Module 3a Consumer Behaviour PDF

MODULE 3a THEORY OF CONSUMER BEHAVIOUR PRINCIPLES OF MICROECONOMICS  Consumer Behaviour and Decision Making Choice and Demand Individuals have preferences for different bundles of goods. They choose the bundle that they prefer the most within the constraints that they have. They der...

MODULE 3a THEORY OF CONSUMER BEHAVIOUR PRINCIPLES OF MICROECONOMICS  Consumer Behaviour and Decision Making Choice and Demand Individuals have preferences for different bundles of goods. They choose the bundle that they prefer the most within the constraints that they have. They derive utility i.e. an overall satisfaction level after consuming these bundles. More of a good is preferred to less. The theory of consumer choice examines the tradeoffs that people face in their role as consumers. When a consumer buys more of one good, he can afford less of other goods. When he spends more time enjoying leisure and less time working, he has lower income and can afford less consumption.  Most people would like to increase the quantity or quality of the goods they consume. People consume less than they desire because their spending is constrained, or limited, by their income.  Let’s examine the decision facing a consumer who buys only two goods: Pepsi and pizza.  Suppose that the consumer has an income of $1,000 per month and that he spends his entire income each month on Pepsi and pizza. The price of a pint of Pepsi is $2, and the price of a pizza is $10. The Consumer’s Budget Constraint  All the points on the line from A to B are possible. This line, called the budget constraint, shows the consumption bundles that the consumer can afford. In this case, it shows the tradeoff between Pepsi and pizza that the consumer faces.  The slope of the budget constraint measures the rate at which the consumer can trade one good for the other. The slope between two points is calculated as the change in the vertical distance divided by the change in the horizontal distance (“rise over run”).  From point A to point B, the vertical distance is 500 pints, and the horizontal distance is 100 pizzas. Thus, the slope is 5 pints per pizza.  Notice that the slope of the budget constraint equals the relative price of the two goods—the price of one good compared to the price of the other.  A pizza costs 5 times as much as a pint of Pepsi, so the opportunity cost of a pizza is 5 pints of Pepsi. The budget constraint’s slope of 5 reflects the tradeoff the market is offering the consumer: 1 pizza for 5 pints of Pepsi. Another example  Utility  The benefit or satisfaction from consuming a good or service is called utility. Ordinal Utility and Cardinal Utility  In economics, an ordinal utility function is a function representing the preferences of an agent on an ordinal scale. The ordinal utility theory claims that it is only meaningful to ask which option is better than the other, but it is meaningless to ask how much better it is.  It generates a ranking of market baskets in order of most to least preferred.  Type of analysis to measure ordinal utility – Indifference curve analysis  The Cardinal Utility approach - Utility is measurable, and the customer can express his satisfaction in cardinal or quantitative numbers, such as 1,2,3, and so on.  Neo-classical economists developed the theory of consumption based on the assumption that utility is measurable and can be expressed cardinally. And to do so, they have introduced a hypothetical unit called as ”Utils” meaning the units of utility.  There is a utility function that describes by how much one market basket is preferred to another.  Type of analysis to measure cardinal utility – Marginal utility analysis.  Preferences – Indifference Curves The consumer’s preferences allow him to choose among different bundles of Pepsi and pizza. If you offer the consumer two different bundles, he chooses the bundle that best suits his tastes. If the two bundles suit his tastes equally well, we say that the consumer is indifferent between the two bundles. An indifference curve shows the bundles of consumption that make the consumer equally happy i.e. every point on the curve has the same utility. In this case, the indifference curves show the combinations of Pepsi and pizza with which the consumer is equally satisfied. Two of the consumer’s many indifference curves are shown in the figure below. The consumer is indifferent among combinations A, B, and C, because they are all on the same curve. If the consumer’s consumption of pizza is reduced from point A to point B, consumption of Pepsi must increase to keep him equally happy. If consumption of pizza is reduced again, from point B to point C, the amount of Pepsi consumed must increase yet again. The Consumer’s Preferences  The slope at any point on an indifference curve equals the rate at which the consumer is willing to substitute one good for the other. This rate is called the marginal rate of substitution (MRS).  In this case, the marginal rate of substitution measures how much Pepsi the consumer requires in order to be compensated for a one-unit reduction in pizza consumption. Notice that because the indifference curves are not straight lines, the marginal rate of substitution is not the same at all points on a given indifference curve.  The consumer is equally happy at all points on any given indifference curve, but he prefers some indifference curves to others. Because he prefers more consumption to less, higher indifference curves are preferred to lower ones. A consumer’s set of indifference curves gives a complete ranking of the consumer’s preferences. That is, we can use the indifference curves to rank any two bundles of goods. For example, the indifference curves tell us that point D is preferred to point A because point D is on a higher indifference curve than point A. Four Properties of Indifference Curves Property 1: Higher indifference curves are preferred to lower ones. Consumers usually prefer more of something to less of it. Higher indifference curves represent larger quantities of goods than lower indifference curves. Thus, the consumer prefers being on higher indifference curves. Property 2: Indifference curves are downward sloping. The slope of an indifference curve reflects the rate at which the consumer is willing to substitute one good for the other. Therefore, if the quantity of one good is reduced, the quantity of the other good must increase in order for the consumer to be equally happy. For this reason, most indifference curves slope downward.  Property 3: Indifference curves do not cross. To see why this is true, suppose that two indifference curves did cross, as shown in the figure. Then, because point A is on the same indifference curve as point B, the two points would make the consumer equally happy. In addition, because point B is on the same indifference curve as point C, these two points would make the consumer equally happy. But these conclusions imply that points A and C would also make the consumer equally happy, even though point C has more of both goods. The Impossibility of Intersecting Indifference Curves Property 4: Indifference curves are bowed inward. The slope of an indifference curve is the marginal rate of substitution— the rate at which the consumer is willing to trade off one good for the other. The marginal rate of substitution (MRS) usually depends on the amount of each good the consumer is currently consuming. In particular, because people are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little, the indifference curves are bowed inward. Bowed Indifference Curves  At point A, because the consumer has a lot of Pepsi and only a little pizza, to induce the consumer to give up 1 pizza, the consumer has to be given 6 pints of Pepsi: The marginal rate of substitution is 6 pints per pizza.  By contrast, at point B, the consumer has little Pepsi and a lot of pizza, so he is very thirsty but not very hungry. At this point, he would be willing to give up 1 pizza to get 1 pint of Pepsi: The marginal rate of substitution is 1 pint per pizza.  Thus, the bowed shape of the indifference curve reflects the consumer’s greater willingness to give up a good that he already has in large quantity. The shape of an indifference curve tells us about the consumer’s willingness to trade one good for the other. When the goods are easy to substitute for each other, the indifference curves are less bowed; when the goods are hard to substitute, the indifference curves are very bowed. To see why this is true, let’s consider the extreme cases. Perfect Substitutes and Perfect Compliments Perfect Substitutes: Suppose someone offered you bundles of nickels and dimes or rupees and paisas. How to rank the different bundles? According to total monetary value of each bundle. In other words, willing to trade 1 dime for 2 nickels or 1 Rupee for 100 paisas, regardless of the number of nickels and dimes (or, paisas and rupees) in the bundle. Marginal rate of substitution between nickels and dimes is a fixed number—2 (and between paisas and rupees 100). Because the marginal rate of substitution is constant, the indifference curves are straight lines. We say that the two goods are perfect substitutes Perfect Substitutes and Perfect Complements  Perfect Complements: Suppose now that someone offered you bundles of shoes. Some of the shoes fit your left foot, others your right foot. How would you rank these different bundles? In this case, you might care only about the number of pairs of shoes. A bundle of 5 left shoes and 7 right shoes yields only 5 pairs. Getting 1 more right shoe has no value if there is no left shoe to go with it.  We can represent the preferences for right and left shoes with indifference curves. In this case, a bundle with 5 left shoes and 5 right shoes is just as good as a bundle with 5 left shoes and 7 right shoes. It is also just as good as a bundle with 7 left shoes and 5 right shoes. The indifference curves, therefore, are right angles. In this case of right-angle indifference curves, we say that the two goods are perfect complements. Perfect Substitutes and Perfect Complements Optimization – What the consumer chooses  Now let’s put the budget constraint and indifference curves together to arrive at the optimum. Consider once again our Pepsi and pizza example. The consumer would like to end up with the best possible combination of Pepsi and pizza—that is, the combination on the highest possible indifference curve. But the consumer must also end up on or below his budget constraint, which measures the total resources available to him.  The figure shows the consumer’s budget constraint and three of his many indifference curves. The highest indifference curve that the consumer can reach is the one that just barely touches the budget constraint. The point at which this indifference curve and the budget constraint touch is called the optimum. The Consumer’s Optimum At the optimum, the slope of the indifference curve equals the slope of the budget constraint. We say that the indifference curve is tangent to the budget constraint. The slope of the indifference curve is the marginal rate of substitution between Pepsi and pizza, and the slope of the budget constraint is the relative price of Pepsi and pizza. Thus, the consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.  How changes in income affect the consumer’s choice Suppose that income increases. With higher income, the consumer can afford more of both goods. The increase in income, therefore, shifts the budget constraint outward. Because the relative price of the two goods has not changed, the slope of the new budget constraint is the same as the slope of the initial budget constraint. That is, an increase in income leads to a parallel shift in the budget constraint. If a consumer wants more of a good when his income rises, economists call it a normal good. If a consumer buys less of a good when his income rises, economists call it an inferior good. An Increase in Income An Inferior Good  How changes in prices affect the consumer’s choice  Let’s now use the model of consumer choice to consider how a change in the price of one of the goods alters the consumer’s choices. Suppose, in particular, that the price of Pepsi falls from $2 to $1 a pint. The lower price expands the consumer’s set of buying opportunities. In other words, a fall in the price of any good shifts the budget constraint outward.  If the consumer spends his entire $1,000 income on pizza, then the price of Pepsi is irrelevant. Thus, point A in the figure stays the same. Yet if the consumer spends his entire income of $1,000 on Pepsi, he can now buy 1,000 rather than only 500 pints. Thus, the end point of the budget constraint moves from point B to point D. A Change in Price Income and Substitution Effect  The impact of a change in the price of a good on consumption can be decomposed into two effects: an income effect and a substitution effect. To see what these two effects are, consider how our consumer might respond when he learns that the price of Pepsi has fallen. He might reason in the following ways:  “Now that Pepsi is cheaper, my income has greater purchasing power. I am, in effect, richer than I was. Because I am richer, I can buy both more Pepsi and more pizza.” (This is the income effect.)  “Now that the price of Pepsi has fallen, I get more pints of Pepsi for every pizza that I give up. Because pizza is now relatively more expensive, I should buy less pizza and more Pepsi.” (This is the substitution effect.) Income and Substitution Effects  The decrease in the price of Pepsi makes the consumer better off. If Pepsi and pizza are both normal goods, the consumer will want to spread this improvement in his purchasing power over both goods. This income effect tends to make the consumer buy more pizza and more Pepsi. Yet, at the same time, consumption of Pepsi has become less expensive relative to consumption of pizza. This substitution effect tends to make the consumer choose more Pepsi and less pizza.  The income effect is the change in consumption that results from the movement to a higher indifference curve. The substitution effect is the change in consumption that results from being at a point on an indifference curve with a different marginal rate of substitution. Income and Substitution Effects When the Price of Pepsi Falls Measuring Cardinal Utility  Utility: The benefit or satisfaction from consuming a good or service.  Type of analysis to measure cardinal utility – Marginal utility analysis.  Total Utility: Total utility is the total benefit a person gets from the consumption of goods. Generally, more consumption gives more total utility. Marginal Utility  Marginal utility from a good is the change in total utility that results from a unit-increase in the quantity of the good consumed.  As the quantity consumed of a good increases, the marginal utility from it decreases.  We call this decrease in marginal utility as the quantity of the good consumed increases - the principle of diminishing marginal utility. While total utility increases with extra consumption, the additional (marginal) utility from each orange consumed falls. Oranges Total Utility Marginal Utility 1 100 2 190 90 3 270 80 4 340 70 5 400 60 6 450 50 6 490 40  Utility-Maximizing Choice  The key assumption is that the household chooses the consumption possibility that maximizes total utility. Note: Lisa is at the highest indifference curve touching the budget line. A more natural way of finding the consumer equilibrium is to use the idea of choices made at the margin. Choosing at the Margin: Having made a choice, would spending a dollar more or a dollar less on a good bring more total utility? Marginal utility is the increase in total utility that results from consuming one more unit of the good. The marginal utility per dollar is the marginal utility from a good that results from spending one more dollar on it.  The marginal utility per dollar equals the marginal utility from a good divided by its price.  Calling the marginal utility from movies MUM and the price of a movie PM, then the marginal utility per dollar from movies is MUM/PM.  Calling the marginal utility of pop MUP and the price of pop PP , then the marginal utility per dollar from pop is MUP/PP.  By comparing MUM/PM and MUP/PP , we can determine whether Lisa has allocated her budget in the way that maximizes her total utility.  Consider a small movement down the indifference curve. Because all points on an indifference curve generate the same level of utility, the total gain in utility associated with the increase in F must balance the loss due to the lower consumption of C.  MRS is the ratio of the marginal utility of F to the marginal utility of C. As the consumer gives up more and more of C to obtain more of F, the marginal utility of F falls and that of C increases, so MRS decreases.  MRS = MUF/MUC = PF/PC at the optimum (utility maximization) (To be contd.) References  N. Gregory Mankiw, “Principles of Microeconomics”, Cengage Learning, 2015.  Pindyck, R.S. and Rubinfeld, D.L; “Microeconomics”, Pearson Education edition-9, 2022.