Consumer Behavior

Lecture notes
How do consumers allocate income among different goods and services to maximize utility or satisfaction? Consumer preferences Budget constraints Consumer choices

Notation of Consumer Preference A B: A is preferred to B A~ B: A is indifferent to B Basic assumptions for preferences Completeness -can rank any basket of goods.(always possible to decide preference or indifference) Transitivity -AB and BC implies A C. This assumption seems obvious, but can have contradiction Non-satiation -more is better. (Monotonicity) Convexity -given two indifferent bundles, always prefer the average to each of them. In the given Figure, the average point C is preferred to A

Total Vs Marginal Utility

Total Utility: Total amount of satisfaction derived by consuming a specific amount of a commodity. Marginal Utility: The extra amount of satisfaction derived by consuming one extra unit of a commodity. The table below illustrates the relationship that exists between total and marginal utility associated with an individual's consumption of pizza (in a given time period).

# of slices Total utility Marginal utility 0 1 2 3 4 5 6 0 70 110 130 140 145 140 70 40 20 10 5 -5

As the table above indicates, the marginal utility associated with an additional slice of pizza is just the change in the level of total utility that occurs when one more slice of pizza is consumed. Note, for example, that the marginal utility of the third slice of pizza is 20 since total utility increases by 20 units (from 110 to 130) when the third slice of pizza is consumed. More generally, marginal utility can be defined as:

The table above also illustrates a phenomena known as the law of diminishing marginal utility. This law states that marginal utility declines as more of a particular good is consumed in a given time period, ceteris paribus. In the example above, the marginal utility of additional slices of pizza declines as more pizza is consumed (in this time period). In this example, the marginal utility of pizza consumption becomes negative when the 6th slice of pizza is consumed. Note, though, that even though the marginal utility from pizza consumption declines, total utility still increases as long as marginal utility is positive. Total utility will decline only if marginal utility is negative. This law of diminishing marginal utility is believed to occur for virtually all commodities. Relation between MU and TU

Indifference Curve Analysis:

An indifference curve shows all the different combinations of two goods X and Y which give the same level of satisfaction or utility.

Features:
Indifference curves are downward sloping as loss of one good must be compensated by gain in another to give the same level of satisfaction. Indifference curves are convex to the origin as more of good X is consumed, good Y becomes more highly valued. The rate of trade-off between two goods is called the Marginal Rate of Substitution (MRS) and it falls as we move down the indifference curve. MRS = Slope of Indifference Curve. MRS is equals also the ratio of the marginal utilities of the two products MRS= MUx /MUy Indifference curves never intersect Higher indifference curves represent higher levels of utility and are preferred to lower ones Y slope = Y/X = MRS

X Two Extreme Situations: Perfect Substitutes (a) Perfect Complements (b)

Indifference Curve with Utility Function u(x,y)= xy

The Budget Constraint:

The budget constraint shows the various bundles of goods that the consumer can afford with his given income. Let's consider the budget constraint facing an individual who has a fixed level of income (I) that can be used to buy two goods (X and Y) at fixed prices (PX and Py). The budget constraint facing this individual can be expressed as:

A graph of this budget constraint appears below. The intercepts of this budget constraint on each axis equals income divided by the price of the good represented on the axis (this can be demonstrated quite easily using basic algebra).

As your text illustrates on p. 182, changes in income will result in a parallel shift in the budget constraint while changes in the prices of goods X and Y will affect the slope of the budget constraint. The slope of budget constraint equals to the ration: - Px / Py

We can derive the budget line by rearranging the terms in the income equation, as follows: I = X . P X + Y . PY I X . P X = Y . PY I X .PX = Y PY PY I P Y = X X PY PY

Increase in Income will shift the budget line to the right. More of each product becomes affordable Decrease in Income will shift the budget line to the left. Less of each product becomes affordable

Consumer equilibrium

Individuals maximizing utility subject to their budget constraint attain the highest possible level of utility at a point of tangency between their budget constraint and an indifference curve. In the diagram below, this occurs when the individual consumes X* units of good X and Y* units of good Y. While other points on the budget constraint, such as point A, are feasible, they provide a lower level of utility. Points such as point B provide a higher level of utility, but are not feasible. It is not possible to attain a higher level of utility than Uo without violating the budget constraint (and there are laws that prevent people from acquiring more goods than they can pay for...).

Interior Optimum: The optimal consumption basket is at a point where the indifference curve is just tangent to the budget line. The slope of each indifference curveis the ratio of the marginal utilities of the two products, MUx /MUy. A tangent: to a function is a straight line that has the same slope as the function therefore.

MRSx,y = MUx/MUy = Px/Py

Thus, when consumer has chosen the consumption bundle that maximizes his satisfaction, he is in equilibrium.