Consumer Behavior
Budget Constraint
• Shows the consumption bundles that the consumer can afford.
• The slope of the budget constraint measures the rate at which the consumer
can trade one good for the other.
• Example
• Income= 100 Draw Budget Line
• Price of Coke = $2
• Price of Piza = $10
Pp*Qp+Pc*Qc= I
10*Qp +2*Qc = 100 Draw Budget Line if one price change
If Qp= 0, what is Qc = ?
If Qc= 0, what is Qp = ?
Max Qc and Max Qp
Slope = rise of run Draw Budget Line if income change but price remain same
∆Qy/∆Qy=-Px/py
Preferences
• An indifference curve shows the bundles of consumption that make the consumer equally
happy.
• In this case, the indifference curves show the combinations of pizza and Coke with which the
consumer is equally satisfied.
• Marginal rate of substitution (MRS).
• measures how much Coke the consumer requires to be compensated for a one unit reduction in pizza
consumption.
• How to draw indifference curve
Assumptions of Indifference Curve
• Completeness:
• 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.
• Transitivity:
• 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.
• More is better than less:
• Goods are assumed to be desirable—i.e., to be good.
Properties of Indifference Curve
• Property 1:
• Higher indifference curves are preferred
to lower ones.
• Property 2:
• Indifference curves are downward
sloping.
• Property 3:
• Indifference curves do not cross.
• Property 4:
• Indifference curves are bowed inward
(Convex)
• The slope of an indifference curve is
the marginal rate of substitution
• Left to right MRS is decreasing
DESIGNING NEW AUTOMOBILES
Preferences for automobile attributes can be described by indifference curves. Each curve
shows the combination of acceleration and interior space that give the same satisfaction .
PREFERENCES FOR AUTOMOBILE ATTRIBUTES
The opposite is true for owners of Ford
Owners of Ford Mustang-sport (a) are willing
Explorers-SUV. They prefer interior space to
to give up considerable interior space for
acceleration (b).
additional acceleration.
Two Extreme Example of IC
• Perfect Substitutes:
• Two goods for which the marginal rate of substitution of one
for the other is a constant
• 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.
• He opt either orange or an apple.
• 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.
• Perfect complements:
• Two goods for which the MRS is zero or infinite; the
indifference curves are shaped as right angles.
Utility and Utility Function
• 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.
𝑈(𝑥,𝑦)=𝑥𝑎𝑦𝑏
• Cobb-Douglas utility function
• Perfect substitutes utility function
• Perfect complements utility function (leontief)
U(x,y) = min (ax, by)
Utility and Specific Preferences
The Consumer’s Optimal Choice
• The consumer chooses the point on his budget
constraint that lies on the highest indifference curve.
• At optimum, the marginal rate of substitution equals
the relative price of the two goods. Here the highest
indifference curve the consumer can reach is I2
• The consumer prefers point A, which lies on
indifference curve I3 , but the consumer cannot
afford this bundle of pizza and Pepsi.
• By contrast, point B is affordable, but because it lies
on a lower indifference curve, the consumer does
not prefer it.
CONSUMER CHOICE OF AUTOMOBILE ATTRIBUTES
Different preferences of consumer groups for automobiles can affect their purchasing decisions. we
consider two groups of consumers planning to buy new cars.
Consumers in (a) will choose a car that Consumers in (b) will choose a car that
emphasizes acceleration. emphasizes Interior space
Difference in Preferences and Consumer Choices
Change in Income and Consumer
Choice
Change in Income and Good
become inferior
Change in Price and Consumer
Choice
Income and Substitution Effect
Derivation of Demand Curve
Corner Solution for Perfect
Substitute
Corner Solution
Situation in which the marginal rate of
substitution
for one good in a chosen market basket is
not equal to the slope of the budget line.
• When a corner solution arises, the
consumer maximizes satisfaction by
consuming only one of the two goods.
• Given budget line AB, the highest level
of satisfaction is achieved at B on
indifference curve U1, where the MRS
(of ice cream for frozen yogurt) is
greater than the ratio of the price of ice
cream to the price of frozen yogurt.
Utility Maximization for Special Types of Goods
Assignment No 3
Google Class Room