3

CHAPTER
Consumer
Behavior
 CHAPTER 3 OUTLINE

3.1 Consumer Preferences

3.2 Budget Constraints

3.3 Consumer Choice

3.4 Revealed Preference

Chapter 3: Consumer Behavior

3.5 Marginal Utility and Consumer Choice

3.6 Cost-of-Living Indexes

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 Consumer Behavior

● theory of consumer behavior Description of how

consumers allocate incomes among different goods and
services to maximize their well-being.

Consumer behavior is best understood in three distinct steps:

1. Consumer preferences
Chapter 3: Consumer Behavior

2. Budget constraints

3. Consumer choices

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 3.1 CONSUMER PREFERENCES

Market Baskets
● market basket (or bundle) List with specific quantities
of one or more goods.

TABLE 3.1 Alternative Market Baskets

Market Basket Units of Food Units of Clothing

A 20 30
B 10 50
Chapter 3: Consumer Behavior

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.

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 3.1 CONSUMER PREFERENCES

Some Basic Assumptions about Preferences

1. Completeness: Preferences are assumed to be complete. In

other words, consumers can compare and rank all possible
baskets. Thus, for any two market baskets A and B, a consumer
will prefer A to B, will prefer B to A, or will be indifferent between
the two. By indifferent we mean that a person will be equally
satisfied with either basket.
Chapter 3: Consumer Behavior

Note that these preferences ignore costs. A consumer might

prefer steak to hamburger but buy hamburger because it is
cheaper.

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 3.1 CONSUMER PREFERENCES

Some Basic Assumptions about Preferences

2. Transitivity: Preferences are transitive. Transitivity means that

if a consumer prefers basket A to basket B and basket B to
basket C, then the consumer also prefers A to C. Transitivity is
normally regarded as necessary for consumer consistency.

3. More is better than less: Goods are assumed to be

desirable—i.e., to be good. Consequently, consumers always
Chapter 3: Consumer Behavior

prefer more of any good to less. In addition, consumers are

never satisfied or satiated; more is always better, even if just a
little better. This assumption is made for pedagogic reasons;
namely, it simplifies the graphical analysis. Of course, some
goods, such as air pollution, may be undesirable, and
consumers will always prefer less. We ignore these “bads” in
the context of our immediate discussion.

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 3.1 CONSUMER PREFERENCES

Indifference curves

Figure 3.1
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
Chapter 3: Consumer Behavior

clearly preferred to A.
However, A cannot be compared
with B, D, or H without additional
information.

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 3.1 CONSUMER PREFERENCES

Indifference curves
● indifference curve Curve representing all combinations of market
baskets that provide a consumer with the same level of satisfaction.

Figure 3.2
An Indifference Curve

The indifference curve U1 that

passes through market basket
A shows all baskets that give
the consumer the same level of
Chapter 3: Consumer Behavior

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.

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 3.1 CONSUMER PREFERENCES

Indifference Maps
● indifference map Graph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.

Figure 3.3
An Indifference Map

An indifference map is a set of

indifference curves that
describes a person's
preferences.
Chapter 3: Consumer Behavior

Any market basket on

indifference curve U3, such as
basket A, is preferred to any
basket on curve U2 (e.g.,
basket B), which in turn is
preferred to any basket on U1,
such as D.

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 3.1 CONSUMER PREFERENCES

Indifference Maps

Figure 3.4
Indifference Curves Cannot Intersect

If indifference curves U1 and U2

intersect, one of the
assumptions of consumer
theory is violated.
According to this diagram, the
consumer should be indifferent
Chapter 3: Consumer Behavior

among market baskets A, B,

and D. Yet B should be
preferred to D because B has
more of both goods

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 3.1 CONSUMER PREFERENCES

The Marginal Rate of Substitution

● marginal rate of substitution Maximum amount of a good that a
consumer is willing to give up in order to obtain one additional unit of
another good.
Figure 3.5
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.
Chapter 3: Consumer Behavior

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.

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 3.1 CONSUMER PREFERENCES

Perfect Substitutes and Perfect Complements

● perfect substitutes Two goods for which the marginal rate

of substitution of one for the other is a constant.

● perfect complements Two goods for which the MRS is

zero or infinite; the indifference curves are shaped as right
Chapter 3: Consumer Behavior

angles.
Bads
● bad Good for which less is preferred rather than more.

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 3.1 CONSUMER PREFERENCES

Perfect Substitutes and Perfect Complements

Figure 3.6
Perfect Substitutes and Perfect Complements
Chapter 3: Consumer Behavior

In (a), Bob views orange juice and In (b), Jane views left shoes and
apple juice as perfect substitutes: right shoes as perfect complements:
He is always indifferent between a An additional left shoe gives her no
glass of one and a glass of the extra satisfaction unless she also
other. obtains the matching right shoe.

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 3.1 CONSUMER PREFERENCES

Figure 3.7
Preferences for Automobile Attributes

Preferences for automobile attributes can be described by

indifference curves. Each curve shows the combination of
acceleration and interior space that give the same satisfaction.
Chapter 3: Consumer Behavior

Owners of Ford Mustang coupes are The opposite is true for owners of
willing to give up considerable interior Ford Explorers. They prefer
space for additional acceleration. interior space to acceleration.

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 3.1 CONSUMER PREFERENCES

Utility and Utility Functions

● utility Numerical score representing the satisfaction that a
consumer gets from a given market basket.

● utility function Formula that assigns a level of utility to individual

market baskets.
Figure 3.8
Utility Functions and Indifference Curves

A utility function can be

represented by a set of
Chapter 3: Consumer Behavior

indifference curves, each

with a numerical
indicator.
This figure shows three
indifference curves (with
utility levels of 25, 50,
and 100, respectively)
associated with the utility
function:
u(F,C) = FC

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 3.1 CONSUMER PREFERENCES

Ordinal versus Cardinal Utility

● ordinal utility function Utility function that generates a ranking
of market baskets in order of most to least preferred.

● cardinal utility function Utility function describing by how much

one market basket is preferred to another.

Figure 3.9
Income and Happiness
Chapter 3: Consumer Behavior

A cross-country
comparison shows that
individuals living in
countries with higher
GDP per capita are on
average happier than
those living in countries
with lower per-capita
GDP.

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 3.2 BUDGET CONSTRAINTS

The Budget Line

● budget constraints Constraints that consumers face
as a result of limited incomes.

● budget line All combinations of goods for which the total

amount of money spent is equal to income.

TABLE 3.2 Market Baskets and the Budget Line

Market Basket Food (F) Clothing (C) Total Spending

Chapter 3: Consumer Behavior

A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80

Market baskets associated with the budget line F + 2C = $80

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 3.2 BUDGET CONSTRAINTS

The Budget Line

Figure 3.10

A Budget Line

A budget line describes the

combinations of goods that can be
purchased given the consumer’s
income and the prices of the goods.
Line AG (which passes through
points B, D, and E) shows the
budget associated with an income
Chapter 3: Consumer Behavior

of $80, a price of food of PF = $1 per

unit, and a price of clothing of PC =
$2 per unit.
The slope of the budget line
(measured between points B and D)
is −PF/PC = −10/20 = −1/2.

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 3.2 BUDGET CONSTRAINTS
The Effects of Changes in Income and Prices

Figure 3.11
Effects of a Change in Income on the
Budget Line

Income changes A change in

income (with prices unchanged)
causes the budget line to shift
parallel to the original line (L1).
When the income of $80 (on L1) is
increased to $160, the budget line
Chapter 3: Consumer Behavior

shifts outward to L2.

If the income falls to $40, the line
shifts inward to L3.

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 3.2 BUDGET CONSTRAINTS
The Effects of Changes in Income and Prices

Figure 3.12
Effects of a Change in Price on the
Budget Line

Price changes A change in the

price of one good (with income
unchanged) causes the budget line
to rotate about one intercept.
When the price of food falls from
$1.00 to $0.50, the budget line
Chapter 3: Consumer Behavior

rotates outward from L1 to L2.

However, when the price increases
from $1.00 to $2.00, the line rotates
inward from L1 to L3.

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 3.3 CONSUMER CHOICE
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination of
goods and services.
Figure 3.13

Maximizing Consumer Satisfaction

A consumer maximizes satisfaction

by choosing market basket A. At
this point, the budget line and
indifference curve U2 are tangent.
Chapter 3: Consumer Behavior

No higher level of satisfaction (e.g.,

market basket D) can be attained.
At A, the point of maximization, the
MRS between the two goods equals
the price ratio. At B, however,
because the MRS [− (−10/10) = 1] is
greater than the price ratio (1/2),
satisfaction is not maximized.

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 3.3 CONSUMER CHOICE

Satisfaction is maximized (given the budget constraint) at the

point where MRS = PF/PC.

● marginal benefit Benefit from the consumption of one

additional unit of a good.
● marginal cost Cost of one additional unit of a good.

Using these definitions, we can then say that satisfaction is

Chapter 3: Consumer Behavior

maximized when the marginal benefit—the benefit associated

with the consumption of one additional unit of food—is equal to
the marginal cost—the cost of the additional unit of food. The
marginal benefit is measured by the MRS.

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 3.3 CONSUMER CHOICE

Figure 3.14
Consumer Choice of Automobile Attributes
Chapter 3: Consumer Behavior

The consumers in (a) are willing to trade off a considerable amount of interior space
for some additional acceleration. Given a budget constraint, they will choose a car
that emphasizes acceleration. The opposite is true for consumers in (b).

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 3.3 CONSUMER CHOICE
Corner Solutions
● corner solution Situation in which the marginal rate of
substitution for one good in a chosen market basket is
not equal to the slope of the budget line.
Figure 3.15

A Corner Solution

When a corner solution arises,

the consumer maximizes
satisfaction by consuming only
Chapter 3: Consumer Behavior

one of the two goods.

Given budget line AB, the highest
level of satisfaction is achieved at
B on indifference curve U1, where
the MRS (of ice cream for frozen
yogurt) is greater than the ratio of
the price of ice cream to the price
of frozen yogurt.

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 3.3 CONSUMER CHOICE

Figure 3.16
A College Trust Fund

When given a college

trust fund that must be
spent on education, the
student moves from A to
B, a corner solution.
If, however, the trust fund
could be spent on other
Chapter 3: Consumer Behavior

consumption as well as
education, the student
would be better off at C.

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 3.4 REVEALED PREFERENCE
If a consumer chooses one market basket over another, and if
the chosen market basket is more expensive than the alternative,
then the consumer must prefer the chosen market basket.

Figure 3.17
Revealed Preference:
Two Budget Lines
If an individual facing budget line l1
chose market basket A rather than
market basket B, A is revealed to be
preferred to B.
Chapter 3: Consumer Behavior

Likewise, the individual facing

budget line l2 chooses market
basket B, which is then revealed to
be preferred to market basket D.
Whereas A is preferred to all market
baskets in the green-shaded area,
all baskets in the pink-shaded area
are preferred to A.

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 3.4 REVEALED PREFERENCE

Figure 3.18
Revealed Preference:
Four Budget Lines
Facing budget line l3 the
individual chooses E, which is
revealed to be preferred to A
(because A could have been
chosen).
Likewise, facing line l4, the
Chapter 3: Consumer Behavior

individual chooses G which is

also revealed to be preferred to
A.
Whereas A is preferred to all
market baskets in the green-
shaded area, all market baskets
in the pink-shaded area are
preferred to A.

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 3.4 REVEALED PREFERENCE

Figure 3.19
Revealed Preference for Recreation

When facing budget line l1, an

individual chooses to use a
health club for 10 hours per week
at point A.
When the fees are altered, she
faces budget line l2.
Chapter 3: Consumer Behavior

She is then made better off

because market basket A can
still be purchased, as can market
basket B, which lies on a higher
indifference curve.

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 3.5 MARGINAL UTILITY AND CONSUMER CHOICE

● marginal utility (MU)Additional satisfaction obtained

from consuming one additional unit of a good.
● diminishing marginal utility Principle that as more of a good is
consumed, the consumption of additional amounts will yield
smaller additions to utility.
0 = MU (DF ) + MU (DC )
F C
-(DC / DF ) = MU + MU (DC )
F C
MRS = MU /MU (3.5)
Chapter 3: Consumer Behavior

F C
MRS = P / P (3.6)
F C
MU / MU = P / P
F C F C
MU / P = MU / P (3.7)
F F C C
● equal marginal principle Principle that utility is maximized
when the consumer has equalized the marginal utility per dollar of
expenditure across all goods.
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 3.5 MARGINAL UTILITY AND CONSUMER CHOICE

Figure 3.20
Marginal Utility and Happiness
Chapter 3: Consumer Behavior

A comparison of mean levels of satisfaction with life across income classes in the
United States shows that happiness increases with income, but at a diminishing rate.

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 3.5 MARGINAL UTILITY AND CONSUMER CHOICE

Figure 3.21
Inefficiency of Gasoline Rationing
When a good is rationed, less
is available than consumers
would like to buy. Consumers
may be worse off. Without
gasoline rationing, up to 20,000
gallons of gasoline are
available for consumption (at
Chapter 3: Consumer Behavior

point B).
The consumer chooses point C
on indifference curve U2,
consuming 5000 gallons of
gasoline.
However, with a limit of 2000
gallons of gasoline under
rationing (at point E), the
consumer moves to D on the
lower indifference curve U1.

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 3.5 MARGINAL UTILITY AND CONSUMER CHOICE

Figure 3.22
Comparing Gasoline Rationing to the
Free Market
If the price of gasoline in a competitive
market is $2.00 per gallon and the
maximum consumption of gasoline is
10,000 gallons per year, the woman is
better off under rationing (which holds
the price at $1.00 per gallon), since
Chapter 3: Consumer Behavior

she chooses the market basket at

point F, which lies below indifference
curve U1 (the level of utility achieved
under rationing).
However, she would prefer a free
market if the competitive price were
$1.50 per gallon, since she would
select market basket G, which lies
above indifference curve U1.

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 3.6 COST-OF-LIVING INDEXES

● cost-of-living index Ratio of the present cost of a

typical bundle of consumer goods and services compared
with the cost during a base period.

Ideal Cost-of-Living Index

● ideal cost-of-living index Cost of attaining a given

Chapter 3: Consumer Behavior

level of utility at current prices relative to the cost of

attaining the same utility at base-year prices.

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 3.6 COST-OF-LIVING INDEXES

Ideal Cost-of-Living Index

TABLE 3.3 Ideal Cost-of-Living Index
1995 (Sarah) 2005 (Rachel)
Price of books $20/book $100/bk
Figure 3.23
Number of books 15 6
Cost-of-Living Indexes
Price of food $2.00/lb. $2.20/lb.
Pounds of food 100 300
Expenditure $500 $1260
Chapter 3: Consumer Behavior

The initial budget constraint

facing Sarah in 1995 is given by
line l1; her utility-maximizing
combination of food and books
is at point A on indifference
curve U1.
Rachel requires a budget
sufficient to purchase the food-
book consumption bundle given
by point B on line l2 (and tangent
to indifference curve U1).

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 3.6 COST-OF-LIVING INDEXES

Ideal Cost-of-Living Index

TABLE 3.3 Ideal Cost-of-Living Index
1995 (Sarah) 2005 (Rachel)
Price of books $20/book $100/bk
Figure 3.23
Number of books 15 6
Cost-of-Living Indexes
Price of food $2.00/lb. $2.20/lb.
Pounds of food 100 300
Expenditure $500 $1260
Chapter 3: Consumer Behavior

A price index, which represents

the cost of buying bundle A at
current prices relative to the
cost of bundle A at base-year
prices, overstates the ideal cost-
of-living index.

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 3.6 COST-OF-LIVING INDEXES

Laspeyres Index
● Laspeyres price index Amount of money at current year
prices that an individual requires to purchase a bundle of goods
and services chosen in a base year divided by the cost of
purchasing the same bundle at base-year prices.
Comparing Ideal Cost-of-Living and Laspeyres Indexes
The Laspeyres index overcompensates Rachel for the higher
cost of living, and the Laspeyres cost-of-living index is, therefore,
greater than the ideal cost-of-living index.

Paasche Index
Chapter 3: Consumer Behavior

● Paasche index Amount of money at current-year prices that

an individual requires to purchase a current bundle of goods and
services divided by the cost of purchasing the same bundle in a
base year.
Comparing the Laspeyres and Paasche Indexes Just as the
Laspeyres index will overstate the ideal cost of living, the
Paasche will understate it because it assumes that the individual
will buy the current year bundle in the base period.

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 3.6 COST-OF-LIVING INDEXES

● fixed-weight index Cost-of-living index in which the

quantities of goods and services remain unchanged.

Price Indexes in the United States: Chain Weighting

● chain-weighted price index Cost-of-living index that

accounts for changes in quantities of goods and services.
Chapter 3: Consumer Behavior

A commission chaired by Stanford University professor Michael

Boskin concluded that the CPI overstated inflation by
approximately 1.1 percentage points—a significant amount given
the relatively low rate of inflation in the United States in recent
years.
Approximately 0.4 percentage points of the 1.1-percentage-point
bias was due to the failure of the Laspeyres price index to
account for changes in the current year mix of consumption of the
products in the base-year bundle.
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