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CONSUMER BEHAVIOR

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The consumer's spending on the two goods together must be less than or equal to ... It is the extra utility you can get from spending another $ on S. Consumer behavior ... – PowerPoint PPT presentation

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Title: CONSUMER BEHAVIOR


1
CONSUMER BEHAVIOR
  • Preferences.
  • The conflict between opportunities and desires.
  • Utility maximizing behavior.

2
Preferences or Tastes
  • All consumers are endowed with a set of
    preferences among all of the goods and services
    from which they can choose.
  • These preferences are embodied in a "utility
    function."

3
  • Economists impose 4 assumptions on the
    preferences in the standard case of the utility
    function
  • 1. A consumer can decide for any pair of
    bundles of goods which bundle is preferred, or
    whether he/she is indifferent.
  • 2. Preferences are transitive (consistent).
  • 3. More is better.
  • 4. Indifference curves are convex. (See
    below for a discussion of indifference curves.)

4
A utility function for two goods.
5
Indifference curve
  • Definition All combinations of goods among
    which the consumer is indifferent.
  • That is, all the combinations of goods that give
    the consumer a particular level of utility or
    satisfaction.

6
  • The previous graph can be rotated to show
    indifference curves

7
Marginal Rate of Substitution
  • Definition The Marginal Rate of Substitution of
    X for Y is the amount of Y it takes to make up
    for the loss of one unit of X.
  • (Its minus the slope of an indifference curve.)

8
Some indifference curves U1 lt U2 lt U3
TACOS
SPAGHETTI
9
MRS is minus the slope of an indifference curve.
TACOS
MRSS for T -(?T/?S)
U3
?T
U2
?S
SPAGHETTI
10
  • Characteristics of indifference curves in the
    standard case
  • 1) They fill the goods space.
  • 2) They cannot intersect.
  • 3) Higher curves lie above and to the right of
    others.
  • 4) They are convex. (There is increasing
    marginal rate of substitution.)

11
Woeful tales of preferences
  • Nickels and dimes.
  • Right shoes and left shoes.
  • "I wouldn't eat acorns even if you paid me."
  • "I would eat acorns only if you paid me."

12
Budget Constraints
  • Definition The consumers budget constraint
    shows all of the combinations of goods and
    services the consumer is able to buy, given
    income and prices.

13
  • Standard case assumptions
  • 1. The consumer has a fixed, known money income
    in each time period.
  • 2. The consumer pays a fixed price (in terms of
    dollars) for each good.

14
Two good case
  • Consumers income is I dollars per period.
  • There are two goods, S and T, that have prices PS
    and PT.
  • The consumers spending on the two goods together
    must be less than or equal to total income in
    each time period.

15
The Budget Constraint is
  • PS S PTT ??I
  • This can be written as
  • T ??I/PT - (PS /PT)S

16
  • Remember that income and prices are givens
    here, so the last equation is a linear
    relationship between T and S.

slope - PS / PT
17
  • Where are feasible and non-feasible consumption
    bundles?

T
I/PT
S
I/PS
18
Changing income and prices
  • Whats the effect on the consumers opportunities
    if income increases?
  • I gt I
  • PS S PTT I
  • PS S PTT I

19
  • Wheres the new budget constraint when I
    increases to I?

T
I/PT
S
hidden slide
I/PS
20
An increase in income expands the consumer's
opportunities.
T
I/PT
S
I/PS
21
Changing prices
  • Whats the effect on the consumers opportunities
    if the price of spaghetti falls?
  • PS' gt PS
  • PS' S PTT I
  • PS S PTT I

22
  • Wheres the new budget constraint when the price
    of spaghetti falls?

T
I/PT
S
hidden slide
I/P'S
23
  • Wheres the budget constraint when the price of
    spaghetti falls?

A fall in the price of spaghetti also expands the
consumer's opportunities, but in a different way.
T
I/PT
S
I/P'S
I/PS
24
Choice
  • If a consumer wants to choose S and T so as to
    maximize total utility, what should he/she do?

hidden slide
25
Constraints and choices
TACOS
What to choose??
SPAGHETTI
26
Maximizing total utility
TACOS
T and S are best.
T
U3
U
U2
U1
S
SPAGHETTI
27
To maximize utility
  • 1) Spend all of your income.
  • 2) Choose a point on the budget constraint
    where
  • (a) an indifference curve is tangent to the
    constraint, or
  • (b) the MRS is equal to the ratio of the prices
    of the goods. (MRSS for T PS/PT)

28
More woeful tales
  • Nickels dimes.
  • Left shoes and right shoes.
  • Work for pay.
  • Two part pricing.

29
Changes in prices and income
  • 1) Price changes and price consumption curves.
  • 2) Income changes and income consumption curves.
  • 3) Income and substitution effects.
  • 4) Consumer Surplus.

30
Effects of a price change
  • If the price of a good declines, consumers will
    change the amount they want to buy (demand), in
    general.

31
  • Here the price of spaghetti falls. The consumer
    changes the amounts chosen.

T
I/PT
U'
S
I/P'S
S'
32
Price consumption curve
  • Locus of utility maximizing amounts of goods at
    different prices for one of the goods.
  • Information from the PCC can be used to derive
    the consumer's demand curve for a good.

33
Finding the consumer's demand curve for spaghetti.
T
PS
I/PT
P'S
U'
S
S
I/P'S
S'
S'
34
Income increases
Are the goods normal or inferior here?
T
I/PT
U'
I/PS
S'
S
35
Choice and inferior goods
Income increases here. Which good is inferior?
T
I/PT
U'
S'
I/PS
S
36
Income consumption curve
  • Locus of utility maximizing amounts of goods at
    different income levels for the goods.
  • Information from the ICC can be used to derive
    what is called the Engel Curve (or income demand
    curve) for a good.

37
Income and Substitution Effects
  • The consumer is maximizing utility.
  • The price of one good falls.
  • The change in the demand for the good can be
    thought of as having two parts
  • A substitution effect, and
  • An income effect.

38
  • Substitution Effect The change in demand (due
    to a decrease in price) holding the consumer's
    real income constant.
  • Income Effect The change in demand (due to a
    decrease in price) because of the increase in
    real income the consumer receives.

39
  • Start with the consumer maximizing utility by
    choosing amount S0 of good S.

T
I/PT
U'
S
I/P'S
S0
I/PS
40
  • The price of good S falls to PS.
  • The consumer then chooses S2 of good S.

T
I/PT
U'
S
I/P'S
S0
41
  • To find the substitution effect, we must see what
    the consumer will choose at the lower price of S,
    but forcing the consumer to have the same real
    income (i.e., utility) as at S0.
  • The substitution effect is a "pure price effect"
    on demand.

42
  • Isolating the substitution effect is accomplished
    by reducing the consumer's money income after the
    price change until the best he or she can do is
    get to indifference curve U'.

43
  • S1 - S0 is the substitution effect.
  • S2 - S1 is the income effect.

T
I/PT
U'
S
I/P'S
S0
44
  • The substitution effect always works in the
    direction of increasing the demand for a good
    whose price has fallen.
  • The income effect can work in either direction,
    depending on whether the good is normal or
    inferior.

45
  • Income and substitution effects are used to show
    (among other things) the conditions under which
    the Law of Demand is true.

46
  • Note that for normal goods, the Law of Demand
    must hold.
  • For inferior goods, it may hold.
  • But if the income effect is of opposite sign from
    the substitution effect, and is larger in
    magnitude, a decrease in price will lead to lower
    demand. (A Giffen Good.)

47
THE CARDINAL UTILITY APPROACH TO CHOICE
  • Each person has a utility function which is a
    rule or equation that determines the consumers
    utility (satisfaction) for any amounts of goods
    and services consumed.
  • Utility here is assumed to be cardinal, rather
    than ordinal. (Measured in "utils"??)

48
  • The dependent variable in the utility function is
    utility or satisfaction.
  • The independent variables are the amounts of the
    goods and services an individual consumes.

49
LIKE THIS
  • UBROWN f(beer, bicycles, pizza,
  • spaghetti, tacos,
    ...)
  • Browns utility depends on the number of beers
    he consumes, the number of bikes he consumes,
    etc.

50
Browns total utility from pizzas.
PIZZA
TOTAL UTILITY
0
0
1
5
2
13
3
22
4
29
5
35
6
40
7
44
8
47
51
  • You can graph the total utility this way.

TOTAL UTILITY
60
50
40
30
20
10
PIZZAS
0
0
1
2
3
4
5
6
7
8
9
10
52
  • You can graph the total utility this way.

TOTAL UTILITY
PIZZAS
53
  • MARGINAL UTILITY
  • The marginal utility is the increase in utility
    you get from consuming one more unit of the good,
    holding the consumption of all other goods
    constant.

54
  • The marginal utility of pizza is the change in
    utility per unit change in pizza consumption
    (holding the consumption of all other goods
    constant, of course).
  • MUPIZZA the change in U / the change in pizza
  • ??U / ? (PIZZA)

55
  • You can compute marginal utility from the total
    utility curve.

PIZZA
TOTAL UTILITY
MU
0
0
(13-5)/(2-1)
1
5
5
2
13
8
3
22
9
4
29
7
5
35
6
40
7
44
8
47
56
  • You can compute marginal utility from the total
    utility curve.

PIZZA
TOTAL UTILITY
MU
0
0
(13-5)/(2-1)
1
5
5
2
13
8
3
22
9
4
29
7
5
35
6
6
40
5
7
44
4
8
47
3
57
  • Law of Diminishing Marginal Utility
  • The marginal utility of a good will eventually
    decline as more is consumed.

58
  • Marginal utility begins to decline here with the
    consumption of the 4th pizza.

PIZZA
TOTAL UTILITY
MU
0
0
1
5
5
2
13
8
(29-22)/(4-3)
3
22
9
4
29
7
5
35
6
40
7
44
8
47
59
  • Marginal utility is the slope of the total
    utility curve.

MU ?U / ?P
TOTAL UTILITY
60
50
40
30
? U
20
? P
10
0
0
1
2
3
4
5
6
7
8
9
10
PIZZAS
60
  • Draw the marginal utility curve here. Be sure to
    label the axes correctly. Some points are
    already shown.

marginal utility
12
The marginal utility of the 4th pizza is 7 utils.
10
8
6
4
2
0
0
1
2
3
4
5
6
7
8
9
10
pizzas
61
  • The 5th pizza is worth less than the 4th pizza.

marginal utility
And the marginal utility of the 5th pizza is 6.
pizzas
62
  • The Law of Diminishing Marginal Utility is
    assumed to be true for all consumers, and for all
    of the goods a person consumes.

63
The standard problem (same as in ordinal approach)
  • Suppose a person consumes two goods, say, tacos
    and spaghetti.
  • The person has a fixed money income of I dollars
    per time period, say a week.
  • Tacos and spaghetti can be bought at fixed, known
    prices, say PT and PS.
  • What amounts of spaghetti and tacos will maximize
    utility?

64
  • In the earlier solution to this problem, the
    marginal rule was to make the MRS equal to the
    price ratio of the goods. (MRSS for T PS/PT)
  • It's easy to show that the MRS can be expressed
    as a ratio of marginal utilities, land the rule
    rewritten as

65
  • Choose S and T so that
  • MUS / PS MUT / PT.
  • MUS / PS is the marginal utility per spent on
    S.
  • It is the extra utility you can get from spending
    another on S.

66
WHY THE RULE WORKS
  • Suppose the rule were not true, but instead we
    had MUS / PS lt MUT / PT.
  • or 12 lt 20
  • Spending 1 less on S would lower your utility by
    12 utils.
  • Respending that 1 on T would raise your utility
    by 20 utils.
  • This will give you a net gain of 8 (20-12)
    utils.

67
  • So if the MU's per spent on two goods are not
    not equal, then a gain in total utility is
    possible by reallocating your spending.
  • You should spend more on the good whose MU per
    is the highest. In the example on the last
    slide, this was tacos, T.

68
  • Note that as you allocate your from the good
    whose MU per is lower, the MU of that good will
    rise (remember the Law of Diminishing MU).
  • And the MU of the good with the higher MU per
    will fall for the same reason.
  • Thus, as you reallocate spending, the degree of
    inequality between MUs per will diminish.

69
  • Only when the MU per spent on S is equal to the
    MU per spent on T will you be unable to make
    utility larger by reallocating you spending, and
    total utility will be maximized.
  • MUS / PS MUT / PT

70
Consumer Surplus
  • At the level of the individual consumer, CS is
    the difference between what the consumer is
    willing to pay for a good, and the amount the
    consumer actually pays.
  • It's a measure of the welfare to the consumer of
    being able to buy the good in a market.

71
  • Consumer surplus can be measured using the demand
    curve for a product.

P
Demand for tacos
P
D
Q
Q
72
  • When Q is sold, willingness to pay is the shaded
    area.

P
Demand for tacos
P
D
Q
Q
73
  • When Q is sold at a price P, consumers pay P
    times Q. Click to see the cost to consumers.
    Click again to see the shaded area that is
    consumer surplus.

P
P
Demand for tacos
D
Q
Q
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