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Chapter 7

Consumer Behavior

7-2

What will you learn in this chapter?

• How revealed preferences relate to utility.

• How budget constraints affect utility maximization.

• How income affects consumption choices.

• How prices affect consumption choices and how to distinguish between income and substitution effects.

• How utility is influenced by outside perceptions, and how people get utility from altruism and reciprocity.

7-3

• Utility is a measure of the amount of satisfaction a person derives from something.

– Incorporates emotions and sensations.

– Universal measure (or yardstick) that allows individuals to compare choices.

– Not typically comparable across individuals.

• Rational individuals maximize utility when making choices.

– For example, if playing soccer for the next hour yields more utility than playing baseball, rational individuals will play soccer.

Utility basics

7-4

• Utility is hard to measure.

• How can anything meaningful be said about the utility people experience?

– Observe what people actually do.

• The principle of revealed preference is that people’s preferences can be determined by observing their choices and behavior.

• Unique to a specific choice of a particular person at one date.

Revealed preferences

7-5

• The principle of revealed preferences isn’t feasible for analyzing how people make choices.

• Instead, a more formal method is required.• Utility functions aid in systematically analyzing

choices.– A utility function is a formula for calculating the total

utility that a particular person derives from consuming a combination of goods and services.

• A bundle is a unique combination of goods and services that a person could choose to consume.

Utility functions

7-6

• Utility functions quantify preferences.

• Utility measurements are relative, not absolute.

• For example, suppose Sarah receives a utility of 3 for each serving of mac-n-cheese she eats, 2 for broccoli, and 8 for ice cream.

• If she eats 1 serving of mac-n-cheese, 2 servings of broccoli, and 2 of ice cream, then:

total utility = (3 x 1) + (2 x 2) + (8 x 2) = 23

Utility functions

7-7

• When individuals continue to engage in an activity or consume more of one good or service, the utility from the next unit is not as great as the last unit.– Marginal utility is the change in total utility from

consuming an additional unit of a good or service.– The principle of diminishing marginal utility is that the

additional utility gained from consuming successive units of a good or service tends to be smaller than the utility gained from the previous unit or service.

• Sometimes, marginal utility becomes negative.

Marginal utility

7-8

Diminishing marginal utility

Scoops of ice cream-1

0

1

2

3

4

5

6

7

1 2 3 4 5 6 7 8

Marginal utility per scoop

A

Scoops of ice cream

80

5

10

15

20

25

1 2 3 4 5 6 7

Total utility

A

The utility function and the marginal utility can be plotted. An individual maximizes utility when total utility is greatest or marginal utility is zero.

Marginal utility measures the per unit utility from each scoop of ice

cream.

Total utility increases with each scoop of ice cream until point A, the seventh

scoop, at which total utility is maximized.

7-9

• People have many wants and are constrained by the time and money available to them.

• Rational individuals maximize utility within those constraints by spending their resources on the bundle that yields the highest possible total utility.

• A budget constraint provides all possible combinations of goods and services a consumer can buy for a given income.

Maximizing utility with constraints

7-10

The budget constraint

1

2

3

4

5

6

7

8

9

0 1 2 3 4 5

Movie tickets

Concert tickets

A

C

B

Cody can buy 8 movie

tickets for $120 …

…or 4 movie tickets and

2 concert tickets …

…or 4 concert

tickets.

The budget constraint for two goods is displayed using a movie ticket price of $15, a concert ticket price of $30, and an income of $120.

• Point A: All income spent on movies (8 movie tickets).

• Point B: Income spent on both goods (4 movie and 2 concert tickets).

• Point C: All income spent on concerts (4 concert tickets).

• Represents all feasible bundles.

7-11

Active Learning: The budget constraint

1

2

3

4

5

6

7

8

9

0 1 2 3 4 5

Movie tickets

Concert tickets

A

C

B

H

I

F

G

D

J

E

K

Which bundle(s) are not within the following budget constraint?

7-12

Active Learning: The budget constraint

1

2

3

4

5

6

7

8

9

0 1 2 3 4 5

Movie tickets

Concert tickets

A

C

B

H

I

F

G

D

J

E

K

Which bundle(s) are not within the following budget constraint?

7-13

Active Learning: The budget constraint• Find all feasible bundles using a movie ticket price of $15, a

concert ticket price of $30, and an income of $120.

• Is the bundle of 4 concert tickets and 1 movie ticket feasible?

BundleConcerttickets

Movietickets

Total

cost

7-14

Active Learning: The budget constraint• Find all feasible bundles using a movie ticket price of $15, a

concert ticket price of $30, and an income of $120.

• Is the bundle of 4 concert tickets and 1 movie ticket feasible? No

BundleConcerttickets

Movietickets

A 0 8

B 1 6

C 2 4

D 3 2

E 4 0

F 4 1

Total

cost

120

120

120

120

120

135

7-15

Maximizing total utility

Utility from movie tickets

Number of tickets

Marginal utility Total utility

1 95

2 190

3 285

4 365

5 430

6 465

7 475

8 465

Utility from concert tickets

Number of tickets

Marginal utility Total utility

1 100

2 185

3 210

4 210

95

95

95

80

65

35

10

-10

110

85

25

0

Below are the associated utilities from consuming a specific number of concerts and movie tickets.

Utility increases with each concert ticket until 3 tickets, at which total utility is maximized.

Utility increases with each movie ticket until 7 tickets, at which total utility is maximized.

7-16

Maximizing total utility

BundleConcerttickets

Movietickets

Utility frommovie tickets

Total

utility

A 0 8

B 1 6

C 2 4

D 3 2

E 4

0

100

185

210

210 0

465

465

385

190

0

465

565

400

210

Utility fromconcert tickets

570

To maximize total utility, the total utility of each feasible bundle is identified and then compared to each other.

• Bundle C with 2 concert tickets and 4 movie tickets has the highest total utility and is the preferred bundle.

• Given this budget, a rational consumer spends all income on the combination of movie and concert tickets that maximizes utility.

7-17

Maximizing total utility

1

2

3

4

5

6

7

8

9

0 1 2 3 4 5

Concert tickets

A

Budget constraint

At point A, utility from

concert tickets is 0 and

utility from movie tickets is

465. Total utility is 465.

B

C

D

E

At point B, utility from

concert tickets is 100 and

utility from movie tickets is

465. Total utility is 565.

At point D, utility from

concert tickets is 210 and

utility from movie tickets is

190. Total utility is 400.

At point C, utility from

concert tickets is 185 and

utility from movie tickets is

385. Total utility is 570.

At point E, utility from

concert tickets is 210 and

utility from movie tickets is

0. Total utility is 210.

Movie tickets

Each bundle on the budget constraint has a corresponding utility.

• Utility falls as one moves away from the preferred bundle, C.

7-18

• When a person’s income increases, morebundles of goods and services become affordable.

• When income decreases, fewer bundles are affordable, and consumers will probably have to cut consumption of some things.

• A change in income is represented by shifting the entire budget line outward.

Responding to changes in income

7-19

The effect of an increase in income

• An increase in income allows individuals to afford more goods.

• The entire budget line shifts outward.

2

4

6

8

10

12

14

0 1 2 3 4 5 6

Movie tickets

Concert tickets

1. An increase inincome shifts thebudget curve out.

New budget constraint

2. Cody can now afford asmany as 12 movie tickets

or 6 concert tickets.

Suppose a person’s income increases from $120 to $180.

7-20

Active Learning: Effect of a decrease in income

Suppose a mother decides to reduce her child’s movie and concert allowance. Graphically demonstrate the effect.

2

4

6

8

10

12

14

0 1 2 3 4 5 6

Movie tickets

Concert tickets

7-21

Active Learning: Effect of a decrease in income

Suppose a mother decides to reduce her child’s movie and concert allowance. Graphically demonstrate the effect.

2

4

6

8

10

12

14

0 1 2 3 4 5 6

Movie tickets

Concert tickets

1. A decrease inincome shifts thebudget curve in.

New budget constraint

7-22

• When prices change, an individual’s budget constraint is affected in two ways: – An income effect occurs as consumption changes from

increased effective wealth due to a lower price.

– The substitution effect is the change in consumption that results from a change in the relative price of goods.• The opportunity cost of consuming a good changes as prices

change.

• A price change causes the budget line to rotate.

Responding to changes in prices

7-23

The effect of a price change

• When the price of one good changes, the budget constraint rotates outward.

• The new budget line demonstrates the new feasible bundles that are now available.

• The change in the slope of the budget line reflects the change in the relative prices of the two goods.

2

4

6

8

10

12

14

0 1 2 3 4 5 6

Movie tickets

Concert tickets

A change in the price

of one good rotates

the budget curve.

12 movie tickets

are now

affordable.

New budget constraint

Suppose the price of a movie ticket decreases from $15 to $10.

7-24

Active Learning: The effect of a price change

• Suppose that the price of a movie ticket increases from $15 to $30, while the price of a concert ticket and the consumer’s income stay the same at $30 and $120 respectively.

• Find all feasible bundles of movie tickets and concert tickets.

BundleConcerttickets

Movietickets

Total

cost

7-25

Active Learning: The effect of a price change

• Suppose that the price of a movie ticket increases from $15 to $30, while the price of a concert ticket and the consumer’s income stay the same at $30 and $120 respectively.

• Find all feasible bundles of movie tickets and concert tickets.

BundleConcerttickets

Movietickets

A 0 4

B 1 3

C 2 2

D 3 1

Total

cost

120

120

120

120

7-26

• People gain utility from a variety of sources.

– Outside perception:

• What others think of your purchases.

• How much others have.

– Inward preferences:

• How you prefer to spend your money.

• Both outside perception and inward preferences contribute to decision making.

Utility and society

7-27

• Utility maximization encompasses individuals giving to others.– Altruism is a motive for action in which a person’s

utility increases simply because someone else’s utility increases.

– Altruistic and selfish or image-conscious motivations can coexist perfectly well.

• Utility maximization suggests people gain utility by punishing bad behavior and rewarding good behavior.– Reciprocity is responding to another’s action with a

similar action.

Utility, altruism, and reciprocity

7-28

Summary• Economists assume that individuals seek to maximizes

their utility within the limits of their available resources.

• Individuals are constrained by their income and the prices of goods they desire to purchase.

• A budget constraint shows all possible feasible consumption bundles available to an individual given a fixed budget.– An increase in income shifts the budget constraint outward.

– An increase in price causes the budget constraint to rotate inward.

7-29

Summary• Economists generally assume that individuals’

preferences are demonstrated through the choices that they make, a concept known as revealed preference.

• Individuals gain utility from a variety of sources.– Outside perception.– Inward preferences.

• Utility maximization:– Individuals giving to others.– People gain utility by punishing bad behavior and

rewarding good behavior.