CHAPTER 4
Consumer Behavior
McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
INTRODUCTION
Learning objectives
What will you learn in this module?
What are the four basic properties of consumer’s
preference?
How changes in price and income influences individual’s
opportunities?
Explain the consumer equilibrium point where marginal
rate of substitution is equal to the ratio of prices of two
goods.
• Explain how change in price of a good create substitution
effects and income effects of consumer.
2-3
Consumer Behavior
• A consumer is an individual who purchases goods and
services from firms for the purpose of consumption.
• As a manager of a firm, you are interested not only in who
consumes the good but in who purchases it. The theory of
consumer behaviour helps us to draw individual and
market demand curves.
4-4
Consumer Behaviour
In characterising consumer behaviour, there are two
important factors to consider:
1. Consumer Opportunities
• Consumer opportunities are the set of goods and services that
consumers can afford to consume.
2. Consumer Utility Preferences
• Determine what are the particular goods will be consumed.
2-5
CHAPTER 4
Consumer Behavior
McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
UTILITY PREFERENCES
4 Properties of Utility Preferences
Completeness
• Preferences are complete: we assume that an individual
can state which of any two options is preferable.
• Transitivity:
• Preferences are transitive: For any three bundles, , , and : if
A is preferred to B, and B is preferred to C, then A must be
preferred to C
• More is better
• Economic good yields positive benefits to consumer. Thus,
more quantity of a good is always better than less.
• Diminishing marginal rate of substitution
• As an individual will reduce consumption of good Y to get
one more unit of good X
4-8
The Indifference Curve
• Definition: An indifference curve is a graph showing
combination of two goods that give the consumer equal
satisfaction and utility. Each point on an indifference curve
indicates that a consumer is indifferent between the two
and all points give him the same utility.
• Description: Graphically, the indifference curve is drawn
as a downward sloping convex to the origin. The graph
shows a combination of two goods that the consumer
consumes.
• 6 hamburgers, 2 soft drinks a week (point A) have equal
satisfaction and utility with 4 hamburgers and 3 soft drinks
a week (point B)
A VIDEO ABOUT
For more information on indifference curve,
please view:
[Link]
8
The Indifference Curve
• Let's take a look at this
Hamburgers
per week figure
A
6
B
4
3 C
D
2 U1
Soft drinks
0 2 3 4 5 6 per week
2-
The Budget Constraint
• Budget constraint
• Individual’s budget constraint is the limit that a person’s
income places on the combinations of goods and
services that a consumer can buy.
• Budget set:
• Expenditure do no exceed their income M
• Budget line
The consumer's budget constraint shows in Figure: The Budget
Set. The shaded area represents the consumer's budget set or the
opportunity set.
4-
The Budget Constraint
Good
𝑀
𝑃𝑌 Slope
Bundle H
𝑃𝑋 Not affordable Budget set:
𝑃𝑌 Budget line:
Bundle G
Affordable
0 𝑀 Good
𝑃𝑋
A VIDEO ABOUT
For more information on “Budget Constraint”
[Link]
GI
The Budget Line
• The slope of the budget line is given by and
represents the market rate of substitution between
Good
goods X and Y. To obtain a better understanding of
the market rate of substitution between goods X
5 and Y.
Market rate of substitution :
4
Budget line:
0 2 4 10 Good
Changes in Income
Good • Individual’s budget depends on
𝑀1 market price and consumer’s income.
𝑃𝑌 • The shift in the budget line
due to the changes in income
𝑀0
of individuals while prices
𝑃𝑌
remain constant.
𝑀2
𝑀↓ 𝑀↑
𝑃𝑌
0 𝑀2 𝑀0 𝑀1 Good
𝑃𝑌 𝑃𝑌 𝑃𝑌
Changes in Price
• The shift in the budget line as
Good the price of good X decreases
while price of good Y remains
𝑀 0 1 unchanged.
𝑃𝑌 𝑃 𝑋 >𝑃 𝑋
New budget line
Initial budget
line
0 𝑀 𝑀 Good
1
𝑃𝑋
0
𝑃𝑋
CHAPTER 4
Consumer Behavior
McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
UTILITY MAXIMIZATION
Utility Maximization
• Consumer equilibrium
• the consumer chooses X, Y is the affordable point that lies on (is
tangent to) the highest indifference curve, so it represents utility
maximization.
• marginal rate of substitution (Slope of indifference curve) =
Slope of budget constraint
• The marginal rate of substitution (MRS) can be defined as how
many units of good x have to be given up in order to gain an extra
unit of good y, while keeping the same level of utility. Therefore, it
involves the trade-offs of goods, in order to change the allocation of
bundles of goods while maintaining the same level of satisfaction.
Utility Maximization
Consider a bundle such as A in the
Figure: Consumer Equilibrium. This
combination of Goods X and Y lies on
the budget line, so the cost of Bundle A
completely exhausts the consumer's
income.
A VIDEO ABOUT
For more information on “Utility Maximization”
[Link]
Y
Consumer Equilibrium
Good
A
B Consumer equilibrium
III
II
I
0 Good
Change in Consumer Demand
• Price and income changes that influence consumer’s
budget and their level of satisfaction.
• how price and income changes influence consumer
equilibrium.
4-
Price Changes and Consumer Equilibrium
• Price increases (decreases) reduce (expand) a
consumer’s budget.
• The new consumer equilibrium resulting from a price
change depends on consumer preferences:
• Goods X and Y are:
• substitutes when an increase (decrease) in the price of X leads to an
increase (decrease) in the consumption of Y.
• complements when an increase (decrease) in the price of X leads to a
decrease (increase) in the consumption of Y.
4-
Price Changes and Consumer
Equilibrium
Good
𝑀 Point A: Initial consumer equilibrium
𝑃𝑌 Price of good X decreases:
Point B: New consumer equilibrium
Since when :
Conclude that goods and are
A substitutes
𝑌0 B
𝑌1
II
I
0 𝑋0 𝑀𝑋
1
𝑀
Good
0 1
𝑃𝑋 𝑃𝑋
Income Changes and Consumer Equilibrium
• Income increases (decreases) reduce (expand) a
consumer’s budget set.
• The new consumer equilibrium resulting from an income
change depends on consumer preferences:
• Good X is:
• a normal good when an increase (decrease) in income leads to an
increase (decrease) in the consumption of X.
• an inferior good when an increase (decrease) in income leads to
a decrease (increase) in the consumption of X.
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Income Changes and Consumer
Equilibrium
Good
𝑀1 Point A: Initial consumer equilibrium
Price of income increases:
𝑃𝑌
Point B: New consumer equilibrium
Since more of both goods are consumed
𝑀0
when : Conclude that goods
𝑃𝑌 B and are normal goods.
A
II
I
0
0 𝑀 𝑀1 Good
𝑃𝑋 𝑃𝑋
Substitution and Income Effect
• Part of the change in the quantity demanded for other
goods is caused by the substitution of one good for
another: called substitution effect
• Price change creates difference in real purchasing power;
consumers move to a new indifference curve consistent
with their new purchasing power
• Part of the change in the quantity demanded is caused by
the change in real income: called income effect.
2-
Substitution and Income Effects
Good
J
Point A: Initial consumer equilibrium
Price of good X increases:
Point B: substitution effect
F Point C: income effect and new
consumer equilibrium
B
C A
H
0 𝑋1 𝑋𝑀 𝑋0 I G Good
Income Substitution
effect effect
CHAPTER 4
Consumer Behavior
McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
CONSUMER DEMAND
Consumer Demand
• The indifference curves and consumers’ reactions to
changes in prices and income are the basis of the
demand functions
• Relationship between Indifference Curves and Demand
Curves.
• Individual's Demand Curve is to see where the demand
curve for normal goods come from.
• The consumer initially is in equilibrium at Point X’, where
income is fixed and prices at and Pox.
4-
Individual’s Demand Curve
• But when the price of good X falls to the lower level P1x,
the opportunity expands and the consumer reaches a
new equilibrium at Point.
• You may see the relationship between the price of good X
and the quantity consumed of good X is graphed in the
Figure (b) and is individual consumer's demand curve for
good X.
Individual’s Demand Curve
Quantity of Y
per week
Budget constraint for P’X
Budget constraint for P’’X
Budget constraint for P’’’X
U3
U2
U1
0 X’ X” X’” Quantity of X
per week
(a) Individual
s ’indifference curve map
Price
P9
X
P0
X
P-
X
0 X’ X” X’” (b) Demand curve Quantity of Xper week
2-
Market Demand
we can derive market demand curve based on two individuals
PX PX PX
P*
X
0 X* 0 X* 0 X* X
1 2
(a) Individual 1 (b) Individual 2 (c) Market Demand
2-
CHAPTER 4
Market Forces: Demand and Supply
2-38
RECAP
On Key Terms and Concepts
Key Concepts Chapter 4
• Indifference curve properties
• Consumer preferences
• Budget constraint
• Budget line
• Marginal Rate of Substitution
• Substitution effects
• Income effects
• Normal goods and Inferior goods
• Individual Demand
• Market demand.
4-