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

2. Budget constraints

3. Consumer choices

Two major concepts:

1. Cardinal

2. Ordinal
CONSUMER PREFERENCES

Market Baskets

TABLE 3.1 Alternative Market Baskets

Market Basket Units of Food Units of Clothing

A 20 30

B 10 50

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.
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: Goods are assumed to be desirable—i.e., to be good.
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. Of course, some goods, such as air pollution (bads), may be undesirable.
4. Continuity: If A is preferred to B, then situations suitably “close to” A must also be
preferred to B. It is used to analyze individuals’ responses to relatively small
changes in income and prices.
5. Reflexive: We assume that any bundle is at least as good as itself. If A is bundle in
question then there will be no situation when A is not chosen when compared to
itself.
Indifference curves

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 basket
G, while E is clearly
preferred to A.
However, A cannot be
compared with B, D, or H
without additional
information.

● indifference curve Curve representing all combinations of market baskets or

consumption bundles that provide a consumer with the same level of satisfaction.
• E is strictly
preferred to A
and A is strictly
preferred to G
• weakly
preferred (See
IC)
• The consumer
will Be
indifferent
between B, A,
and D.

• Strict Preference

• Weak Preference

• Indifferent
Indifference curves

The technique of indifference curves was originated by Francis Y. Edgeworth

in England in 1881. It was then refined by Vilfredo Pareto, an Italian economist
in 1906. This technique attained perfection and systematic application in
demand analysis at the hands of Prof. John Richard Hicks and R.G.D. Allen
in 1934.
Hicks discarded the Marshallian assumption of cardinal measurement of utility
and suggested ordinal measurement which implies comparison and ranking
without quantification of the magnitude of satisfaction enjoyed by the
consumer .
ASSUMPTIONS
•Rational behavior of the consumer
•Utility is ordinal
•Diminishing marginal rate of substitution
•Consistency in choice
•Transitivity in choice making
•Goods consumed are substitutable
 Properties
• Indifference curve slope down and to the right, and the slope
becomes less steep the farther right you go (this shape is sometimes
described as convex or convex to the origin).
• All the combination on the curve would yield equal satisfaction.
• Indifference curves do not cross.
• An indifference curve shows various combinations of goods that yield
the same utility.
• But different indifference curves show different levels of utility.
• For instance, the indifference curve in the next slide shows that
people want to attain the highest level of utility possible (U3 is better
than U2 which is better than U1). So the farther the indifference curve
from the origin the higher is the utility.
• There are an infinite number of indifference curves in the indifference
map, and each person’s indifference map is unique to that person.
The Marginal Rate of Substitution
● marginal rate of substitution Maximum amount of a good that a consumer is willing
to give up in order to obtain one additional unit of another good.

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 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 The decline in the MRS
reflects a diminishing marginal rate
of substitution. When the MRS
diminishes along an indifference
curve, the curve is convex.
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 infinite; the indifference
curves are shaped as right angles.

Bads
● bad
Good for
which less
is preferred
rather than
more.
(Good, Bad)

(Bad, Bad)

(Bad, Good)
(Good, Good)
Questions for practice 1
1. Draw indifference curves that represent the following individuals’ preferences
for hamburgers and soft drinks. Indicate the direction in which the individuals’
satisfaction (or utility) is increasing.
a) Joe has convex indifference curves and dislikes both hamburgers and soft
drinks.
b) Jane loves hamburgers and dislikes soft drinks. If she is served a soft drink,
she will pour it down the drain rather than drink it.
c) Bob loves hamburgers and dislikes soft drinks. If he is served a soft drink, he
will drink it to be polite.
d) Molly loves hamburgers and soft drinks, but insists on consuming exactly one
soft drink for every two hamburgers that she eats.
e) Bill likes hamburgers, but neither likes nor dislikes soft drinks.
f) Mary always gets twice as much satisfaction from an extra hamburger as she
does from an extra soft drink.

2. Based on his preferences, Bill is willing to trade 4 movie tickets for 1 ticket to
a basketball game. If movie tickets cost $8 each and a ticket to the basketball
game costs $40, should Bill make the trade? Why or why not?
BUDGET CONSTRAINTS
The Budget Line
● budget constraints Constraints that consumers face as a result of limited
incomes.

● budget line All combinations of goods for which the total amount of
money spent is equal to income.

TABLE 3.2 Market Baskets and the Budget Line

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

Market baskets associated with the budget line F + 2C = $80

The Budget Line
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 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.
The Effects of Changes in Income

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
increased to $160, the budget line
shifts outward to L2.
If the income falls to $40, the line
shifts inward to L3.
The Effects of Changes in Prices

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 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.
CONSUMER CHOICE
The maximizing market basket or consumer eqm 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.

Maximizing Consumer
Satisfaction
A consumer maximizes
satisfaction by choosing
market basket A. At this
point, the budget line and
indifference curve U2 are
tangent.
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

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.

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

Using these definitions, we can then say that 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.
Corner Solutions

● corner solution Situation in which the marginal rate of

substitution for one good in a chosen market basket is not
equal to the slope of the budget line.

A Corner Solution
When 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.
CONSUMER CHOICE

Figure 3.16
A College Trust Fund

When given a college trust

fund that must be spent on
education, the student
moves from A to B, a corner
solution.
If, however, the trust fund
could be spent on other
consumption as well as
education, the student would
be better off at C.
Questions for Practice 2
1. The price of DVDs (D) is $20 and the price of CDs (C) is $10. Philip has a
budget of $100 to spend on the two goods. Suppose that he has already
bought one DVD and one CD. In addition, there are 3 more DVDs and 5 more
CDs that he would really like to buy.
a) Given the above prices and income, draw his budget line on a graph with
CDs on the horizontal axis.
b) Considering what he has already purchased and what he still wants to
purchase, identify the three different bundles of CDs and DVDs that he
could choose. For this part of the question, assume that he cannot
purchase fractional units.

2. Anne has a job that requires her to travel three out of every four weeks. She
has an annual travel budget and can travel either by train or by plane. The
airline on which she typically flies has a frequent-traveler program that reduces
the cost of her tickets according to the number of miles she has flown in a
given year. When she reaches 25,000 miles, the airline will reduce the price of
her tickets by 25 percent for the remainder of the year. When she reaches
50,000 miles, the airline will reduce the price by 50 percent for the remainder of
the year. Graph Anne’s budget line, with train miles on the vertical axis and
plane miles on the horizontal axis.
3. Antonio buys five new college textbooks during his first year at school at a cost
of $80 each. Used books cost only $50 each. When the bookstore announces
that there will be a 10 percent increase in the price of new books and a 5
percent increase in the price of used books, Antonio’s father offers him $40
extra.
a) What happens to Antonio’s budget line? Illustrate the change with new
books on the vertical axis.
b) Is Antonio worse or better off after the price change? Explain.
4. Ben allocates his lunch budget between two goods, pizza and burritos.
a) Illustrate Ben’s optimal bundle on a graph with pizza on the horizontal axis.
b) Suppose now that pizza is taxed, causing the price to increase by 20
percent. Illustrate Ben’s new optimal bundle
c) Suppose instead that pizza is rationed at a quantity less than Ben’s desired
quantity. Illustrate Ben’s new optimal bundle.
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.

Utility Functions and Indifference Curves

A utility function can be

represented by a set of
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:

U (F,C) = FC
Cardinal Utility
Total Utility
It refers to the total satisfaction obtained from the
consumption of all possible units of a commodity. It measures
the total satisfaction obtained from consumption of all the
units of that good.

Calculation:
TUn = U1 + U2 + U3 +……………………. + Un
 
Where:
•TUn = Total utility from n units of a given commodity
•U1, U2, U3,……………. Un = Utility from the 1st, 2nd, 3rd nth
unit
•n = Number of units consumed
Marginal Utility

Marginal utility is the additional utility derived from the

consumption of one more unit of the given commodity.
Or
The net addition to the total utility on every consumption
Or
It is the utility derived from the last unit of a commodity purchased.
Calculation:
MUn = TUn – TUn-1
Where:
MUn = Marginal utility from nth unit;
TUn = Total utility from n units;
TUn-1 = Total utility from n – 1 units;
n = Number of units of consumption

TUn= MU1 + MU2 + MU3 +……………………… + MUn

or simply, TU = ∑MU
Derivation of Utility Graphs

Ice Creams Marginal Total

Consumed Utility Utility
(MR) (TU)

1 20 20
2 16 36
3 10 46
4 4 50
5 0 50
6 -6 44
MARGINAL UTILITY AND CONSUMER CHOICE

● Diminishing marginal utility Principle that as more of a good is

consumed, the consumption of additional amounts will yield smaller
additions to utility. (Gossen first law)

● Gossen stated it as "The magnitude of one and the same satisfaction, when
we continue to enjoy it without interruption, continually decreases until
satisfaction is reached."

The above law is based on two facts:

•Human wants are unlimited and each single want is satiable.

•The different goods are not perfect substitute for each other in the satisfaction
of various wants.

Once the consumer reaches his saturation point, he no longer wants to

consume any additional quantity and MU = 0. Zero marginal utility of a good
implies that the individual has all that he wants of the good in question.
The well-known Diamond-water paradox of smith
“although water is on the whole more useful, in terms of survival, than
diamonds, diamonds command a higher price in the market.”
The principle of progression in taxation is also dependent on this law. As a
person's revenue is amplified the rate of tax goes up since the marginal utility of
money to him cascade with the increase in his takings.

0  MU (F )  MU (C )
F C

MU / MU  P / P
F C F C

MU / P  MU / P (3.7)
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. (Gossen second law)
1. Jane receives utility from days spent traveling on vacation domestically
(D) and days spent traveling on vacation in a foreign country (F), as
given by the utility function U(D,F) = 10DF. In addition, the price of a
day spent traveling domestically is $100, the price of a day spent
traveling in a foreign country is $400, and Jane’s annual travel budget is
$4000. Find Jane’s utility maximizing choice of days spent traveling
domestically and days spent in a foreign country.
2. How is the slope of Indifference curve denoted by x+y =10 ?
3. Julio receives utility from consuming food (F) and clothing (C) as given
by the utility function U(C,F) = FC. In addition, the price of food is $2 per
unit, the price of clothing is $10 per unit, and Julio’s weekly income is
$50.
1. What is Julio’s marginal rate of substitution of food for clothing when
utility is maximized? Explain.
2. Suppose instead that Julio is consuming a bundle with more food
and less clothing than his utility maximizing bundle. Would his
marginal rate of substitution of food for clothing be greater than or
less than your answer in part a? Explain.
4. Find out the equilibrium quantity of Apples and Bananas foe the consumer.
Examples of Utility Functions

+
REVEALED PREFERENCE
If a consumer chooses one market basket over another, and if the chosen market
basket is more expensive than the alternative, then the consumer must prefer the
chosen market basket.
Assumptions:
•The underlying preferences—whatever they may be—are known to be strictly
convex.
•There will be a unique demanded bundle at each budget line.

If the above inequality is

satisfied and (y1,y2) is
actually a different bundle
from (x1,x2), we say that
(x1,x2) is directly revealed
preferred to (y1,y2).
The Principle of Revealed Preference. Let (x1,x2) be the chosen bundle when
prices are (p1,p2), and let(y1,y2) be some other bundle such that p1x1 +p2x2 ≥
p1y1 +p2y2. Then if the consumer is choosing the most preferred bundle she can
afford, we must have (x1,x2) (y1,y2).
Now suppose that we happen to know that (y1,y2) is a demanded bundle at
prices (q1,q2) and that (y1,y2) is itself revealed preferred to some other bundle
(z1,z2) such that:

It is natural to say that in this case (x1,x2) is indirectly revealed preferred to

(z1,z2).

Weak Axiom of Revealed Preference (WARP). If (x1,x2) is directly revealed

preferred to (y1,y2), and the two bundles are not the same, then it cannot happen
that (y1,y2) is directly revealed preferred to (x1,x2).

Strong Axiom of Revealed Preference (SARP). If (x1,x2) is revealed preferred to

(y1,y2) (either directly or indirectly) and (y1,y2) is different from (x1,x2), then
(y1,y2) cannot be directly or indirectly revealed preferred to (x1,x2).
Constrained Optimization

λ is the rate of change of the quantity being optimized, with respect to the constraint value .
Questions for practice
Indirect Utility Function
• The indirect utility function is closely related to the utility maximization
problem.
• In microeconomics, the utility maximization problem is an optimal decision
problem that refers to the problem consumers face with regards to how to
spend money in order to maximize utility.
• The indirect utility function is the value function, or the best possible value of
the objective, of the utility maximization problem.
• The indirect utility function is a degree-zero homogeneous function, meaning
that if prices (p) and income (m) are both multiplied by the same constant the
optimal does not change (it has no impact).
• The function adheres to the law of demand.

• Find the indirect utility function from U(X,Y) = XY subject to budget constraint.
Duality
References

1. Microeconomics by Pindyck and Rubinfeld (8th Edition). (Topics to be

covered 3.1, 3.2, 3.3)

2. Intermediate Microeconomics by Hal Varian (Topics to be covered 2.6, 3.1,

3.2, 3.3, 3.4, 3.6, 3.8, 4.4, 4.5)

3. Constrained optimization Appendix ch 4 (Microeconomics by Pindyck

and Rubinfeld)

DIY
Read 3.6 from Microeconomics by Pindyck and Rubinfeld (8th Edition).