Theory of Consumer Behavior

1. Theory ofConsumerBehavior Chapter 3

2. Discussion Topics • Utility theory • Indifference curves • The budget constraint

3. Utility Function A utility function is an algebraic expression that allows us to rank consumption bundles or combinations of goods. Total utility = Qhamburgers x Qpizza Page 48

4. Utility Function A utility function is an algebraic expression that allows us to rank consumption bundles or combinations of goods. Total utility = Qhamburgers x Qpizza This approach assumes that utility is cardinally measurable in the same sense that a ruler measures distance. Page 58

5. Ranking Total Utility Ranking of consumption bundles

6. Ranking Total Utility Rank A and C over B Indifferent between A and C

7. Marginal Utility Marginal utility is the change in utility derived from an increase in consumption of a particular good. MUhamburgers =  utility ÷  hamburgers Page 49

8. Marginal Utility Marginal utility is the change in utility derived from an increase in consumption of a particular good. MUhamburgers =  utility ÷  hamburgers This value will fall (rise) as consumption increases (decreases). Page 49

9. Marginal utility goes to zero at the peak of the total utility curve Page 50

10. Indifference Curves Cardinal measurement of utility is both unreasonable and unnecessary. We can instead use an ordinal measurement of utility, which means all we need to know is that one bundle is preferred over another. Page 51

11. Indifference Curves Cardinal measurement of utility is both unreasonable and unnecessary. We can instead use an ordinal measurement of utility, which means all we need to know is that one bundle is preferred over another. Modern consumption theory is based upon the notion of isoutility curves, where “iso” is the Greek for “equal”. The consumer is assumed to be indifferent among different combinations of goods along a isoutility curve. Page 51

12. Increasing utility Page 52

13. The two indifference curves here can be thought of as providing 200 and 700 utils of utility. Page 52

14. The two indifference curves here can be thought of as providing 200 and 700 utils of utility. One would normally expect a number of additional isoutility or indifference curves. Page 52

15. Slope of Indifference Curve The slope of an indifference curve is known as the marginal rate of substitution (MRS). The marginal rate of substitution of hamburgers for tacos is given by: MRS =  tacos ÷ hamburgers Page 52

16. Slope of Indifference Curve The slope of an indifference curve is known as the marginal rate of substitution (MRS). The marginal rate of substitution of hamburgers for tacos is given by: MRS =  tacos ÷ hamburgers The MRS reflects the number of tacos a consumer is willing to give up for an additional hamburger. Page 52

17. The MRS between points M and Q is equal to: -2.0 = -2 ÷ 1.0 Page 52

18. This means the consumer is willing to give up 2 tacos in exchange for one additional hamburger! Page 52

19. This means the consumer is willing to give up 2 tacos in exchange for one additional hamburger! Page 52

20. Which bundle would you prefer more…bundle M or bundle Q? Page 52

21. The answer is that this we would be indifferent because they give us the same utility. The ultimate choice will depend on the prices of these two products. Page 52

22. What about the choice between bundle M and bundle P? Page 52

23. We would prefer bundle P over bundle M because it gives us more utility or satisfaction. The question is whether we can afford to buy 5 tacos and 5 hamburgers! Page 52

24. Concept of Budget Constraint Weekly budget for fast food: PHAMBURGERS x QHAMBURGERS + PTACOS x QTACOSBUDGET where PHAMBURGERSand PTACOSrepresent the current price of hamburgers and tacos while QHAMBURGERS and QTACOSrepre- sent the quantities you plan to consume during the week. Page 54

25. Concept of Budget Constraint Weekly budget for fast food: PHAMBURGERS x QHAMBURGERS + PTACOS x QTACOSBUDGET where PHAMBURGERSand PTACOSrepresent the current price of hamburgers and tacos while QHAMBURGERS and QTACOSrepre- sent the quantities you plan to consume during the week. The budget constraint limits the amount that you can be spent on these items. A graph depicting this constraint is referred to as the budget line. The slope of this line is given by: Slope of budget line = - (PHAMBURGERS÷ PTACOS) Page 54

26. Example of a Budget Constraint Each of these combinations represent a point on the budget line…. Page 55

27. Original budget line Change in income or both prices Line BA is the original budget line. It says that Carl can afford either 10 tacos or two hamburgers a week with his $5 weekly budget. Change in taco price Change in hamburger price Page 52

28. Original budget line Change in disposable income The original budget line would shift in to line FG if Carl’s available income fell in half (or both prices doubled). It would shift out to line ED if Carl’s income doubled (or both prices fell in half). Change in taco price Change in hamburger price Page 52

29. Original budget line Change in disposable income The budget line would shift out to line AE if the price of tacos fell in half or shift in to line AF if taco prices fell in half. Note the price of hamburgers did not change! Change in taco price Change in hamburger price Page 52

30. Original budget line Change in income or both prices Finally, the budget line would shift out to line BD if the price of hamburgers fell in half, or in to line line BG if the price of hamburgers doubled. Change in taco price Change in hamburger price Page 52

31. In Summary • Consumers rank preferences based upon utility or the satisfaction derived from consumption • Businesses spend millions of dollars on product research • A budget constraint limits the amount we can buy in a particular period • Price is therefore important

32. Chapter 4 unites the concepts of indifference curves with a budget constraint to determine consumer equilibrium….