Transcript Chapter 6 - Pegasus @ UCF

Chapter 7 – The Theory of
Consumer Behavior
 The Theory of Consumer behavior provides
the theoretical basis for buyer decisionmaking and the foundation for demand.
 In essence, we will assume that the
consumer’s goal is to maximize utility
subject to a budget constraint.
 Thus, this theory is an application of the
logic of constrained maximization.
6.1
Assumptions of the Theory of
Consumer Behavior
 Consumers have complete information
– Know goods available and utility provided
– Price of each good is known
– Income is known
 Consumers can rank order their preferences
– Given choices A and B, can determine AB or BA
or AB
– Rationality – transitive preferences, if AB and BC
then AC
– More is preferred to less
6.2
Consumer Preferences and Utility
 Utility is a measure of the benefits received from
the goods consumed.
 The utility function is an equation the relationship
between total utility and the different
combinations(bundles) of goods.
 U=f(X,Y,Z), where U is utility and X,Y, and Z are
quantities of three goods.
 The utility measurement is only important to the
extent that it accurately represents preferences.
6.3
Indifference Curves
 An indifference curve is a locus of points
indicating different combinations of 2 goods
each of which yields the same level of
satisfaction.
 Note 2 goods are assumed since we desire
to present model graphically.
6.4
Characteristics of Indifference
Curves
 Negative slope – tradeoffs, if more of X
then less of Y if utility is held constant
 Convex to the origin – diminishing MRS,
the more of X you have relative to Y the
more willing you are to trade X for Y and
vice-versa.
 Indifference curves cannot intersect –
violation of transitivity assumption
6.5
Marginal Rate of Substitution
 The MRS is the (negative of the) slope of
the indifference curve. Therefore it reflects
Y
MRS 
X
It is a measure of the number of units of Y that must be
given up if X is increased by a single unit, holding utility
constant. Note it will diminish as we move down an
indifference curve.
6.6
Indifference Curves
ac
bc
a  b???
No ba
Y
a
b
c
X
6.7
Concept of an Indifference Map
 Graph of several indifference curves each
representing different levels of utility.
 The higher (further from the origin) an
indifference curve, the greater the level of
utility.
6.8
Marginal Utility and MRS
 Marginal utility of a good is the change in
total utility in response to consuming an
additional unit.
 The change in total utility is given by the
following equation
UU((MU
MUXX XX))((MU
MUYYYY))
6.9
Marginal Utility and MRS
U  (MU X  X )  (MUY  Y )
Along an indifference curve the change in utility is equal
to zero and
0  ( MU X  X )  ( MU Y  Y )
 ( MU Y  Y )  ( MU X  X )
 Y
X
MU
X

MU Y
 MRS
6.10
The Budget Constraint
 Suppose you have $100 to spend on two goods, X
& Y, and the prices of each are $10 and $20
respectively. Determine the equation relating Y to
X reflecting your budget constraint.
 100 = 10X+20Y or
 Y=5-0.5X
 In general, budget constraint is
 Y = M/PY-(PX/PY)X
 Note linear and slope is ratio of prices
6.11
Changes in the Budget
 What happens to the budget line if income,
M, changes?
 What happens to budget line if one of the
prices change?
 Y = M/PY-(PX/PY)X
6.12
Change in Income
Budget line I – M=100, PX=10, PY=20
Y Budget Line II – M=140, Prices same
7
5
I
10
14
X
6.13
Change in Price
Budget line I – M=100, PX=10, PY=20
Y Budget Line II – M=100, P =20, P =20
X
Y
7
5
II
5
I
10
14
X
6.14
Utility Maximization
 In graphical model consumer is trying to
obtain the highest level of utility subject to
the budget constraint which limits his/her
choices.
 The budget line shows what combinations
of X and Y that the consumer is able to
purchase.
 The indifference map shows the consumer’s
preferences for X and Y.
6.15
Utility Maximization
 The Optimal Solution, where the consumer
maximizes utility subject to the budget
constraint, is found where the budget line is
tangent to an indifference curve. Since
indifference curves cannot intersect this will
be the highest possible level of utility given
the constraint.
 See Figure 6.7 page 211
6.16
Utility Maximization
 At any tangency point the slopes of the two
relationships must be equal.
 Slope of Indifference curve is the MRS –
the rate the consumer is willing to substitute
Y for X, holding utility constant.
 Slope of budget line is the ratio of prices,
which reflects the rate the consumer is able
to substitute Y for X
6.17
Utility Maximization
Px
MRS 
PY
Rate willing to sub = Rate able to sub
6.18
Utility Maximization
 Recall the Marginal Utility interpretation of
the MRS or slope of the indifference curve.
MU X
PX
MRS 

MU Y
PY
MU X
MU Y

PX
PY
6.19
An Individual Consumer’s
Demand Curve
 If you change the price of say Good X and
observe the optimal amount purchased of
Good X, you have the required information
to plot the demand curve, ie. Price versus
Quantity Demanded
6.20
Income And Substitution Effects
 If the price of Good X is decreased, we expect the
quantity demanded of Good X to increase. This is
due to two effects:
– Substitution effect – more of X because it is now
relatively cheaper(compared to Y)
– Income effect(for Normal Good) – more of Good X
because the consumer’s real income(purchasing power)
has risen due to lower price of X and constant income
and price of Y.
 Note income effect can differ from example if
Good X is an inferior good
6.21
Income And Substitution Effects
 Income and substitution effects reinforce
each other if the good is normal and
demand curves must be negatively sloped.
 However, if the good is an inferior good the
income and substitution effects of a price
change are in opposite directions and
whether demand curve is negatively sloped
depends on which effect is the larger.
6.22
Giffen Goods
 A Giffen Good is an inferior good for which
the income effect is larger than the
substitution effect and the demand curve
would be upward-sloping.
 Generally ignore Giffen Goods since
– they are rare
– Even if possible for an individual, no evidence
it could happen for the demand of group of
individuals
6.23
Market Demand Curves
 Nothing more than the horizontal
aggregation of the individual demand
curves of all consumers in the market.
 See Table 6.2 and Figure 6.13
6.24
Imperfect Information About
Price and Quantity
 Since consumers do not have perfect information
about prices and products (quality and
characteristics), there is often an incentive to
gather additional information through search.
 Since there are expected benefits associated with
search as well as expected costs – the optimal
amount of search to conduct is to point where MB
= MC.
 Note the full price for the consumer is the money
(product) price plus the per unit search costs.
6.25
Imperfect Information and
Advertising
 Since consumers do not possess perfect
information, firms expend resources to
advertise their products. This takes two
basic forms:
– Purely informative advertising
– Image advertising
6.26