Consumer Behavior
Preferences
McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
The Consumer’s Problem
A consumer’s economic problem is to allocate
limited funds to competing needs and desires
over some time period
Chooses a consumption bundle
4-2
CONSUMER PREFERENCES
Market Baskets
● market basket (or bundle) List with specific quantities
of one or more goods.
Market Baskets
Market Basket Units of Food Units of Clothing
A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
To explain the theory of consumer behavior, we will ask
whether consumers prefer one market basket to another.
Preferences
A consumer’s choices should reflect
preferences over various bundles, not
just feelings about any one good in
isolation
Preferences tell us about a consumer’s
likes and dislikes
Preferences are captured as rankings
over bundles.
Principles of Consumer Decision-
Making
The Ranking Principle: A consumer can
rank, in order of preference, all potentially
available alternatives
The consumer is never uncertain or
befuddled in making comparisons
But the Ranking Principle allows for ties.
A consumer is indifferent between two
alternatives if she likes (or dislikes) them
equally
4-5
The Ranking Principle
The Ranking Principle has two important
implications:
- Preferences are complete: between any
pairs of alternatives, the consumer either
prefers one to the other or is indifferent
between them
- Preferences are transitive
More is better
The More-is-better Principle: Consumers
always prefer more of any good to less
Consumers are never satisfied or
satiated: more is always better, even if
just a little better
For the time being we ignore “bads” like
pollution for which less is better
Principles of Consumer Decision-
Making
The Choice Principle: Among available
alternatives, the consumer chooses the
one that she ranks the highest
Consumers always try to achieve the
highest possible level of well-being
Indifference Curves
Starting with any alternative, an
indifference curve shows all the other
alternatives a consumer likes equally well
Can be used when goods are (or
assumed to be) available in any fraction
of a unit
4-9
CONSUMER PREFERENCES
Indifference Curves
Describing Individual Preferences
Because more of each
good is preferred to less,
we can compare market
baskets in the shaded
areas. Basket A is clearly
preferred to basket G,
while E is clearly
preferred to A.
However, A cannot be
compared with B, D, or H
without additional
information.
CONSUMER PREFERENCES
● indifference curve Curve representing all combinations
of market baskets that provide a consumer with the same
level of satisfaction.
An Indifference Curve
The indifference curve U1 that
passes through market basket
A shows all baskets that give
the consumer the same level of
satisfaction as does market
basket A; these include
baskets B and D.
Our consumer prefers basket
E, which lies above U1, to A,
but prefers A to H or G, which
lie below U1.
Properties of Indifference Curves
Thin
Do not slope upward
Separates bundles that are better from
bundles that are worse than those that
are on the indifference curve
4-12
Thick Indifference Curves and Upward sloping
Indifference Curves Ruled Out by the More-is-better
Principle
4-13
Maps of Indifference Curves
Collection of indifference curves that
represent the preferences of an
individual
Comparing two bundles, the consumer
prefers the one on the indifference
curve further from the origin
Do not cross
4-14
A Map of Indifference Curves
4-15
Indifference Curves Do Not Cross
4-16
Formulas for Indifference Curves
More complete and precise to describe
preferences mathematically
For example, can write a formula for a
consumer’s indifference curves
Formula describes an entire family of
indifference curves
Each indifference curve represents a particular
level of well-being
Higher levels of well-being are on indifference
curves further from the origin
4-17
Plotting Indifference Curves
Formula for
indifference curves is
B = U/S
U is well-being, or
“utility”
To find a particular
curve, plug in a value
for U, then plot the
relationship between
B and S
4-18
Substitution Between Goods
Economic decisions involve trade-offs
To determine whether a consumer has
made the best choice, we need to know
the rate at which she is willing to make
trade-offs between different goods
Indifference curves provide that
information
4-19
Rates of Substitution
Consider moving along an indifference
curve, from one bundle to another
This is the same as subtracting units of one
good and compensating the consumer for
the loss by adding units of another good
Slope of the indifference curve shows how
much of the second good is needed to
make up for the decrease in the first good
4-20
Rates of Substitution
Look at move from
bundle A to C
Consumer loses 1
soup; gains 2 bread
Willing to substitute
for soup with bread
at 2 ounces per pint
4-21
Marginal Rate of Substitution
The marginal rate of substitution for X with Y,
MRSXY, is the rate at which a consumer must
adjust Y to maintain the same level of well-being
when X changes by a tiny amount, from a given
starting point
MRS XY = − ∆Y ∆X
Tells us how much Y a consumer needs to
compensate for losing a little bit of X
Tells us how much Y to take away to compensate
for gaining a little bit of X
4-22
What Determines Rates of
Substitution?
Differences in tastes
Preferences for one good over another
affect the slope of an indifference
curve
Implications for MRS
4-23
Indifference Curves and
Consumer Tastes
4-24
Diminishing MRS
People like variety so most
indifference curves get flatter as we
move from top left to bottom right
Link between slope and MRS implies
that MRS declines; the amount of Y
required to compensate for a given
change in X decreases
CONSUMER PREFERENCES
Convexity of the indifference curves
● marginal rate of substitution (MRS) Maximum amount of a good
that a consumer is willing to give up in order to obtain one additional
unit of another good.
The Marginal Rate of Substitution
The magnitude of the slope of an
indifference curve measures the
consumer’s marginal rate of
substitution (MRS) between two goods.
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).
Convexity The decline in the MRS
reflects a diminishing marginal rate of
substitution. When the MRS
diminishes along an indifference curve,
the curve is convex.
Formulas for MRS
Every indifference curve formula has an
MRS formula that describes the same
preferences
Indifference curves: B=U/S; MRSSB=B/S
4-27
Perfect Substitutes and
Complements
Some special cases of preferences represent
opposite ends of the substitutability spectrum
Two products are perfect substitutes if their
functions are identical; a consumer is willing to
swap one for the other at a fixed rate
Two products are perfect complements if
they are valuable only when used together in
fixed proportions
Note that the goods do not have to be
exchanged one-for-one!
4-28
Perfect Substitutes
4-29
Perfect Complements
4-30
Utility
Summarizes everything that is known about a
consumer’s preferences
Utility is a numeric value indicating the
consumer’s relative well-being
Each such value indicates a ranking
We can describe the value a consumer gets
from consumption bundles mathematically
through a utility function
U (S , B ) = 2 S + 5(S × B )
4-31
Utility Functions and Indifference
Curves
Utility functions must assign the same value
to all bundles on the same indifference
curve
Must also give higher utility values to
indifference curves further from the origin
Can start with information about
preferences and derive a utility function
Or can begin with a utility function and
construct indifference curves
Can also think of indifference curves as
“contour lines” for different levels of utility
4-32
Deriving Indifference Curves from
a Utility Function
For each bundle, the
utility corresponds to
the height of the
utility “hill”
The indifference
curve through A
consists of all
bundles for which the
height of the curve is
the same
4-33
Ordinal vs. Cardinal Utility
Information about preferences can be ordinal or
cardinal
Ordinal information allows us to determine only
whether one alternative is better than another
Cardinal information reveals the intensity of
preferences, “How much worse or better?”
Utility functions are intended to summarize
ordinal information
Scale of utility functions is arbitrary; changing
scale does not change the underlying
preferences
4-34
Marginal Utility
To make a link between MRS and utility,
need a new concept
Marginal utility is the change in a
consumer’s utility resulting from the addition
of a very small amount of some good, divided
by the amount added
MU X = ∆U ∆X
4-35
Utility Functions and MRS
MU X
MRS XY =
MU Y
Small change in X, ∆X, causes utility to
change by MUX∆X
Small change in Y, ∆Y, causes utility to
change by MUY∆Y
If we stay on same indifference curve,
then –∆Y/∆X =MUX/MUY
4-36
Diminishing marginal utility
It used to be assumed that marginal utility
from an object diminishes as more of it is
consumed
Isaac Newton went to the opera only once.
'There was too much of a good thing. 'Twas
like a surfeit of dinner. The first act I
enjoyed, the second stretched my patience,
at the third I ran away.'
Note that diminishing marginal rate of
substitution does not need diminishing
marginal utility
