4

Consumer Behavior
The Consumer’s Preferences and
the Concept of Utility 4.1
Economists assume consumers are rational and able to “optimize”
consumption decisions given scarce resources

Four assumptions about consumer preferences

1. Completeness and rankability
• Consumers can compare bundles of goods and rank them
2. For most goods, more is better than less
• Non-satiation and “free disposal”
3. Transitivity
• Imposes consistency on rankings
4. 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
• Referred to as “diminishing marginal utility”
The Consumer’s Preferences and
the Concept of Utility 4.1
The Concept of Utility
Utility is a measure of how “satisfied” consumers are
• A measure of happiness or satisfaction
• Provides a theoretical basis for decision theory

A utility function describes the relationship between what

consumers actually consume and their level of well-being
• Can take a variety of mathematical forms
• Common assumptions: continuous, differentiable, concave
The Consumer’s Preferences and
the Concept of Utility 4.1
The Concept of Utility
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 D0.2

In general, movies consumed in the theater add more utility than those
consumed at home
* this particular functional form is referred to as “Cobb–Douglas”
The Consumer’s Preferences and
the Concept of Utility 4.1
The Concept of Utility
Marginal utility is the additional utility a consumer receives from
an additional unit of a good or service.
The Consumer’s Preferences and
the Concept of Utility 4.1
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
• Consumers differ in preferences
‒ Ex: Both between consumers and over time
Indifference Curves 4.2
Ordinal rankings mean we care about relative outcomes
• Some bundles are better than others, some are worse
• Start by considering bundles that are relatively equal

A consumer is indifferent between bundles when he or she

derives the same utility level from two or more bundles.

An indifference curve plots out all of the consumption

bundles that provide a consumer with the same level of
utility or satisfaction.
Indifference Curves 4.2
Figure 4.1 Building an Indifference Curve

Number
of friends
living in
building
A
10

B
5
C
3
Indifference
curve (U)

0 500 750 1,000 Apartment size (square feet)

Indifference Curves 4.2
Characteristics of Indifference Curves
1. They can be drawn
• Completeness and rankability
2. Curves farther from the origin represent higher utility
• More is better
3. Curves never cross
• Transitivity
4. Convex to the origin
• Diminishing marginal utility
Indifference Curves 4.2
Figure 4.2 A Consumer’s Indifference Curves

Number
of friends U2 has a
living in greater utility
building

than U1
5

U2

U1

0 500 1,000
Apartment size (square feet)
 Indifference Curves 4.2
Indifference curves can never cross
Call our movie watcher, Joe
Movies at the
Theater 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
F
E
Now, draw another indifference curve through
bundle F that intersects the original curve
D • Implies Joe is also indifferent between points E
and F as well as between points E and D

 Why must Joe prefer bundle E to bundle D?

DVDs ‒ If more is better, at E he has more of
both
Indifference Curves 4.2
Figure 4.4 Tradeoffs Along an Indifference Curve

As apartment size gets larger, Michaela

is less willing to trade off the number
Number of friends for additional apartment size.
of friends
living in A
building

B
U1

0 500 1,000
Apartment size (square feet)
Indifference Curves 4.2
The Marginal Rate of Substitution
Indifference curves describe tradeoffs
• How much of one good you are willing to give up for one more unit of
another good
• The slope of the indifference curve captures this tradeoff
We call this slope the marginal rate of substitution
Y
MRS XY  
X

Describes the rate at which one is willing to trade off or substitute

exactly 1 unit of good X for more of good Y, and be equally well
off.
Indifference Curves 4.2
Figure 4.5 The Slope of an Indifference Curve is the
Marginal Rate of Substitution
Burritos
As you move down an indifference
curve, you experience a diminishing
marginal rate of substitution
A

Slope = –2

B
Slope = –0.5 U
Lattes
Indifference Curves 4.2
The Marginal Rate of Substitution and Marginal Utility
The MRS between two goods is equal to the inverse of the goods’
marginal utilities:
Qburritos MU lattes QY MU X
MRSlb    or MRS XY   
Qlattes MU burritos QX MU Y
Observing the tradeoffs that consumers make provides insight as to the
relative marginal utilities of goods!
What does it mean if the slope of an indifference curve is steeper?
Flatter?
• Steeper curves imply the consumer is willing to give up a lot of Y to get one
unit of X, or could trade 1 unit of X for a lot of good Y
• Flatter curves imply the consumer would require a large increase in good X
to give up one unit of the good Y, or could trade 1 unit of Y for a lot of good X
 In-text
figure it out

Assume Ming’s utility function for music downloads (M ) and

concert tickets (C) is given by

U  0.5M 2  2C 2  MU M  M ; MU C  4C 

Answer the following questions:

a. Write an equation for MRSMC
b. Would bundles of (M = 4 and C = 1) and (M = 2 and C = 2)
be on the same indifference curves?
c. Calculate the MRSMC when (M = 4 and C = 1) and when
(M = 2 and C = 2)
d. Are Ming’s indifference curves convex?
‒ i.e., Does MRSMC fall as M rises?
Indifference Curves 4.2
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

i. Perfect substitutes are goods that the consumer will trade at a fixed rate and
receive the same level of utility (MRS is constant)
ii. Perfect complements are goods that the consumer must consume in a fixed
proportion
Indifference Curves 4.2
Perfect substitutes
2-liter bottles of
root beer

4
Consider a typical consumer’s
preferences for 1- and 2-liter soda bottles
3 This consumer should be willing to trade
one 2-liter bottle for two 1-liter bottles no
2 matter how much of each he or she has

1
MRS is constant in this case

U1 U2 U3 U4
0 2 4 6 8 1-liter bottles of
root beer
Indifference Curves 4.2
Perfect complements

Alternatively, consider preferences for

Hotdogs hotdogs and hotdog buns
Most consumers will prefer to consume
C these goods in constant proportion
3 U3
Consider point A ; this consumer has two
A B
2 U2 hotdogs and two buns
Adding another hotdog bun (bundle B )
1 U1 will not increase utility
The consumer needs another hotdog as
0 1 2 3 Hotdog buns well (bundle C ) if utility is to increase
Indifference Curves 4.2
Figure 4.8 The Curvature of Indifference Curves
Indifference Curves 4.2
Figure 4.11 The Same Consumer Can Have Indifference
Curves with Different Shapes

Initially, for low levels of utility

(UA), bananas and strawberries
might be substitutes.

As utility increases (UB), the

consumer might prefer a variety
of fruit in their diet more than
initially.
 In-text
figure it out

Jasmine can watch Baseball (B, in hours) or reality shows (R,

in hours). Watching more baseball makes Jasmine happier,
but she really does not care about reality shows—good or
bad.

Answer the following:

a. Draw a diagram showing a set of Jasmine’s indifference
curves for Baseball and Reality Shows (put R on the
horizontal axis).
b. What is Jasmine’s MRSRB when she is consuming one
hour of each show?
The Consumer’s Income and the
Budget Constraint 4.3
The budget constraint is a curve that describes the entire set of
consumption bundles a consumer can purchase when spending all of
their income. It is generally plotted alongside indifference curves.
• For two goods (X and Y), mathematically:

Income = PX Q X + PY QY
To find the slope of the budget constraint, solve for QY
Income P
QY =  X Qx
PY PY
Returning to the burrito/latte example, and setting income to $50, the
price of lattes to $5, and the price of burritos to $10 yields
1
Or, graphically, QY = 5  Q X
2
The Consumer’s Income and the
Budget Constraint 4.3
Figure 4.14 The Budget Constraint

Burritos
I B
Py = 5 Slope is negative because
purchasing more lattes means
less income for Burritos.
4 Infeasible

C
3

2 Px Why does the

Slope = - = −5/10= − 1/2
Feasible
Py budget constraint
1 slope downward?
A
0 I
2 4 6 8 = 10 Lattes
Px
The Consumer’s Income and the
Budget Constraint 4.3
Factors that Affect the Budget Constraint’s Position
The slope and position of the budget constraint are a function of two
factors: income and relative prices
1. Changes in income shifts the budget constraint by changing the intercepts
2. Changes 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
The Consumer’s Income and the
Budget Constraint 4.3
Figure 4.15 The Effects of Price or Income Changes on the
Budget Constraint
(a) (b) (c)

Burritos Burritos Burritos

B Old budget B Old budget B Old budget
5 constraint 5 constraint 5 constraint
New budget New budget
constraint with higher constraint with higher 4 New budget
4 4
price for lattes price for burritos constraint with
lower income
3 3 3
Loss of feasible B' Loss of feasible B' Loss of feasible
bundles bundles bundles
2 2 2

1 1 1
Feasible Feasible Feasible
bundles bundles bundles
A' A A A' A
0 0 0
2 4 6 8 10 2 4 6 8 10 2 4 6 8 10
Lattes Lattes Lattes
 In-text
figure it out

Braden has $20 per week he can spend on video game

rentals (R) at $5 dollars each, or candy bars (C) at $ 1each.

Answer the following:

a. Write an equation for Braden’s budget constraint and draw
it on a graph that has video game rentals on the horizontal
axis
b. Assuming he spends the entire $20, how many candy
bars can he purchase if he chooses to rent 3 video
games?
c. Suppose the price of video game rentals falls from $5 to
$4. Draw Braden’s new budget constraint
Combining Utility, Income, and Prices:
What Will the Consumer Consume? 4.4
The concepts of utility and indifference curves describe consumer
preferences; the budget constraint describes which bundles are feasible
Combining these concepts, we can begin to understand consumer
choices

Solving the Consumer’s Optimization Problem

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

The optimal choice can be interpreted most easily using a graph

Combining Utility, Income, and Prices:
What Will the Consumer Consume? 4.4
Utility Maximization

Good Y
With one budget constraint,
search for indifference curve
that maximizes utility

A
U2

U*

U1
BC*
Good X
Combining Utility, Income, and Prices:
What Will the Consumer Consume? 4.4
Tangency is the key to finding the optimal bundle, and occurs
• where the slope of the indifference curve is equal to the slope of the budget
constraint
‒ i.e. when the marginal rate of substitution is equal to the price ratio

Mathematically,
Slope of indifferen ce curve  Slope of budget constraint

MU X P
 MRS XY    X
MU Y PY
MU X PX

MU Y PY
Combining Utility, Income, and Prices:
What Will the Consumer Consume? 4.4
What does this imply? Rewriting the tangency condition yields

MU X PX MU X MU Y
  
MU Y PY PX PY
The consumer finds the consumption bundle that provides the most
benefit on a cost-adjusted basis
• Occurs when marginal utility per dollar spent is equalized across all products

 What does it imply if MU X MUY ?


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
 In-text
figure it out

Antonio gets utility from burgers (B ) and fries (F ); his utility

function is given by


U  B 0.5 F 0.5 MU B  0.5B 0.5 F 0.5 ; MU F  0.5B 0.5 F 0.5 
Antonio’s income is $20, and the prices of burgers and fries
are $5 and $2, respectively

Answer the following:

What is Antonio’s utility-maximizing bundle of burgers and
fries?