Consumer
Behaviour
Consumer Behaviour: Introduction
❑ General Mills introduced a new breakfast cereal. The new brand, Apple-
Cinnamon Cheerios.
❑ But before Apple-Cinnamon Cheerios could be extensively marketed, the
company had to resolve an important problem: How high a price should it
charge?
❑ General Mills had to conduct a careful analysis of consumer preferences to
determine the demand for the product.
❑ Federal Food Stamps program: Give low-income households coupons that can be
exchanged for food.
❑ The federal government must determine how spending on food, as opposed to
spending on other goods, is affected by changing income levels and prices.
Contd.
❑ To what extent do food stamps provide people with more food, as opposed to
simply subsidizing the purchase of food.
❑ Has the program turned out to be little more than an income supplement that
people spend largely on nonfood items instead of a solution to the nutritional
problems of the poor?
❑ Solving these problems needs the understanding of theory of consumer
behaviour.
What is theory of consumer behaviour?
❑ Description of how consumers allocate incomes among different
goods and services to maximize their well-being.
❑ The explanation of how consumers allocate incomes to the
purchase of different goods and services.
❑ Fundamental question: How can a consumer with a limited income
decide which goods and services to buy?
Contd.
❑ Consumer behavior is best understood in three distinct steps:
❑ Consumer Preferences: The first step is to find a practical way to describe the
reasons people might prefer one good to another.
❑ Budget Constraints: consumers have limited incomes which restrict
the quantities of goods they can buy. The prices play a
determining role.
❑ Consumer Choices: Given their preferences and limited incomes,
consumers choose to buy combinations of goods that maximize
their satisfaction.
❑ These combinations will depend on the prices of various goods.
❑ Understanding consumer choice will help us understand demand.
What do consumers do?
❑ We need to be clear about assumptions of consumer behaviour and whether
those assumptions are realistic.
❑ Proposition that consumers have preferences among the various goods and
services available to them, and that they face budget constraints which put
limits on what they can buy.
❑ Do consumers behave rationally always?
Contd.
❑ Consumers decide which combinations of goods and services to buy so as to
maximize their satisfaction?
❑ Behavioural economics: Developing models of consumer behavior that
incorporate more realistic assumptions about rationality and decision making.
Contd.
❑ Consumer Preferences:
❑ How a consumer might compare different groups of items available for
purchase?
❑ Will one group of items be preferred to another group, or will the consumer be
indifferent between the two groups?
Contd.
❑ Market Basket/Bundle:
❑ Market basket/bundle refers to a group of items.
❑ Market basket/bundel is a list with specific quantities of one or
more good.
❑ Example: A market basket might contain the various food items in a
grocery cart.
Contd.
❑ A market basket might also refer to quantities of food, clothing and housing that
a consumer buys each month.
❑ How do consumers select market baskets?
❑ How do they decide how much food versus clothing to buy each month?
❑ Consumers usually select market baskets that make them as well off as possible.
Contd.
❑ To explain the theory of consumer behavior, we will ask whether consumers
prefer one market basket to another.
❑ The theory assumes that consumers’ preferences are consistent and make
sense.
Assumptions about prefernces:
❑ Completeness:
❑ Preferences are assumed to be complete.
❑ Consumers can compare and rank all possible baskets.
❑ 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.
Contd.
❑ 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.
❑ For example, if a Car is preferred to Bike and Bike to a public transport, then
a car is also preferred to public transport.
❑ Transitivity is normally regarded as necessary for consumer consistency.
Contd.
❑ More is better than less (Nonsatiation):
❑ More is better than less: Goods are assumed to be desirable i.e., to
be good. Consequently, consumers always prefer more of any good
to less.
❑ Consumers are never satisfied or satiated; more is always better,
even if just a little better.
Indifference Curves:
❑ We can show a consumer’s preferences graphically with the use of
indifference curves.
❑ An indifference curve represents all combinations of market baskets
that provide a consumer with the same level of satisfaction.
❑ The consumer is indifferent among the market baskets represented
by the points graphed on the curve.
❑ In order to graph a consumer’s indifference curve, it helps first to
graph his or her individual preferences.
Contd.
❑ Comparisons of market basket A with baskets B, D, and H are not possible
without more information about the consumer’s ranking.
❑ This additional information is provided in Figure 3.2, which shows an
indifference curve, labeled U1, that passes through points A, B, and D.
❑ This curve indicates that the consumer is indifferent among these three market
baskets.
Contd.
❑ The consumer prefers A to H, which lies below U1.
❑ Indifference map:
Contd.
❑ Indifference curve U3 generates the highest level of satisfaction, followed by
indifference curves U2 and U1.
❑ The indifference curves cannot intersect. Why?
❑ Because A and B are both on indifference curve U1, the consumer must be
indifferent between these two market baskets.
❑ Because both A and D lie on indifference curve U2, the consumer is also
indifferent between these market baskets.
❑ Consequently, using the assumption of transitivity, the consumer is also
indifferent between B and D.
❑ Market basket B must be preferred to D because it contains more of both food
and clothing.
❑ The intersecting indifference curves contradicts our assumption that more is
preferred to less.
❑ The shape of indifference curves:
❑ When the amount of food increases along an indifference curve, the amount of
clothing decreases.
❑ The fact that indifference curves slope downward follows directly from our
assumption that more of a good is better than less.
❑ The shape of an indifference curve describes how a consumer is willing to
substitute one good for another.
Contd.
❑ Starting at market basket A and moving to basket B, we see that the consumer
is willing to give up 6 units of clothing to obtain 1 extra unit of food.
❑ However, in moving from B to D, he is willing to give up only 4 units of clothing
to obtain an additional unit of food;
❑ Moving from D to E, he will give up only 2 units of clothing for 1 unit of food.
❑ The more clothing and the less food a person consumes, the more clothing he
will give up in order to obtain more food.
Contd.
❑ Similarly, the more food that a person possesses, the less clothing he will give
up for more food.
❑ Diminishing Marginal Rate of Substitution (MRS): The Indifference curve is
convex to the origin.
Marginal rate of substitution:
❑ Marginal rate of substitution (MRS): Maximum amount of a good that a
consumer is willing to give up in order to obtain one additional unit of another
good.
❑ The MRS of food (F) for clothing (C) is the maximum amount of clothing that a
person is willing to give up to obtain one additional unit of food.
❑ Suppose, for example, the MRS is 3. This means that the consumer will give up 3
units of clothing to obtain 1 additional unit of food.
❑ Thus the MRS at any point is equal in magnitude to the slope of the
indifference curve.
contd
❑ Convexity of indifference curve:
❑ Diminishing marginal rate of substitution.
❑ An indifference curve is convex if the MRS diminishes along the curve.
❑ The indifference curve in Figure 3.5 is convex.
❑ Starting with market basket A in Figure 3.5 and moving to basket B, the MRS of
food F for clothing C is -ΔC/ΔF = -(-6)/1 = 6.
❑ We add the negative sign in the formula for Marginal rate of
Substitution to make the marginal rate of substitution a
positive number.
Contd.
❑ However, when we start at basket B and move from B to D, the MRS falls to 4.
❑ If we start at basket D and move to E, the MRS is 2.
❑ Starting at E and moving to G, we get an MRS of 1.
❑ As food consumption increases, the slope of the indifference curve falls in
magnitude.
❑ Thus the MRS also falls.
❑ Consumption of food increases, the additional satisfaction that a consumer gets
from still more food will diminish.
❑ Thus, he will give up less and less clothing to obtain additional food.
❑ Consumers generally prefer balanced market baskets to market baskets that
contain all of one good and none of another.
Diminishing marginal rate of substitution:
Additional assumption Regarding consumer preference:
❑ Diminishing marginal rate of substitution:
❑ An indifference curve is convex if the MRS diminishes along the curve.
❑ As food consumption increases, the slope of the indifference curve falls in
magnitude.
❑ Thus the MRS also falls.
Perfect Substitutes and Perfect complements:
❑ Perfect substitutes: Two goods for which the marginal rate of substitution of
one for the other is a constant.
❑ Two goods are perfect substitutes when indifference curves are straight line.
❑ Perfect complements: Two goods for which the MRS is zero or infinite; the
indifference curves are shaped as right angles.
❑ Two goods are perfect complements when the indifference curves for both are
shaped as right angles.
❑ Figure 3.6 (a) shows Bob’s preferences for apple juice and orange juice.
❑ These two goods are perfect substitutes for Bob because he is entirely
indifferent between having a glass of one or the other.
❑ The MRS of apple juice for orange juice is 1: Bob is always willing to trade 1
glass of one for 1 glass of the other.
❑ MRS of one for the other is constant.
❑ Indifference curves describing the trade-off between the consumption of the
goods are straight lines.
❑ The slope of the indifference curves need not be -1 in the case of perfect
substitutes.
❑ Suppose, for example, that Dan believes that one 16 MB memory chip is equivalent to two 8
MB chips because both combinations have the same memory capacity.
❑ In that case, the slope of Dan’s indifference curve will be -2 (with the number of 8 MB chips on
the vertical axis).
Perfect Complements:
❑ Figure 3.6 (b) illustrates Jane’s preferences for left shoes and right shoes. For
Jane, the two goods are perfect complements because a left shoe will not
increase her satisfaction unless she can obtain the matching right
shoe.
❑ The MRS of right shoes for left shoes is zero whenever there are more right
shoes than left shoes.
❑ Jane will not give up any left shoes to get additional right shoes.
❑ The MRS is infinite whenever there are more left shoes than right because Jane
will give up all but one of her excess left shoes in order to obtain an additional
right shoe.
Contd.
❑ Bads: So far, all of our examples have involved products that are “goods”—i.e.,
cases in which more of a product is preferred to less.
❑ However, some things are bads: Less of them is preferred to more.
❑ Air pollution is a bad; How do we account for bads in the analysis of consumer
preferences?
❑ We redefine the product under study so that consumer tastes are represented
as a preference for less of the bad. This reversal turns the bad into a good.
Thus, for example, instead of a preference for air pollution, we will discuss the
preference for clean air, which we can measure as the degree of reduction in air
pollution.
Utility and Utility function:
❑ The indifference curves simply allow us to describe consumer preferences
graphically, building on the assumption that consumers can rank alternatives.
❑ With respect to the indifference curve, the highest curve describes
the most satisfaction as compared to the one which is lowest.
❑ It has not been necessary to associate a numerical level of satisfaction with
each market basket consumed. (See 3 indifference curve in fig 3.3).
❑ Market basket A (or any other basket on indifference curve U3) gives more
satisfaction than any market basket on U2, such as B.
❑ Likewise, we know that the market baskets on U2 are preferred to those on U1
Contd.
❑ It is often useful to assign numerical values to individual baskets.
❑ Using this numerical approach, we can describe consumer preferences by
assigning scores to the levels of satisfaction associated with each indifference
curve.
❑ The concept is called as utility.
❑ The concept of Utility:
❑ Utility refers to the numerical score representing the satisfaction that a consumer gets
from a market basket.
❑ If buying three copies of this textbook makes you happier than buying one shirt, then
we say that the three books give you more utility than the shirt.
❑ What is utility function?
❑ A utility function is a formula that assigns a level of utility to each market basket.
❑ Suppose, that Phil’s utility function for food (F) and clothing (C) is u(F,C) = F + 2C.
❑ What is the utility from market basket consisting of 8 units of food and 3 units of
clothing ?
Contd.
❑ A market basket would generate utility of 8 + (2)(3) = 14.
❑ Phil is therefore indifferent between this market basket and a market basket
containing 6 units of food and 4 units of clothing [6 + (2)(4) = 14]
❑ The either market basket is preferred to a third containing 4 units of food and 4
units of clothing. Why? Because this last market basket has a utility level of only
4 + (4)(2) = 12.
❑ We assign utility levels to market baskets so that if market basket A is preferred
to basket B, the number will be higher for A than for B.
❑ Compare the U1, U2 and U3 in figure 3.3.
❑ The utility function provides the same information about preferences that an
indifference map does: Both order consumer choices in terms of levels of
satisfaction.
Contd.
❑ The utility function u(F,C) = F*C tells us that the level of satisfaction obtained
from consuming F units of food and C units of clothing is the product of F and C.
❑
Contd.
❑ The graph was drawn by initially choosing one particular market basket-say, F = 5 and
C = 5 at point A.
❑ This market basket generates a utility level U1 of 25.
❑ Then the indifference curve (also called an iso-utility curve) was drawn by finding all
market baskets for which FC = 25 (e.g., F = 10,C = 2.5 at point B; F = 2.5,C = 10 at point
D).
❑ The second indifference curve, U2, contains all market baskets for which FC = 50 and
❑ The third, indifference curve U3, contains all market baskets for which FC = 100.
❑ It is important to stress that the utility function is simply a way of ranking different
market baskets;
❑ It is important to note that the numbers attached to the indifference curves are
for convenience only.
❑ Suppose the utility function were changed to u(F,C) = 4FC.
❑ U1=4*25.
❑ Now the level of utility has increased, by a factor of 4, to 100.
Contd.
❑ The magnitude of the utility difference between any two market baskets does
not really tell us anything.
❑ The fact that U3 has a level of utility of 100 and U2 has a level of 50 does not
mean that market baskets on U3 generate twice as much satisfaction as those
on U2.
❑ This is so because we have no means of objectively measuring a person’s
satisfaction or level of well-being from the consumption of a market basket.
❑ Thus whether we use indifference curves or a measure of utility, we know only
that U3 is better than U2 and that U2 is better than U1.
❑ We do not know by how much one is preferred to the other.
Properties of Indifference curves:
1. Higher Indifference curves are preferred to lower ones.
2. Indifference curves are downward sloping
3. Indifference curves do not intersect.
4. Indifference curves are convex (diminishing marginal rate of substitution).
Ordinal versus cardinal measure of
utility:
❑ Ordinal utility function: Utility function that generates a ranking of market
baskets in order of most to least preferred.
❑ The ranking associated with the ordinal utility function places market baskets in
the order of most to least preferred.
❑ However, it does not indicate by how much one is preferred to another.
❑ Any market basket on U3, such as A, is preferred to any on U2, such as B.
However, the amount by which A is preferred to B (and B to D) is not revealed
by the indifference map or by the ordinal utility function that generates it.
Contd.
❑ Cardinal Utility function:
❑ Cardinal utility function: Utility function describing by how much one market
basket is preferred to another.
❑ Suppose that John’s utility function attaches a utility level of 5 to a copy of
textbook; meanwhile Maria’s utility function attaches a level of 10.
❑ Using Cardinal utility approach, we could say that Maria gets twice as much
satisfaction as John from a copy of book.
❑ Numbers assigned to market basket provide cardinal ranking by alternatives.
❑ Interpersonal comparison of utility is possible.
contd.
❑ Having a second copy of the book increased John’s utility level to 10, we
could say that his happiness has doubled.
❑ If the numerical values assigned to market baskets did have meaning in this
way, we would say that the numbers provided a cardinal ranking of
alternatives.
Law of diminishing marginal utility:
❑ Cardinal Utility: Law of diminishing marginal Utility
❑ The marginal utility of any good is the increase in total utility that the consumer
gets from an additional unit of that good.
❑ Goods exhibit diminishing marginal utility: The more of the good the consumer
already has, the lower the marginal utility provided by an extra unit of that
good.
❑ The marginal rate of substitution between two goods depends on their
marginal utilities.
❑ For example, if the marginal utility of good X is twice the marginal utility of
good Y, then a person would need 2 units of good Y to compensate for losing 1
unit of good X, and the MRS equals 2.
❑ More generally, the marginal rate of substitution (and thus the slope of the
indifference curve) equals the marginal utility of one good divided by the
marginal utility of the other good.
❑ Why marginal utility diminishes?
Contd.
❑ We will continue our analysis with ordinal utility functions.
❑ This approach is sufficient for understanding how individual
consumer decisions are made.
Budget Constraint:
❑ We have seen first element of consumer behaviour: Consumer preferences
(indifference curves).
❑ Second element of consumer theory: the budget constraints that consumer
faces due to limited income.
❑ Budget Line:
❑ Indicates all combinations of goods for which the total amount of money
spent is equal to income.
❑ Suppose the individual has a fixed income (I).
❑ Income is spent on two goods (Food and Clothing).
❑ Let (F) be the amount of food purchased and (C) be the amount of clothing.
Contd.
contd.
❑ Suppose that our consumer has a weekly income of $80.
❑ The price of food is $1 per unit, and the price of clothing is $2 per unit.
Contd.
❑ Table 3.2 shows various combinations of food and clothing that consumer can
purchase each week with her $80.
❑ If her entire budget were allocated to clothing, the most that she could buy
would be 40 units (at a price of $2 per unit), as represented by market basket A
❑ If she spent her entire budget on food, she could buy 80 units (at $1 per unit),
as given by market basket G.
❑ Market baskets B, D, and E show three additional ways in which her $80 could
be spent on food and clothing.
❑ The budget line for market baskets given in the Table:
Contd.
❑ A budget line describes the combinations of goods that can be purchased given
the consumer’s income and the prices of the goods.
❑ The budget line is given by the equation: F + 2C = $80
❑ The budget line is a straight line (from A to G): the amount of clothing given up for
food along the budget line must be the same everywhere.
❑ The intercept of the budget line is represented by basket A.
Contd.
❑ The extra clothing which must be given up to consume an additional unit of
food is given by the ratio of the price of food to the price of clothing ($1/$2 = ½).
❑ Since clothing costs $2 per unit and food only $1 per unit, 1/2 unit of clothing
must be given up to get 1 unit of food. (The slope is therefore -1/2)
❑ The slope of the line, ΔC/ΔF = -1/2, measures the relative cost of food and
clothing.
❑ How do we get the slope of the budget line?
Contd.
The Effect of changes in income and
prices:
Contd.
❑ Consumer can now double her purchases of both food and clothing.
❑ Likewise, if her income is cut in half (from $80 to $40), the budget line shifts
inward, from L1 to L3.
❑ When we allow the income to change we keep prices constant.
Contd.
Contd.
Contd.
Contd.
❑ Because of the decline in the price of food, the maximum amount of food that
can be purchased has doubled.
❑ When the price of food doubles from $1 to $2, the budget line rotates inward
to line L3 because the person’s purchasing power has diminished.
❑ Again, a person who consumed only clothing would be unaffected by the food
price increase.
Contd.
❑ What happens if the prices of both food and clothing change, but in a way that
leaves the ratio of the two prices unchanged?
❑ The slope will remain the same.
❑ The intercept of the budget line must shift so that the new line is parallel to the
old one.
❑ If the prices of both goods fall by half, then the slope of the budget line does
not change.
❑ However, both intercepts double, and the budget line is shifted outward.
❑ Purchasing power is determined not only by income, but also by prices.
Contd.
❑ Consumer’s purchasing power can double either because her income doubles
or because the prices of all the goods that she buys fall by half.
❑ Consider what happens if everything doubles- the prices of both food and
clothing and the consumer’s income.
❑ All prices and income levels rise proportionately will not affect the consumer’s
budget line or purchasing power.
Case Study: Designing new
automobiles.
❑ Suppose you worked for the Ford Motor Company and had to help plan new
models to introduce.
❑ You would want to know how people value the various attributes of a car, such
as power, size, handling, gas mileage, interior features, and so on.
❑ The more desirable the attributes, the more people would be willing to pay for
a car.
❑ However, the better the attributes, the more the car will cost to manufacture.
❑ How should Ford trade off these different attributes and decide which ones to
emphasize?
❑ The answer depends in part on the cost of production, but it also depends on
consumer preferences.
❑ To find out how much people are willing to pay for various attributes,
economists and marketing experts look at the prices that people actually do pay
for a wide range of models with a range of attributes.
Contd.
❑ By evaluating car purchases over a range of buyers and a range of models, one
can estimate the values associated with various attributes.
❑ One recent statistical study looked at a wide range of Ford models with varying
attributes.
❑ The figure 3: two sets of indifference curves, derived from an analysis that
varies two attributes: interior size (measured in cubic feet) and acceleration
(measured in horsepower) for typical consumers of Ford automobiles.
❑ Panel A) Describes the preferences of typical owners of Ford Mustang coupes.
❑ Because they tend to place greater value on acceleration than size, Mustang
owners have a high marginal rate of substitution for size versus acceleration.
❑ They are willing to give up quite a bit of size to get better acceleration
Panel B) Preferences of Ford Explorer Owners.
❑ They have a lower MRS and will consequently give up a considerable amount of
acceleration to get a car with a roomier interior.
Consumer Choice: Consumer’s Equilibrium Using
Indifference Curve
❑ Given preferences and budget constraints, we can now determine how
individual consumers choose how much of each good to buy.
❑ Consumers make a rational choice: Choose goods to maximize the satisfaction
they can achieve, given the limited budget available to them.
❑ The maximising market basket must satisfy two conditions:
❑ It must be located on the budget line.
❑ It must give the consumer the most preferred combination of goods and services.
❑ These two conditions reduce the problem of maximizing consumer satisfaction
to one of picking an appropriate point on the budget line.
❑ Three indifference curves describe a consumer’s preferences for food and
clothing.
❑ Remember that of the three curves, the outermost curve yields the highest
amount of satisfaction.
❑ Point B is not the most preferred choice, because a reallocation of income in
which more is spent on food and less is spent on clothing can increase
consumer satisfaction.
❑ By moving to point A, the consumer spends the same amount of money and
achieves the increased level of satisfaction associated with indifference curve
U2.
❑ The basket associated with D on indifference curve U3, achieve a higher level of
satisfaction but cannot be purchased with the available income.
❑ Therefore, basket ‘A’ maximizes the consumer’s satisfaction.
❑ The consumer’s equilibrium is achieved at point A.
Contd.
Contd.
❑ Optimization condition: Satisfaction is maximized when Marginal benefit
(MB)=Marginal Cost (MC).
❑ Marginal Benefit-The benefit associated with the consumption of one
additional unit of food.
❑ Marginal Cost: the cost of the additional unit of food.
❑ The Marginal Benefit is measured by MRS (slope of the indifference
curve).
❑ The Marginal Cost is measured by the slope of the budget line.
❑ At Point A: Marginal Benefit (slope of indifference curve)=Marginal cost
(the slope of budget line)=1/2
❑ Marginal Benefit: the consumer is willing to give up 1/2 unit of clothing to obtain
1 unit of food.
❑ Marginal Cost: the cost of getting one unit of food is giving up 1/2 unit of clothing .
❑ If the MRS is less or greater than the price ratio, the consumer’s satisfaction has not
been maximized.
❑ At Point B:
❑ Marginal Benefit= Magnitude of Slope of IC= MRS= 1
❑ Marginal Cost= Magnitude of Slope of Budget line= ½
❑ MRS>Price Ratio OR Marginal benefit is greater than marginal cost.
❑ Hence consumer can substitute one unit of food for one unit of clothing
without any loss of satisfaction.
❑ But food is cheaper hence it is in her interest to buy more food.
❑ If our consumer purchases 1 unit less of clothing, $2 can be saved and
allocated to two units of food.
❑ The reallocation of the budget continues in this manner (moving along the budget
line), until we reach point A, where the price ratio of 1/2 just equals the MRS of 1/2.
❑ At point ‘A’ consumer is willing to trade one unit of clothing for two units of food.
Marginal Utility and Consumer Choice:
❑ We showed graphically how a consumer can maximize his or her satisfaction,
given a budget constraint.
❑ We do this by finding the highest indifference curve that can be reached, given
that budget constraint.
❑ The highest indifference curve also has the highest attainable level of utility.
❑ Marginal utility (MU) measures the additional satisfaction obtained from
consuming one additional unit of a good.
❑ The marginal utility associated with a consumption increase from 0 to 1 unit of food might be
9; from 1 to 2, it might be 7; from 2 to 3, it might be 5.
❑ Suppose that a person gets more utility from spending an additional dollar on food than on
clothing.
❑ In this case, her utility will be increased by spending more on food.
❑ As long as the marginal utility of spending an extra dollar on food exceeds the marginal utility of
spending an extra dollar on clothing, she can increase her utility by shifting her budget toward
food and away from clothing.
❑ Eventually, the marginal utility of food will decrease (because there is diminishing marginal
utility in its consumption) and the marginal utility of clothing will increase
❑ Only when the consumer has satisfied the equal marginal principle—i.e., has equalized the
marginal utility per dollar of expenditure across all goods—will she have maximized utility
❑ Equal marginal principle: Principle that utility is maximized when the consumer has equalized
the marginal utility per dollar of expenditure across all goods.