CH 03

Chapter 3
Consumer Behavior
Consumer Behavior
The theory of consumer behavior can be
used to help answer these and many
more questions
Theory of consumer behavior
The explanation of how consumers allocate
income to the purchase of different goods
and services
2005 Pearson Education, Inc.
Chapter 3
Consumer Behavior
There are three steps involved in the
study of consumer behavior
1. Consumer Preferences
To describe how and why people prefer one
good to another
2. Budget Constraints
People have limited incomes
Chapter 3
Consumer Behavior
3. Given preference sand limited incomes,
what amount and type of goods will be
purchased?
What combination of goods will consumers
buy to maximize their satisfaction?
Chapter 3
Consumer Preferences
How might a consumer compare different
groups of items available for purchase?
A market basket is a collection of one or
more commodities.
Individuals can choose between market
baskets containing different goods
Chapter 3
Consumer Preferences Basic

Assumptions
1. Preferences are complete.
Consumers can rank market baskets
2. Preferences are transitive.

If prefer A to B, and B to C, the must prefer
A to C
3. Consumers always prefer more of any

good to less.
More is better
Chapter 3
Consumer preferences can be
represented graphically using
indifference curves
Indifference curves represent all
combinations of market baskets that the
person is indifferent to
A person will be equally satisfied with either
choice
Chapter 3
Indifference Curves: An
Example
Market Basket
Units of Food
Units of Clothing
20
30
10
50
40
20
30
40
10
20
10
40
Chapter 3
Example
Graph the points with one good on the xaxis and one good on the y-axis
Plotting the points we can make some
immediate observations about
preferences
More is better
Chapter 3
Example
Clothin 50
g
The consumer prefers

A to all combinations
in the blue box, while
all those in the pink
box are preferred to A.
40
30
E
A
20
10
10
20
30
Chapter 3
40
Food
10
Example
Points such as B & D have more of one
good but less of another compared to A
Need more information about consumer
ranking
Consumer may decide they are

indifference between B, A and D
We can then connect those points with an
indifference curve
Chapter 3
11
Example
Clothin
g
50
40
E
A
30
20
10
Indifferent
between B,
A, & D
E is
preferred to
U1
U1 is
preferred to
UH & G
1
10
20
30
Chapter 3
40
Food
12
Indifference Curves
Any market basket lying northeast of an
indifference curve is preferred to any
market basket that lies on the
indifference curve.
Points on the curve are preferred to
points southwest of the curve
Chapter 3
13
Indifference Curves
Indifference curves slope downward to
the right.
If it sloped upward it would violate the
assumption that more is preferred to less.
Some
points that had more of both goods would

be indifferent to a basket with less of both goods
Chapter 3
14
Indifference Curves
To describe preferences for all
combinations of goods/services, we have
a set of indifference curves an
indifference map
Each indifference curve in the map shows
the market baskets among which the person
is indifferent.
Chapter 3
15
Indifference Map
Clothing
Market basket A
is preferred to B.
Market basket B is
preferred to D.
D
B
A
U3
U2
U1
Food
Chapter 3
16
Indifference Maps
Indifference maps give more information
about shapes of indifference curves
Indifference curves can not cross
Violates
assumption that more is better
Why? What if we assume they can cross.
Chapter 3
17
Indifference Maps
Clothing
U1
B is preferred to D
A is indifferent to B
&D
B must be
indifferent to D but
that cant be if B is
preferred to D
A
B
D
U2
U1
Food
Chapter 3
18
Indifference Curves
The shapes of indifference curves
describes how a consumer is willing to
substitute one good for another
A to B, give up 6 clothing to get 1 food
D to E, give up 2 clothing to get 1 food
The more clothing and less food a

person has, the more clothing they will
give up to get more food
Chapter 3
19
Indifference Curves
A
Clothing 16
14
12
Observation: The amount

of clothing given up for
1 unit of food decreases
from 6 to 1
-6
10
1
-4
8
6
B
D
1
-2
E
1 -1
2
1
4
Chapter 3
Food
20
Indifference Curves
We measure how a person trades one
good for another using the marginal rate
of substitution (MRS)
It quantifies the amount of one good a
consumer will give up to obtain more of
another good.
It is measured by the slope of the
indifference curve.
Chapter 3
21
Marginal Rate of Substitution

A
Clothing 16
14
12
MRS C
MRS =
6
-6
10
1
-4
8
6
B
D
1
-2
MRS = 2
E
1 -1
1
4
Chapter 3
G
Food
22

Indifference curves are convex
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 generally prefer a balanced

market basket
Chapter 3
23

The MRS decreases as we move down
the indifference curve
Along an indifference curve there is a
diminishing marginal rate of substitution.
The MRS went from 6 to 4 to 1
Chapter 3
24

Indifference curves with different shapes
imply a different willingness to substitute
Two polar cases are of interest
Perfect substitutes
Perfect complements
Chapter 3
25

Perfect Substitutes
Two goods are perfect substitutes when the
marginal rate of substitution of one good for
the other is constant.
Example: a person might consider apple
juice and orange juice perfect substitutes
They
would always trade 1 glass of OJ for 1

glass of Apple Juice
Chapter 3
26
Apple
4
Juice
(glasses)
Perfect
Substitute
s
1
0
3
Chapter 3
Orange Juice
(glasses)
27
Perfect Complements
Two goods are perfect complements when
the indifference curves for the goods are
shaped as right angles.
Example: If have 1 left shoe and 1 right
shoe, you are indifferent between having
more left shoes only
Must
have one right for one left
Chapter 3
28
Left
Shoes
Perfect
Complements
4
3
2
1
0
3
Chapter 3
Right Shoes
29
We have assumed all our commodities
are goods
There are commodities we dont want
more of - bads
Things for which less is preferred to more
Examples
Air pollution
Asbestos
Chapter 3
30
How do we account for bads in our
preference analysis?
We redefine the commodity
Clean
air
Pollution reduction
Asbestos removal
Chapter 3
31
Consumer Preferences: An
Application
In designing new cars, automobile
executives must determine how much
time and money to invest in restyling
versus increased performance
Higher demand for car with better styling and
performance
Both cost more to improve
Chapter 3
32
Application
An analysis of consumer preferences
would help to determine where to spend
more on change: performance or styling
Some consumers will prefer better styling
and some will prefer better performance
Chapter 3
33
Application
Styling
These
consumers
place a
greater value
on
performance
than styling
Performance
Chapter 3
34
Application
Styling
These consumers
place a greater
value on styling
than performance
Performance
Chapter 3
35
Application
Knowing which groups dominates the
market will help decide where
redesigning dollars should go
A recent study in the US shows that over
the past two decades most consumers
have preferred styling over performance.
Chapter 3
36
The theory of consumer behavior does
not required assigning a numerical value
to the level of satisfaction
Although ranking of market baskets are
good, sometimes numerical value are
useful
Chapter 3
37
Utility
A numerical score representing the
satisfaction that a consumer gets from a
given market basket.
If 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.
Chapter 3
38
Utility
Utility function
Formula that assigns a level of utility to
individual market baskets
If the utility function is
U(F,C) = F + 2C
A market basket with 8 units of food and 3 units of
clothing gives a utility of
14 = 8 + 2(3)
Chapter 3
39
Utility - Example
Market
Basket
Food
Clothing
Utility
8 + 2(3) = 14
6 + 2(4) = 14
4 + 2(4) = 12
Consumer is indifferent between A & B and

prefers both to C
Chapter 3
40
Utility - Example
Baskets for each level of utility can be
plotted to get an indifference curve
To find the indifference curve for a utility of
14, we can change the combinations of food
and clothing that give us a utility of 14
Chapter 3
41
Utility - Example
Clothing
Basket
C
2.5(10)
A
B
10(2.5)
15
10
0
25 = 5(5)
25 =
U3 = 100
U = FC
25 =
10
Chapter 3
U2 = 50
15
U1 = 25
Food
42
Utility
Although we numerically rank baskets
and indifference curves, numbers are
ONLY for ranking
A utility of 4 is not necessarily twice as
good as utility of 2
There are two types of ranking
Ordinal ranking
Cardinal ranking
Chapter 3
43
Utility
Ordinal Utility Function
Places market baskets in the order of most
preferred to least preferred, but it does not
indicate how much one market basket is
preferred to another.
Cardinal Utility Function

Utility function describing the extent to which
one market basket is preferred to another.
Chapter 3
44
Utility
The actual unit of measurement for utility
is not important.
An ordinal ranking is sufficient to explain
how most individual decisions are made.
Chapter 3
45
Budget Constraints
Preferences do not explain all of
consumer behavior.
Budget constraints also limit an
individuals ability to consume in light of
the prices they must pay for various
goods and services.
Chapter 3
46
Budget Constraints
The Budget Line
Indicates all combinations of two
commodities for which total money spent
equals total income.
We assume only 2 goods are consumed, so
we do not consider savings
Chapter 3
47
The Budget Line

Let F equal the amount of food
purchased, and C is the amount of
clothing.
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.
Chapter 3
48
The Budget Line

The budget line then can be written:
PFF PCC I
All income is allocated to food (F) and/or clothing
(C)
Chapter 3
49
The Budget Line

Different choices of food and clothing
can be calculated that use all income
These choices can be graphed as the budget
line
Example:
Assume income of $80/week, PF = $1 and PC
= $2
Chapter 3
50
Budget Constraints
Market
Basket
Food
PF = $1
Clothing
PC = $2
I = PFF + PCC
40
$80
20
30
$80
40
20
$80
60
10
$80
80
$80
Chapter 3
Income
51
The Budget Line

Clothing
(I/PC) = 40
C
1
PF
Slope
- F
2
PC
30
10
20
D
20
E
10
G
0
20
40
60
Chapter 3
80 = (I/PF)
Food
52
The Budget Line

As consumption moves along a budget
line from the intercept, the consumer
spends less on one item and more on the
other.
The slope of the line measures the
relative cost of food and clothing.
The slope is the negative of the ratio of
the prices of the two goods.
Chapter 3
53
The Budget Line

The slope indicates the rate at which the
two goods can be substituted without
changing the amount of money spent.
We can rearrange the budget line
equation to make this more clear
Chapter 3
54
The Budget Line
I PX X PY Y
I PX X PY Y
I PX
X Y
PY PY
Chapter 3
55
Budget Constraints
The Budget Line
The vertical intercept (I/PC), illustrates the
maximum amount of C that can be
purchased with income I.
The horizontal intercept (I/PF), illustrates the
maximum amount of F that can be
purchased with income I.
Chapter 3
56
The Budget Line

As we know, income and prices can
change
As incomes and prices change, there are
changes in budget lines
We can show the effects of these
changes on budget lines and consumer
choices
Chapter 3
57
The Budget Line - Changes

The Effects of Changes in Income
An increase in income causes the budget
line to shift outward, parallel to the original
line (holding prices constant).
Can buy more of both goods with more
income
Chapter 3
58

The Effects of Changes in Income
A decrease in income causes the budget line
to shift inward, parallel to the original line
(holding prices constant).
Can buy less of both goods with less income
Chapter 3
59

Clothing
(units
per week)
A increase in
income shifts
the budget line
outward
80
60
A decrease in
income shifts
the budget line
inward
40
20
0
L3
(I = L1
(I = $80)
$40)
40
80
120
Chapter 3
L2
(I = $160)
160
Food
(units per week)
60

The Effects of Changes in Prices
If the price of one good increases, the
budget line shifts inward, pivoting from the
other goods intercept.
If price of food increases and you buy only
food (x-intercept), then cant buy as much
food. The point shifts in
If buy only clothing (y-intercept), can buy the
same amount. No change
Chapter 3
61

If the price of one good decreases, the
budget line shifts outward, pivoting from the
other goods intercept.
If price of food decreases and you buy only
food (x-intercept), then can buy more food.
The point shifts out.
If buy only clothing (y-intercept), can buy the
same amount. No change
Chapter 3
62

Clothing
(units
per week)
A decrease in the
price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.
40
L3
L2
L1
(PF = 1/2)
(PF = 1)
(PF = 2)
40
80
An increase in the
price of food to
$2.00 changes
the slope of the
budget line and
rotates it inward.
120
Chapter 3
160
Food
(units per week)
63

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
Chapter 3
64

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
Chapter 3
65
Consumer Choice
Given preferences and budget
constraints, how do consumers choose
what to buy?
Consumers choose a combination of
goods that will maximize their
satisfaction, given the limited budget
available to them.
Chapter 3
66
Consumer Choice
The maximizing market basket must
satisfy two conditions:
1. It must be located on the budget line.
They spend all their income more is better
2. It must give the consumer the most

preferred combination of goods and
services.
Chapter 3
67
Consumer Choice
Graphically we can see different
indifference curves of a consumer
choosing between clothing and food
Remember that U3 > U2 > U1 for our
indifference curves
Consumer wants to choose highest utility
within their budget
Chapter 3
68
Consumer Choice
Clothing
(units per
week)
A, B, C on budget line
D highest utility but
not affordable
C highest affordable
utility
Consumer chooses C
40
A
30
20
C
U3
U1
B
0
20
40
Chapter 3
80
U2
Food (units per week)
69
Consumer Choice
Consumer will choose highest
indifference curve on budget line
In previous graph, point C is where the
indifference curve is just tangent to the
budget line
Slope of the budget line equals the slope
of the indifference curve at this point
Chapter 3
70
Consumer Choice
Recall, the slope of an indifference curve
is:
C
MRS
F
Further, the slope of the budget line is:
PF
Slope
PC
Chapter 3
71
Consumer Choice
Therefore, it can be said at consumers
optimal consumption point,
PF
MRS
PC
Chapter 3
72
Consumer Choice
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).
Note this is ONLY true at the optimal
consumption point
Chapter 3
73
Consumer Choice
Optimal consumption point is where
marginal benefits equal marginal costs
MB = MRS = benefit associated with
consumption of 1 more unit of food
MC = cost of additional unit of food
1 unit food = unit clothing
PF/PC
Chapter 3
74
Consumer Choice
If MRS PF/PC then individuals can
reallocate basket to increase utility
If MRS > PF/PC
Will increase food and decrease clothing
until MRS = PF/PC
If MRS < PF/PC

Will increase clothing and decrease food until
MRS = PF/PC
Chapter 3
75
Consumer Choice
Clothing
(units per
week)
Point B does not

maximize satisfaction
because the
MRS =-10/10 = 1
is greater than the
price ratio = 1/2
40
B
30
-10C
20
+10F
20
40
U1
Chapter 3
80
Food (units per week)
76
Consumer Choice: An
Application Revisited
Consider two groups of consumers, each
wishing to spend $10,000 on the styling
and performance of a car.
Each group has different preferences.
Chapter 3
77
Consumer Choice: An
By finding the point of tangency between
a groups indifference curve and the
budget constraint auto companies can
see how much consumers value each
attribute.
Chapter 3
78
Consumer Choice: An
Styling
$10,000
These consumers
Want performance
worth $7000 and
styling worth $3000
$3,000
$7,000
Chapter 3
$10,000Performance
79
Consumer Choice: An
Styling
These
consumers want
styling worth
$7000 and
performance
worth $3000
$10,000
$7,000
$10,000Performance
$3,000
Chapter 3
80
Consumer Choice: An
Once know preferences, can design a
production and marketing plan
Company can then make a sensible
strategic business decision on how to
allocate performance and styling on new
cars
Chapter 3
81
Consumer Choice
A corner solution exists if a consumer
buys in extremes, and buys all of one
category of good and none of another.
MRS is not necessarily equal to PA/PB
Chapter 3
82
A Corner Solution
Frozen
Yogurt
(cups
monthly)
A
U1 U2 U3
B
Chapter 3
A corner solution
exists at point B.
Ice Cream (cup/month)

83
A Corner Solution
At point B, the MRS of ice cream for
frozen yogurt is greater than the slope of
the budget line.
f 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
Opposite is true if corner solution was at
point A
Chapter 3
84
A Corner Solution
When a corner solution arises, the
consumers MRS does not necessarily
equal the price ratio.
In this instance it can be said that:
PIceCream
MRS
PFrozen Yogurt
Chapter 3
85
A Corner Solution
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 consumers market basket.
Chapter 3
86
A Corner Solution - Example

Suppose Jane Does parents set up a
trust fund for her college education.
The money must be used only for
education.
Although a welcome gift, an unrestricted
gift might be better
Chapter 3
87

Original budget line, PQ, with a market
basket, A, of education and other goods
Trust fund shifts out the budget line as
long as trust fund, PB, spent on
education
Jane increases satisfaction moving to
higher indifference curve, U2
Chapter 3
88

Other
Consumption
($)
U2
Jane better off

on U2
B is corner
solution
MRS PE/POG
U1
Q
Chapter 3
Education ($)
89

Other
Consumption
($)
C
U3
U2
If gift is
unrestricted,
Jane can be at
point C on U3
Better off
than with
restricted gift
U1
Q
Chapter 3
Education ($)
90
Revealed Preferences
If we know the choices a consumer has
made, we can determine what their
preferences are if we have information
about a sufficient number of choices that
are made when prices and incomes vary.
Chapter 3
91
Revealed Preferences Two

Budget Lines
Clothing
(units per
month)
l1
I1: Chose A over B

A is revealed
preferred to B
l2: Choose B over
D
B is revealed
preferred to D
l2
A
B
D
Food (units per month)

Chapter 3
92
Revealed Preferences-Two Budget Lines

Clothing
(units per
month)
l1
All market baskets

in the pink
shaded area are
preferred to A.
l2
A
B is
preferred
to
all market
baskets
in the
yellow
area
B
D

Chapter 3
93
Revealed Preference
As you continue to change the budget
line, individuals can tell you which basket
they prefer to others.
More the individual reveals, the more you
can discern about their preferences
Eventually you can map out an
indifference curve
Chapter 3
94
Revealed Preferences Four

Budget Lines
I3: E revealed preferred to A
Clothing
(units per
month)
l3
l1
All market baskets in the

pink area preferred to A
l4
A
l2
B
A: preferred to all
market baskets in
the yellow area
I4: G revealed preferred to

Chapter 3
95
Marginal Utility and Consumer

Choice
Marginal utility measures the additional
satisfaction obtained from consuming
one additional unit of a good.
How much happier is the individual from
consuming one more unit of food
Chapter 3
96
Marginal Utility - Example

The marginal utility derived from
increasing from 0 to 1 units of food might
be 9
Increasing from 1 to 2 might be 7
Increasing from 2 to 3 might be 5
Observation: Marginal utility is
diminishing as consumption increases
Chapter 3
97
Marginal Utility
The principle of diminishing marginal
utility states that as more of a good is
consumed, the additional utility the
consumer gains will be smaller and
smaller.
Note that total utility will continue to
increase since consumer makes choices
that make them happier
Chapter 3
98
Marginal Utility and Indifference

Curves
As consumption moves along an
indifference curve:
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).
Chapter 3
99

Choice
Formally:
0 MUF(F) MUC(C)
No change in total utility along an indifference curve.
Trade off of one good to the other leaves the consumer
just as well off
Chapter 3
100

Choice
Rearranging:
C / F MU F / MU C
Since
C / F MRS of F for C
We can say
MRS MUF/MUC
Chapter 3
101

Choice
When consumers maximize satisfaction:
MRS PF/PC
Since the MRS is also equal to the ratio of
the marginal utility of consuming F and C
MUF/MUC PF/PC
Chapter 3
102

Choice
Rearranging, gives the equation for utility
maximization:
MU F / PF MU C / PC
Chapter 3
103

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.
Chapter 3
104

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Chapter 3

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Consumer Preferences Basic

2. Preferences are transitive.

3. Consumers always prefer more of any

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

The consumer prefers

Consumer may decide they are

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

points that had more of both goods would

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

assumption that more is better

Why? What if we assume they can cross.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

The more clothing and less food a

Observation: The amount

2005 Pearson Education, Inc.

Marginal Rate of Substitution

Marginal Rate of Substitution

Consumers generally prefer a balanced

2005 Pearson Education, Inc.

Marginal Rate of Substitution

2005 Pearson Education, Inc.

Marginal Rate of Substitution

2005 Pearson Education, Inc.

Marginal Rate of Substitution

would always trade 1 glass of OJ for 1

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

have one right for one left

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Consumer is indifferent between A & B and

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

Cardinal Utility Function

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2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

2005 Pearson Education, Inc.

The Budget Line

2005 Pearson Education, Inc.

The Budget Line

2005 Pearson Education, Inc.

The Budget Line