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CHAPTER3Consumer BehaviorCHAPTER OUTLINE3.1Consumer Preferences3.2Budget Constraints3.3Consumer Choice3.4Revealed Preference3.5Marginal Utility andConsumer Choice3.6Cost-of-Living IndexesPrepared by:Fernando Quijano, IllustratorCopyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.1 of 40Consumer Behavior theory of consumer behavior Description of how consumersallocate incomes among different goods and services to maximize their wellbeing.Consumer behavior is best understood in three distinct steps:1.Consumer Preferences2.Budget Constraints3.Consumer ChoicesWHAT DO CONSUMERS DO?Recent models of consumer behavior incorporate more realistic assumptionsabout rationality and decision making.A basic “workhorse” of economics, our model makes simplifying assumptions toexplain much of what we actually observe regarding consumer choice and thecharacteristics of consumer demand.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.2 of 40

3.1 Consumer PreferencesMarket Baskets market basket (or bundle)goods.TABLE 3.1List with specific quantities of one or moreALTERNATIVE MARKET BASKETSMARKET BASKETUNITS OF FOODUNITS OF CLOTHINGA2030B1050D4020E3040G1020H1040To explain the theory of consumer behavior, we will ask whether consumersprefer one market basket to another.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.3 of 40Some Basic Assumptions about Preferences1. Completeness: Preferences are assumed to be complete. In other words,consumers can compare and rank all possible baskets. Thus, for any twomarket baskets A and B, a consumer will prefer A to B, will prefer B to A, orwill be indifferent between the two. By indifferent we mean that a person willbe equally satisfied with either basket.Note that these preferences ignore costs. A consumer might prefer steak tohamburger but buy hamburger because it is cheaper.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.4 of 40

2. Transitivity: Preferences are transitive. Transitivity means that if aconsumer prefers basket A to basket B and basket B to basket C, then theconsumer also prefers A to C. Transitivity is normally regarded asnecessary for consumer consistency.3. More is better than less: Goods are assumed to be desirable—i.e., to begood. Consequently, consumers always prefer more of any good to less. Inaddition, consumers are never satisfied or satiated; more is always better,even if just a little better.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.5 of 40Indifference CurvesFIGURE 3.1DESCRIBING INDIVIDUALPREFERENCESBecause more of each goodis preferred to less, we cancompare market baskets inthe shaded areas.Basket A is clearly preferredto basket G, while E is clearlypreferred to A.However, A cannot becompared with B, D, or Hwithout additional information. indifference curve Curve representing all combinations of market basketsthat provide a consumer with the same level of satisfaction.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.6 of 40

FIGURE 3.2AN INDIFFERENCE CURVEThe indifference curve U1 thatpasses through marketbasket A shows all basketsthat give the consumer thesame level of satisfaction asdoes market basket A; theseinclude baskets B and D.Our consumer prefers basketE, which lies above U1, to A,but prefers A to H or G, whichlie below U1.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.7 of 40Indifference Maps indifference map Graph containing a set of indifference curvesshowing the market baskets among which a consumer is indifferent.FIGURE 3.3AN INDIFFERENCE MAPAn indifference map is a setof indifference curves thatdescribes a person'spreferences.Any market basket onindifference curve U3, suchas basket A, is preferred toany basket on curve U2(e.g., basket B), which inturn is preferred to anybasket on U1, such as D.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.8 of 40

FIGURE 3.4INDIFFERENCE CURVESCANNOT INTERSECTIf indifference curves U1 andU2 intersect, one of theassumptions of consumertheory is violated.According to this diagram, theconsumer should beindifferent among marketbaskets A, B, and D. Yet Bshould be preferred to Dbecause B has more of bothgoods.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.9 of 40The Shape of Indifference CurvesFIGURE 3.5THE MARGINAL RATE OFSUBSTITUTIONThe magnitude of the slope ofan indifference curvemeasures the consumer’smarginal rate of substitution(MRS) between two goods.In this figure, the MRSbetween clothing (C) andfood (F) falls from 6 (betweenA and B) to 4 (between B andD) to 2 (between D and E) to1 (between E and G).Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.10 of 40

The Marginal Rate of Substitution marginal rate of substitution (MRS) Maximum amount of a goodthat a consumer is willing to give up in order to obtain one additional unit ofanother good.CONVEXITYObserve that the MRS falls as we move down the indifference curve. Thedecline in the MRS reflects our fourth assumption regarding consumerpreferences: a diminishing marginal rate of substitution. When the MRSdiminishes along an indifference curve, the curve is convex.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.11 of 40Perfect Substitutes and Perfect Complements perfect substitutes Two goods for which the marginal rate of substitutionof one for the other is a constant. perfect complements Two goods for which the MRS is zero or infinite; theindifference curves are shaped as right angles.BADS badGood for which less is preferred rather than more.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.12 of 40

FIGURE 3.6PERFECT SUBSTITUTES AND PERFECT COMPLEMENTSIn (a), Bob views orange juice andapple juice as perfect substitutes: Heis always indifferent between a glassof one and a glass of the other.In (b), Jane views left shoes and right shoesas perfect complements: An additional leftshoe gives her no extra satisfaction unlessshe also obtains the matching right shoe.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.EXAMPLE 3.113 of 40DESIGNING NEW AUTOMOBILES (I)Preferences for automobile attributes can be described byindifference curves. Each curve shows the combination ofacceleration and interior space that give the samesatisfaction.FIGURE 3.7PREFERENCES FOR AUTOMOBILEATTRIBUTESOwners of Ford Mustang coupes (a) arewilling to give up considerable interior spacefor additional acceleration.The opposite is true for owners ofFord Explorers. They prefer interiorspace to acceleration (b).Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.14 of 40

UTILITY AND UTILITY FUNCTIONS utility Numerical score representing the satisfaction that aconsumer gets from a given market basket. utility functionmarket baskets.Formula that assigns a level of utility to individualFIGURE 3.8UTILITY FUNCTIONS ANDINDIFFERENCE CURVESA utility function can berepresented by a set ofindifference curves, each witha numerical indicator.This figure shows threeindifference curves (withutility levels of 25, 50, and100, respectively) associatedwith the utility function:u (F,C ) FCCopyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.15 of 40ORDINAL VERSUS CARDINAL UTILITY ordinal utility function Utility function that generates a ranking ofmarket baskets in order of most to least preferred. cardinal utility function Utility function describing by how much onemarket basket is preferred to another.EXAMPLE 3.2CAN MONEY BUY HAPPINESS?FIGURE 3.9INCOME AND HAPPINESSA cross-country comparisonshows that individuals livingin countries with higher GDPper capita are on averagehappier than those living incountries with lower percapita GDP.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.16 of 40

3.2 Budget Constraints budget constraintsof limited incomes.Constraints that consumers face as a resultThe Budget Line budget line All combinations of goods for which the total amount of moneyspent is equal to income.PF F PC C ITABLE 3.2(3.1)MARKET BASKETS AND THE BUDGET LINEMARKET BASKETFOOD (F)CLOTHING (C) TOTAL SPENDINGA040 80B2030 80D4020 80E6010 80G800 80Market baskets associated with the budget line F 2C 80Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.17 of 40FIGURE 3.10A BUDGET LINEA budget line describes thecombinations of goods thatcan be purchased given theconsumer’s income and theprices of the goods.Line AG (which passesthrough points B, D, and E)shows the budget associatedwith an income of 80, a priceof 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 Band D) is PF/PC 10/20 1/2.C ( I / PC ) ( PF / PC ) FCopyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.(3.2)18 of 40

The Effects of Changes in Income and PricesFIGURE 3.11EFFECTS OF A CHANGE ININCOME ON THE BUDGETLINEINCOME CHANGESA change in income (withprices unchanged) causes thebudget line to shift parallel tothe original line (L1).When the income of 80 (onL1) is increased to 160, thebudget line shifts outward toL2.If the income falls to 40, theline shifts inward to L3.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.19 of 40FIGURE 3.12EFFECTS OF A CHANGE INPRICE ON THE BUDGETLINEPRICE CHANGESA change in the price of onegood (with incomeunchanged) causes thebudget line to rotate aboutone intercept.When the price of food fallsfrom 1.00 to 0.50, thebudget line rotates outwardfrom L1 to L2.However, when the priceincreases from 1.00 to 2.00, the line rotates inwardfrom L1 to L3.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.20 of 40

3.3 Consumer ChoiceThe 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 andservices.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.21 of 40FIGURE 3.13MAXIMIZING CONSUMERSATISFACTIONA consumer maximizessatisfaction by choosingmarket basket A. At thispoint, the budget line andindifference curve U2 aretangent.No higher level ofsatisfaction (e.g., marketbasket D) can be attained.At A, the point ofmaximization, the MRSbetween the two goodsequals the price ratio. At B,however, because theMRS [ ( 10/10) 1] isgreater than the price ratio(1/2), satisfaction is notmaximized.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.22 of 40

(3.3) marginal benefitof a good.Benefit from the consumption of one additional unit marginal cost Cost of one additional unit of a good.So, we can then say that satisfaction is maximized when the marginalbenefit—the benefit associated with the consumption of one additional unit offood—is equal to the marginal cost—the cost of the additional unit of food.The marginal benefit is measured by the MRS.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.EXAMPLE 3.323 of 40DESIGNING NEW AUTOMOBILES (II)Different preferences of consumer groups for automobiles can affect theirpurchasing decisions. Following up on Example 3.1, we consider two groups ofconsumers planning to buy new cars.FIGURE 3.14CONSUMER CHOICE OF AUTOMOBILE ATTRIBUTESGiven a budget constraint, they will chooseThe consumers in (a) are willing to tradea car that emphasizes acceleration.off a considerable amount of interiorspace for some additional acceleration.The opposite is true for consumers in (b).Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.24 of 40

Corner Solutions corner solution Situation in which the marginal rate of substitutionfor one good in a chosen market basket is not equal to the slope of the budgetline.FIGURE 3.15A CORNER SOLUTIONWhen a corner solutionarises, the consumermaximizes satisfaction byconsuming only one of thetwo goods.Given budget line AB, thehighest level of satisfaction isachieved at B on indifferencecurve U1, where the MRS (ofice cream for frozen yogurt) isgreater than the ratio of theprice of ice cream to the priceof frozen yogurt.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.EXAMPLE 3.425 of 40CONSUMER CHOICE OF HEALTH CAREFIGURE 3.16CONSUMER PREFERENCES FORHEALTH CARE VERSUS OTHER GOODSThese indifference curves show the tradeoff between consumption of health care(H) versus other goods (O). Curve U1applies to a consumer with low income;given the consumer’s budget constraint,satisfaction is maximized at point A.As income increases the budget line shiftsto the right, and curve U2 becomesfeasible. The consumer moves to point B,with greater consumption of both healthcare and other goods.Curve U3 applies to a high-incomeconsumer, and implies less willingness togive up health care for other goods.Moving from point B to point C, theconsumer’s consumption of health careincreases considerably (from H2 to H3),while her consumption of other goodsincreases only modestly (from O2 to O3).Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.26 of 40

EXAMPLE 3.5A COLLEGE TRUST FUNDFIGURE 3.17A COLLEGE TRUST FUNDWhen given a college trustfund that must be spent oneducation, the student movesfrom A to B, a corner solution.If, however, the trust fundcould be spent on otherconsumption as well aseducation, the student wouldbe better off at C.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.27 of 403.4 Revealed PreferenceIf a consumer chooses one market basket over another, and if thechosen market basket is more expensive than the alternative, thenthe consumer must prefer the chosen market basket.FIGURE 3.18REVEALED PREFERENCE:TWO BUDGET LINESIf an individual facing budgetline l1 chose market basket Arather than market basket B,A is revealed to be preferredto B.Likewise, the individual facingbudget line l2 chooses marketbasket B, which is thenrevealed to be preferred tomarket basket D.Whereas A is preferred to allmarket baskets in the greenshaded area, all baskets inthe pink-shaded area arepreferred to A.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.28 of 40

FIGURE 3.19REVEALED PREFERENCE:FOUR BUDGET LINESFacing budget line l3, theindividual chooses E, which isrevealed to be preferred to A(because A could have beenchosen).Likewise, facing line l4, theindividual chooses G, which isalso revealed to be preferredto A.Whereas A is preferred to allmarket baskets in the greenshaded area, all marketbaskets in the pink-shadedarea are preferred to A.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.EXAMPLE 3.629 of 40REVEALED PREFERENCE FOR RECREATIONFIGURE 3.20REVEALED PREFERENCE FOR RECREATIONWhen facing budget line l1, an individual chooses to use a health club for 10 hoursper week at point A.When the fees are altered, she faces budget line l2.She is then made better off because market basket A can still be purchased, ascan market basket B, which lies on a higher indifference curve.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.30 of 40

3.5 Marginal Utility and Consumer Choice marginal utility (MU) Additional satisfaction obtained fromconsuming one additional unit of a good. diminishing marginal utility Principle that as more of a good is consumed,the consumption of additional amounts will yield smaller additions to utility.0 MU F (ΔF ) MU C (ΔC ) (ΔC / ΔF ) MU F / MU CMRS MU F / MU C(3.5)MRS PF / PC(3.6)MU F / MU C PF / PCMU F / PF MU C / PCor(3.7) equal marginal principle Principle that utility is maximized when theconsumer has equalized the marginal utility per dollar of expenditure across allgoods.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.EXAMPLE 3.731 of 40MARGINAL UTILITY AND HAPPINESSWhat, if anything, does research on consumer satisfaction tell us about therelationship between happiness and the concepts of utility and marginal utility?FIGURE 3.21MARGINAL UTILITY AND HAPPINESSA comparison of mean levels of satisfaction with life across income classes in theUnited States shows that happiness increases with income, but at a diminishing rate.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.32 of 40

RationingFIGURE 3.22INEFFICIENCY OFGASOLINE RATIONINGWhen a good is rationed, lessis available than consumerswould like to buy. Consumersmay be worse off.Without gasoline rationing, upto 20,000 gallons of gasolineare available for consumption(at point B).The consumer chooses pointC on indifference curve U2,consuming 5000 gallons ofgasoline.However, with a limit of 2000gallons of gasoline underrationing, the consumermoves to D on the lowerindifference curve U1.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.33 of 40FIGURE 3.23COMPARING GASOLINERATIONING TO THE FREEMARKETSome consumers will beworse off, but others may bebetter off with rationing. Withrationing and a gasoline priceof 1.00, she buys themaximum allowable 2000gallons per year, putting heron indifference curve U1.Had the competitive marketprice been 2.00 per gallonwith no rationing, she wouldhave chosen point F, whichlies below indifference curveU1.However, had the price ofgasoline been only 1.33 pergallon, she would havechosen point G, which liesabove indifference curve U1.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.34 of 40

3.6 Cost-of-Living Indexes cost-of-living index Ratio of the present cost of a typical bundle ofconsumer goods and services compared with the cost during a base period.Ideal Cost-of-Living Index ideal cost-of-living index Cost of attaining a given level of utility at currentprices relative to the cost of attaining the same utility at base-year prices.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.FIGURE 3.24(1 of 2)COST-OF-LIVING INDEXESTABLE3.335 of 40IDEAL COST-OF-LIVING INDEXPrice of booksNumber of booksPrice of food2000 (SARAH) 2010 (RACHEL) 20/book 100/bk156 2.00/lb. 2.20/lb.Pounds of food100300Expenditure 500 1260The initial budget constraintfacing Sarah in 2000 is givenby line l1; her utility-maximizingcombination of food and booksis at point A on indifferencecurve U1.Rachel requires a budgetsufficient to purchase the foodbook consumption bundlegiven by point B on line l2 (andtangent to indifference curveU1).Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.36 of 40

FIGURE 3.24(2 of 2)COST-OF-LIVING INDEXESTABLE3.3IDEAL COST-OF-LIVING INDEXPrice of booksNumber of booksPrice of food2000 (SARAH) 2010 (RACHEL) 20/book 100/bk156 2.00/lb. 2.20/lb.Pounds of food100300Expenditure 500 1260A price index, whichrepresents the cost of buyingbundle A at current pricesrelative to the cost of bundle Aat base-year prices, overstatesthe ideal cost-of-living index.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.37 of 40Laspeyres Index Laspeyres price index Amount of money at current year prices that anindividual requires to purchase a bundle of goods and services chosen in abase year divided by the cost of purchasing the same bundle at base-yearprices.COMPARING IDEAL COST-OF-LIVING AND LASPEYRES INDEXESThe Laspeyres index overcompensates Rachel for the higher cost of living, andthe Laspeyres cost-of-living index is, therefore, greater than the ideal cost-ofliving index.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.38 of 40

Paasche Index Paasche index Amount of money at current-year prices that an individualrequires to purchase a current bundle of goods and services divided by the costof purchasing the same bundle in a base year.COMPARING THE LASPEYRES AND PAASCHE INDEXESJust as the Laspeyres index will overstate the ideal cost of living, the Paaschewill understate it because it assumes that the individual will buy the current yearbundle in the base period.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.39 of 40 fixed-weight index Cost-of-living index in which the quantities ofgoods and services remain unchanged.Price Indexes in the United States: Chain Weighting chain-weighted price index Cost-of-living index that accounts for changesin quantities of goods and services.EXAMPLE 3.8THE BIAS IN THE CPIA commission chaired by Stanford University professor Michael Boskinconcluded that the CPI overstated inflation by approximately 1.1 percentagepoints—a significant amount given the relatively low rate of inflation in theUnited States in recent years.Approximately 0.4 percentage points of the 1.1-percentage-point bias wasdue to the failure of the Laspeyres price index to account for changes in thecurrent year mix of consumption of the products in the base-year bundle.Copyright 2013 Pearson Education, Inc. Microeconomics Pindyck/Rubinfeld, 8e.40 of 40

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

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