ECO101 PRINCIPLES OF MICROECONOMICS Notes Consumer Behaviour Overview The aim of this chapter is to analyse the behaviour of rational consumers when consuming goods and services, to explain how they may allocate their income (budget) among various goods, and to relate the curve to a model of consumer choice and utility maximization. In this analysis, the income and substitution effects are highlighted and indifference curve analysis is introduced. Marginal Utility Analysis Utility is the satisfaction people derive from the consumption of goods and services. We will be mostly concerned with marginal utility (the additional satisfaction one receives from the consumption of one additional unit of a good). Total utility, on the other hand, is the total satisfaction one gets from consuming all the units of a good. Note that utility is not a characteristic of the good, but rather it is in the mind of the consumer. Therefore, the value of utility each individual attaches to the consumption of one good may be different than the utility derived by another person. Therefore, utility is subjective (it is personal for each individual). Diminishing Marginal Utility: Imagine that you go to McDonalds and order a Big Mac. Initially you enjoy the hamburger very much because you are hungry, therefore utility is very high. Now you order a second Big Mac and you manage to finish it, but you start to get full. By the end of the second hamburger, the utility was less than for the first one. In other words, your marginal utility (the additional satisfaction) is less than before, even though the total utility (the sum of utilities for both hamburgers) is higher. If your buddy dares you to eat a third Big Mac, you will probably take on the challenge and order the third hamburger. But since you are nearly full, you really don t enjoy it this time, and therefore, the marginal (additional) utility for the third Big Mac is even less than before. Up to this point, your total utility still increases, though by smaller increments! If your friend dares you to eat a fourth one (or even if the store offers free Big Macs), you would most probably refuse to eat a fourth one because it might even make you throw up. In other words, you value the marginal (additional) utility as zero (or may even be negative)! We can generalise from the description of behavior above to say that the principle of diminishing marginal utility says that as we consume successive (more and more) units of one good, the additional satisfaction (marginal utility) we derive diminishes (gets less and less!). MU = TU / Q We can now represent the relationship between total utility and marginal utility in a table (schedule) as well as in a graph, as shown below: U tility fro m c o n s u m in g B ig M a c s U tility ( U tils ) 1 3 1 1 TU 7 Big M acs TU M U 0 1 2 3 4 5 0 7 11 13 13 12-7 4 2 0-1 0-1 1 2 3 4 N u m b e r o f B i g M a c s C o n s u m e d p e r V i s i t 5 M U 3 1
We can identify the following relationships from the above graph: The TU curve slopes upwards, and reaches a maximum at the number of units where MU is zero (at 4 Big Macs). The MU curve has a negative slope reflecting the concept of diminishing marginal utility as explained above Budget Line (or Income Constraint) As we mentioned in Chapter 1, human wants are unlimited, but resources are limited. For each individual consumer (or business firm) there is a limited amount of income (or budget) per time period that can be devoted for spending on goods and services. This is the concept of a budget line (the income constraint). This determines the maximum bundle of goods, which the consumer is able to consume (given the market prices of the goods) while living within his/her means, in other words, his/her ability to pay for the goods, that is, within his/her income. Graphically, this approach resembles the concept of the production possibility frontier (discussed in Chapter 1), although we are examining consumption rather than production, in the sense that on one axis we measure the units of one good and on the other axis the units of another good. The budget line indicates the combinations of two goods, which a consumer can afford to buy. In the graph below, we assume that the individual (say a student at Cyprus College) has a monthly income (a budget) of 50, which he/she can spend on goods and services. We will assume for simplicity that the student is faced with choosing between only two goods, meals and cigarettes. Assume further that the price of meals = 1.0 and that of cigarette packs = 2.0. The insert in the graph below, presents the various combinations of the two goods that the student can consume by fully spending his/her monthly income. The budget line, which graphs these combinations of the two goods and represented by points A through F, expresses the limits of the student s spending capability with respect to consumption of meals and cigarettes, again given the monthly income of 50 and the prices of the two goods. Units of Cigarette Packs 25 A Y 20 B Budget Line C 15 X 10 D Units of Cig. packs A 25 0 B 20 10 C 15 20 D 10 30 E 5 40 F 0 50 Units of Meals 5 F 10 20 30 40 50 Units of Meals E The budget line separates the affordable from the unaffordable. In other words, to the left of the budget line all combinations (including the ones on the budget line) are affordable. To the right of the budget line, any combination cannot be afforded, since it requires a higher budget than the 50 the students has. Therefore, a point such as Y is not affordable, but a point such as X is affordable. In this case, however, the student is not spending all his/her income. The student saves some of his/her income. For simplicity, we will assume that students don t save any of their income, but rather spend it all on meals and cigarettes in combinations that they choose. 2
The Budget Equation Let us examine the budget line using simple algebra. We defined the budget as the sum of expenditures by the student on meals and cigarettes. The expenditure on each good is of course the number of units consumed multiplied by the price of that good. Therefore in the case of the student in the above example: Total Expenditure (Budget) = (Price of Meal X Quantity of meals) + (Price of cigarette pack X Quantity of Cigarette packs) If we denote the price of meals as P m, the number of meals as Q m, the price of cigarettes per pack as P c, and the number of cigarette packs consumed as Q c, then we can express the budget for the student as: Y = P m Q m + P c Q c Using the prices of meals ( 1) and cigarette packs ( 2) as given above, we get: Y = 1Q m + 2Q c The student can choose any combination of meals and cigarettes that satisfies the above equation, the student s budget constraint. If we assume that the student chooses the combination denoted by point C in the above graph, then the expression of the budget line becomes: 50 = ( 1 X 20) + ( 2 X 15). Therefore the budget constraint is satisfied. In the same way, all points on the budget line will exactly use up all the available income of the student. We said that point X (20 meals and 10 packs of cigarettes) is affordable since it lies inside and to the left of the budget line, but that the student is not using all his/her income. Let s see this calculation: 40 = ( 1 X 20) + ( 2 X 10). Therefore, the student saves 10. Likewise, let s examine point Y (10 meals and 25 cigarette packs). The total expenditures (budget) becomes: 60 = ( 1 X 10) + ( 2 X 25) Therefore, the student does not have enough money (income or budget) to consume this combination of goods. Point Y then is not an affordable combination. Using the general budget equation Y = P m Q m + P c Q c, we can derive a general expression to determine the quantities of meals and cigarettes that is feasible (affordable) for the student to consume. If we solve the budget equation for Q m, we get: Q c = (Y / P c ) (P m / P c ) x Q m So, given the income and the prices, the student must choose the number of meals and packs of cigarettes per month that satisfy the following equation: Q c = ( 50 / 2) ( 1 / 2) x Q m or Q c = 25 0.5 x Q m Real Income: The expression (Y / P c ) defines what we call real income, since it adjusts (divides) the money income by prices to give us the purchasing power of the individual. It tells us in other words, the maximum amount of a goods (cigarette packs in this case) that the student can afford to buy, and is the student s real income in terms of cigarette packs. Thus, the student s real income in terms of cigarettes is 25 cigarette packs per month. In terms of the graph, this is point A, which is also called the intercept the point where the budget line touches the axis. Slope: As you recall, we defined in Chapter 2 the slope of a line as the change of the variable in the vertical axis (the y -axis) over the change of the variable on the horizontal axis (the x axis) or ( Υ / Χ), where stands for change in. As a simple way of remembering the formula for the slope remember we defined it as: (the rise ) / (the run). In the above graph, the slope of the budget line between point B and C is: ( Υ / Χ) = - 5 / 10 = - 0.5 (a negative value indicates that the line is downward-sloping). 3
In economic terms now, the slope of the budget line is determined by the relative prices, that is, the ratio of the prices of the two goods in question (P m / P c ) and indicates how many units of one good must be given up (sacrificed) in order to consume one more unit of the other good. In our example, it is the ratio of meal prices to cigarette prices ( 1 / 2). The slope here then is 0.5. It indicates that to consume one more meal the student must give up (sacrifice) half a pack of cigarettes. This is nothing more than the student s opportunity cost of meal consumption! Adjustments (Changes) in Income Let us now examine the case of an increase in the level of the student s income, assuming for now that relative prices of goods remain constant. This means that the slope of the budget line which is given by the ratio of prices (P m / P c ) remains the same as the original one (in this case it stays at - 0.5). What changes is only the intercept of the budget line given by (Y / P c ), since we assume that money income (Y) changes. Graphically this is represented by a rightward (outward) shift of the budget line. For example, if we assume that the student s income increase to 60 per month, then with prices remaining the same, the maximum number of cigarettes that the student can consume if all income is devoted to smoking is 30 cigarette packs per month (instead of 25 previously)-- 60 / 2 = 30. Cigarette packs 30 25 Income of 50 Income of 60 50 60 Meals Adjustments (Changes) in Prices Let us now examine the adjustment to quantities consumed when relative prices change, assuming that income remains fixed at the previous level. When the price of a good decreases, then the budget line must shift outward at that particular axis, rotating around the intercept, in other words, the point where it cuts the other axis. In our example, where cigarettes are measured on the vertical axis and meals on the horizontal axis, the slope of the budget line (P m / P c ) at the original income of 50 was found to be 0.5 ( = 1 / 2). If we now assume that the price of meals decreases to 0.75 (75 cents), then the slope of the budget line would get smaller -- 0.75 / 2.0 = 0.375, instead of 0.50 before and the line would rotate outwards to the right. With the reduction in the price of meals to 0.75 the maximum number of meals that the student can consume now is approximately 66 meals per month (again assuming that the income remains fixed at 50. Cigarette packs 25 P m = 1.0 P m = 0.75 P m = 1.25 40 50 66 Meals 4
If we now assume that the price of meals increases to 1.25, then the slope of the budget line increases (it becomes steeper) since the relative price ratio is now 1.25 / 2.0 = 0.625, compared with 0.50 previously. Therefore the line would rotate inwards to the left. As a result of the increase in the price of meals, the student would be able to afford at the maximum 40 meals per month ( 50.0 / 1.25 = 40). Notice that in both the cases of a decrease and an increase in the price of meals, the intercept remains unchanged. Recall that the expression for the intercept is (Y / P c ). Since neither income (Y) or the price of cigarettes has changed, the value of the intercept remains unchanged at 25. Utility Maximization Since people s incomes (their budgets) are limited, and given the prices of goods, the rational consumer is expected to choose and consume that combination of goods and services that would give him/her the maximum satisfaction (utility). In making their choices, people (consumers) seek to get the maximum possible satisfaction from the goods and services, given their available budgets. In other words, they try to maximize their total utility. Let s continue with the example of the student we were using above, to see how she/he decides to allocate her/his income (budget) between meals and cigarettes to derive the maximum utility (satisfaction). The rule is that the rational consumer would maximize utility at the point where the marginal utility derived per pound spent form each good is equal for all goods consumed. This measure of optimum comparative marginal utility is derived by dividing the Marginal Utility of each good (the extra satisfaction derived from consuming an extra unit of a good) by the price of the good. This may be expressed as: (MU m / P m ) = (MU c / P c ), where MU m and MU c are the respective marginal utilities of meals and cigarette smoking. In other words, the rational consumer is interested to get maximum utility from his money spent whether he is consuming meals or cigarettes. The point may become clearer if we assume that the two ratios are not equal. Specifically, let s assume that both MU m and MU c are equal to 10 units of utility (satisfaction). Given the prices of the two goods used in the example above (P m = 1.0 and P c = 2.0), we end up with an inequality of the two ratios: (MU m / P m ) > (MU c / P c ) (10 / 1.0) > ( 10 / 2.0) 10 > 5 In this case, the student gets more utility from a pound spent on meals than from a pound spent on cigarettes. Naturally then he would tend to switch money from cigarette smoking to meals, thereby increasing his total (combined) utility. This process of readjustment of consumption habits will continue until the last pound spent derives the same amount of utility whether spent on meals or on cigarettes. A similar conclusion can be arrived by looking at the same relationship from a different angle using the following expression (which is equivalent to the previous one): (MU m / MU c ) = (P m / P c ) This says that the student will derive the maximum utility from his income if the ratio of the marginal utilities of the two goods is equal to their relative prices. Again, by investigating a situation where there is no equality between the ratios would clarify things better. Assume as we did above that the marginal utility of one extra meal is the same as that for smoking an extra pack of cigarette (10 units of satisfaction or utility), yet the student pays twice the price for a pack of cigarettes than for a meal ( 2 instead of 1). Therefore, the equality of the ratios does not hold. (MU m / MU c ) > (P m / P c ) (10 / 10) > ( 2.0 / 1.0 ) 1 > 0.5 As we concluded above, the student in this case would tend to switch money from cigarette smoking to meals from which the student gets more utility per pound spent, thereby increasing his total (combined) utility. This process of readjustment of consumption habits will continue until the last pound spent derives the same amount of utility whether spent on meals or on cigarettes. 5
Indifference Curve Analysis The concept of indifference curve analysis (or utility analysis) is based on some key assumptions: Firstly, we assume that consumers can rank their preferences or tastes between these alternative combinations, giving a consistent utility ranking; Secondly, we assume that rational consumers prefer more good to less; and Thirdly, that to hold utility constant, less needs given up of one good, to obtain successive equal increases in the quantity of the other good (the assumption of diminishing marginal rates of substitution). An indifference curve shows the various combinations of two goods that yield the same utility or satisfaction to the consumer. Indifference curves are negatively sloped because by consuming more of say meals, the individual would have to consume less of the other good (say cigarettes) in order to remain on the same indifference curve (that is, have the same level of satisfaction). The amount of cigarettes that the consumer would be willing to give up in order to acquire one additional unit of meals is called the marginal rates of substitution (MRS). Algebraically this is represented as: MRS = Q c / Q m P m Q m + P c Q c This can be illustrated on the graph using the concept of the indifference curve. When a consumer (student) has a lot of one good, but little of the other, they would be willing to exchange a lot of the good, which is plentiful, for a little of the good they are short of. Using our example, a hungry student would normally be prepared to give up several packs of cigarettes for some more meals you can t live on cigarettes alone. Cigarettes (Y) Y X U 1 U 2 U 3 An indifference curve like U 2 shows the combination of consumption of cigarettes and meals that yield the same utility Indifference curves slope downwards Their slope gets smaller as we go from left to right They never intersect Number of Meals (X) Note that as we move down an indifference curve, the MRS declines (i.e., the individual is willing to give up less and less of cigarettes for each additional meal. This declining nature of the MRS is reflected in the convex shape of the indifference curves. Note also that if goods are close substitutes for each other then the curves will be less curved. If goods are not close substitutes then more will have to be given up of one to compensate for an increase in the other, while utility remains constant. Unlike demand curves, because of their nature, indifference curves cannot cross. This follows from assumption No 2 above which says that more is preferred to less thus crossed indifference curves would be illogical. Consumer Equilibrium Using indifference curve and the budget line, we can show that the optimum point for consumption is the tangency point between the budget constraint and the indifference curve representing consumption of the greatest amount of goods. At that point there is nowhere upon the existing budget line which would result in a greater satisfaction for the individual. Different individuals (with different indifference curves) will end up at a different tangency point on the same budget line. 6
Cigarettes (Y) A E D B U 1 U 2 The optimum point (consumer equilibrium) is reached at point E where the budget line is tangent to the indifference curve. Points A and B are also affordable but lie on a lower indifference curve Point D, on the other hand, is not an affordable given the budget Number of Meals (X) Substitution and Income Effects (Without Indifference Curves) Recall that we have already come across the concepts of substitution and income effects when we first introduced shifts in the demand curve. According to the substitution effect, a decrease in the price of a good will always increase the quantity demanded of the specific good as consumers will switch away from the consumption of substitute goods. This can be shown by the shift (rotation outward) of the budget line to a new one. For example, from a point A on the original budget line the student moves to a point such as C on the new budget line. This is the result of the combined effect of substitution (direct effect) and income (indirect effect). The price decrease creates the real income effect since people now have more purchasing power due to the decrease in the price of even one good (meals in this case). Therefore, the consumption of meals (in addition to perhaps the consumption of cigarettes) will increase due to the real income effect. The student moves to a point such as B. But part of the change from A to C is the direct impact of the substitution effect brought about by the price change, as the student substitutes more meals for less cigarettes in an attempt to maximize utility. The final change in quantity then is a combination of the substitution effect and the income effect. This is shown graphically below: In co m e a n d S u b stitu tio n E ffe cts C ig a r e t t e s B A C N e w B u d g e t L in e O r i g in a l B u d g e t L i n e Incom e Substitution T o ta l E ffe c t M e a ls 11 Derivation of the Consumer s Demand Curve Using the concept just developed for price changes, we can now show how the individual consumer s demand curve is derived. In the upper portion of the graph below we have a situation where the price of meals successively falls and this is shown by the rotation of the budget line outwards and to the right. 7
Equilibrium in each case is found at different points on the different budget lines reflecting the changing preferences of the student at different meal prices, for example at 0.75, 1.00 and at 1.25. We can now take the information from the upper portion of the graph about the combinations of prices and quantities that the student maximizes his/her utility and put them in the standard demand graph where price is shown on the vertical axis and quantity on the horizontal axis. This produces the three points on the lower graph. If we join these three points we will derive the familiar downward-sloping demand curve, which shows the inverse relationship between price changes and quantities demanded. Derivation of Consumer Demand Curve Cigarette packs 2 5 P m = 1.25 P m = 1.0 P m = 0.75 4 0 5 0 6 6 Num ber of M eals M eal Prices 1.50 1.25 1.00 0.75 0.50 4 0 5 0 6 0 Number of Meals 13 Derivation of the Market Demand Curve So far we came full circle to the starting point of Chapter 3 where we drew the individual s demand curve as downward-sloping. With the analysis in this chapter we went deeper and investigated the behaviour of individuals and explained why we end up with the downward-sloping demand curve. The next step is easy and straight forward going from individual demand curves to market demand curves. If we assume that the price of meals is 1.0 as in the example above and we want to find the total quantity demanded by the class of ECO101A for the past month, we would simply ask all the students in the class how many meals each one had during the month and simply add up all the numbers to get the total. We use same principle in order to find graphically the market demand. In the graph below we assume that there are only two students in the market. At 1.0 we ask them how many meals they had during the month, and find that one had 20 meals and the second 25. Therefore, the total market demand is 45 found by the horizontal summation of the two individual graphs. References for further reading: Bade, R. and Parkin, (2007). Foundations of Economics 3 rd edition (Pearson Education). Begg, D., Fischer, S. and Dornbusch, R. (2005). Economics 8 th edition (McGraw-Hill). Mankiew N. Gregory (2007). Principles of Economics 4 th edition (Thomson, South-Western). 8
McConnel C. and S. Brue (2005). Economics 16 th edition (McGraw-Hill). Miller, R.L (2006). Economics Today 13 th edition (Pearson Addison Wesley). Sloman John (2006). Economics 6 th edition (Prentice Hall). 9