Consumer Behavior: Preferences and Choices

• Consumers allocate incomes to purchase goods and services.

Consumer Behavior: The 3 Steps

• Step 1: Consumer Preferences
• Step 2: Budget
• Step 3: Consumer Choice

Consumer Preferences

• Preferences relate to Market Baskets, also known as Bundles.
• Different items have different groups within the Market Basket.
• Market Basket is a list of specific quantities of one or more goods
• Examples of Market Baskets: Food, Clothing, Housing

Consumer Preferences Assumptions

• Consumer preferences are consistent and rational.
• Consumer preferences are based on self-awareness.
• Assumption 1: Completeness
• Consumers can compare all baskets
• Consumers can rank all baskets
• Preferences ignore costs
• Given 2 baskets, A and B:
• You may prefer A over B.
• You may prefer B over A.
• You may be indifferent between A and B, getting equal satisfaction.
• Assumption 2: Transitivity
• If you prefer A over B, and you prefer B over C
• Then you prefer A over C.
• Transitivity is an important assumption necessary for consumer consistency.
• For example:
  • If you prefer Basketball over Running and Running over Swimming
  • Then you prefer Basketball over Swimming
• Assumption 3: More is better than less.
• Goods should be desirable.
• Consumers are never satisfied or satiated
• More is always better even if just a little better.
• Example of a "bad": air pollution.
• Assumption 4: Diminishing MRS.
• Indifference curves are convex or bowed inward.
• The slope of the IC increases when you move down the curve and becomes less negative.
• Convex if the MRS diminishes along the curve.
• More of a good = diminishing satisfaction, becomes less willing to give up more.
• Balanced baskets preferred; avoid a basket with 1 good or no goods.

Indifference Curves

• "More is better than less" can be used to compare market baskets in shaded areas.
• Basket A is clearly preferred to basket G, while E is clearly preferred to A.
• A cannot be compared with B, D, or H without additional information.
• It is a curve representing combinations of market baskets that provide a consumer with the same level of satisfaction.
• A person is "indifferent" among market baskets represented by points graphed on the curve.
• Contains a set of indifference curves showing market baskets among which a consumer is indifferent.
• Can be an infinite number, where every basket has an IC
• Indifference curves cannot intersect, as it contradicts "more is preferred to less."
• Shape of an indifference curve shows how a consumer is willing to substitute one good for another.
• Downward Sloping
  • Increase food = Decrease clothing
  • More of a good is better than less
  • It involves Trade-offs
• Must not be upward-sloping
  • Consumer would be indifferent between 2 market baskets even with more food and clothing
• Diminishing Marginal Rate of Substitution (MRS) exists along an indifference curve, and it is convex.

Marginal Rate of Substitution (MRS)

• Formula: MRS = -(ΔC/ΔF).
• It represents the slope of the indifference curve (rise/run).
• It represents the tradeoff
• Good in the horizontal axis = Good that consumer gets
• Good in the vertical axis = Good that consumer gives up.
• Maximum amount of a good that a consumer is willing to give up to obtain one additional unit of another good.
• Value that an individual places on 1 extra unit of a good in terms of another.
• The magnitude of the slope of an indifference curve.
• Example:
  • MRS = -3= Give up 3 units of clothing to get 1 unit of food.
  • MRS = - ½ = give up 0.5 units of clothing to get 1 unit of food.
• Perfect Substitutes
  • Entirely indifferent between 2 goods
  • 2 goods for which the MRS of one for the other is a constant
  • Can be 1:1.
  • Can be another ratio depending on units
    • For example: 10 local machines = 5 imported machines
• Perfect Complements
  • "Left shoe will not increase satisfaction without a right shoe". _ 2 goods for which the MRS is 0 or infinite.
  • Indifference curves are shaped as right angles.
• Bad
  • Good for which less is preferred rather than more.

Theory of Consumer Behavior

• Associate a numerical level of satisfaction with each market basket consumed.
• Indifference curves describe consumer preferences graphically.
• Consumers can rank alternatives.

Utility

• It is a numerical score representing the satisfaction a consumer gets from a given market basket.
• It is also known as a benefit or well-being.
• Higher utility = getting pleasure, avoiding pain.
• It simplifies the ranking of market baskets.
• Example: 3 textbooks make me happier than 1 shirt = Utility of 3 textbooks is higher than 1 shirt.
• Ordinal Utility: ranking of market baskets in order of most to least preferred. The focus.
• Cardinal Utility: describing how much one market basket is preferred to another.
• Using Utility Functions:
  • A formula assigns a level of utility to the individual market baskets.
  • Example:
    • Utility Function = u(F,C) = F + 2C, where F is Food and C is Clothing.
    • Compute Utility if F=8 units and C=3 units: A u(F,C) = 8 + (2)(3) = 14
      • Compute Utility if F=4 units and C=4 units: B u(F,C) = 4 + (2)(4) = 12
    • In this case, A u(F,C) is preferred over B u(F,C) due to its higher utility score.
• Utility functions provide the same information about preferences that an IC map does.
• Utility functions order consumer choices in terms of satisfaction.
• Utility is better than another, but not sure how much one is preferred to another.

Budget

• Constraints consumers face as a result of limited incomes
• Budget Line: all combinations of goods for which total amount of money spent is equal to income.
• 2 Determinants: income and prices
• Spending > income = unattainable
• Spending < income = saving
• Example -Food (F) and Clothing (C)
  • PFF + PCC = I
• Using a budget of PHP 80, food costs PHP 1, and clothing costs PHP 2. This results in the equation "1F + 2C = 80".
• An increase in income shifts the budget line right, while a decrease shifts it left.
• A drop in price shifts the line right, an increase shifts the line left.

Consumer Choice

• Budget and preferences are key.
• Consumers maximize satisfaction they achieve, given the limited budget.
• Maximizing Market Basket involves:
  • Being located on the budget line.
  • Having the most preferred combination of goods and services
• The maximum satisfaction point is where the budget line and indifference curve U₂ are tangent.
• At the point of maximization, MRS between the two goods equals the price ratio.
• D is not affordable; B is a lower Utility.
• Marginal Cost is the cost of one additional unit of a good.
• Marginal Benefit is the benefit from the consumption of 1 additional unit of a good.
• The slope of the IC equals the Slope of BL, where MRS = PF/PC.
• Marginal Benefit = Marginal Cost
• Corner Solution
• Situation where MRS of one good for another is not equal to the slope of the budget line.
• Consumers can buy to extremes
• Consumers choose not to consume a particular good.
• For Example: Yogurt (Y) and Ice Cream (IC); MRS >= Pic/Py
• If a consumer chooses one market basket over another, and the chosen market basket is more expensive, the consumer "prefers" the chosen basket. (Revealed Preference).
• Equal Marginal Principle: when the budget is allocated, marginal utility per peso of expenditure is the same for each good.
  • Formula: MUf / Pf = MUc / Pc

Marginal Utility

• This is an additional satisfaction from consuming one more unit of a good
• Explains the Law of Diminishing Marginal Utility

Cost of Living Index (COLI)

• Represents the ratio of the present cost of a typical bundle of consumer goods and services compared with the cost during a base period.
• It is $1,260 in the current year, compared to $500 from a base-year, shows the COLI at 2.52. ($1,260/$500 = 2.52 )
• COL Adjustment includes 1,260-500 = 760.

Types of Cost of Living Indexes

• Ideal Cost: attaining a given level of utility at current prices relative to attaining same utility at base-year prices.
• Fixed Weight: index in which quantities of goods and services remain unchanged Chain Weighted: index that accounts for changes in quantities of goods and services.
• Laspeyres Price Index
  • Measures the 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
• Paasche Index
  • Measures the 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