Chapter 3: Consumer Behavior
Slide 1
Consumer Behavior
nThere are 3 steps involved in studying consumer behavior.
1)Consumer preferences: describe how and why people prefer one good to another.
2)Budget constraints: people have limited incomes.
3)We will combine consumer preferences and budget constraints to determine consumer choices.
uWhat combination of goods will consumers buy to maximize their satisfaction?

Chapter 3: Consumer Behavior
Slide 2
Consumer Preferences
nA market basket is a collection of one or more commodities.
nOne market basket may be preferred over another market basket containing a different combination
of goods.
nThree Basic Assumptions
n 1) Preferences are complete (comparison => A>B or A<B or   A=B)
n 2) Preferences are transitive (if A>B and B>C than A>C)
n 3) Consumers always prefer more of a good to less.
Market Baskets

Chapter 3: Consumer Behavior
Slide 3
Consumer Preferences
n A 20 30
n B 10 50
n D 40 20
n E 30 40
n G 10 20
n H 10 40
Market Basket Units of Food   Units of Clothing

Chapter 3: Consumer Behavior
Slide 4
U1
Combination B,A, & D
yield the same satisfaction
•E  is  preferred to U1
•U1 is preferred to H & G
Consumer Preferences
Food
(units per week)
10
20
30
40
10
20
30
40
Clothing
(units per week)
50
G
D
A
E
H
B

Chapter 3: Consumer Behavior
Slide 5
Consumer Preferences
nIndifference curves represent all combinations of market baskets that provide the same level of
satisfaction to a person.
nIndifference Curves slope downward to the right.
uIf they sloped upward it would violate the assumption that more of any commodity is preferred to
less.

Chapter 3: Consumer Behavior
Slide 6
Consumer Preferences
nIndifference Curves
lAny market basket lying above and to the right of an indifference curve is preferred to any market
basket that lies on the indifference curve.
nIndifference Curves
lIndifference curves cannot cross as this would violate the assumption that more is preferred to
less

Chapter 3: Consumer Behavior
Slide 7
Consumer Preferences
nAn indifference map is a set of indifference curves that describes a person’s preferences for all
combinations of two commodities.
lEach indifference curve in the map shows the market baskets among which the person is indifferent.
Indifference Maps

Chapter 3: Consumer Behavior
Slide 8
Consumer Preferences
Food
(units per week)
Clothing
(units per week)
A
B
D
Market basket A
is preferred to B.
Market basket B is
preferred to D.
IC1
IC2
IC3

Chapter 3: Consumer Behavior
Slide 9
A
B
D
E
G
-1
-6
1
1
-4
-2
1
1
Observation: The amount
of clothing given up for
a unit of food decreases
from 6 to 1
Consumer Preferences
Food
(units per week)
Clothing
(units
per week)
2
3
4
5
1
2
4
6
8
10
12
14
16
Question: Does this
relation hold for giving
up food to get clothing?
IC

Chapter 3: Consumer Behavior
Slide 10
Consumer Preferences
nThe marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up
to obtain more of another good.
lIt is measured by the slope of the indifference curve.
lAlong an indifference curve there is a diminishing marginal rate of substitution.
Marginal Rate of Substitution

Chapter 3: Consumer Behavior
Slide 11
Consumer Preferences
Food
(units per week)
Clothing
(units
per week)
2
3
4
5
1
2
4
6
8
10
12
14
16
A
B
D
E
G
-6
1
1
1
1
-4
-2
-1
MRS = 6
MRS = 2
IC

Indifference curves are convex because as more of one good is consumed, a consumer would prefer to
give up fewer units of a second good to get additional units of the first one. Consumers prefer a
balanced market basket.

Chapter 3: Consumer Behavior
Slide 12
Consumer Preferences
nPerfect Substitutes and Perfect Complements
lTwo goods are perfect substitutes when the marginal rate of substitution of one good for the other
is constant (not curve but straight line). Wine?
lTwo goods are perfect complements when the indifference curves for the goods are shaped as right
angles. Shoes?
Marginal Rate of Substitution

Chapter 3: Consumer Behavior
Slide 13
40
Perfect substitutes
Food
(units per week)
40
60
80
20
10
20
30
0
Clothing
(units
per week)
IC1
IC2
IC3

Chapter 3: Consumer Behavior
Slide 14
40
Perfect complements
Food
(units per week)
40
60
80
20
10
20
30
0
Clothing
(units
per week)
IC1
IC2
IC3

Chapter 3: Consumer Behavior
Slide 15
Consumer Preferences
nBADS
lThings for which less is preferred to more
nExamples
lAir pollution
lAsbestos
nWhat Do You Think?
lHow can we account for Bads in the analysis of consumer preferences?
l

Chapter 3: Consumer Behavior
Slide 16
Consumer Preferences
Cigarette smoke
(units per week)
Chilli
(units per week)
IC1
IC2
IC3

Chapter 3: Consumer Behavior
Slide 17
Consumer Preferences
nCar executives must regularly decide when to introduce new models and how much money to invest in
restyling.
nAn analysis of consumer preferences would help to determine when and if car companies should
change the styling of their cars.
nWhat Do You Think? How can we determine the consumers’ preferences?
n
n
Application: Designing New Automobiles

A recent study of automobile demand in the US shows that over the past two decades most consumers
have preferred styling over performance.
Growth of Japanese Imports: 1970s and 1980s - 15% of domestic cars underwent a style change each
year, compared to 23% for imports.

Chapter 3: Consumer Behavior
Slide 18
Consumer Preferences
nUtility
lUtility: Numerical score representing the satisfaction that a consumer gets from a given market
basket.
nIf buying 3 copies of Microeconomics makes you happier than buying one shirt, then we say that the
books give you more utility than the shirt.
l

Chapter 3: Consumer Behavior
Slide 19
Consumer Preferences
nUtility Functions
lAssume: The utility function for food (F) and clothing (C)     U(F,C) = F + 2C
l    Market Baskets: F units  C units   U(F,C) = F + 2C            A               8
3           8 + 2x3 = 14            B               6             4           6 + 2x4 = 14
C               4             4           4 + 2x4 = 12 The consumer is indifferent to A & B
The consumer prefers A & B to C

Chapter 3: Consumer Behavior
Slide 20
Consumer Preferences
Food
(units per week)
10
15
5
5
10
15
0
Clothing
(units
per week)
IC1 = 25
IC2 = 50 (Preferred to IC1)
IC3 = 100 (Preferred to IC2)
A
B
C
Assume: U = FC
Market Basket       U  =  FC
C                25 = 2.5(10)
A                25 = 5(5)
B                25 = 10(2.5)
Utility Functions & Indifference Curves

Chapter 3: Consumer Behavior
Slide 21
Consumer Preferences
nOrdinal Versus Cardinal Utility
lOrdinal Utility Function: places market baskets from most preferred to least preferred, but does
not indicate how much one market basket is preferred to another.
lCardinal Utility Function: describes the extent to which one market basket is preferred to another
(we can measure utility)
nOrdinal Versus Cardinal Rankings
lThe actual unit of measurement for utility is not important. Therefore, an ordinal ranking is
sufficient to explain how most individual decisions are made.

Chapter 3: Consumer Behavior
Slide 22
Budget Constraints
nPreferences do not explain all of consumer behavior.
nBudget constraints also limit an individual’s ability to consume in light of the prices they must
pay for various goods and services.
nThe Budget Line: indicates all combinations of two commodities for which total money spent equals
total income.
n

Chapter 3: Consumer Behavior
Slide 23
Budget Constraints
nThe Budget Line
lLet F equal the amount of food purchased, and C is the amount of clothing.
lIf the price of food = Pf  and price of         clothing = Pc, then Pf F is the amount of money
spent on food, and Pc C is the amount of money spent on clothing.
l

Chapter 3: Consumer Behavior
Slide 24
Budget Constraints
n A 0 40 $80
n B 20 30 $80
n D 40 20 $80
n E 60 10 $80
n G 80 0 $80
Market Basket Food (F)   Clothing (C) Total Spending
Pf  = ($1) Pc = ($2) PfF + PcC = I

Chapter 3: Consumer Behavior
Slide 25
Budget Line  F + 2C = $80
10
20
(I/PC) = 40
Budget Constraints
Food
(units per week)
40
60
80 = (I/PF)
20
10
20
30
0
A
B
D
E
G
Clothing
(units
per week)
Pc = $2      Pf = $1        I = $80

Chapter 3: Consumer Behavior
Slide 26
Budget Constraints
nThe Budget Line
lAs consumption moves along a budget line from the intercept, the consumer spends less on one item
and more on the other.
lThe slope of the line measures the relative cost of food and clothing = the negative of the ratio
of the prices of the two goods.
lThe slope indicates the rate at which the two goods can be substituted without changing the amount
of money spent.

Chapter 3: Consumer Behavior
Slide 27
Budget Constraints: Changes in Income and Prices
Food
(units per week)
Clothing
(units
per week)
80
120
160
40
20
40
60
80
0
An increase in
income shifts
the budget line
outward (holding
prices constant)
(I = $160)
L2
(I = $80)
L1
L3
(I =
$40)
A decrease in
income shifts
the budget line
inward

Chapter 3: Consumer Behavior
Slide 28
Budget Constraints: Changes in Income and Prices
Food
(units per week)
Clothing
(units
per week)
80
120
160
40
40
(PF = 1)
L1
An increase in PF
to $2.00 changes
the slope of the
budget line and
rotates it inward
 pivoting from the
other good’s intercept.
L3
(PF = 2)
(PF = 1/2)
L2
A decrease in the
price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.

Chapter 3: Consumer Behavior
Slide 29
Budget Constraints
nThe Effects of Changes in Income and Prices
lPrice Changes 1: If the two goods increase in price, but the ratio of the two prices is unchanged,
the slope will not change. However, the budget line will shift inward to a point parallel to the
original budget line.
lPrice Changes 2: If the two goods decrease in price, but the ratio of the two prices is unchanged,
the slope will not change. However, the budget line will shift outward to a point parallel to the
original budget line.
l

Chapter 3: Consumer Behavior
Slide 30
Consumer Choice
nConsumers choose a combination of goods that maximizes their satisfaction, given the limited
budget available to them.
nThe maximizing market basket must satisfy two conditions:
n 1) It must be located on the budget line.
n 2) It must give the consumer the most preferred combination of goods and services.

Chapter 3: Consumer Behavior
Slide 31
nRecall, the slope of an indifference curve is:
Consumer Choice
Further, the slope of the budget line is:

Chapter 3: Consumer Behavior
Slide 32
Consumer Choice
nTherefore, it can be said that satisfaction is maximized where:

It can be said that satisfaction is maximized when marginal rate of substitution (of F and C) is
equal to the ratio of the prices (of F and C).

Chapter 3: Consumer Behavior
Slide 33
Consumer Choice
Food (units per week)
Clothing
(units per
 week)
40
80
20
20
30
40
0
IC1
B
Budget Line
Pc = $2     Pf = $1     I = $80
Point B does not
maximize satisfaction
because the
MRS (-(-10/10) = 1
is greater than the
price ratio (1/2).
-10C
+10F

Chapter 3: Consumer Behavior
Slide 34
Consumer Choice
Budget Line
IC3
D
Market basket D
cannot be attained
given the current
budget constraint.
 Pc = $2     Pf = $1     I = $80
Food (units per week)
Clothing
(units per
 week)
40
80
20
20
30
40
0

Chapter 3: Consumer Behavior
Slide 35
U2
Consumer Choice
Pc = $2     Pf = $1     I = $80
Budget Line
A
At market basket A
the budget line and the
indifference curve are
tangent and no higher
level of satisfaction
can be attained.
At A:
MRS =Pf /Pc =0.5
Food (units per week)
Clothing
(units per
 week)
40
80
20
20
30
40
0

Chapter 3: Consumer Behavior
Slide 36
Consumer Choice
nConsider two groups of consumers, each wishing to spend $10,000 on the styling and performance of
cars.
nEach group has different preferences.
nBy finding the point of tangency between a group’s indifference curve and the budget constraint
auto companies can design a production and marketing plan.
Application: Designing New Automobiles

Chapter 3: Consumer Behavior
Slide 37
Consumer Choice
nA corner solution exists if a consumer buys in extremes, and buys all of one category of good and
none of another.
lThis exists where the indifference curves are tangent to the horizontal and/or vertical axis.
lMRS is not equal to PA/PB at the chosen bundle.
A Corner Solution

Chapter 3: Consumer Behavior
Slide 38
A Corner Solution
Ice Cream (cup/month)
Frozen
Yogurt
(cups
monthly)
B
A
IC2
IC3
IC1
A corner solution
exists at point B.

At point B, the MRS of ice cream for frozen yogurt  is greater than the slope of the budget line.
This suggests that if the consumer could give up more frozen yogurt for ice cream he would do so.
However, there is no more frozen yogurt to give up! If the MRS is, in fact, significantly greater
than the price ratio, then a small decrease in the price of frozen yogurt will not alter the
consumer’s market basket.

Chapter 3: Consumer Behavior
Slide 39
Consumer Choice
nA Corner Solution
lWhen a corner solution arises, the consumer’s MRS does not necessarily equal the price ratio.
nIn this instance it can be said that:

Chapter 3: Consumer Behavior
Slide 40
Consumer Choice
nSuppose Jane Doe’s parents set up a trust fund for her college education.
nOriginally, the money must be used for education.
nIf part of the money could be used for the purchase of other goods, her preferred consumption
bundle changes.
A College Trust Fund

Chapter 3: Consumer Behavior
Slide 41
 The trust fund shifts the budget line
Consumer Choice
P
Q
Education ($)
Other
Consumption
($)
IC2
A College Trust Fund
A
IC1
A: Consumption before the trust fund
B
    B: Requirement that the trust fund
         must be spent on education
C
IC3
C: If the trust could be spent on
     other goods

Chapter 3: Consumer Behavior
Slide 42
Revealed Preferences
nIf we know the choices a consumer has made, we can determine what her preferences are if we have
information about a sufficient number of choices that are made when prices and income vary.

Chapter 3: Consumer Behavior
Slide 43
D
Revealed Preferences – 2 Budget Lines
l1
l2
B
A
I1: Chose A over B
       A is revealed preferred to B
l2: Choose B over D
        B is revealed preferred to D
Food (units per month)
Clothing
(units per
month)

Chapter 3: Consumer Behavior
Slide 44
Amount of Exercise
(hours)
Revealed Preferences for Recreation
Other
Recreational
Activities
($)
0
25
50
75
20
40
60
80
100
l1
C
l2
U2
B
•The rate changes to $1/hr + $30/wk
•New budget line I2 & combination B
•Reveal preference of B to A
U1
A
Scenario
•Roberta’s recreation budget = $100/wk
•Price of exercise = $4/hr/week
•Exercises 10 hrs/wk at A given U1 & I1
Would the Club’s
profits increase?

Chapter 3: Consumer Behavior
Slide 45
nMarginal utility = the additional satisfaction obtained from consuming one additional unit of a
good.
nExample
lThe marginal utility derived from increasing from 0 to 1 units of food might be 9
lIncreasing from 1 to 2 might be 7
lIncreasing from 2 to 3 might be 5
nObservation: Marginal utility is diminishing: as more and more of a good is consumed, consuming
additional amounts will yield smaller and smaller additions to total utility.
Marginal Utility and Consumer Choice
Marginal Utility

Chapter 3: Consumer Behavior
Slide 46
nMarginal Utility and the Indifference Curve
lIf consumption moves along an indifference curve, the additional utility derived from an increase
in the consumption one good, food (F),  must balance the loss of utility from the decrease in the
consumption in the other good, clothing (C).
Marginal Utility and
Consumer Choice

Chapter 3: Consumer Behavior
Slide 47
nFormally:
Marginal Utility and
Consumer Choice
n Rearranging:

Chapter 3: Consumer Behavior
Slide 48
nBecause:
Marginal Utility and
Consumer Choice

Chapter 3: Consumer Behavior
Slide 49
nWhen consumers maximize satisfaction the:
Marginal Utility and
Consumer Choice
nSince the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it
follows that:

Chapter 3: Consumer Behavior
Slide 50
nWhich gives the equation for utility maximization:
Marginal Utility and
Consumer Choice

Total utility is maximized when the budget is allocated so that the marginal utility per dollar of
expenditure is the same for each good.
This is referred to as the equal marginal principle.