Chapter 3- Consumer Behaviour

IMPORTANT
MRS is given as the the marginal rate of substituion of good on the y axis for x axis, so
if MRSX y then it is Delta Y/ Delta X
Normally, indifference curves dont touch the axis because people dont derive the
maximum satisfaction from just one good rather than a basket unless in very rare cases
of corner solution
Survey: Coca Cola example- Whether they didn't ask if they liked Blue Cola more than
Red Cola, they just said do you like blue cola - Sales crashed caause even tho they
liked blue cola, not more than the red one
Consumer Behaviour: Description of how consumers allocate incomes among different
goods and services to maximise their well-being
Consumer Behaviour: Description of how consumers allocate incomes among different
goods and services to maximise their well-being

Steps

1. Consumer Preferences: Why choose one product over the other

2. Budget Constraints: Consumers have limited income which restricts the quantities
of goods

3. Consumer Choices: Combination of goods that will maximise their satidfaction

Consumer Behaviour:

Not always rational

Swayed by preferences and decisions of friends and neighbours or even changes in

mood

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 Not possible for them to account fully for the multitude of price and choices that they
face daily

Assumptions:

1. Consumers' preferences are consistent and make sense

2. Completeness: Preferences are assumed to be complete, a consumer if indifferent/

equally satisfied with any of the baskets and preferences ignore costs (A consumer
might prefer steak to hamburger but buy hamburger because it is cheaper) - smooth
curve ie infinitely divisible

3. Transitivity: A to B, B to C, prefers A to C- required for consumer consistency

4. More is better than less: goods are assumed to be desirable and the more the
better even if a little better.

Indifference Curves:
Curve representing all combinations of market baskets that a consumer with the same
level of satisfaction.

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 B is preferred to H as B has more clothing

Indifference Maps:

Assumption: Its a smooth curve- the goods are finitely divisible

The preferences remain the same due to which the shape of the IC remains the
same

To describe a consumers preference for all the combinations of food and clothing,
we can graph a set of different indifference curves called as an Indifference Map

Indifference Curves cannot intersect: If they were to intersect then

Shape

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 Convex implies a falling MRS

A very steep slope implies a high MRS

A non steep slope implies a low MRS

A lies on both curves- Consumer is indifferent between A and D, and A and B, so

should be indifferent between B and D which it isnt, cause of intersection.

Marginal Rate of Substitution

REMEMBER : MRS is -Delta Y/Delta X and NOT the other way around, where -
indicates the negative slope so the negative sign makes the value positive

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 Satisfaction remains the same in point A and B, so the amount of goods cant be
increased

Here, we are getting a comparison of the benefits

Why does the slope keeping falling?

The more clothing and the less food a person consumes, the more clothing he will
give up in order to obtain more food. Similarly, the more food that a person
possesses, the less clothing he will give up for more food.

How many units of Y are you willing to lose to gain 1 X is MRS

MRS of food for clothing- The MRS of food F for clothing C is the maximum amount
of clothing that a person is willing to give up to obtain one additional unit of food.

MRS of product on X axis for product on Y axis

MRS: Maximum amount of a good that a consumer is willing to give up in order to

obtain one additional unit of another good.

Vertical Axis- Giving up and Horizontal Axis- Gaining 1 unit of it

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 Shape of the Indifference Curve

1. Convexity- In case of Diminishing marginal rate of substitution- where the slope of

indifference curve increases (becomes less negative) - In other words, an
indifference curve is convex if the MRS diminishes along the curve

a. Yes. As more and more of one good is consumed, we can expect that a
consumer will prefer to give up fewer and fewer units of a second good to get
additional units of the first one.

b. consumption of food increases, the additional satisfaction that a consumer gets

from still more food will diminish.

c. Consumers generally prefer balanced baskets as in 3.5, A has 16+1 goods and
D has 6+3 and they both have same level of satisfaction

d. It means that food and clothing aren't close substitutes- thats why the IC is
concex

Perfect Substitutes and Perfect Complements

Perfect Substitutes: Two goods for MRS of one for the other is a constant

Here you're willing to give up only one of one product for the other

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 the slope remains constant

Even if only one is preferred, that wouldnt make a difference- therefore touches
the axes

Perfect substitutes just need to have a constant ratio, not necessarily 1

Perfect Complements- Two goods for which the MRS is zero or infinite, the ICs are
shaped as right angles

Here they are preferred in a rigid ratio or strict combinations

Increase in one without the increase in other will not give any additional utility,
hence L shaped curve

Hence MRS is 0, cause obv no amount of one shoe can substitute for another
type of shoe, like no amount of right shoes can substitute even one left shoe

Figure 3.7- The more steeper it is, the more is the MRS- willing to sacrifice a lot for 1
unit

The more gentle slopping it is- willing to not sacrifice a lot for 1 additional unit

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.

Iso Utility Curve- All long the curve the utlity remaine the same

u (X,Y)= XY (one of the types of utility function

3.8

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 Ordinal Vs Cardinal Utility

Ordinal Utility given by Hicks

For this reason, a utility function that generates a ranking of market baskets is
called an ordinal utility function.

The ranking associated with the ordinal utility function places market baskets in the
order of most to least preferred.

We know, for example, that any market basket on U3, such as A, is

preferred to any on U2, such as B. However, the amount by which A is preferred to
B (and B to D) is not revealed by the indifference map or by the ordinal utility
function that generates it

A utility function that describes by how much one market basket is preferred to
another is called a cardinal utility function.

Ordinal Utility: Utility function that generates a ranking of market baskets in order of
most to least preferred

Maybe we can measure utility by the amount of money we are willing to give up, but
it also depends from time to time

Utility in interpersonal cases, is really subjective, so its not possible

3.2

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 Happiness increases with per capita income, but the increase in happiness with MU
of income isnt that much

Basically Satisfaction in life is dependent on other relative factors than income

SL= (I, F, ....)- Satisfaction in Life depends on many factors

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.

I = PF F + PC C
PC C = I − PF F
C = (I/PC ) − (PF /PC )F
(Assumption: We aren't saving for the future aka making a choice between current
and future consumption

Also I and the prices are a constant

Two goods X and Y, Price of X* Quantity of X + Price of Y* Quantity of Y

X = (I/Px ) − (Px /Py )X

Y vertical intercept: I/Pc

X horizontal intercept: I/PF

Ratio of the prices is the slope, it is negative as it is downward sloping

Slope= Rise over the run ( (I/PC )/(I/PF ) = PF /PC

i.e. (Delta Y/Delta X)= How many units of clothing are you willing to give up for
every additional unit of food

The Effects of Changes in Income and Prices

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 Intercepts are just the highest amount of good you can buy with the income-
Income/ Price of the Good

Income Changes

Cause a shift in the budget line (because the vertical intercept increase/ decrease),
because slope remains the same ( why - because slope is the ratio of prices that
does not change ) hence since the slope remains the same a shifted budget line,
parallel to the previous one is made

Price Changes

1. Price of one good changes but the other doesn't:

a. C = (I/PC) − (PF/PC)F

b. Change in slope

c. Intercept on one axis will change

d. BL rotates outward

2. Price of both the goods change but leaves ration unchanged (change in the same
percentage

a. No change in slope

b. Intercepts on both the axes will change

Purchasing power is determined not only by income, but also by prices. For
example, our consumer’s purchasing power can double either because her income
doubles or because the prices of all the goods that she buys fall by half.

Consumer Choice

Assumption:

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 1. We assume that consumers
make their choice in a rational way—that they choose goods to maximise the
satisfaction they can achieve, given the limited budget available to them

The maximising market basket must satisfy two conditions:

1. It must be located on the budget line: any market

basket to the right of and above the budget line cannot be purchased with available
income. Thus, the only rational and feasible choice is a basket on
the budget line.

Assumption: All income is spent now

2. It must give the consumer the most preferred combination of goods and services.

Note that point B on indifference curve U1 is not the most preferred choice, because
a reallocation of income in which more is spent on food and less on
clothing can increase the consumer’s satisfaction

At B, the slope of the IC (Delta C/ Delta F> PF /PC )

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 At A, the slope of the budget line is exactly equal to the slope of the indifference
curve.

Budget Line slope: Ratio of Prices

IC slope: −DeltaY /DeltaX

Satisfaction is maximum at

MRS = −PF /PC

Satisfaction is maximized when the marginal rate of substitution (of F for C)
is equal to the ratio of the prices (of F to C).

Marginal Benefit: Benefit from the consumption of one additional unit of a good.

is equal to the

Marginal Cost: Cost of one additional unit of a good.

1. The marginal benefit is measured by the MRS. At point A, it equals 1/2 (the
magnitude of the slope of the indifference curve), which implies that the consumer is
willing to give up 1/2 unit of clothing to obtain 1 unit of food.

2. At the same point, the marginal cost is measured by the magnitude of the slope
of the budget line; it too equals 1/2 because the cost of getting one unit of food is
giving up 1/2 unit of clothing (PF 1 and PC 2 on the budget line).

3. the marginal benefit–marginal cost equality that we described in the previous

section holds only when positive quantities of all goods are consumed.

4. If the MRS is less or greater than the price ratio, the consumer’s satisfaction has not
been maximized

By this, we can use the prices of the goods to found out the MRS, but we cannot
find the quantity of goods purchased cause that is dependent on individual
preferences

Corner Solutions

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 Situation in which the marginal rate of substitution of one good for another in a
chosen market basket is not equal to the slope of the budget line (MC)

Optimal point off solution is where the IC and Budget line intersect with one of th
axes

When the consumer’s marginal rate of substitution

is not equal to the price ratio for all levels of consumption, a corner solution arises.

Maximising satisfaction here: MRS >= PIC /PY

Revealed Preference

Preferences and budget constraints determines consumer choice. revealed

preferences means going in the reverse order and using that choice to reveal the
preferences and budget constraints.

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 (external)Revealed preference, a theory offered by American economist Paul
Anthony Samuelson in 1938, states that consumer behavior, if their income and the
item's price are held constant, is the best indicator of their preferences.

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.

A is preferred to B and all the baskets in the green area

1. comparing A, B and D

2. since B or any other basket below L1 could've been bought, but wasn't, we can say
b is preferred to a. (a>b)

3. direct comparison between a and d is not possible as the lie on different lines.

4. but, since b is preferred to d and a is preferred to b, a>d.

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 IC- Assumed set of curves, could be consumers choice
RP- Only when actual choices can be weighed

Given: E and G are preferred over A

Hence in the pink shaded area, the right angle type things from A, E and G would
be preferred over A because

They have either more of both quantities, or more of one and equal of the other
comparedto A, E and G respectovely

Marginal utility and consumer choice

Marginal utility: the additional satisfaction obtained by 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 to smaller additions to utility.

Utility maximization is achieved when the budget is allocated so that the marginal
utility per dollar of expenditure is the same for each good.
what we intend to prove: MUF /PF = MUC /PC
Additional consumption of food will delta F will generate marginal utility MUF ,
hence, total increase in utility will be MUF ∗ (delta)F

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 At the same time, the reduced consumption of clothing, (delta) C, will lower utility
per unit by MUC , resulting in a total loss of
MUC ∗ (delta)C
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.

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.

Assumption: when consumers maximize their satisfaction, the MRS of F for C is

equal to the ratio of the prices of the two goods

Hence, utility maximization is achieved when the budget is allocated so that the
marginal utility per dollar of expenditure is the same for each good.

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 Equal marginal principle: Principle that utility is maximized when the consumer
has equalized the marginal utility
per dollar of expenditure across all goods.

Rationing:
Sometimes mostly wars etc the govt. fixes prices (rations) of goods rather than
leaving it to market forces.

By guaranteeing every eligible person a minimum amount of gasoline, rationing can

provide some people with access to a product that they could not otherwise afford.
But rationing hurts others by limiting the amount of gasoline that they can buy.

that while rationing is a less efficient means of allocating goods and serves, under any
particular rationing
scheme some individuals may well be better off, even though others will necessarily be
worse off.

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