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Managerial Economics
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Chapter 3Consumer Behavior
Chapter 11
Topics to be DiscussedConsumer PreferencesBudget ConstraintsConsumer ChoiceRevealed Preferences
Chapter 12
Topics to be DiscussedMarginal Utility and Consumer ChoicesCost-of-Living Indexes
Chapter 13
Consumer BehaviorTwo applications that illustrate the importance of the economic theory of consumer behavior are:Apple-Cinnamon CheeriosThe Food Stamp Program.
Chapter 14
Consumer BehaviorGeneral Mills had to determine how high a price to charge for Apple-Cinnamon Cheerios before it went to the market.
Chapter 15
Consumer BehaviorWhen the food stamp program was established in the early 1960s, the designers had to determine to what extent the food stamps would provide people with more food and not just simply subsidize the food they would have bought anyway.
Chapter 16
Consumer BehaviorThese two problems require an understanding of the economic theory of consumer behavior.
Chapter 17
Consumer BehaviorThere are three steps involved in the study of consumer behavior.
1) We will study consumer preferences.To describe how and why people prefer one good to another.
Chapter 18
Consumer BehaviorThere are three steps involved in the study of consumer behavior.
2)Then we will turn to budget constraints.People have limited incomes.
Chapter 18
Consumer BehaviorThere are three steps involved in the study of consumer behavior.
3) Finally, we will combine consumer preferences and budget constraints to determine consumer choices.What combination of goods will consumers buy to maximize their satisfaction?
Chapter 19
Consumer PreferencesA market basket is a collection of one or more commodities.One market basket may be preferred over another market basket containing a different combination of goods.
Market Baskets
Chapter 110
Consumer PreferencesThree Basic Assumptions
1) Preferences are complete.2) Preferences are transitive.3) Consumers always prefer more of any good to less.Market Baskets
Chapter 111
Consumer PreferencesA2030B1050D4020E3040G1020H1040Market BasketUnits of Food Units of Clothing
Chapter 112
Consumer PreferencesIndifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person.
Indifference Curves
Chapter 113
Consumer PreferencesFood(units per week)1020304010203040Clothing(units per week)50
Chapter 115
Consumer PreferencesFood(units per week)1020304010203040Clothing(units per week)50
Chapter 117
Consumer PreferencesIndifference CurvesIndifference curves slope downward to the right.If it sloped upward it would violate the assumption that more of any commodity is preferred to less.
Chapter 118
Consumer PreferencesIndifference CurvesAny market basket lying above and to the right of an indifference curve is preferred to any market basket that lies on the indifference curve.
Chapter 119
Consumer PreferencesAn indifference map is a set of indifference curves that describes a persons preferences for all combinations of two commodities.Each indifference curve in the map shows the market baskets among which the person is indifferent.
Indifference Maps
Chapter 120
Consumer PreferencesIndifference CurvesFinally, indifference curves cannot cross.This would violate the assumption that more is preferred to less.
Chapter 121
Consumer PreferencesFood(units per week)Clothing(units per week)
Chapter 124
Consumer PreferencesFood(units per week)Clothing(units per week)Indifference CurvesCannot Cross
Chapter 126
Consumer PreferencesFood(units per week)Clothing(units per week)23451246810121416Question: Does thisrelation hold for givingup food to get clothing?
Chapter 132
Consumer PreferencesThe marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good.It is measured by the slope of the indifference curve.
Marginal Rate of Substitution
Chapter 129
Consumer PreferencesFood(units per week)Clothing(units per week)23451246810121416ABDEG-61111-4-2-1MRS = 6MRS = 2
Chapter 132
Consumer PreferencesWe will now add a fourth assumption regarding consumer preference:Along an indifference curve there is a diminishing marginal rate of substitution.Note the MRS for AB was 6, while that for DE was 2.
Marginal Rate of Substitution
Chapter 133
Consumer PreferencesQuestionWhat are the first three assumptions?
Marginal Rate of Substitution
Chapter 133
Consumer PreferencesIndifference curves are convex because as more of one good is consumed, a consumer would prefer to give up fewer units of a second good to get additional units of the first one.Consumers prefer a balanced market basket
Marginal Rate of Substitution
Chapter 134
Consumer PreferencesPerfect Substitutes and Perfect ComplementsTwo goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant.
Marginal Rate of Substitution
Chapter 135
Consumer PreferencesPerfect Substitutes and Perfect ComplementsTwo goods are perfect complements when the indifference curves for the goods are shaped as right angles.
Marginal Rate of Substitution
Chapter 136
Consumer PreferencesOrange Juice(glasses)Apple Juice(glasses)234112340PerfectSubstitutes
Chapter 138
Consumer PreferencesRight ShoesLeftShoes234112340PerfectComplements
Chapter 140
Consumer PreferencesBADSThings for which less is preferred to moreExamplesAir pollutionAsbestos
Chapter 1
Consumer PreferencesWhat Do You Think?How can we account for Bads in the analysis of consumer preferences?
Chapter 1
Consumer PreferencesAutomobile executives must regularly decide when to introduce new models and how much money to invest in restyling.
Designing New Automobiles (I)
Chapter 141
Consumer PreferencesAn analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars.
Designing New Automobiles (I)
Chapter 141
Consumer Preferences
StylingPerformanceConsumerPreference A:High MRS
Chapter 143
Consumer Preferences
StylingPerformanceConsumerPreference B:Low MRS
Chapter 144
Consumer PreferencesWhat Do You Think?How can we determine the consumers preference?
Designing New Automobiles (I)
Chapter 141
Consumer PreferencesA recent study of automobile demand in the United States shows that over the past two decades most consumers have preferred styling over performance.
Designing New Automobiles (I)
Chapter 145
Consumer PreferencesGrowth of Japanese Imports1970s and 1980s15% of domestic cars underwent a style change each yearThis compares to 23% for imports
Designing New Automobiles (I)
Chapter 145
Consumer PreferencesUtilityUtility: Numerical score representing the satisfaction that a consumer gets from a given market basket.
Chapter 1103
Consumer PreferencesUtilityIf buying 3 copies of Microeconomics makes you happier than buying one shirt, then we say that the books give you more utility than the shirt.
Chapter 1104
Consumer PreferencesUtility FunctionsAssume:The utility function for food (F) and clothing (C) U(F,C) = F + 2C
Market Baskets: F units C units U(F,C) = F + 2C A 8 3 8 + 2(3) = 14 B 6 4 6 + 2(4) = 14 C 4 4 4 + 2(4) = 12 The consumer is indifferent to A & B The consumer prefers A & B to C
Chapter 1104
Consumer Preferences
Food(units per week)10155510150Clothing(unitsper week)Utility Functions & Indifference Curves
Chapter 15442
Consumer PreferencesOrdinal Versus Cardinal UtilityOrdinal Utility Function: places market baskets in the order of most preferred to least preferred, but it does not indicate how much one market basket is preferred to another.Cardinal Utility Function: utility function describing the extent to which one market basket is preferred to another.
Chapter 127
Consumer PreferencesOrdinal Versus Cardinal RankingsThe actual unit of measurement for utility is not important.Therefore, an ordinal ranking is sufficient to explain how most individual decisions are made.
Chapter 128
Budget ConstraintsPreferences do not explain all of consumer behavior.Budget constraints also limit an individuals ability to consume in light of the prices they must pay for various goods and services.
Chapter 14642
Budget ConstraintsThe Budget LineThe budget line indicates all combinations of two commodities for which total money spent equals total income.
Chapter 14742
Budget ConstraintsThe Budget LineLet F equal the amount of food purchased, and C is the amount of clothing.Price of food = Pf and price of clothing = PcThen Pf F is the amount of money spent on food, and Pc C is the amount of money spent on clothing.
Chapter 14842
Budget ConstraintsThe budget line then can be written:
Chapter 14942
Budget ConstraintsA040$80B2030$80D4020$80E6010$80G800$80Market BasketFood (F) Clothing (C)Total SpendingPf = ($1)Pc = ($2)PfF + PcC = I
Chapter 15012
Budget Constraints
(I/PC) = 40Food(units per week)406080 = (I/PF)201020300Clothing(unitsper week)Pc = $2 Pf = $1 I = $80
Chapter 15442
Budget ConstraintsThe Budget LineAs consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other.The slope of the line measures the relative cost of food and clothing.The slope is the negative of the ratio of the prices of the two goods.
Chapter 15542
Budget ConstraintsThe Budget LineThe slope indicates the rate at which the two goods can be substituted without changing the amount of money spent.
Chapter 15642
Budget ConstraintsThe Budget LineThe vertical intercept (I/PC), illustrates the maximum amount of C that can be purchased with income I.The horizontal intercept (I/PF), illustrates the maximum amount of F that can be purchased with income I.
Chapter 15742
Budget ConstraintsThe Effects of Changes in Income and PricesIncome ChangesAn increase in income causes the budget line to shift outward, parallel to the original line (holding prices constant).
Chapter 15842
Budget ConstraintsThe Effects of Changes in Income and PricesIncome ChangesA decrease in income causes the budget line to shift inward, parallel to the original line (holding prices constant).
Chapter 15842
Budget Constraints
Food(units per week)Clothing(unitsper week)8012016040204060800
Chapter 16142
Budget ConstraintsThe Effects of Changes in Income and PricesPrice ChangesIf the price of one good increases, the budget line shifts inward, pivoting from the other goods intercept.
Chapter 16242
Budget ConstraintsThe Effects of Changes in Income and PricesPrice ChangesIf the price of one good decreases, the budget line shifts outward, pivoting from the other goods intercept.
Chapter 16242
Budget Constraints
Food(units per week)Clothing(unitsper week)801201604040
Chapter 16542
Budget ConstraintsThe Effects of Changes in Income and PricesPrice ChangesIf the two goods increase in price, but the ratio of the two prices is unchanged, the slope will not change.
Chapter 16642
Budget ConstraintsThe Effects of Changes in Income and PricesPrice ChangesHowever, the budget line will shift inward to a point parallel to the original budget line.
Chapter 16642
Budget ConstraintsThe Effects of Changes in Income and PricesPrice ChangesIf the two goods decrease in price, but the ratio of the two prices is unchanged, the slope will not change.
Chapter 16742
Budget ConstraintsThe Effects of Changes in Income and PricesPrice ChangesHowever, the budget line will shift outward to a point parallel to the original budget line.
Chapter 16742
Consumer ChoiceConsumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.
Chapter 168
Consumer ChoiceThe maximizing market basket must satisfy two conditions:
1) It must be located on the budget line.2) Must give the consumer the most preferred combination of goods and services.
Chapter 169
Consumer ChoiceRecall, the slope of an indifference curve is:Further, the slope of the budget line is:
Chapter 170
Consumer ChoiceTherefore, it can be said that satisfaction is maximized where:
Chapter 171
Consumer ChoiceIt can be said that satisfaction is maximized when marginal rate of substitution (of F and C) is equal to the ratio of the prices (of F and C).
Chapter 172
Consumer ChoiceFood (units per week)Clothing(units per week)4080202030400
Chapter 176
Consumer ChoicePc = $2 Pf = $1 I = $80Food (units per week)Clothing(units per week)4080202030400
Chapter 177
Consumer ChoicePc = $2 Pf = $1 I = $80Food (units per week)Clothing(units per week)4080202030400
Chapter 178
Consumer ChoiceConsider two groups of consumers, each wishing to spend $10,000 on the styling and performance of cars.Each group has different preferences.
Designing New Automobiles (II)
Chapter 179
Consumer ChoiceBy finding the point of tangency between a groups indifference curve and the budget constraint auto companies can design a production and marketing plan.
Designing New Automobiles (II)
Chapter 179
Designing New Automobiles (II)
StylingPerformance$10,000$10,000$3,000$7,000
Chapter 181
Designing New Automobiles (II)
Styling$10,000$10,000Performance
Chapter 181
Consumer ChoiceChoosing between a non-matching and matching grant to fund police expenditures
Decision Making & Public Policy
Chapter 1
Consumer Choice
Non-matching GrantPoliceExpenditures ($)PrivateExpenditures ($)O
Chapter 1
Consumer Choice
RNon-matching GrantPPoliceExpenditures ($)PrivateExpenditures ($)OSQA
Chapter 1
Consumer Choice
TMatching GrantPolice ($)PrivateExpenditures ($)OQSRA
Chapter 1
Consumer Choice
TNonmatching GrantPoint BOU: Private expenditureOZ: Police expenditure
Matching GrantPoint COW: Private expenditureOX: Police expenditure
WXMatching GrantPPolice ($)PrivateExpenditures ($)OQAU2CR
Chapter 1
Consumer ChoiceA corner solution exists if a consumer buys in extremes, and buys all of one category of good and none of another. This exists where the indifference curves are tangent to the horizontal and vertical axis.MRS is not equal to PA/PB
A Corner Solution
Chapter 183
A Corner SolutionIce Cream (cup/month)FrozenYogurt(cupsmonthly)BA
Chapter 184
Consumer ChoiceA Corner SolutionAt point B, the MRS of ice cream for frozen yogurt is greater than the slope of the budget line.This suggests that if the consumer could give up more frozen yogurt for ice cream he would do so.However, there is no more frozen yogurt to give up!
Chapter 185
Consumer ChoiceA Corner SolutionWhen a corner solution arises, the consumers MRS does not necessarily equal the price ratio.In this instance it can be said that:
Chapter 186
Consumer ChoiceA Corner SolutionIf the MRS is, in fact, significantly greater than the price ratio, then a small decrease in the price of frozen yogurt will not alter the consumers market basket.
Chapter 187
Consumer ChoiceSuppose Jane Does parents set up a trust fund for her college education.Originally, the money must be used for education.
A College Trust Fund
Chapter 188
Consumer ChoiceIf part of the money could be used for the purchase of other goods, her consumption preferences change.
A College Trust Fund
Chapter 188
Consumer ChoiceEducation ($)OtherConsumption($)A College Trust Fund
Chapter 192
Revealed PreferencesIf we know the choices a consumer has made, we can determine what her preferences are if we have information about a sufficient number of choices that are made when prices and incomes vary.
Chapter 193
Revealed Preferences--Two Budget Lines
Dl1AI1: Chose A over B A is revealed preferred to Bl2: Choose B over D B is revealed preferred to DFood (units per month)Clothing(units permonth)
Chapter 197
Revealed Preferences--Two Budget Lines
Food (units per month)Clothing(units permonth)
Chapter 197
Revealed Preferences--Four Budget Lines
Food (units per month)Clothing(units permonth)
Chapter 1102
Revealed Preferences for Recreation
Amount of Exercise (hours)OtherRecreationalActivities($)025507520406080100ScenarioRobertas recreation budget = $100/wkPrice of exercise = $4/hr/weekExercises 10 hrs/wk at A given U1 & I1
Would the Clubs profits increase?
Chapter 1102
Marginal Utility andConsumer ChoiceMarginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.
Marginal Utility
Chapter 1107
Marginal Utility andConsumer ChoiceExampleThe marginal utility derived from increasing from 0 to 1 units of food might be 9Increasing from 1 to 2 might be 7Increasing from 2 to 3 might be 5Observation: Marginal utility is diminishing
Marginal Utility
Chapter 1108
Marginal Utility andConsumer ChoiceThe principle of diminishing marginal utility states that as more and more of a good is consumed, consuming additional amounts will yield smaller and smaller additions to utility.
Diminishing Marginal Utility
Chapter 1109
Marginal Utility andConsumer ChoiceMarginal Utility and the Indifference CurveIf consumption moves along an indifference curve, the additional utility derived from an increase in the consumption one good, food (F), must balance the loss of utility from the decrease in the consumption in the other good, clothing (C).
Chapter 1110
Marginal Utility andConsumer ChoiceFormally:
Chapter 1111
Marginal Utility andConsumer ChoiceRearranging:
Chapter 1112
Marginal Utility andConsumer ChoiceBecause:
Chapter 1
113
Marginal Utility andConsumer ChoiceWhen consumers maximize satisfaction the:
Since the MRS is also equal to the ratio of the marginal utilities of consuming F and C, it follows that:
Chapter 1115
Marginal Utility andConsumer ChoiceWhich gives the equation for utility maximization:
Chapter 1116
Marginal Utility andConsumer ChoiceTotal utility is maximized when the budget is allocated so that the marginal utility per dollar of expenditure is the same for each good.This is referred to as the equal marginal principle.
Chapter 1117
Marginal Utility andConsumer ChoiceIn 1974 and again in 1979, the government imposed price controls on gasoline.This resulted in shortages and gasoline was rationed.
Gasoline Rationing
Chapter 1118
Marginal Utility andConsumer ChoiceNonprice rationing is an alternative to market rationing.Under one form everyone has an equal chance to purchase a rationed good.Gasoline is rationed by long lines at the gas pumps.
Gasoline Rationing
Chapter 1118
Marginal Utility andConsumer ChoiceRationing hurts some by limiting the amount of gasoline they can buy.This can be seen in the following model.It applies to a woman with an annual income of $20,000.
Chapter 1119
Marginal Utility andConsumer ChoiceThe horizontal axis shows her annual consumption of gasoline at $1/gallon.The vertical axis shows her remaining income after purchasing gasoline.
Chapter 1120
Marginal Utility andConsumer Choice
Gasoline(gallons per year)Spendingon othergoods ($)20,000
Chapter 1123
Cost-of-Living IndexesThe CPI is calculated each year as the ratio of the cost of a typical bundle of consumer goods and services today in comparison to the cost during a base period.
Chapter 1124
Cost-of-Living IndexesWhat Do You Think?Does the CPI accurately reflect the cost of living for retirees?Is it appropriate to use the CPI as a cost-of-living index for other government programs, for private union pensions, and for other private wage agreements?
Chapter 1125
Cost-of-Living IndexesExampleTwo sisters, Rachel and Sarah, have identical preferences.Sarah began college in 1987 with a $500 discretionary budget. In 1997, Rachel started college and her parents promised her a budget that was equivalent in purchasing power.
Chapter 1126
Cost-of-Living IndexesPrice of books$20/book$100/bookNumber of books156Price of food$2.00/lb.$2.20/lbPounds of food100300Expenditure$500$1,260 1987 (Sarah) 1997 (Rachel)
Chapter 1127
Cost-of-Living Indexes
Chapter 1128
Cost-of-Living IndexesThe ideal cost-of-living adjustment for Rachel is $760.The ideal cost-of-living index is $1,260/$500 = 2.52 or 252.This implies a 152% increase in the cost of living.
Chapter 1129
Cost-of-Living Indexes
Food(lb./quarter)Books(per quarter)450252015105060050100200250300350400550500
Chapter 1131
Cost-of-Living IndexesThe ideal cost of living index represents the cost of attaining a given level of utility at current (1997) prices relative to the cost of attaining the same utility at base (1987) prices.
Chapter 1132
Cost-of-Living IndexesTo do this on an economy-wide basis would entail large amounts of information.Price indexes, like the CPI, use a fixed consumption bundle in the base period.Called a Laspeyres price index
Chapter 1133
Cost-of-Living IndexesThe Laspeyres index tells us:The amount of money at current year prices that an individual requires to purchase the bundle of goods and services that was chosen in the base year divided by the cost of purchasing the same bundle at base year prices.
Laspeyres Index
Chapter 1134
Cost-of-Living IndexesCalculating Rachels Laspeyres cost of living index Setting the quantities of goods in 1997 equal to what were bought by her sister, but setting their prices at their 1997 levels result in an expenditure of $1,720 (100 x 2.20 + 15 x $100)
Chapter 1135
Cost-of-Living IndexesHer cost of living adjustment would now be $1,220.The Laspeyres index is: $1,720/$500 = 344.This overstates the true cost-of-living increase.
Chapter 1136
Cost-of-Living Indexes
l2Food(lb./quarter)Books(per quarter)450252015105060050100200250300350400550500
Chapter 1131
Cost-of-Living IndexesWhat Do You Think?Does the Laspeyres index always overstate the true cost-of-living index?
Chapter 1138
Cost-of-Living IndexesYes!The Laspeyres index assumes that consumers do not alter their consumption patterns as prices change.
Chapter 1139
Cost-of-Living IndexesYes!By increasing purchases of those items that have become relatively cheaper, and decreasing purchases of the relatively more expensive items consumers can achieve the same level of utility without having to consume the same bundle of goods.
Chapter 1139
Cost-of-Living IndexesThe Paasche IndexCalculates 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 the base year.
Chapter 1140
Cost-of-Living IndexesBoth indexes involve ratios that involve todays current year prices, PFt and PCt.However, the Laspeyres index relies on base year consumption, Fb and Cb.Whereas, the Paasche index relies on todays current consumption, Ft and Ct .
Comparing the Two Indexes
Chapter 1141
Cost-of-Living IndexesThen a comparison of the Laspeyres and Paasche indexes gives the following equations:
Chapter 1142
Cost-of-Living IndexesSuppose:Two goods: Food (F) and Clothing (C)
Comparing the Two Indexes
Chapter 1141
Cost-of-Living IndexesLet:PFt & PCt be current year pricesPFb & PCb be base year pricesFt & Ct be current year quantities Fb & Cb be base year quantities
Comparing the Two Indexes
Chapter 1141
Cost-of-Living IndexesSarah (1990)Cost of base-year bundle at current prices equals $1,720 (100 lbs x $2.20/lb + 15 books x $100/book)Cost of same bundle at base year prices is $500 (100 lbs x $2.00/lb + 15 books x $20/book)
Comparing the Two Indexes
Chapter 1141
Cost-of-Living IndexesSarah (1990)
Comparing the Two Indexes
Chapter 1141
Cost-of-Living IndexesSarah (1990)Cost of buying current year bundle at current year prices is $1,260 (300 lbs x $2.20/lb + 6 books x $100/book)Cost of the same bundle at base year prices is $720 (300 lbs x $2/lb + 6 books x $20/book)
Comparing the Two Indexes
Chapter 1141
Cost-of-Living IndexesSarah (1990)
Comparing the Two Indexes
Chapter 1141
Cost-of-Living IndexesThe Paasche index will understate the cost of living because it assumes that the individual will buy the current year bundle in the base year.
The Paasche Index
Chapter 1143
Cost-of-Living IndexesIn 1995, the government adopted the chain-weighted price index to deflate its measure of real GDP.Developed to overcome problems that arose when long-term comparisons of GDP were made using fixed-weight price indexes and prices were rapidly changing.
Chapter 1144
Cost-of-Living IndexesWhat Do You Think?What is the impact on the Federal budget of using the CPI (a Laspeyres index) to adjust social security and other programs for changes in the cost of living?
The Bias of the CPI
Chapter 1144
SummaryPeople behave rationally in an attempt to maximize satisfaction from a particular combination of goods and services.Consumer choice has two related parts: the consumers preferences and the budget line.
Chapter 1145
SummaryConsumers make choices by comparing market baskets or bundles of commodities.Indifference curves are downward sloping and cannot intersect one another.Consumer preferences can be completely described by an indifference map.
Chapter 1145
SummaryThe marginal rate of substitution of F for C is the maximum amount of C that a person is willing to give up to obtain one additional unit of F.Budget lines represent all combinations of goods for which consumers expend all their income.
Chapter 1146
SummaryConsumers maximize satisfaction subject to budget constraints.The theory of revealed preference shows how the choices that individuals make when prices and income vary can be used to determine their preferences.
Chapter 1148
End of Chapter 3Consumer Behavior
Chapter 11
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