1 Block Four: Objectives and Introduction After working through Block Four of this course, you should be able to: 1. Explain the essence of ordinal approach to utility analysis. 2. Explain the concept of utility maximization and consumer's equilibrium. 3. Describe the applications of indifference curves analysis and apply the analysis to a variety of consumer situations. 4. Explain how individual demand curve is derived from the indifference curve analysis, 5. Explain the concept of attribute approach to consumer choice. 6. Explain the difference between the traditional theory and the Attribute approach to consumer choice 7. Describe the application of the Attribute approach in the marketing field and apply this approach to marketing situations. 14 Introduction This Block develops tools that help a manager understand the behaviour of individual consumers and the impact of alternative incentives on their decisions. Despite the complexities of human thought processes, managers need a model that explains how individuals behave in the marketplace and in the work environment. As we have illustrated, consumers’ efforts to get the most for their money are reflected in their individual demand funetions. Market-demand curves are simply the aggregates of all individual consumer-demand curves. Since utility is based on individual taste and preferences, each market-demand curve reflects the aggregate market preferences of all consumers in that market. Therefore, a market-demand curve is a powerful signal to producers about what and how much to produce. The Utility approach offers useful insights into consumer behaviour. In this context, consumer preferences, which are subjective, are connected to changes in prices, incomes, and other variables in the marketplace, which are objective. This approach, which is referred to as the ordinal approach, requires that combinations of produets be ranked in order of preference. The ordinal approach to consumer behaviour (demand analysis) assumes that consumers are able to rank all conceivable bundles of commodities; that is, when confronted with two or more bundles of goods and services, consumers can determine an order of preference among them. 5, Managerial Economies, Block 4 Page 1 of 28Order of preference does not require consumers to estimate how much utility will be attained from a bundle of goods. Only the ability to rank is fundamental, Furthermore, the degree of preference is irrelevant. It is quite enough for the consumer to think. subjectively and idiosyneratically. that one product or bundle of goods is better than another. In more precise terms, we assume that the consumer's preference pattern possess the following properties, Property 1: Completeness. If an individual can rank any pair of bundles chosen at random from all conceivably bundles, he or she ean rank all conceivable bundles. Put differently, for any two bundles, say A and B, either A > B or B> A. or A ~B. Property 2: More is better than less. If bundle A contains at least as many units of each good as bundle B, and more units of at least one commodity, A must be preferred to B. If more is better than less, the consumer must view the produets under consideration as “goods’ instead of “bads.” 2 Indifference Curves Let us consider some implications of these assumptions about preference orderings. Most important, they enable us to generate a graphical description of consumers” preferences. An indifference curve defines the combinations of two goods (or two bundles of goods) that give the consumer the same level of satisfaction, i... they are equally preferred. Along an indifference curve, the consumer is indifferent between alternative combinations of goods X and Y. This is shown as the curve labeled I. in Figure 4-1 Bundles A, B, C, and D are all equally preferred combinations of X and Y located on the indifference curve providing the consumer with the same level of satisfaction, Figure 4-1 5, Managerial Economies, Block 4 Page 2 of 28An indifference curve also allows us to compare the satisfaction implicit in bundles that lie along it with those that lie either above or below it. The completeness property of preferences implies that there is an indifference curve that passes through every possible bundle. Therefore, we can represent a consumer's preference with an indifference map. 1h, fa, and Ih, in Figure 4-2, are index values used to denote the order of preference that corresponds to the respective indifference curves. Figure 4-2 Y a Increasing satisfaction Property 3: Transitivity: Given three bundles of goods (A. B, and C), if an individual prefers A to B and B to C, he must prefer A to C. Similarly, ifan individual is indifferent between A and B and between B and C, he must be indifferent between A and C. Finally, if he is indifferent between A and B and prefers B to C, he must prefer A to C. This, assumption obviously can be carried over to four or more different bundles. Figure 4-3 Y x The assumption of transitive preferences, together with the ‘more is better than less? assumption, implies that indifference curves (from the same indifference map) cannot cross. To see why, since A and B are on the same indifference curve (ly), A ~ B. in Figure 4-3, and since A and C are on the same indifference curve (li), A ~ C, the consumer must be indifferent between B and C also. This, however, ean happen if these 5, Managerial Economies, Block 4 Page 3 of 28points are on the same indifference curve. This situation implies that the consumer cannot make a choice. Property 4. Indifference curves are coneave from above (convex to the origin). In the preceding discussion, it was seen that indifference curves are concave from above and downward sloping. These characteristics arise from the assumption of diminishing marginal utility that was built into the concept from which the indifference curves were derived: the more of a product you consume, the less will be the additional satisfaction (utility) obtained from additional consumption of that product. Since diminishing marginal utility plays a crucial role in the consumer behaviour model. it must be thoroughly understood, As previously noted, different combinations of goods can provide equal levels of total utility. When a consumer remains on a particular indifference curve, one commodity can be substituted for the other so that the consumer remains as well off as before. The rate at which a consumer is willing to make such a substitution is a matter of great interest and importance. We call it the marginal rate of substitution (MRSxy) of X for Y, defined as the number of units of Y that must be given up to acquire one additional unit of X while satisfying the condition of constant total utility MRSy., or simply MRS. is measured as the slope of the indifference curve, which is, different at each point along the curve. Since each point represents a different combination of goods X and Y, it follows that each combination has a different MRS. Is there a relationship between marginal utility and the marginal rate of substitution? Indeed there is, since the slope of the indifference curve is the direct result of the law of diminishing marginal utility, Consider what happens when we move down the indifference curve between any two points. Consumption of Y is reduced by AY unitcausing a loss of utility, which is equal to the change in Y, (AY), times the loss of utility associated with this change in Y (marginal utility of Y = MU,). That is, AY x MU. But, since total utility is unchanged as we move down the curve, the loss of utility from consuming less Y is precisely offset by a gain from consuming more X, AX x MUx: -AY x MU, = AX x MUx a) Rearranging this equation, we get (2) (3) ES, Managerial Economies, Block 4 Page 4 of 28The continuously declining MRS is the logical result of the assumption that the marginal utility of a product decreases as we obtain more of it. It follows, then, that the more of a product one has, the more willing one is to trade it for another product. This willingness to exchange what we value less for what we value more is true whether the owners of the commodities are individuals. firms, or nations. Thus the marginal rate of substitution governs both domestic and foreign trade 2.1 Budget Constraint Indifference curves reflect the consumer's personal feelings and the relative values regarding the consumption of various combinations of any two products. They show what combinations of X and Y the consumer is willing to accept as equally satisfactory and they are totally independent of the consumer's income and market prices. Whereas indifference curves show what the consumer is willing to do, income and market prices determine what a consumer is able to do. In other words, the budget constraint determines the combinations of X and Y that are affordable. The consumer's expenditure on X plus his or her expenditure on Y cannot and does not exceed the consumer’s income. Assuming that the consumer's income is entirely spent on these two goods, we can write a budget line relationship as follows: PxxX+Pyx Y=M @) where Px and Py are the price of good X and Y, respectively. and M is the income or the budget constraint. Suppose that the available money income is $100, P= $5. and Py= $10. If the entire $100 is spent on good X, a maximum of 20 units (100/$5) of X can be bought, whereas if the entire $100 is spent on Y, as much as 10 units (100/$10) of Y can be purchased. These combinations are illustrated in Figure 4-4. A straight line joining these two points on the graph shows aif the other combinations of X and Y that the consumer's income will allow him or her to purchase at these prices. Figure 4-4 Y MiPy M/Px=20 X 5, Managerial Economies, Block 4 Page 5 of 28The points inside the budget line are attainable while those outside are not. The slope of the budget line is given by ~Px/Py the rise (M/Py divides by the run M/Px) that represents the rate at which the X can be exchanged for Y in the market place. In the example above, the slope equals —1/2. 2.2. Changes in Income The consumer’s opportunity set depends on market prices and the consumer's income. As these parameters change, so will the consumer’s opportunities. Let us now examine the effects on the opportunity set of changes in income by assuming prices remain constant. Suppose the consumer's initial income in Figure 4-5 is My. What happens if My increases to Mi while prices remain unchanged? Recall that the slope of the budget line is given by —Py/Py. Under the assumption that prices remain unchanged, the increase in income will not affect the slope of the budget line. However, the vertical and horizontal intercepts of the budget line both increase as the consumer's income increases, because more of each good can be purchased at the higher income. Thus, when income increases from Mgto M,, the budget line shifts to the right in a parallel fashion. This reflects an inerease in the consumer's opportunity set, because more goods are affordable after the increase in income than before. Similarly. if ineome decreases to Mz from Mo, the budget line shifts, toward the origin and the slope of the budget line remains unchanged. Figure 4-5 MP; Mo/Py} My/P¥ Mo!Px Mo/Px. Mi/Px, x 2.3 Changes in Price Now suppose the consumer's income remains fixed at M, but the price of good X decreases to P; from Pp, Furthermore, suppose the price of good Y remains unchanged. Since the slope of the budget line is given by P3/Py, the reduetion in the price of good X changes the slope, making it flatter than before. Since the maximum amount of good Y that can be purchased is M/Py, a reduction in the price of good X does not change the Y intercept of the budget line. But the maximum amount of good X that can be purchased at 5, Managerial Economies, Block 4 Page 6 of 28the lower price (the X intercept of the budget line) is M/Px1, which is greater than My/Pyo. Thus, the effect of a reduetion in the price of good X is rotate the budget line counterclockwise, as in Figure 4-6 Figure 4-6 MP, MIPxo MiPxi XX Similarly, an increase in the price of good X leads to a clockwise rotation of the budget line. 2.4 Consumer Equil The principal assumption upon which the theory of consumer behaviour rests is that consumers attempt to allocate their limited money incomes to purchase available goods and services so as to maximize their satisfaction (utility). In other words, consumers” indifference map provides a diagrammatic representation of a consumer's taste and intensity of desire for different product combinations while the consumer's purchasing power (and thus ability to satisfy material wants) is reflected by the line of attainable combinations. Putting the two together shows all the desired product combinations on the indifference curves that are also attainable, As illustrated in Figure 4-7, the point of equilibrium can be located by drawing the budget line on the indifference map for goods X and Y. Since the number of indifference curves upon the indifference map is infinite, one curve will be tangent to the budget line regardless of where the budget line lies. The point of tangency is the point of equilibrium, representing the attainable combination of X and Y that gives the highest level of utility As indicated in this Figure, the budget line is tangent to the indifference curve, ls at point E, where the consumer acquires Yr units of Y and Xr of X. Since indifference curves may not intersect, itis clear that I represents the highest level of utility that can be obtained with the budget available. An indifference curve representing a higher level. Ix does not touch the budget line, and hence is unattainable, whereas an indifference curve representing a lower level, h, intersecting the budget line at two places is inferior to b. It should not be difficult to see why point E is preferable to any other point on the budget line. For example, point B also exhausts the income, but it clearly offers less utility than point E because it lies on a lower indifference curve 5, Managerial Economies, Block 4 Page 7 of 28Figure 4-7 Ye E Is Xe x Note, at the point of tangeney between the indifference curve and the budget line, the slope of the indifference curve equals the slope of the budget line, that is, Pe i MRS (5) The condition for maximizing satisfaction requires that the consumer allocate his or her purchasing power so that the marginal rate of substitution of X for Y is equal to the ratio of the price of X to the price of Y. The interpretation of this condition is straightforward, The MRS defines the rate at which the consumer is willing to exchange X for Y. The price ratio (Px/Py) shows the rate at which the consumer can exchange X for Y. Unless the two rates are equivalent, it is possible for the consumer to alter purchases of X and Y and achieve a greater degree of satisfaction, Suppose that at the current purchase combination, MRS= 4, meaning that the consumer is willing to exchange 4 units of Y for 1 more unit of X. If Py = $6 and Py = $2, then the consumer need only give up 3 units of Y at $2 each to obtain the dollars needed to buy another unit of X. This situation is reflected by point B in Figure 4-7, where the slope of the indifference curve is steeper than the slope of the budget line. This means the consumer is willing to give up more of good Y to get an additional unit of good X than he or she actually has to give up, based on market, Confronted with these circumstances, itis in the consumer’s interest to consume less of good Y and more of good X. This substitution continues until ultimately the consumer is at point E, in Figure 4-7, where the MRS is equal to the ratio of prices. In general, then, consumer maximization of satisfaction requires equality between the marginal rate of substitution for any pair of products and the ratio of their prices, other some exchange can be made which will increase consumers’ overall satisfaction 5, Managerial Economies, Block 4 Page 8 of 28If goods X and Y were complements, a reduction in the price of X would have led the consumer to move from point A in Figure 4-8 to a point such as C, where more of Y is consumed than before, Please note that this would require a new set of indiffence curves (showing a different consumer’s preferences), which is not shown here. Price changes alter consumer incentives to buy different goods, thereby changing the mix of goods they purchase in equilibrium. The primary advantage of indifference curve analysis is that it allows a manager to see how price changes affect the mix of goods that consumers purchase in equilibrium. These changes may be the result of other firms initiating price changes, or due to a change in the frim’s own strategy. 2.6 Income Changes Indifference curve analysis also allows us to see how changes in income affect the mix of goods purchased by consumers. When the consumer’ income changes, the consumer will respond by changing his or her optimal bundle of goods (X and Y). Normally. increases in income. all else remaining constant, will lead to increased demand for the products available to the consumer, We show such a situation in Figure 4-9, where the consumer's income has inereased and that consumer subsequently purchases more of both products available, Note that at the initial prices and income level (Ma), and given the consumer's taste and preference pattern (indicated by the indifference curves). the consumer maximizes at point A. Now suppose the consumer's income increases to M; so that his or her budget line shifts, out in aparallel fashion. Clearly the consumer can now achieve a higher level of satisfaction than before. This particular consumer finds it in his or her interest to choose bundle B in Figure 4-9, where the indifference curve through point B is tangent to the new budget line. Figure 4-9 Xo Xr MyPx MyPy Xx In this case, the quantity demanded of both produets has inereased as a result of the increase in the consumer’s income. Since income and quantity demanded moved in the 5, Managerial Economies, Block 4 Page 10 of 28same direction, we say that the income effet was positive for both goods. We call such products normal goods. For some produets the income effect is negative, meaning that if income increases, the quantity demanded of those products actually declines. This may happen to a product that is an inferior substitute for some superior product. As people become richer. they tend to switch away from inferior goods to superior substitutes. Conversely. as incomes fall (in a recession, for example). people tend to switch back to the inferior substitutes as they find themselves unable to afford the superior substitutes. In Figure 4-10 we show the income effect for an inferior good. The product on the horizontal axis, travel by train, is an inferior good, and travel by air isa superior substitute for this particular consumer. Note that when the consumer’s income increases and the budget line moves outward, the quantity demanded of travel by train actually decreases while travel by air increases. This consumer. now able to afford more air travel. substitutes away from the inferior good and in favour of the superior good. Looking at this from the opposite perspective, if the consumer's income were to fall from the higher level to the lower level, the consumer would reduce consumption of the superior good and increase consumption of the inferior good Figure 4-10 1X0 MyPx MiyPy —X For any particular product at any particular point in time, some consumers may regard that product as a superior good while others may regard it as an inferior good. This difference in attitude toward a particular product stems from a difference in income levels and/or a different pattern of tastes and preferences, 2.7 The Income and Substitution Effects of a Price Change We can combine our analysis of price and income changes to gain a better understanding of the effect of a price change on consumer behaviour. The effect of the price change can be thought of as comprising two separate effeets, known as the income effect and the substitution effect. When a product’ price falls (and all other things remain unchanged), 5, Managerial Economies, Block 4 Page 11 of 28