Consumer Behavior

How People Choose

Preferences: Origin Where they come from

“The economist is not concerned with ends as such. He is concerned with the way in which the attainment of ends is limited. The ends may be noble or they may be base. They may be “material” or” immaterial” –if ends can be so described. But if the attainment of one set of ends involves the sacrifice of others, then it has an economic aspect” (Robbins, 1932, p. 25).

Consumer is faced to choices: between one good or another how much of two goods

Decisions are made from an individual’s ordering observed as one structure of preferences

Preferences: Assumptions Baskets: A, B, C, …

Completeness A B B A A B

Reflexivity If A B then B A

More is better than less Example: B H

Transitivity If A B and B C then A C

Example: E A and A G then E G

Continuity If A B, Then there exists a C

such that A CFood

Clothing

10

10

20

20

30

30

40

40

50

A

B

H

DG

E

Structure of Preferences and Indifference Curves

Food

Clothing

10

10

20

20

30

30

40

40

50

A

B

H

DG

E

Indifference Curves: The same level of

satisfaction

Preferences:Indifference Curves and Indifference Maps

U1

U2

U3 >>

U1

U2

U3

Preferences: The Marginal Rate of Substitution

Food

Clothing

2

2

4

4

6

6

8

8

10U = U(C,F)

U’ C

UU F+

U(4,3)

The total variation of U at (4,3)

is

=

the variation with respect to C

of Uplus

the variation with respect to F

Preferences: The Marginal Rate of Substitution

Food

Clothing

2

2

4

4

6

6

8

8

10 U’ = 0

U(4,3)

The Marginal Rate of Substitution of C

U’ C

UU F+= = 0

is the quantity of clothes the actor is

willing to give up for oneone unit of food

MRSC

MRSC(4,3) = -2

MRSF(4,3) = -½

Preferences: The Marginal Rate of Substitution

Food

Clothing

2

2

4

4

6

6

8

8

10

U(4,3)

MRSC(4,3) = -2

MRSF(4,3) = -½

Preferences (Substitutes) Substitutes

X

Y

2

2

4

4

6

6

8

8

MRSY= -1

X

Y

2

2

4

4

6

6

8

8

MRSY= - ½

Preferences (Substitutes) Complements

X

Y

2

2

4

4

6

6

8

8 X

Y

2

2

4

4

6

6

8

8

Budget

Example:

The market price per unit of clothes is Pc = 2€ The market price per unit of food is Pf = 1€ How many units of clothes or food can be acquired with a Budget of 10€?

10 = Pc*XC = 2*XC

Food

Clothing

2

2

4

4

6

6

8

8

10

10

10 = 2*XC

2 2

XC = 5

10 = Pf*Xf = 1*Xf

10 = 1*Xf

Xf = 10

How can be used the budget to acquire goods?

Consider the extremes

Budget Line

Xf

Xc

2

2

4

4

6

6

8

8

10

10

B = pc Xc + pf Xf

10 = 2 * Xc + 1 * Xf

10 = 2Xc + Xf

Xc

: slope

y = ax + b

x

y

y=b 1

a

Slope:

= Bpc

-pf

pcXf

pf

pc

Cross with the vertical axis:

Bpc

Budget Line and Changes on Prices

Xf

Xc

2

2

4

4

6

6

8

8

10

10

10 = 2Xc + Xf

Let consider the price of clothes decreased to Pc = 1,25€

10 = Pc*XC = 1,25*XC

10 = 1,25*XC

XC = 8

1,25 1,25

Consumer Choice

10 = 2Xc + Xf

U = U(Xc,Xf)

Xf

Xc

2

2

4

4

6

6

8

8

10

10

How does she choose?

She spends all her budget (No savings)

She tries to maximize her satisfaction

The choice has to be on the line

The choice has to reach the highest possible level of satisfaction

Consumer Choice

10 = 2Xc + Xf

U = U(Xc,Xf)

Xf

Xc

2

2

4

4

6

6

8

8

10

10

How does she choose?

She spends all her budget (No savings)

The choice has to be on the line

B

Consumer Choice

10 = 2Xc + Xf

U = U(Xc,Xf)

Xf

Xc

2

2

4

4

6

6

8

8

10

10

How does she choose?

She tries to maximize her satisfaction

The choice has to reach the highest possible level of satisfaction

B C

Consumer Choice

B = pcXc + pfXf

U = U(Xc,Xf)

Xf

Xc

2

2

4

4

6

6

8

8

10

10

How does she choose?

Graphically, the solution takes place where the line touches tangentially the indifference curve.

The solution takes place where the slope of the line equals the tangent of the utility function

Mathematically:

(Xc , Xf )** pf

pc=MRSC

Corner Solutions

Food

Clothing

2

2

4

4

6

6

8

8

10

pf

pcMRSC

Marginal Utility and Choice

U(food)

Foodx

U(x)

x+1

U(x+1)

U(x+2)

x+2

The Marginal Utility measures the additional satisfaction obtained from consuming one additional unit of a good.

The Marginal Utility is decreasingdecreasing: as the consumption grows more and more, the additional satisfaction obtained is less and less