (given the budget constraint) at the

point where
MRS  PF / PC

● marginal benefit Benefit from the consumption of one

additional unit of a good.
Chapter 3: Consumer Behavior

● marginal cost Cost of one additional unit of a good.

In this instance, satisfaction is maximized when the marginal

benefit—the benefit associated with the consumption of one
additional unit of food—is equal to the marginal cost—the cost
of the additional unit of food. The marginal benefit is measured
by the MRS.

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 3.3 CONSUMER CHOICE
Corner Solutions
● corner solution Situation in which the marginal rate of
substitution of one good for another in a chosen market
basket is not equal to the slope of the budget line.
Figure 3.15

A Corner Solution

When the consumer’s marginal

rate of substitution is not equal to
the price ratio for all levels of
Chapter 3: Consumer Behavior

consumption, a corner solution

arises. The consumer
maximizes satisfaction by
consuming only one of the two
goods.
Given budget line AB, the
highest level of satisfaction is
achieved at B on indifference
curve U1, where the MRS (of ice
cream for frozen yogurt) is
greater than the ratio of the price
of ice cream to the price of
frozen yogurt. 22 of 37
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 3.5 MARGINAL UTILITY AND CONSUMER CHOICE

● marginal utility (MU) Additional satisfaction obtained

from consuming one additional unit of a good.
● diminishing marginal utility Principle that as more of a good is
consumed, the consumption of additional amounts will yield
smaller additions to utility.
0  MU (F )  MU (C )
F C
(C / F )  MU / MU
F C
MRS  MU /MU
Chapter 3: Consumer Behavior

F C
MRS  P / P
F C
MU / MU  P / P
F C F C
MU / P  MU / P
F F C C
● equal marginal principle Principle that utility is maximized
when the consumer has equalized the marginal utility per dollar of
expenditure across all goods.

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 QUIZ 1

1. Are the following statements true or false? Explain your

answer.
i. The elasticity of demand is same as the slope of demand curve.
ii. The cross price elasticity will always be positive.
2. Use supply and demand curves to illustrate how each of
the following events would affect the price of butter and
the quantity of butter bought and sold:
i. An increase in the price of margarine.
ii. An increase in the price of milk.
Chapter 3: Consumer Behavior

3. Use supply and demand curves to illustrate how each of

the following events would affect the equilibrium quantity
and price:
i. Increase in demand with inelastic supply
ii. Increase in supply with perfectly elastic demand

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