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3.1 ConsumerPreferences3.2 BudgetConstraints3.3 ConsumerChoice3.4 RevealedPreference3.5 MarginalUtilityandConsumerChoice3.6 Cost-of-LivingIndexes
ConsumerBehaviorCHAPTEROUTLINEConsumerBehavior●
theoryofconsumerbehaviorDescriptionofhowconsumers
allocateincomesamongdifferentgoodsandservicestomaximizetheirwell-being.Consumerbehaviorisbestunderstoodinthreedistinctsteps:ConsumerPreferencesBudgetConstraintsConsumerChoicesWHATDOCONSUMERSDO?Recentmodelsofconsumerbehaviorincorporatemorerealisticassumptionsaboutrationalityanddecisionmaking.Abasic“workhorse”ofeconomics,ourmodelmakessimplifyingassumptionstoexplainmuchofwhatweactuallyobserveregardingconsumerchoiceandthecharacteristicsofconsumerdemand.ConsumerPreferences3.1MarketBaskets●
marketbasket(orbundle)
Listwithspecificquantitiesofoneormoregoods.TABLE3.1ALTERNATIVEMARKETBASKETSA2030B1050D4020E3040G1020H1040MARKETBASKETUNITSOFFOODUNITSOFCLOTHINGToexplainthetheoryofconsumerbehavior,wewillaskwhetherconsumerspreferonemarketbaskettoanother.SomeBasicAssumptionsaboutPreferencesCompleteness:Preferencesareassumedtobecomplete.Inotherwords,consumerscancompareandrankallpossiblebaskets.Thus,foranytwomarketbasketsAandB,aconsumerwillpreferAtoB,willpreferBtoA,orwillbeindifferentbetweenthetwo.Byindifferentwemeanthatapersonwillbeequallysatisfiedwitheitherbasket.
Notethatthesepreferencesignorecosts.Aconsumermightprefersteaktohamburgerbutbuyhamburgerbecauseitischeaper.Transitivity:Preferencesaretransitive.TransitivitymeansthatifaconsumerprefersbasketAtobasketBandbasketBtobasketC,thentheconsumeralsoprefersAtoC.Transitivityisnormallyregardedasnecessaryforconsumerconsistency.Moreisbetterthanless:Goodsareassumedtobedesirable—i.e.,tobegood.Consequently,consumersalwaysprefermoreofanygoodtoless.Inaddition,consumersareneversatisfiedorsatiated;moreisalwaysbetter,evenifjustalittlebetter.DESCRIBINGINDIVIDUALPREFERENCESBecausemoreofeachgoodispreferredtoless,wecancomparemarketbasketsintheshadedareas.BasketAisclearlypreferredtobasketG,whileEisclearlypreferredtoA.However,AcannotbecomparedwithB,D,orHwithoutadditionalinformation.FIGURE3.1IndifferenceCurves●indifferencecurveCurverepresentingallcombinationsofmarketbasketsthatprovideaconsumerwiththesamelevelofsatisfaction.TheindifferencecurveU1thatpassesthroughmarketbasketAshowsallbasketsthatgivetheconsumerthesamelevelofsatisfactionasdoesmarketbasketA;theseincludebasketsBandD.
ANINDIFFERENCECURVEFIGURE3.2OurconsumerprefersbasketE,whichliesaboveU1,toA,butprefersAtoHorG,whichliebelowU1.Anindifferencemapisasetofindifferencecurvesthatdescribesaperson'spreferences.ANINDIFFERENCEMAPFIGURE3.3IndifferenceMaps●
indifferencemapGraphcontainingasetofindifferencecurves
showingthemarketbasketsamongwhichaconsumerisindifferent.AnymarketbasketonindifferencecurveU3,suchasbasketA,ispreferredtoanybasketoncurveU2(e.g.,basketB),whichinturnispreferredtoanybasketonU1,suchasD.IfindifferencecurvesU1andU2intersect,oneoftheassumptionsofconsumertheoryisviolated.INDIFFERENCECURVESCANNOTINTERSECTFIGURE3.4Accordingtothisdiagram,theconsumershouldbeindifferentamongmarketbasketsA,B,andD.YetBshouldbepreferredtoDbecauseBhasmoreofbothgoods.Themagnitudeoftheslopeofanindifferencecurvemeasurestheconsumer’smarginalrateofsubstitution(MRS)betweentwogoods.THEMARGINALRATEOFSUBSTITUTIONFIGURE3.5TheShapeofIndifferenceCurvesInthisfigure,theMRSbetweenclothing(C)andfood(F)fallsfrom6(betweenAandB)to4(betweenBandD)to2(betweenDandE)to1(betweenEandG).TheMarginalRateofSubstitution●
marginalrateofsubstitution(MRS)Maximumamountofagood
thataconsumeriswillingtogiveupinordertoobtainoneadditionalunitofanothergood.CONVEXITYObservethattheMRSfallsaswemovedowntheindifferencecurve.ThedeclineintheMRSreflectsourfourthassumptionregardingconsumerpreferences:adiminishingmarginalrateofsubstitution.WhentheMRSdiminishesalonganindifferencecurve,thecurveisconvex.PerfectSubstitutesandPerfectComplements●
perfectsubstitutesTwogoodsforwhichthemarginalrateofsubstitutionofonefortheotherisaconstant.●
perfectcomplementsTwogoodsforwhichtheMRSiszeroorinfinite;theindifferencecurvesareshapedasrightangles.●
badGoodforwhichlessispreferredratherthanmore.BADSIn(a),Bobviewsorangejuiceandapplejuiceasperfectsubstitutes:Heisalwaysindifferentbetweenaglassofoneandaglassoftheother.PERFECTSUBSTITUTESANDPERFECTCOMPLEMENTSFIGURE3.6In(b),Janeviewsleftshoesandrightshoesasperfectcomplements:Anadditionalleftshoegiveshernoextrasatisfactionunlessshealsoobtainsthematchingrightshoe.Preferencesforautomobileattributescanbedescribedbyindifferencecurves.Eachcurveshowsthecombinationofaccelerationandinteriorspacethatgivethesamesatisfaction.PREFERENCESFORAUTOMOBILEATTRIBUTESOwnersofFordMustangcoupes(a)arewillingtogiveupconsiderableinteriorspaceforadditionalacceleration.FIGURE3.7TheoppositeistrueforownersofFordExplorers.Theypreferinteriorspacetoacceleration(b).EXAMPLE3.1DESIGNINGNEWAUTOMOBILES(I)Autilityfunctioncanberepresentedbyasetofindifferencecurves,eachwithanumericalindicator.Thisfigureshowsthreeindifferencecurves(withutilitylevelsof25,50,and100,respectively)associatedwiththeutilityfunction:UTILITYANDUTILITYFUNCTIONS●
utilityNumericalscorerepresentingthesatisfactionthata
consumergetsfromagivenmarketbasket.●
utilityfunctionFormulathatassignsalevelofutilitytoindividual
marketbaskets.UTILITYFUNCTIONSANDINDIFFERENCECURVESFIGURE3.8u(F,C)=FCAcross-countrycomparisonshowsthatindividualslivingincountrieswithhigherGDPpercapitaareonaveragehappierthanthoselivingincountrieswithlowerper-capitaGDP.ORDINALVERSUSCARDINALUTILITY●
ordinalutilityfunctionUtilityfunctionthatgeneratesarankingof
marketbasketsinorderofmosttoleastpreferred.●
cardinalutilityfunctionUtilityfunctiondescribingbyhowmuchonemarketbasketispreferredtoanother.INCOMEANDHAPPINESSFIGURE3.9EXAMPLE3.2CANMONEYBUYHAPPINESS?MarketbasketsassociatedwiththebudgetlineF+2C=$80TheBudgetLine●
budgetconstraintsConstraintsthatconsumersfaceasaresult
oflimitedincomes.●
budgetlineAllcombinationsofgoodsforwhichthetotalamountofmoneyspentisequaltoincome.BudgetConstraints3.2TABLE3.2MARKETBASKETSANDTHEBUDGETLINEMARKETBASKETFOOD(F)CLOTHING(C)TOTALSPENDINGA040$80B2030$80D4020$80E6010$80G800$80(3.1)Abudgetlinedescribesthecombinationsofgoodsthatcanbepurchasedgiventheconsumer’sincomeandthepricesofthegoods.LineAG(whichpassesthroughpointsB,D,andE)showsthebudgetassociatedwithanincomeof$80,apriceoffoodofPF=$1perunit,andapriceofclothingofPC=$2perunit.Theslopeofthebudgetline(measuredbetweenpointsBandD)is?PF/PC=?10/20=?1/2.ABUDGETLINEFIGURE3.10(3.2)INCOMECHANGESAchangeinincome(withpricesunchanged)causesthebudgetlinetoshiftparalleltotheoriginalline(L1).Whentheincomeof$80(onL1)isincreasedto$160,thebudgetlineshiftsoutwardtoL2.Iftheincomefallsto$40,thelineshiftsinwardtoL3.TheEffectsofChangesinIncomeandPricesEFFECTSOFACHANGEININCOMEONTHEBUDGETLINEFIGURE3.11PRICECHANGESAchangeinthepriceofonegood(withincomeunchanged)causesthebudgetlinetorotateaboutoneintercept.Whenthepriceoffoodfallsfrom$1.00to$0.50,thebudgetlinerotatesoutwardfromL1toL2.However,whenthepriceincreasesfrom$1.00to$2.00,thelinerotatesinwardfromL1toL3.EFFECTSOFACHANGEINPRICEONTHEBUDGETLINEFIGURE3.12Themaximizingmarketbasketmustsatisfytwoconditions:ConsumerChoice3.3
Itmustbelocatedonthebudgetline.
It
mustgivetheconsumerthemostpreferredcombinationofgoodsandservices.AconsumermaximizessatisfactionbychoosingmarketbasketA.Atthispoint,thebudgetlineandindifferencecurveU2aretangent.Nohigherlevelofsatisfaction(e.g.,marketbasketD)canbeattained.AtA,thepointofmaximization,theMRSbetweenthetwogoodsequalsthepriceratio.AtB,however,becausetheMRS[?(?10/10)=1]isgreaterthanthepriceratio(1/2),satisfactionisnotmaximized.MAXIMIZINGCONSUMERSATISFACTIONFIGURE3.13●
marginalbenefitBenefitfromtheconsumptionofoneadditionalunit
ofagood.●
marginalcostCostofoneadditionalunitofagood.So,wecanthensaythatsatisfactionismaximizedwhenthemarginalbenefit—thebenefitassociatedwiththeconsumptionofoneadditionalunitoffood—isequaltothemarginalcost—thecostoftheadditionalunitoffood.ThemarginalbenefitismeasuredbytheMRS.Satisfactionismaximized(giventhebudgetconstraint)atthepointwhereMRS=PF/PC (3.3)Theconsumersin(a)arewillingtotradeoffaconsiderableamountofinteriorspaceforsomeadditionalacceleration.FIGURE3.14CONSUMERCHOICEOFAUTOMOBILEATTRIBUTESGivenabudgetconstraint,theywillchooseacarthatemphasizesacceleration.Theoppositeistrueforconsumersin(b).Differentpreferencesofconsumergroupsforautomobilescanaffecttheirpurchasingdecisions.FollowinguponExample3.1,weconsidertwogroupsofconsumersplanningtobuynewcars.EXAMPLE3.3DESIGNINGNEWAUTOMOBILES(II)●
cornersolution Situationinwhichthemarginalrateofsubstitution
foronegoodinachosenmarketbasketisnotequaltotheslopeofthebudgetline.ACORNERSOLUTIONFIGURE3.15CornerSolutionsWhenacornersolutionarises,theconsumermaximizessatisfactionbyconsumingonlyoneofthetwogoods.GivenbudgetlineAB,thehighestlevelofsatisfactionisachievedatBonindifferencecurveU1,wheretheMRS(oficecreamforfrozenyogurt)isgreaterthantheratioofthepriceoficecreamtothepriceoffrozenyogurt.CONSUMERPREFERENCESFORHEALTHCAREVERSUSOTHERGOODSTheseindifferencecurvesshowthetrade-offbetweenconsumptionofhealthcare(H)versusothergoods(O).CurveU1appliestoaconsumerwithlowincome;giventheconsumer’sbudgetconstraint,satisfactionismaximizedatpointA.Asincomeincreasesthebudgetlineshiftstotheright,andcurveU2becomesfeasible.TheconsumermovestopointB,withgreaterconsumptionofbothhealthcareandothergoods.CurveU3appliestoahigh-incomeconsumer,andimplieslesswillingnesstogiveuphealthcareforothergoods.MovingfrompointBtopointC,theconsumer’sconsumptionofhealthcareincreasesconsiderably(fromH2toH3),whileherconsumptionofothergoodsincreasesonlymodestly(fromO2toO3).FIGURE3.16EXAMPLE3.4CONSUMERCHOICEOFHEALTHCAREACOLLEGETRUSTFUNDWhengivenacollegetrustfundthatmustbespentoneducation,thestudentmovesfromAtoB,acornersolution.If,however,thetrustfundcouldbespentonotherconsumptionaswellaseducation,thestudentwouldbebetteroffatC.FIGURE3.17EXAMPLE3.5ACOLLEGETRUSTFUNDIfanindividualfacingbudgetlinel1chosemarketbasketAratherthanmarketbasketB,AisrevealedtobepreferredtoB.Likewise,theindividualfacingbudgetlinel2choosesmarketbasketB,whichisthenrevealedtobepreferredtomarketbasketD.WhereasAispreferredtoallmarketbasketsinthegreen-shadedarea,allbasketsinthepink-shadedareaarepreferredtoA.REVEALEDPREFERENCE:
TWOBUDGETLINESFIGURE3.18Ifaconsumerchoosesonemarketbasketoveranother,andifthechosenmarketbasketismoreexpensivethanthealternative,thentheconsumermustpreferthechosenmarketbasket.RevealedPreference3.4Facingbudgetlinel3,theindividualchoosesE,whichisrevealedtobepreferredtoA(becauseAcouldhavebeenchosen).Likewise,facinglinel4,theindividualchoosesG,whichisalsorevealedtobepreferredtoA.WhereasAispreferredtoallmarketbasketsinthegreen-shadedarea,allmarketbasketsinthepink-shadedareaarepreferredtoA.REVEALEDPREFERENCE:
FOURBUDGETLINESFIGURE3.19REVEALEDPREFERENCEFORRECREATIONWhenfacingbudgetlinel1,anindividualchoosestouseahealthclubfor10hoursperweekatpointA.Whenthefeesarealtered,shefacesbudgetlinel2.SheisthenmadebetteroffbecausemarketbasketAcanstillbepurchased,ascanmarketbasketB,whichliesonahigherindifferencecurve.FIGURE3.20EXAMPLE3.6REVEALEDPREFERENCEFORRECREATION●
marginalutility(MU)Additionalsatisfactionobtainedfrom
consumingoneadditionalunitofagood.●
diminishingmarginalutilityPrinciplethatasmoreofagoodisconsumed,theconsumptionofadditionalamountswillyieldsmalleradditionstoutility.●
equalmarginalprinciplePrinciplethatutilityismaximizedwhentheconsumerhasequalizedthemarginalutilityperdollarofexpenditureacrossallgoods.MarginalUtilityandConsumerChoice3.5or(3.5)(3.6)(3.7)MARGINALUTILITYANDHAPPINESSAcomparisonofmeanlevelsofsatisfactionwithlifeacrossincomeclassesintheUnitedStatesshowsthathappinessincreaseswithincome,butatadiminishingrate.FIGURE3.21EXAMPLE3.7MARGINALUTILITYANDHAPPINESSWhat,ifanything,doesresearchonconsumersatisfactiontellusabouttherelationshipbetweenhappinessandtheconceptsofutilityandmarginalutility?INEFFICIENCYOFGASOLINERATIONINGWhenagoodisrationed,lessisavailablethanconsumerswouldliketobuy.Consumersmaybeworseoff.Withoutgasolinerationing,upto20,000gallonsofgasolineareavailableforconsumption(atpointB).TheconsumerchoosespointConindifferencecurveU2,consuming5000gallonsofgasoline.However,withalimitof2000gallonsofgasolineunderrationing,theconsumermovestoDonthelowerindifferencecurveU1.FIGURE3.22RationingCOMPARINGGASOLINERATIONINGTOTHEFREEMARKETSomeconsumerswillbeworseoff,butothersmaybebetteroffwithrationing.Withrationingandagasolinepriceof$1.00,shebuysthemaximumallowable2000gallonsperyear,puttingheronindifferencecurveU1.Hadthecompetitivemarketpricebeen$2.00pergallonwithnorationing,shewouldhavechosenpointF,whichliesbelowindifferencecurveU1.However,hadthepriceofgasolinebeenonly$1.33pergallon,shewouldhavechosenpointG,whichliesaboveindifferencecurveU1.FIGURE3.23IdealCost-of-LivingIndex●
cost-of-livingindexRatioofthepresentcostofatypicalbundleofconsumergoodsandservicescomparedwiththecostduringabaseperiod.●idealcost-of-livingindexCostofattainingagivenlevelofutilityatcurrentpricesrelativetothecostofattainingthesameutilityatbase-yearprices.Cost-of-LivingIndexes3.6TheinitialbudgetconstraintfacingSarahin2000isgivenbylinel1;herutility-maximizingcombinationoffoodandbooksisatpointAonindifferencecurveU1.Rachelrequiresabudgetsufficienttopurchasethefood-bookconsumptionbundlegivenbypointBonlinel2(andtangenttoindifferencecurveU1).TABLE3.3IDEALCOST-OF-LIVINGINDEXPriceofbooks$20/book$100/bkNumberofbooks156Priceoffood$2.00/lb.$2.20/lb.Poundsoffood100300Expenditure$500$12602010(RACHEL)2000(SARAH)COST-OF-LIVINGINDEXESFIGURE3.24(1of2)Apriceindex,whichrepresentsthecostofbuyingbundleAatcurrentpricesrelativetothecostofbundleAatbase-yearprices,overstatestheidealcost-of-livingindex.COST-OF-LIVINGINDEXESFIGURE3.24(2of2)TABLE3.3IDEALCOST-OF-LIVINGINDEXPriceofbo
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