Microeconomics

Session 3-5

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

CONSUMER PREFERENCES
Market Baskets
market basket (or bundle)
of one or more goods.

List with specific quantities

TABLE 3.1 Alternative Market Baskets

Market Basket

Units of Food

Units of Clothing

20

30

10

50

40

20

30

40

10

20

10

40

To explain the theory of consumer behavior, we will ask

whether consumers prefer one market basket to another.

CONSUMER PREFERENCES
Some Basic Assumptions about Preferences
1. Completeness: Preferences are assumed to be
complete. In other words, consumers can compare and
rank all possible baskets. Thus, for any two market
baskets A and B, a consumer will prefer A to B, will prefer
B to A, or will be indifferent between the two. By
indifferent we mean that a person will be equally satisfied
with either basket.
Note that these preferences ignore costs. A consumer
might prefer steak to hamburger but buy hamburger
because it is cheaper.

CONSUMER 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.

CONSUMER PREFERENCES

3. More is better than less: Goods are assumed to

be desirablei.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. This assumption is made for pedagogic
reasons; namely, it simplifies the graphical
analysis. Of course, some goods, such as air
pollution, may be undesirable, and consumers will
always prefer less. We ignore these bads in the
context of our immediate discussion.

CONSUMER PREFERENCES
Indifference Curves

Figure 3.1
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.

CONSUMER PREFERENCES
Indifference Curves
Curve representing all combinations of market
baskets that provide a consumer with the same level of satisfaction.

indifference curve
Figure 3.2
An Indifference Curve

The indifference curve U1 that

passes through market basket
A shows all baskets that give
the consumer the same level of
satisfaction as does market
basket A; these include
baskets B and D.
Our consumer prefers basket
E, which lies above U1, to A,
but prefers A to H or G, which
lie below U1.

CONSUMER PREFERENCES
Indifference Maps
indifference map Graph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.
Figure 3.3
An Indifference Map

An indifference map is a set of

indifference curves that
describes a person's
preferences.
Any market basket on
indifference curve U3, such as
basket A, is preferred to any
basket on curve U2 (e.g.,
basket B), which in turn is
preferred to any basket on U1,
such as D.

CONSUMER PREFERENCES
Indifference Maps
Figure 3.4
Indifference Curves Cannot Intersect

If indifference curves U1 and U2

intersect, one of the
assumptions of consumer
theory is violated.
According to this diagram, the
consumer should be indifferent
among market baskets A, B,
and D. Yet B should be
preferred to D because B has
more of both goods.

CONSUMER PREFERENCES
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.
Figure 3.8
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 FC.

Marginal Utility

Additional satisfaction obtained

from consuming one additional unit of a good.

marginal utility (MU)

diminishing marginal utility Principle that as more of a good is

consumed, the consumption of additional amounts will yield
smaller additions to utility.

CONSUMER PREFERENCES
Maximum amount of
a good that a consumer is willing to give up in order to obtain
one additional unit of another good.

marginal rate of substitution (MRS)

The magnitude of the slope

of an indifference curve
measures the consumers
marginal rate of
substitution (MRS)
between two goods.

The decline in the

MRS reflects a
diminishing marginal
rate of substitution.

CONSUMER PREFERENCES
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

zero or infinite; the indifference curves are shaped as right
angles.

Bads
bad

Good for which less is preferred rather than more.

CONSUMER PREFERENCES
Perfect Substitutes and Perfect Complements
Figure 3.6
Perfect Substitutes and Perfect Complements

In (a), Bob views orange juice and

apple juice as perfect substitutes:
He is always indifferent between a
glass of one and a glass of the
other.

In (b), Jane views left shoes and

right shoes as perfect complements:
An additional left shoe gives her no
extra satisfaction unless she also
obtains the matching right shoe.

3.2

BUDGET CONSTRAINTS
budget constraints are Constraints that consumers
face as a result of limited incomes.

The Budget Line

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

PF F + PC C = I

(3.1)

TABLE 3.2 Market Baskets and the Budget Line

Market Basket

Food (F)

Clothing (C)

Total Spending

40

$80

20

30

$80

40

20

$80

60

10

$80

G shows market80baskets associated

0
$80 line
The table
with the budget
F + 2C = $80

BUDGET CONSTRAINTS
The Budget Line
Figure 3.10
A Budget Line

A budget line describes the

combinations of goods that can be
purchased given the consumers
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.

C = ( I / PC ) ( PF / PC ) F

(3.2)

BUDGET CONSTRAINTS
The Effects of Changes in Income and Prices
Figure 3.11
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.

BUDGET CONSTRAINTS
The Effects of Changes in Income and Prices
Figure 3.12
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 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.
Figure 3.13
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.

CONSUMER CHOICE
Satisfaction is maximized (given the budget constraint) at the
point where
Slope of the indifference curve = Slope of the budget line

MRS = PF / PC

MARGINAL UTILITY AND CONSUMER CHOICE

0 = MU (F ) + MU (C )
F
C
(C / F ) = MU / MU
F
C
MRS = MU /MU
F
C
MRS = P / P
F C
MU / MU = P / P
F
C F C
MU / P = MU / P
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.

 Sonakshi lives in a dormitory that offers soft

drinks and chips for sale in vending machines.
Her utility function is U = 3SC (where S is the
number of soft drinks per week and C the
number of bags of chips per week). Soft drinks
are priced at Rupees 50 each, chips Rupees 25
per bag.
What are Sonakshis marginal utilities of soft
drink and chips?
Write an expression for Sonakshi's marginal rate
of substitution between soft drinks and chips.
If Sonakshi has Rupees 500 per week to spend
on chips and soft drinks, how many of each
should she purchase per week?

Shai buys only pomegranates and mangos. In

July, pomegranates sell for rupees 20 each
and mangos sell for rupees 10 each. In
January, pomegranates sell for rupees 10
each and mangos sell for rupees 20 each.
Shais income is rupees 200, both in July and
January. If Shai buys exactly eight
pomegranates in July, then she is
__________.

certainly happier in July

certainly happier in January
equally happy in July and January
There is not enough information to answer this
question

INDIVIDUAL DEMAND
Price Changes
Figure 4.1
Effect of Price Changes

A reduction in the price of food,

with income and the price of
clothing fixed, causes this
consumer to choose a different
market basket.
In (a), the baskets that
maximize utility for various
prices of food (point A, $2; B,
$1; D, $0.50) trace out the
price-consumption curve.
Part (b) gives the demand
curve, which relates the price of
food to the quantity demanded.
(Points E, G, and H correspond
to points A, B, and D,
respectively).

INDIVIDUAL DEMAND
Income Changes
Figure 4.2
Effect of Income Changes

An increase in income, with the

prices of all goods fixed, causes
consumers to alter their choice of
market baskets.
In part (a), the baskets that
maximize consumer satisfaction
for various incomes (point A, $10;
B, $20; D, $30) trace out the
income-consumption curve.
The shift to the right of the
demand curve in response to the
increases in income is shown in
part (b). (Points E, G, and H
correspond to points A, B, and D,
respectively.)

INDIVIDUAL DEMAND
Engel Curves
Engel curve

Curve relating the quantity of a good consumed to income.

Figure 4.4
Engel Curves

Engel curves relate the

quantity of a good
consumed to income.
In (a), food is a normal
good and the Engel curve
is upward sloping.
In (b), however,
hamburger is a normal
good for income less than
$20 per month and an
inferior good for income
greater than $20 per
month.

The Engel curves we just examined apply to

individual consumers. However, we can also
derive Engel curves for groups of consumers.
This information is particularly useful if we
want to see how consumer spending varies
among different income groups. Table 4.1
illustrates spending patterns for several items
taken from a survey by the U.S. Bureau of
Labor Statistics.
TABLE 4.1 Annual U.S. Household Consumer Expenditures
INCOME GROUP (2005$)
Expenditures Less than 10,000($) on:
$10,000
19,999
Entertainment
Owned Dwelling
Rented Dwelling
Heath Care
Food
Clothing

844
4272
2672
1108
2901
861

947
4716
2779
1874
3242
884

20,00029,999

30,00039,999

40,00049,999

1191
5701
2980
2241
3942
1106

1677
6776
2977
2361
4552
1472

1933
7771
2818
2778
5234
1450

50,000
70,000
69,999 and above
2402
8972
2255
2746
6570
1961

4542
14763
1379
3812
9247
3245

Source: U.S. Department of Labor, Bureau of Labor Statistics, Consumer Expenditure Survey, Annual Report 2005.

Figure 4.5
Engel Curves for U.S.
Consumers

Average per-household
expenditures on rented
dwellings, health care, and
entertainment are plotted as
functions of annual income.
Health care and
entertainment are normal
goods, as expenditures
increase with income.
Rental housing, however, is
an inferior good for incomes
above $35,000.

INDIVIDUAL DEMAND
Normal versus Inferior Goods
Figure 4.3
An Inferior Good

An increase in a persons
income can lead to less
consumption of one of the
two goods being
purchased.
Here, hamburger, though
a normal good between A
and B, becomes an
inferior good when the
income-consumption
curve bends backward
between B and C.

INCOME AND SUBSTITUTION EFFECTS

A fall in the price of a good has two effects:

1. INCOME EFFECT Because one of the goods is now
cheaper, consumers enjoy an increase in real
purchasing power.
2. SUBSTITUTION EFFECT Consumers will tend to buy
more of the good that has become cheaper and less of
those goods that are now relatively more expensive.

INCOME AND SUBSTITUTION EFFECTS

Figure 4.6
Income and Substitution Effects:
Normal Good

A decrease in the price of food

has both an income effect and a
substitution effect.
The consumer is initially at A, on
budget line RS.
When the price of food falls,
consumption increases by F1F2 as
the consumer moves to B.
The substitution effect F1E
(associated with a move from A to
D) changes the relative prices of
food and clothing but keeps real
income (satisfaction) constant.
The income effect EF2
(associated with a move from D to
B) keeps relative prices constant
but increases purchasing power.
Food is a normal good because
the income effect EF2 is positive.

 substitution effect Change in

consumption of a good associated with a
change in its price, with the level of utility
held constant.
income effect Change in consumption of
a good resulting from an increase in
purchasing power, with relative prices held
constant.
The total effect of a change in price is given theoretically by the
sum of the substitution effect and the income effect:
Total Effect (F1F2) = Substitution Effect (F1E) + Income Effect (EF2)

Figure 4.7
Income and Substitution Effects:
Inferior Good

The consumer is initially at A on

budget line RS.
With a decrease in the price of food,
the consumer moves to B.
The resulting change in food
purchased can be broken down into a
substitution effect, F1E (associated
with a move from A to D), and an
income effect, EF2 (associated with a
move from D to B).
In this case, food is an inferior good
because the income effect is negative.
However, because the substitution
effect exceeds the income effect, the
decrease in the price of food leads to
an increase in the quantity of food
demanded.

A Special Case: The Giffen Good

Giffen good Good whose demand curve slopes upward
because the (negative) income effect is larger than the
substitution effect.
Upward-Sloping Demand Curve: The
Giffen Good

When food is an inferior good, and

when the income effect is large
enough to dominate the
substitution effect, the demand
curve will be upward-sloping.
The consumer is initially at point
A, but, after the price of food falls,
moves to B and consumes less
food.
Because the income effect EF2 is
larger than the substitution effect
F1E, the decrease in the price of
food leads to a lower quantity of
food demanded.

Example
Income = Rs 500

Income = Rs 500

Chicken = Rs. 200/kg

Potato = Rs. 20/kg

Chicken = Rs. 200

Potato = Rs. 50/kg

Consumption
Chicken = 2 Kg
Potato = 5 Kg

Consumption
Chicken = 1 Kg
Potato = 6 Kg