3. Consumer Behavior

Transcription

1 3. Consumer Behavior References: Pindyck und Rubinfeld, Chapter 3 Varian, Chapter 2, 3, Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 1

2 Chapter Outline 1. Consumer Preferences 2. Budget Constraints 3. Consumer Choice 4. Revealed Preference 5. Marginal Utility and Consumer Choice Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 2

3 Consumer Behavior Theory of consumer behavior: description of how consumers allocate incomes among different goods and services to maximize their well-being. Consumer behavior is best understood in three distinctive steps 1) Consumer Preferences Is used to describe how and why consumers prefer one good in comparison to another Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 3

4 Consumer Behavior 2) Budget Constraints People have limited incomes. 3) Consumer Choice Which combination of goods do consumers buy to maximize their utility? Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 4

5 Consumer Preferences A market basket (or bundle) is a list with specific quantities of one or more goods. One basket may be preferred to another basket containing a different combination of goods Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 5

6 Preferences Let s consider two different consumption bundels, x and y. Our two bundles can be valued in the three different ways: Strongly preferred: x is preferred to y Weakly preferred: x is at least as good as y. Indifferent: x is as good as y Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 6

7 Preferences indicates strong preference relation; x y means that bundle x is strictly preferred to bundel y. ~ indicates being indifferent; x ~ y means that the consumers are indifferent between x and y. indicates weak preference relation; x y means that consumers find x to be at least as good as y Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 7

8 Assumptions Four basic assumptions: 1) Preferences are complete. 2) Preferences are reflexive. 3) Preferences are transitive. 4) More is better than less Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 8

9 Assumptions about preferences 1. Completeness: Preferences are assumed to be complete. In other words, consumers can compare and rank all possible baskets. x y or y x Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 9

10 Assumptions about preferences 2. Reflexivity: means that if x and y are identical in all respects the consumer will recognize this fact and will be indifferent between x and y. x x Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 10

11 Assumptions of preferences 3. 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. Transitivity is normally regarded as necessary for consumer consistency. x y and y z x z Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 11

12 Assumptions of preferences 4. Strong monotonicity (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. In addition, consumers are never satisfied or satiated; more is always better, even if just a little better. Thus if x has a little more than y x y Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 12

13 Consumer Preferences Consumer preferences can be represented graphically through indifference curves. Indifference curve: curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 13

14 Example Market basket Units of food Units of Clothing A B D E G H Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 14

15 Consumer preferences Clothing (units per week) B H E Basket A is clearly preferred to all combinations of the orange field, whilst all baskets of the green field are preferred to basket A. 30 A 20 G D Food (units per week) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 15

16 Indifference Curves Indifference curves are negatively sloped and convex to the origin If they were positively sloped, this would violate the assumption that a larger quantity of a good is always preferred to a smaller quantity. Each basket above and to the right of an indifference curve, is preferred to every basket that is on the indifference curve Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 16

17 Indifference Curves Clothing (units per week) 50 B Taking the combination B, A & D, yields the same utility function. E is preferred to U 1 U 1 is preferred to H & G H G A E D B ~ A ~ D E A G U Food (units per week) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 17

18 Indifference Curves An indifference map is a set of indifference curves that describes a person s preferences. Each indifference curve (U 1, U 2, ) represents the commodity bundles, between which the person is indifferent. Indifference curves cannot intersect: This will violate the assumption that more is better than less Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 18

19 Indifference Maps Clothing (units per week) D B A U 3 U 2 U 1 Food (units per week) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 19

20 Indifference Maps Clothing (units per week) U 2 U 1 A Indifference curves cannot intersect The consumers should be indifferent among A, B and D. Yet, B should be preferred to D, because B has more of both goods. B D Food (units per week) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 20

21 The Shape of Indifference Curves Clothing (units per week) A In this figure, the MRS between clothing (C) and food (F) falls from 6 (between A and B) to 4 (between B and D) to 2 (between D and E) to 1 (between E and G) B 1-2 D 1-1 E 1 Question: does this relation also hold in terms of giving up food for clothing? G Food (units per week) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 21

22 The Marginal Rate of Substitution The marginal rate of substitution (MRS) quantifies the maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good. It is measured by the magnitude of the slope of the indifference curve Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 22

23 The Marginal Rate of Substitution Clothing (units per week) A MRS = 6 MRS = ΔC ΔF B 1-2 D 1-1 MRS = 2 E G 1 MRS of B is lim {DC/DF} Dx 0 = -dc/df at point B Food (units per week) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 23

24 The Marginal Rate of Substitution Convexity Observe that the MRS falls as we move down the indifference curve. The decline in the MRS reflects our fourth assumption regarding consumer preferences: a diminishing marginal rate of substitution. When the MRS diminishes along an indifference curve, the curve is convex. In our example, the MRS for AB is 6 whereas for DE it has the value Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 24

25 The Marginal Rate of Substitution Indifference curves are convex, since when a larger quantity of a product is consumed, a consumer would prefer to give fewer units of a second good to obtain additional units of the first. Consumers prefer a balanced consumption basket Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 25

26 Convex Preferences Clothing A C Preferences are strictly convex when all combinations in C are preferred to combinations in A and B. B Food Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 26

27 Perfect Substitutes and Perfect Compliments Perfect substitutes and perfect complements: Perfect substitutes: two goods for which the marginal rate of substitution of one for the other is a constant. Perfect complements: two goods for which the MRS is zero or infinite; the indifference curves are shaped as right angles. Bads: goods for which less is preferred rather than more Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 27

28 Consumer preferences Apple juice (glasses) 4 Perfect Substitutes Orange juice (glasses) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 28

29 Consumer preferences Left shoe 4 3 Perfect Complements Right shoe Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 29

30 Consumer preferences - Example The board of directors for an automobile firm has to regularly decide when and how much to invest in new features for cars. Analyzing consumer preferences would help the board in making the decision whether or not to invest in new features (e.g., interior space and/or amenities) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 30

31 Consumer preferences - Example Space Owners of Ford Mustang coupes are willing to give up considerable interior space for additional acceleration. Acceleration (horsepower) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 31

32 Consumer preferences - Example Space The opposite is true for owners of Ford Explorers. They prefer interior space to acceleration. Acceleration (horsepower) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 32

33 Utility and Utility Functions Utility: numerical score representing the satisfaction that a consumer gets from a given market basket. Utility function: A formula that assigns a level of utility to individual market baskets. For example, the utility function for food (F) and clothing (C) is U(F,C) = F + 2C Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 33

34 Utility - Example Market basket Food Clothing Utility A = 14 B = 14 C = 12 The consumer is indifferent between A and B. The consumer prefers A and B in comparison to C Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 34

35 Utility - Example Clothing (units per week) 15 Market basket U = F C C 25 = 2,5 10 A 25 = 5 5 B 25 = 10 2,5 10 C A B U 3 = 100 (preferred to U 2 ) U 2 = 50 (preferred to U 1 ) U 1 = 25 Food (units per week) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 35

36 Cobb-Douglas Utility function The following is called a Cobb-Douglas utility function: U(x,y) = x a y b, with a > 0 and b > 0. Example: U(x,y) = x 1/2 y 1/2 (a = b = 1/2) V(x,y) = x y 3 (a = 1, b = 3) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 36

37 Cobb-Douglas Indifference Curves Y All curves are hyperbolas and are asymptotic to both axes; i.e., they move along the axes without ever touching them. x Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 37

38 Ordinal versus Cardinal Utility Ordinal and cardinal utility function Ordinal utility function: a utility function that generates a ranking of baskets of goods in order of preference from most to least. Cardinal utility function: utility function describing how much one basket of goods is preferred to another Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 38

39 Consumer Preferences Ordinal und cardinal ranking: The actual unit of measure for utility is not important. Consequently, an ordinal range is sufficient to explain how most individuals make decisions Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 39

40 Budget Constraints Preferences do not explain overall consumer behavior. Budget constraints also limit the consumption possibilities of an individual in terms of the prices that must be paid for different goods and services Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 40

41 Budget Constraints The Budget line: The Budget line represents all combinations of goods for which the total amount of money spent is equal to income. P F P C I F C Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 41

42 Budget Constraints The Budget line: Let F be equal to the quantity of food bought, and let C be the quantity of clothing bought. Price of food = P F and Price of clothing = P C Accordingly P F F is the amount of money spent for food and P C C the amount of money spent for clothing Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 42

43 Budget Constraints Market basket Food (F) Clothing (C) Total spending P F = ( 1) P c = ( 2) P F F+ P c C = I A B D E G Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 43

44 Budget line Clothing (units per week) Pc = 2 P F = 1 I = 80 (I/P C ) = 40 A Budget line F + 2C = B 20 1 Slope DC / DF - - P F / P 2 D E C G = (I/P F ) Food (units per week) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 44

45 Budget line As we move along the budget line from one axis to the other, the consumer gives less for one good and more for the other good. The slope of the budget line measures the relative costs of food and clothing. The slope is equal to the negative value of the ratio of the prices of the two goods Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 45

46 Budget line - In general The slope indicates the degree to which the two goods X and Y can be exchanged without changing the total sum of expenditures I. I I I P Y P P X X X P P X X Y X P Y Y P Y Y Y Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 46

47 Budget Constraint The Budget line The vertical y-axis ( I P y ) represents the maximum quantity Y that can be purchased with income I. The horizontal x-axis section ( I P x ) represents the maximum quantity X that can be purchased with the income I. Y I Py I Px X Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 47

48 The Budget line: The Effects of Changes in Income and Price Income changes A change in income (with prices unchanged) causes the budget line to shift parallel to the original line. If income falls, the budget line shifts inward, parallel to the original budget line (prices being constant) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 48

49 The Budget line: The Effects of Changes in Income and Price Clothing (units per week) 80 When income increases, the budget line shifts outward If income falls, the line shifts inward L 1 (I = 80) L (I = 160) Food (units per week) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 49

50 The Budget line: The Effects of Changes in Income and Price Price Changes A change in the price of one good (with income unchanged) causes the budget line to rotate about one intercept. When the price of a good decreases, the budget line rotates outwards, denoted by a rotation in the intercept of the other good Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 50

51 The Budget line: The Effects of Changes in Income and Price Clothing (units per week) When the price of food increases to 2.00, the slope of the budget line changes and rotates inwards. 40 If the income of food falls to 0.50, the slope of the budget line changes and rotates outward. L 3 L 1 L 2 (P F = 2) 40 (P F = 1) (P F = 1/2) Food (units per week) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 51

52 The Budget line: The Effects of Changes in Income and Price Price Changes If the prices for both goods increases and the ratio of the two prices remains unchanged, this does not cause a change in the slope. However, the budget line shifts inwards to a point parallel to the original budget line Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 52

53 Consumer Choice Consumers choose a combination of goods that maximizes their satisfaction, taking into consideration the limited budget available to them. This combination of goods is also called the optimal consumption plan Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 53

54 Consumer Choice The maximizing basket of goods must satisfy two conditions: 1) It must be located on the budget line. 2) It must give the consumer the most preferred combination of goods and services Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 54

55 Consumer Choice As mentioned before, the slope of the indifference curve is as follows: As mentioned before, the slope of the indifference curve for any two baskets of goods, F and C, is given by the marginal rate of substition (MRS) between baskets F and C: MRS = ΔC ΔF = dc df In addition, the slope of the budget curve is as follows: Slope = P F P C Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 55

56 Consumer Choice Thus we can say that utility is maximized at the point where the indifference curve is equal to the budget constraint: MRS = dc df =P F P C Thus, we can then say that satisfaction is maximized when the marginal benefit (the benefit associated with the consumption of one additional unit of food) is equal to the marginal cost (the cost of the additional unit of food). The marginal benefit is measured by the MRS Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 56

57 Consumer Choice Clothing (units per week) 40 Pc = 2 P F = 1 I = 80 Point B is not optimal, because the MRS (-(-10/10) = 1 is greater than the price ratio (1/2). 30 B -10C 20 Budget line +10F U Food (units per week) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 57

58 Consumer Choice Clothing (units per week) Pc = 2 P F = 1 I = D Market basket D, is not feasible with the current budget constraint. 20 U 3 Budget line Food (units per week) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 58

59 Consumer Choice Clothing (units per week) P C = 2 P F = 1 I = 80 In market basket A, the budget line and the indifference curve are tangent to each other. No higher level of satisfaction can be attained. At point A, consumers have maximized their. 20 A In A: MRS =P F /P c = 0,5 U 2 Budget line Food (units per week) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 59

60 Consumer Choice Example Consider two groups of consumers who want to spend $ 10,000 each for the interior space and performance of automobiles. Each group has different preferences. The car manufacturer can create a production and marketing plan by determining the tangential point between the indifference curve and the budget constraint of a consumer group Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 60

61 Consumer Choice Example Space $10,000 Consumers here are willing to trade a considerable amount of interior space for some additional acceleration. $3,000 $7,000 $10,000 Acceleration (horsepower) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 61

62 Consumer Choice Example Space $10,000 $7,000 The opposite is true for these consumers; they would choose a car that emphasizes interior space over acceleration. $3,000 $10,000 Acceleration (horsepower) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 62

63 Corner Solution 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. For the selected bundle (corner solution) the MRS is not equal to P A /P B Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 63

64 Corner Solution Frozen yoghurt (cups per month) A U 1 U 2 U 3 The highest level of satisfaction is achieved at B on the indifference curve U 1. B Ice cream (cups/month) Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 64

65 Marginal Utility Marginal utility is the additional utility from the consumption of an additional unit of a good Formally this is the partial derivative of the utility function with respect to the consumption good: U ( C, F) oder U ( C, F) C F The principle of diminishing marginal utility states that as the quantity consumed increases, the additional utility decreases Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 65

66 Marginal Utilitity and the Indifference Curve If consumption moves along an indifference curve, the additional benefit resulting from an increase in the consumption of food (F), must compensate for the loss of utility due to the decrease in consumption of clothing (C). Expressed in the following formula: 0 MU ( DF) MU ( DC) F or 0 U df U dc F C C Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 66

67 Marginal Unity and Indifference Curve By rearrainging we get the following: DC / DF MU / MU DC / DF MRS von of F F for für C C Es gilt: MRS MU F / MUC and MRS It follows that U F U C F C Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 67

68 Marginal Utility and Consumer Choice Consumers maximize their utility as follows: MRS P P F C Since the MRS is also equal to the ratio of the marginal consumption of F and C, it follows that MU F / MU C P F / PC Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 68

69 Marginal Utility and Consumer Choice From this we determine the equation for the maximization of utility: MU / P MU / P F F C C Utility is maximized when the budget is split so that the marginal utility per Euro spent is the same for each good Prof. Dr. Kerstin Schneider Chair of Public Economics and Business Taxation Microeconomics Chapter 3 Slide 69