Consumer Behavior

Mir Ahasan Kabir, Ph.D.

Department of Economics
University of Toronto
[email protected]

October 10, 2024

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Overview

1 Introduction

2 The Consumer’s Preferences and the Concept of Utility

3 Indifference Curves

4 The Consumer’s Income and the Budget Constraint

5 Combining Utility, Income, and Prices

6 Solving Problems

7 Conclusion

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 Introduction

Introduction

This chapter focuses on a key question: How do consumers decide

which products (and how much of each) to buy?
This chapter introduces a theory of consumer behavior.
The theory is used to investigate why consumers make purchases.
Ultimately, consumers are assumed to “optimize” their utility given
scarce resources.
Consumer theory is the basis for the “demand” side of the supply and
demand model.

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 The Consumer’s Preferences and the Concept of Utility

Consumer Preferences and Utility

Utility is a measure of satisfaction or happiness that consumers

derive from consuming goods and services.
Consumers aim to maximize utility given their preferences and budget
constraints.
Preferences are usually assumed to have the following properties:
Completeness: Consumers can rank any two bundles of goods.
Transitivity: If A is preferred to B, and B to C, then A is preferred to C.
Non-satiation: More of a good is always preferred to less.
Variety: The more a consumer has of a particular good, the less she is
willing to give up of something else to get even more of that good.

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 The Consumer’s Preferences and the Concept of Utility

Utility Function

Utility can be represented by a function U(X , Y ), where X and Y are

quantities of two goods.
Example: U(X , Y ) = X α Y β , where α and β are constants reflecting
the consumer’s preferences.
Marginal Utility (MU): The additional satisfaction from consuming
one more unit of a good.
∂U ∂U
MUX = , MUY =
∂X ∂Y
Assumption: Diminishing Marginal Utility—each additional unit of a
good provides less additional satisfaction than the previous unit.

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 The Consumer’s Preferences and the Concept of Utility

Utility Function
Example: Consider the utility someone enjoys from seeing a movie in a
theater vs. watching a DVD
U = U(T , D)
where T is the number of movies “consumed” at the theater, and D is the
number of DVDs consumed at home. Utility might be represented by
U = T 0.8 D 0.2
In general, movies consumed in the theater add more utility than those
consumed at home because the exponent on movies in the theater (0.8) is
larger than that on movies at home (0.2).
MUT = 0.8T −0.2 D 0.2 > 0 MUTT = −0.16T −1.2 D 0.2 < 0

MUD = 0.2T 0.8 D −0.8 > 0 MUDD = −0.16T 0.8 D −1.8 < 0
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 The Consumer’s Preferences and the Concept of Utility

Question 1

The utility George enjoys from consuming a bag of popcorn (P) and a
candy bar (C) at a movie is given by the following utility function:

U = P 0.6 C 0.4
Which of the following statements is true for George?
(A) Candy adds more utility than popcorn.
(B) Popcorn adds more utility than candy.
(C) Popcorn and candy add the same utility.
(D) Popcorn adds less utility than candy.

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 The Consumer’s Preferences and the Concept of Utility

Question 1: Solution

The utility George enjoys from consuming a bag of popcorn (P) and a
candy bar (C) at a movie is given by the following utility function:

U = P 0.6 C 0.4
Which of the following statements is true for George?
(A) Candy adds more utility than popcorn.
(B) Popcorn adds more utility than candy.
(C) Popcorn and candy add the same utility.
(D) Popcorn adds less utility than candy.

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 The Consumer’s Preferences and the Concept of Utility

Question 2

The utility George enjoys from consuming a bag of popcorn (P) and a
candy bar (C) at a movie is given by the following utility function:

U = P 0.6 C 0.4
Which of the following represents the marginal utility of popcorn (MUP )
for George?
(A) 0.6P −0.4 C −0.6
(B) 0.4P −0.6 C 0.4
(C) 0.6P −0.4 C 0.4
(D) 0.4P 0.6 C −0.6

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 The Consumer’s Preferences and the Concept of Utility

Question 2: Solution

The utility George enjoys from consuming a bag of popcorn (P) and a
candy bar (C) at a movie is given by the following utility function:

U = P 0.6 C 0.4
Which of the following represents the marginal utility of popcorn (MUP )
for George?
(A) 0.6P −0.4 C −0.6
(B) 0.4P −0.6 C 0.4
(C) 0.6P −0.4 C 0.4 Correct
(D) 0.4P 0.6 C −0.6

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 The Consumer’s Preferences and the Concept of Utility

Comparing Consumption Outcomes

The “rules” for utility allows only for an ordinal ranking of consumption
bundles.
An ordinal ranking implies bundles can be ranked from best to worse.
A cardinal ranking would allow a person to determine how much
better one bundle is, compared to another.
Why not cardinal?

Many questions can be answered with only an ordinal ranking.

Ex: Predicting what will be consumed
There is no real-world measure of how much more a consumer likes
the bundle of goods A to the bundle of goods B.

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 Indifference Curves

Indifference Curves
An indifference curve represents all combinations of two goods that
give the consumer the same level of utility.
Properties:
Downward sloping: If you consume more of one good, you need less of
the other to maintain the same utility.
Do not intersect: This would violate the assumption of transitivity.
Convex to the origin: This reflects diminishing marginal rates of
substitution.

Figure 4.1
Building an Indifference Curve
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 Indifference Curves

Characteristics of Indifference Curves

The stem from the four assumptions about consumer preferences.

1 They can be drawn.

Completeness and rankability

2 Curves further from the origin represent higher utility.
More is better
3 Curves never cross.
Transitivity
4 Convex to the origin.
Consumers like variety / diminishing marginal utility

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 Indifference Curves

Indifference Curves

Figure 4.2 A Consumers Indifference Curves

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 Indifference Curves

Indifference Curves
To see why indifference curves
cannot cross, consider bundles D and
F. These bundles are on the same
indifference curve, therefore Joe
must be indifferent between them.

Now, draw another indifference curve

through bundle F that intersects the
original curve. Implies Joe is also
indifferent between points E and F as
Figure 4.3 A Consumers well as between points F and D
Indifference Curves Cannot
Cross Why must Joe prefer bundle E to
bundle D?
If more is better, at E he has more of
both.
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 Indifference Curves

Indifference Curves
As apartment size gets larger, Michaela is less willing to trade off the
number of friends for additional apartment size.

Figure 4.4 Tradeoffs along an Indifference Curve

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 Indifference Curves

Marginal Rate of Substitution (MRS)

The MRS is the rate at which a consumer is willing to trade one good
for another while maintaining the same level of utility.
MUX
MRSXY =
MUY
MRS is the slope of the indifference curve at any point. As we move
along the curve, the MRS decreases (diminishing MRS).
Example:
αY
MRSXY =
βX
Interpretation: At a certain point, the consumer is willing to give up
MRSXY units of good Y to obtain one additional unit of good X .

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 Indifference Curves

The Marginal Rate of Substitution (MRS)

Figure 4.5 The Slope of an Indifference Curve is the Marginal Rate

of Substitution
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 Indifference Curves

The Marginal Rate of Substitution and Marginal Utility

What does this mean in terms of the change in level of utility?

∆ = MUlattes ∗ ∆Qlattes + MUburritos ∗ ∆Qburritos = 0

−MUburritos ∗ ∆Qburritos = MUlattes ∗ ∆Qlattes

∆Qburritos MUlattes
MRSXY = − =
∆Qlattes MUburritos

Steeper curves imply the consumer is willing to give up a lot of Burritos to

get one unit of Lattes, or could trade 1 unit of Lattes for a lot of good
Burritos.
Flatter curves imply the consumer would require a large increase in good
Lattes to give up one unit of the good Burritos, or could trade 1 unit of
Burritos for a lot of good Lattes.
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 Indifference Curves

The Curvature of Indifference Curves: Substitutes and

Complements

The shape of indifference curves reveals information about the relationship

between products.
Relatively straight indifference curves describe goods that are more
easily substitutable for one another.
Indifference curves that are more convex to the origin describe goods
that are more complementary to one another.
To illustrate, consider extreme cases:
A Perfect substitutes are goods that the consumer will trade at a fixed
rate and receive the same level of utility (MRS is constant).
B Perfect complements are goods that the consumer must consume in
a fixed proportion.

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 Indifference Curves

The Curvature of Indifference Curves: Substitutes and

Complements

Consider a typical consumers

preferences for 3-oz and 12-oz bags
of tortilla chips.

This consumer should be willing to

trade one 12-oz bag for four 3-oz
bags no matter how much of each he
or she has.
Figure 4.9 Indifference Curves
for Perfect Substitutes
MRS is constant in this case.

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 Indifference Curves

The Curvature of Indifference Curves: Substitutes and

Complements

Alternatively, consider preferences for

right and left shoes.

Most consumers will prefer to consume

these goods in constant proportion.

Consider point A; this consumer has two

right shoes and two left shoes.

Adding another right shoe (bundle B)

Figure 4.10 Indifference will not increase utility.
Curves for Perfect
Complements The consumer needs another left shoe as
well (bundle D) if utility is to increase.

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 Indifference Curves

Question 3

An individuals indifference curves for hot dogs and hot dog buns are most
likely:
(A) to be L-shaped.
(B) to have a constant MRS (marginal rate of substitution).
(C) to be differentiable.
(D) to have a constant slope.

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 Indifference Curves

Question 3

An individuals indifference curves for hot dogs and hot dog buns are most
likely:
(A) to be L-shaped.
(B) to have a constant MRS (marginal rate of substitution).
(C) to be differentiable.
(D) to have a constant slope.

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 Indifference Curves

The Curvature of Indifference Curves: Substitutes and

Complements

Initially, for low levels of utility (UA),

bananas and strawberries might be
substitutes.

As utility increases (UB), the

Figure 4.11 The Same consumer might prefer a variety of
Consumer Can Have fruit in their diet more than initially.
Indifference Curves with
Different Shapes

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 The Consumer’s Income and the Budget Constraint

The Budget Constraint

The consumer’s budget constraint represents the combinations of
goods X and Y that the consumer can afford given their income and
the prices of goods.
PX X + PY Y = I
where PX and PY are the prices of goods X and Y , and I is the
consumer’s income.
To find the slope of the budget constraint,
I PX
Y = − X
PY PY
Slope of the budget line:
∂Y −PX
=
∂X PY
This represents the opportunity cost of consuming one more unit of X
in terms of Y .
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 The Consumer’s Income and the Budget Constraint

The Budget Constraint

Why does the budget constraint

slope downward?

Slope is negative because purchasing

more lattes means less income for
burritos.
Figure 4.14 The Budget
Constraint

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 The Consumer’s Income and the Budget Constraint

Factors that Affect the Budget Constraints Position

The slope and position of the budget constraint are a function of two
factors: income and relative prices.
1 Change in income shifts the budget constraint by changing the
intercepts.
2 Change in the price of one good pivots the budget constraint by
changing the slope.
Consider, again, the budget constraint for burritos and lattes. The graphs
on the next slide represent the following changes:
A Doubling of the price of lattes
B Doubling of the price of burritos
C Reduction in income by 1/2

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 The Consumer’s Income and the Budget Constraint

Factors that Affect the Budget Constraints Position

Figure 4.15 The Effects of Price or Income Changes on the Budget

Constraint

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 The Consumer’s Income and the Budget Constraint

Shifts in the Budget Line

An increase in income shifts the budget line outward (parallel shift).

A change in the price of one good causes the budget line to pivot.
If PX increases, the line becomes steeper (rotates inward).
If PX decreases, the line becomes flatter (rotates outward).
The budget line represents the trade-offs a consumer faces given their
income and market prices.

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 The Consumer’s Income and the Budget Constraint

Nonstandard Budget Constraints

Quantity Discounts
Sometimes, consumers may secure a discounted price if a minimum
quantity of a good is purchased (e.g., buy two, get one free).
This results in a kink in the budget constraint.
Ex: Income = $100; Ppizza = $10 and Pminute = $0.10
Initially, the consumer could consume 10 pizzas or 1,000 phone
minutes if they spent all of their income on either product; result is
normal linear budget constraint.
- Introduce a quantity discount of $.05 per minute for every minute
used over 600.
- Result is a kink at 600 minute (and 4 pizzas) because every minute
over 600 now only costs $0.05 compared to $0.10 originally

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 The Consumer’s Income and the Budget Constraint

Nonstandard Budget Constraints

Figure 4.16 Quantity Discounts and the Budget Constraint

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 The Consumer’s Income and the Budget Constraint

Nonstandard Budget Constraints

Quantity Limits
Alternatively, there may be limits on how much of a good can be
purchased (e.g., gasoline in the 1970s).
Ex: Income = $100; Ppizza = $10 and Pminute = $0.10
Now, instead of a discount after 600 minutes, the phone company
puts a cap at 600 minutes so his phone will not work after the 600th
minute.
- Result is a kink in the opposite direction as before at 600 minutes

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 The Consumer’s Income and the Budget Constraint

Nonstandard Budget Constraints

Figure 4.17 Quantity Limits and the Budget Constraint

When there is a limit on how much of a good a person can consume, a

budget constraint will be kinked.
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 Combining Utility, Income, and Prices

Combining Utility, Income, and Prices

Consumers face a constrained optimization problem. Maximize utility,
subject to income and market prices.

Figure 4.18 The Consumers Optimal Choice

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 Combining Utility, Income, and Prices

Combining Utility, Income, and Prices

At the optimal consumption bundle, the slope of the indifference

curve (MRS) equals the slope of the budget constraint.

MUX PX
MRSXY = − =−
MUY PY
This condition means that the marginal utility per dollar spent is the
same for both goods.
MUX MUY
=
PX PY
MUX MUY
What does it imply if PX > PY ?
Marginal Utility per dollar spent on good X is more than good Y.
Getting more utility per dollar from X so you should consume more of
good X until the MUX decreases until the ratio is equal.

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 Combining Utility, Income, and Prices

Implications of Utility Maximization

What if two consumers have different preferences?

Will they have the same MRS at their optimal bundles?

Yes! Because they face the same ratio of prices!

Although they have different optimal

consumption bundles, the MRS for
both are the same at points J and M
because they face the same prices.

Figure 4.19 Two Consumers

Optimal Choices
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 Combining Utility, Income, and Prices

Corner Solutions: A Special Case

So far, we have considered situations in which the consumer optimally

consumes some of both goods – called interior solutions.

Interior solution: a utility-maximizing bundle that contains positive

quantities of both goods

Depending on consumers preferences and relative prices, in some cases a

consumer will not want to spend any of their money on a good.

Corner solution: a utility-maximizing bundle located at the “corner” of

the budget constraint where the consumer purchases only one of two
goods.

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 Combining Utility, Income, and Prices

Corner Solutions: A Special Case

Given the consumers income and

relative prices of mystery novels and
Bluetooth speakers, the optimal
consumption bundle is A.

All other feasible bundles (such as B)

correspond to lower levels of utility
than point A.

The consumer cannot afford

Figure 4.20 A Corner Solution consumption bundles at higher utility
levels such as U3.

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 Combining Utility, Income, and Prices

Utility Maximization Example

Utility function: U(X , Y ) = X α Y β

Budget constraint: PX X + PY Y = I
Optimal consumption:
αY PX
=
βX PY
Solve for X and Y using the budget constraint and this condition to
find the optimal bundle.

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 Solving Problems

Question 1: Maggie’s Utility Function

Maggie cares only about chai (C ) and bagels (B). Her utility function is
given by:
U =C ·B
The prices are:
PC = 3, PB = 1.5
Maggie has $6 to spend.
(a) What is Maggie’s objective function?
(b) What is Maggie’s constraint?
(c) Write a statement of Maggie’s constrained optimization problem.
(d) Solve Maggie’s constrained optimization problem using a Lagrangian.

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 Solving Problems

Solution to Question 1

(a) Objective function:

max U = CB
C ,B

(b) Budget constraint:

6 = PC C + PB B ⇒ 6 = 3C + 1.5B ⇒ 6 − 3C − 1.5B = 0

(c) Constrained optimization problem:

max CB s.t. 6 − 3C − 1.5B = 0

C ,B

(d) Write out the Lagrangian:

L(C , B, λ) = CB + λ(6 − 3C − 1.5B)

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 Solving Problems

Solution (d): Lagrangian FOCs

First-order conditions (FOCs):
∂L
= B − 3λ = 0
∂C
∂L
= C − 1.5λ = 0
∂B
∂L
= 6 − 3C − 1.5B = 0
∂λ
From the first two conditions:
B C
λ= = ⇒ B = 2C ⇒ B ∗ = 2 ∗ 1 = 2
3 1.5
Substituting into the third FOC:
6 − 3C − 1.5(2C ) = 0
6 − 3C − 3C = 0 ⇒ 6 − 6C = 0 ⇒ C∗ = 1
So Maggie buys 1 cup of chai and 2 bagels per day.
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 Solving Problems

Question 2: Utility Maximization for Two Consumers

Suppose that there are two goods (X and Y ). The prices are:
PX = 2, PY = 1
The utility functions for the consumers are:
UA (X , Y ) = X 0.5 Y 0.5
UB (X , Y ) = X 0.8 Y 0.2
Consumer A has an income of $100, and Consumer B has an income of
$300.
(a) Use Lagrangians to solve the constrained utility-maximization
problems for Consumer A and Consumer B.
(b) Calculate the marginal rate of substitution for each consumer at their
optimal consumption bundles.
(c) What can we say about Consumer C’s MRS at her optimal
consumption bundle?
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 Solving Problems

Solution (a): Consumer A’s Optimization Problem

For Consumer A:

max X 0.5 Y 0.5 s.t. 100 = 2X + Y

X ,Y

The Lagrangian is:

L(X , Y , λ) = X 0.5 Y 0.5 + λ(100 − 2X − Y )

First-order conditions (FOCs):

∂L
= 0.5X −0.5 Y 0.5 − 2λ = 0
∂X
∂L
= 0.5X 0.5 Y −0.5 − λ = 0
∂Y
∂L
= 100 − 2X − Y = 0
∂λ
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 Solving Problems

Solution (a): Consumer A’s FOCs and Solving

From the first two FOCs:

λ = 0.25X −0.5 Y 0.5 = 0.5X 0.5 Y −0.5

Setting these equal:

0.25Y = 2X ⇒ Y = 2X

Substituting into the budget constraint:

100 − 2X − 2X = 0 ⇒ 100 − 4X = 0 ⇒ XA = 25

Then substituting XA back to find YA :

YA = 2(25) = 50

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 Solving Problems

Solution (a): Consumer B’s Optimization Problem

For Consumer B:

max X 0.8 Y 0.2 s.t. 300 = 2X + Y

X ,Y

The Lagrangian is:

L(X , Y , λ) = X 0.8 Y 0.2 + λ(300 − 2X − Y )

First-order conditions (FOCs):

∂L
= 0.8X −0.2 Y 0.2 − 2λ = 0
∂X
∂L
= 0.2X 0.8 Y −0.8 − λ = 0
∂Y
∂L
= 300 − 2X − Y = 0
∂λ
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 Solving Problems

Solution (a): Consumer B’s FOCs and Solving

From the first two FOCs:

λ = 0.4X −0.2 Y 0.2 = 0.2X 0.8 Y −0.8

Setting these equal:

0.4Y = 0.2X ⇒ Y = 0.5X

Substituting into the budget constraint:

300 − 2X − 0.5X = 0 ⇒ 300 − 2.5X = 0 ⇒ XB = 120

Then substituting XB back to find YB :

YB = 0.5(120) = 60

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 Solving Problems

Solution (b): Marginal Rate of Substitution

The first terms in the FOCs represent the marginal utilities:

MUX 0.5X −0.5 Y 0.5 YA 50

MRSA (X , Y ) = = = = =2
MUY 0.5X 0.5 Y −0.5 XA 25
For Consumer B:
MUX 0.8X −0.2 Y 0.2 4YB 4(60)
MRSB (X , Y ) = = 0.8 −0.8
= = =2
MUY 0.2X Y XB 120

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 Solving Problems

Solution (c): Consumer C’s Marginal Rate of Substitution

Both Consumers A and B have the same price ratio:

PX 2
= =2
PY 1
Since A and B both have an MRS equal to 2, we can infer that Consumer
C’s MRS will also be equal to 2, provided she consumes both goods. This
is due to the principle of utility maximization, where MRS equals the price
ratio under optimal consumption.
Thus:
MRSC = 2

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 Solving Problems

Question 3: Katie’s Utility Maximization Problem

Katie likes to paint and sit in the sun. Her utility function is given by:

U(P, S) = 3PS + 6P
Where:
P is the number of paint brushes.
S is the number of straw hats.
The prices are:
PP = 1, PS = 5
Katie has $50 to spend on paint brushes and straw hats.
(a) Solve Katie’s utility-maximization problem using a Lagrangian.
(b) How much does Katie’s utility increase if she receives an extra dollar
to spend?

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 Solving Problems

Solution (a): Lagrangian Setup

We want to maximize Katie’s utility subject to her budget constraint.

Objective function:
max 3PS + 6P
P,S

Subject to the constraint:

50 = P + 5S

Lagrangian:

L(P, S, λ) = 3PS + 6P + λ(50 − P − 5S)

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 Solving Problems

Solution (a): First-Order Conditions (FOCs)

The first-order conditions (FOCs) are derived by taking partial derivatives

of the Lagrangian:

∂L
= 3S + 6 − λ = 0
∂P
∂L
= 3P − 5λ = 0
∂S
∂L
= 50 − P − 5S = 0
∂λ

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 Solving Problems

Solution (a): Solving the System

From the first two FOCs, solve for λ:

λ = 3S + 6 and λ = 0.6P
Equating the two expressions:

3S + 6 = 0.6P

Solve for S in terms of P:

S = 0.2P − 2

Substitute this into the budget constraint:

50 − P − 5(0.2P − 2) = 0

50 − P − (P − 10) = 0
60 − 2P = 0 ⇒ P = 30
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 Solving Problems

Solution (a): Finding S

Now that we have P = 30, substitute into the equation for S:

S = 0.2(30) − 2 = 6 − 2 = 4

Thus, the optimal bundle is:

P = 30, S =4

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 Solving Problems

Solution (b): How Much Does Utility Increase?

To find how much Katie’s utility increases if she receives an extra dollar,
we need to solve for the Lagrange multiplier λ.
From the first two FOCs:

λ = 3S + 6 = 0.6P

Substituting the optimal values of S or P gives:

λ = 3(4) + 6 = 18

Therefore, Katie’s level of utility would increase by 18 units if she receives

an extra dollar to spend.

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 Solving Problems

Question 4: Utility Function and Expenditure Minimization

Suppose that a consumer’s utility function for two goods (X and Y ) is

given by:

U(X , Y ) = 10X 0.5 + 2Y

The prices are:
PX = 5, PY = 10
The consumer wants to achieve a utility level of 80 units while minimizing
expenditure.
(a) Write the statement of the constrained optimization problem.
(b) Use a Lagrangian to solve the expenditure-minimization problem.

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 Solving Problems

Solution (a): Constrained Optimization Problem

The consumer seeks to minimize the expenditure on goods X and Y while

ensuring they achieve the target utility level.
Objective function (expenditure to minimize):

min 5X + 10Y
X ,Y

Subject to the constraint (utility requirement):

80 − 10X 0.5 − 2Y = 0

This forms the constrained optimization problem, where the goal is to

minimize expenditure while satisfying the utility constraint.

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 Solving Problems

Solution (b): Lagrangian Setup

To solve the expenditure-minimization problem, we use the Lagrangian

method:

L(X , Y , λ) = 5X + 10Y + λ 80 − 10X 0.5 − 2Y

The first-order conditions (FOCs) are derived by taking partial derivatives

of the Lagrangian with respect to X , Y , and λ:

∂L
= 5 − 5λX −0.5 = 0
∂X
∂L
= 10 − 2λ = 0
∂Y
∂L
= 80 − 10X 0.5 − 2Y = 0
∂λ

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 Solving Problems

Solution (b): Solving the First-Order Conditions

Solve for λ from the first two FOCs:

λ = X 0.5 , λ=5

Set these two expressions equal:

X 0.5 = 5

X = 25
Substitute X = 25 into the third constraint to solve for Y :

80 − 10(25)0.5 − 2Y = 0

80 − 10(5) − 2Y = 0 ⇒ 80 − 50 = 2Y ⇒ 2Y = 30 ⇒ Y = 15

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 Solving Problems

Solution (b): Minimum Expenditure Calculation

Now that we have the optimal values for X and Y :

X = 25, Y = 15

We can calculate the minimum expenditure:

Expenditure = 5(25) + 10(15) = 125 + 150 = 275

Thus, the minimum expenditure required to achieve 80 units of utility is

$275.

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 Conclusion

Conclusion

Consumer behavior is driven by the goal of utility maximization, given

preferences and budget constraints.
The optimal consumption bundle occurs where the marginal utility
per dollar spent is equal for all goods.
Changes in income and prices lead to changes in the budget
constraint, which in turn affects the consumer’s choices.

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 Conclusion

Questions ???
Comments !!!
Suggestions ...

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