Transcript Lecture 7

Lecture 7
Consumer Behavior
Required Text:
Frank and Bernanke – Chapter 5
Consumption Decision

Consumers choose from a “menu” of items in various
combinations
 Must be affordable, given income and prices of goods

Factors affecting the consumption decision:
 An individual’s taste & preferences



Microeconomists take people’s taste & preference as given
How much money an individual has to spend (budget)
Price of the goods in the marketplace
Consumption & Utility

Utility – a measure of the satisfaction derived from
consuming a product, good, or service

Since utility is derived from the inherent
characteristics or qualities that make a product
desirable, utility may be objective or subjective.

Util - a hypothetical numerical measurement of
utility (used to represent the satisfaction derived
from consuming products).
Total Utility and Marginal Utility

Total Utility (TU) – total satisfaction derived from
consumption of a good.

Marginal Utility (MU) – The amount of additional
utility derived from the consumption of an additional
unit of a good when the quantity of consumption of all
other goods are held constant
 MU = ΔTU / ΔQ
 MU is the utility provided by the last unit of the good
consumed
Example
Total Utility Curve
80
70
60
Total Utility
Consumption Total Utility
(doughnuts)
0
0
1
24
2
44
3
60
4
69
5
73
6
73
7
68
50
40
30
20
10
0
0
1
2
3
4
Doughnuts
5
6
7
8
Example (Cont.)
Total
Utility
0
Marginal
Utility
>
1
2
3
4
5
6
7
Marginal Utility Curve
30
24
24
25
>
20
>
16
44
60
>
9
>
4
69
73
15
10
5
0
0
1
2
3
4
-5
>
0
>
-5
73
68
20
Marginal Utility
Consumption
(doughnuts)
0
-10
Doughnuts
5
6
7
8
Law of Diminishing Marginal Utility
Law of Diminishing Marginal Utility - as
additional units of a good are consumed a point
is always reached where the utility derived
from each additional unit declines.
Example (Cont.)
Consumption
(doughnuts)
0
1
2
3
4
5
6
7
Total
Utility
0
Marginal
Utility
>
24
>
18
>
10
>
4
>
0
>
-1
>
-10
24
42
52
56
56
55
45
Indifference Curves

Indifference Curve (IC) - a line showing all combinations of two
goods (products) that provide the same level of utility i.e., the
consumer
Qy
is indifferent
between them

As we move along the
IC, the utility level
remains the same but
quantities of goods consumed
change as one good replaces
(or substitutes) for the other.
Y2
Y1
IC
X1
X2
Qx
Characteristics of Indifference Curves

The closer to the origin, the
lower the level of utility and vice
versa.

Each IC represents a unique
utility level - - Hence, ICs never
intersect

ICs are negatively sloped and
convex. The downward slope of
the IC indicates that if the
consumer consumes less of one
good, she would consume more
of the other (for utility to remain
constant).

The whole set of IC is called an
indifference map.
Qy
IC2
IC1
Qx
Indifference Curves

Marginal Rate of Substitution (MRS) – The number of units of one
good that must be given up to receive an extra unit of another good,
holding the level of satisfaction constant.
Qy

MRSXY = Y / X
Y2

MRS is the slope of the
indifference curve.
Y
Y1
X
IC
X1
X2
Qx
Marginal Rate of Substitution
Y
Y
25
X
MRSXY= Y/X
5
-6
19
1
-6
2
-2.50
3
-1.33
4
-0.75
5
-0.40
6
-5
14
8
-4
10
11
-3
7
15
-2
5
X
20
Diminishing Marginal Rate of
Substitution

More the consumer has of a particular good, say X, the less of another
good, say Y, he would be willing to give up to obtain an additional unit
of X.
Y

That is, MRS of X for Y
gets smaller as the
consumer has more of X
and less of Y.

This is applicable only
if Y and X are
imperfect substitutes.
IC
X
Budget Constraint

Budget Constraint – price & availability of goods in
the market, along with the size of the budget, place a
constraint on consumption.

Budget and budget
constraint are
represented by
the budget line.
Y
X
Budget Line

Budget Line – a line indicating all combinations of two
goods that can be purchased using all of the
consumer’s budget, i.e., I = X Px + Y Py

Assume I = 30, PX = 1, & PY = 2
X
30
24
18
12
0
Y
0
3
6
9
15
Total Expenditure
30
30
30
30
30
Budget Line

Every combination of goods along the budget line can
be purchased for the same total expenditure.



The distance from
the origin is an indication
of the size of the budget.
The closer to the origin,
the lower the budget
and vice versa.
Only purchases on the
budget line use all of the
consumer’s budget.
Y
X
Budget Line

I = X Px + Y Py
Y
OR


Y = I/Py – (Px / Py) X
Where, I/Py is the
Y-intercept, I/PX is
the X-intercept and
- (Px / Py) is the slope
I/PY
Slope = - (Px / Py)
I/PX
X
Changes in Budget
Y

A budget increase
(decrease) will result in
a parallel shift of the
budget line to the right
(left)
X
Y

If the price of one good
changes, slope of budget
line changes
X
Review of Budget Line and
Indifference Curve

Budget Line: a line indicating all
combinations of two goods that can be
purchased using all of the consumer’s
budget.


Y
Only purchases on the budget line use
all of the consumer’s budget.
X
Y
Indifference Curve (IC): a line showing
all combinations of two goods (products)
that provide the same level of utility.

ICs that are higher in graphs
represent greater level of satisfaction.
IC3
IC2
IC1
X
Consumer Choice Problem

The basic problem a consumer faces is how to
allocate the budget among various goods to
maximize utility (satisfaction).

That is, the consumer’s objective is to select from all
combinations of goods within her means (i.e.,
combinations on his budget line) the one that gives
him the maximum utility (i.e., the one that lies on the
highest indifference curve.)
Utility Maximization Decision
Y
U
T
S
V
IC3
IC2
W
IC1
X
Utility Maximization Decision
It is then clear that from all the market
baskets that are within the consumer’s
reach, market basket
“V” would give the consumer the
maximum utility.
Y
U
S
T
Note that the market basket V is at a point
where the budget line is tangent to IC2.
V
IC3
W
IC2
IC1
X
Thus, the slope of the budget line should
be equal to the slope of the indifference
curve.
Utility Maximization Decision

Slope of the budget line = PX / PY

Slope of the indifference curve
= MRSXY = Y / X

Thus at the point of tangency:
MRS = Y / X = PX / PY

Thus, the consumer maximizes his utility where
MRS is equal to the ratio of prices.
Impact of Changes in Product Prices

If the consumer’s income and the price of good Y
remains the same, a change in the price of X causes
the consumer’s budget line to pivot around its Yintercept


A rise in the price of X causes the budget line to pivot
inward
A fall in the price of X causes the budget line to pivot
outward
Impact of Changes in Product Prices:
Non-Giffen Goods

IF PX increases- X becomes relatively more expensive
than Y
Y



The (absolute) slope of the budget
line increases and the budget
line rotates inward
The consumer can no longer
afford to remain on original
indifference curve and must
move to a lower indifference
curve
The new equilibrium will be at S.
S
V
W
IC2
IC1
X
Impact of Changes in Product Prices

IF PX decreases- X becomes cheaper relative to Y
Y



The slope of the budget line
decreases and the budget line
rotates outward
The consumer can afford to
move to a higher indifference
curve
The new equilibrium will be at S
V
S
IC1 IC2
X
Price Consumption Curve (PCC)
Y

The PCC connects points
representing equilibrium
market baskets corresponding
to all possible levels of the
price of good X, while price of
Y and income remain the
same.
PCC
a
b
c
IC1
IC2 IC3
X
Deriving a Demand Curve
An individual’s demand curve for a particular
good is derived from the individual’s budget
(budget line) & taste & preferences (indifference
curve) or the PCC.
The law of demand states that, ceteris paribus, the
quantity of a product demanded will vary
inversely to the price of that product.
Y
PCC
W
Y3
Y2
Y1
V
S
IC1
X1
X2
IC2
X3
IC3
X
Price of X
P1
P2
P3
Demand Curve for X
X
X1
X2
X3
Deriving a Demand Curve


Demand Curve – a line
connecting all combinations
of price and quantities
consumed
Each point on a demand
curve gives the price and
quantity combination of a
good that a consumer will
buy, given his or her budget
constraint and the prices of
other goods.
Each point on the demand
curve gives a quantity of the
good that a consumer will
buy to maximize utility.
P1
Price of X

P2
P3
Demand Curve for X
X1
X2
X3
X