Economic
An economics professor and her husband went out to dinner and she observed one of her students drinking alcoholic beverages to excess. The professor knew the economics final exam was scheduled for the next morning. When the professor’s husband realized that the student was in his wifes economics class, he described the students behavior as irrational. The professor disagreed.
Under what conditions is behavior irrational according to the properties of consumer behavior discussed in the chapter? What situations could make the student’s behavior rational?
Title: The Theory of Individual Behavior
Contents
Understanding Consumer Behavior ………………………………………………………………………………. 3
Check Your Understanding ………………………………………………………………………………………….. 3
Question 1 ………………………………………………………………………………………………………………………………. 3
Question 2 ………………………………………………………………………………………………………………………………. 3
Consumer Behavior ……………………………………………………………………………………………………. 3
The Four Basic Properties of Consumer Behavior ……………………………………………………………………….. 4
Property 1: Completeness……………………………………………………………………………………………. 4
Property 2: More is Better ……………………………………………………………………………………………. 4
Property 3: Diminishing Marginal Rate of Substitution………………………………………………………. 6
Property 4: Transitivity ………………………………………………………………………………………………… 6
Constraints………………………………………………………………………………………………………………… 7
Budget constraints restrict consumers to the purchases that they can afford. ………………………………….. 7
Budget Set………………………………………………………………………………………………………………………………. 8
Budget Line …………………………………………………………………………………………………………………………….. 8
Budget Line Graph …………………………………………………………………………………………………………………… 9
Slope of the Budget………………………………………………………………………………………………………………….. 9
Changes in Income ………………………………………………………………………………………………………………… 10
Check Your Understanding ………………………………………………………………………………………….11
Question 3 …………………………………………………………………………………………………………………………….. 11
Question 4 …………………………………………………………………………………………………………………………….. 11
Consumer Equilibrium…………………………………………………………………………………………………12
Reaching A Balance……………………………………………………………………………………………………………….. 12
Price Changes and Consumer Equilibrium……………………………………………………………………..12
If X and Y are Substitutes ……………………………………………………………………………………………………….. 12
If X and Y are Complements ……………………………………………………………………………………………………. 13
Income Changes and Consumer Equilibrium ………………………………………………………………….13
Normal Good …………………………………………………………………………………………………………………………. 14
Inferior Good …………………………………………………………………………………………………………………………. 14
Substitution and Income Effects……………………………………………………………………………………14
Check Your Understanding ………………………………………………………………………………………….15
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10
)
Question 5 …………………………………………………………………………………………………………………………….. 15
Question 6 …………………………………………………………………………………………………………………………….. 16
Applications of Indifference Curve Analysis: Choices by Customers …………………………………..16
Applications of Indifference Curve Analysis: Cash Gifts, Certificates and In-kind Gifts …………..17
Applications of Indifference Curve Analysis: Income Leisure Choices…………………………………18
Check Your Understanding ………………………………………………………………………………………….18
Question 7 …………………………………………………………………………………………………………………………….. 18
Question 8 …………………………………………………………………………………………………………………………….. 18
Concept Scenarios……………………………………………………………………………………………………..19
Scenario 1 …………………………………………………………………………………………………………………………….. 19
Scenario 1: Solution ……………………………………………………………………………………………………………….. 19
Scenario 2 …………………………………………………………………………………………………………………………….. 19
Scenario 2: Solution ……………………………………………………………………………………………………………….. 20
Scenario 3 …………………………………………………………………………………………………………………………….. 20
Scenario 3: Solution ……………………………………………………………………………………………………………….. 20
Summary ………………………………………………………………………………………………………………….20
Review Questions ………………………………………………………………………………………………………21
Question 1 …………………………………………………………………………………………………………………………….. 21
Question 2 …………………………………………………………………………………………………………………………….. 22
Question 3 …………………………………………………………………………………………………………………………….. 22
Question 4 …………………………………………………………………………………………………………………………….. 22
Question 5 …………………………………………………………………………………………………………………………….. 23
Question 6 …………………………………………………………………………………………………………………………….. 23
Question 7 …………………………………………………………………………………………………………………………….. 23
Question 8 …………………………………………………………………………………………………………………………….. 23
Question 9 …………………………………………………………………………………………………………………………….. 23
Whats Next ………………………………………………………………………………………………………………24
Reference …………………………………………………………………………………………………………………24
Understanding Consumer Behavior
In this module we will explore the tools that help a manager understand behavior of individuals like, consumers and workers, and the impact of alternative incentives on their decisions. This is not as simple as you might think.
Human beings use complicated thought processes to make decisions. As a result, attempts to model individual behavior cannot capture the full range of real- world behavior.
However, in business, firms attempt to get a sense of what drives consumer behavior and use that information to describe how consumers make decisions using models of consumer behavior.
In this module, we will walk through the basics of how consumer behavior models are put together. Our model of behavior will necessarily be an abstraction of the way individuals make decisions. We will begin with a simple model that focuses on essentials instead of dwelling on behavioral features that would do little to enhance our understanding.
Check Your Understanding
Question 1
Which of the following statements is true?
Consumers rely on artificial intelligence to make decisions.
Understanding consumer behavior is only relevant for psychologists.
Taking into account consumer behavior should be a part of a firms planning processes.
Workers do not respond to incentives.
Answer
Its important for any business to take into account consumer behavior and then base their business decisions on that.
Question 2
Is the following statement true or false? Consumer decision making is easy to model. Answer
Human behavior is a result of a very complex brain. It is not easy to model its functionality.
Consumer Behavior
Two important but distinct factors to consider when characterizing consumer behavior are:
Consumer opportunities: These are the set of goods and services that a consumer can afford to purchase.
Consumer preferences: These are the preferences that consumers have determine the actual goods consumers end up purchasing.
In todays global economy, literally millions of goods are offered for sale. However, to focus on the essential aspects of individual behavior and to keep things manageable, we will assume that
only two goods exist in the economy. This assumption is made purely to simplify our analysis. All of the conclusions that we draw from this two-goods setting remain valid when there are many goods. We will let X represent the quantity of one good and Y the quantity of the other good. By using this notation to represent the two goods, we have a very general model in the sense that X and Y can be any two goods rather than restricted to, say, beef and pork.
The Four Basic Properties of Consumer Behavior
Assume a consumer is able to order his or her preferences for alternative bundles or combinations of goods from best to worst. We will let the greater than symbol denote a higher preference ordering and write A is greater than B whenever a consumer prefers bundle A over bundle B. If the consumer views both A and B equally satisfying, we will say she or he is indifferent between bundles B and A and use A is approximately equal to B as shorthand notation.
Thus:
If A > B, then, if given a choice between bundle A and bundle B, the consumer will choose bundle A.
If A B, the consumer, given a choice between bundle A and bundle B, will not care which bundle he or she gets.
These preference orderings are assumed to satisfy four basic properties:
Completeness
More is better
Diminishing marginal rate of substitution
Transitivity
We shall examine these properties and their implications in more detail.
Property 1: Completeness
For any two bundlessay, A and Beither A is greater than B, B is greater than A, or A is approximately equal to B. By assuming that preferences are complete, we assume the consumer is capable of expressing a preference for, or indifference among, all bundles.
If preferences were not complete, there might be cases where a consumer would claim to not know whether he or she preferred bundle A to B, preferred B to A, or was indifferent which of the two bundles they chose.
Property 2: More is Better
If bundle A has at least as much of every good as bundle B and some more goods, bundle A is preferred to bundle B. If more is better, the consumer views the products under consideration as goods instead of bads.
While the assumption that more is better provides important information about consumer preferences, it does not help us determine a consumers preference for all possible bundles. For example, the more is better property does not reveal whether bundle B is preferred to bundle A or bundle A is preferred to bundle B.
To be able to make such comparisons, we will need to make some additional assumptions. An indifference curve represents the combinations of two goods, say goods X and Y, that would give the consumers the same level of utility or satisfaction; that is, the combinations that would make them indifferent between any combination of goods along an indifference curve. The shape of the indifference curve depends on the consumers preferences (refer to the image).
A typical indifference curve is depicted in the given image.
By definition, all combinations of X and Y located on the indifference curve provide the consumer with the same level of satisfaction. For example, if you asked the consumer, Which would you preferbundle A, bundle B, or bundle C? the consumer would reply, I dont care, because bundles A, B, and C all lie on the same indifference curve. In other words, the consumer is indifferent among the three bundles. The shape of the indifference curve depends on the consumers preferences. Consumers have different preferences. Therefore, different consumers generally will have indifference curves of different shapes.
One important way to summarize information about a consumers preferences is in terms of the marginal rate of substitution (M R S). The concept of the marginal rate of substitution is actually quite simple. When the consumer is indifferent between bundles A and B, in moving from A to B, the consumer gains 1 unit of good X. To remain on the same indifference curve, she or he gives up 2 units of good Y (refer to the image).
The marginal rate of substitution (M R S) is the absolute value of the slope of an indifference curve. The marginal rate of substitution between two goods is rate at which a consumer is willing to substitute one good for another while keeping their level of satisfaction constant.
Thus, in moving from point A to point B, the marginal rate of substitution between goods X and Y is 2. The marginal rate of substitution associated with moving from A to B (in the image) differs from the rate at which the consumer is willing to substitute between the two goods in moving from B to C.
In particular, in moving from B to C, the consumer gains 1 unit of good X. But now he or she is willing to give up only 1 unit of good Y to get the additional unit of X. The reason is that this indifference curve satisfies the property of diminishing marginal rate of substitution.
Property 3: Diminishing Marginal Rate of Substitution
As a consumer obtains more of good X, the amount of good Y he or she is willing to give up, to obtain another unit of good X, decreases.
This assumption implies that indifference curves are convex from the origin; that is, they look like the indifference curve (refer to the image).
To see how the locations of various indifference curves can be used to illustrate different levels of consumer satisfaction, we must make an additional assumption that preferences are transitive.
Property 4: Transitivity
For any three bundles, A, B, and C:
If A is greater than B and B is greater than C, then A is greater than C
Similarly, if A is approximately equal to B and B is approximately equal to C, then A is approximately equal to C
The more is better assumption together with the transitive preferences assumption, imply that indifference curves cannot intersect.
To understand this, suppose Billys preferences are such that he prefers jelly beans to licorice, licorice to chocolate, and chocolate to jelly beans. He asks the clerk to fill a bag with jelly beans, because he prefers jelly beans to licorice.
When the clerk hands him a bagful of jelly beans, Billy tells her he likes chocolate even more than jelly beans. When the clerk hands him a bagful of chocolate, he tells her he likes licorice even more than chocolate. When the clerk hands him a bagful of licorice, Billy tells her he likes
jelly beans even more than licorice. The clerk puts back the licorice and hands Billy a bagful of jelly beans.
Now Billy is right back where he started! He is unable to choose the best kind of candy because his preferences for kinds of candy are not transitive.
The implications of these four properties are conveniently summarized in the image, which depicts three indifference curves.
The further away an indifference curve is from the origin, the higher the level of satisfaction.
Every bundle on the third indifference curve is preferred to those on the first and/or second indifference curve; just like the bundles on the second indifference curve are preferred to those on the first.
Each indifference curve is convex, and they do not cross or intersect each other.
Constraints
In making decisions, individuals face
constraints
. There are legal constraints, time constraints, physical constraints, and, of course, budget constraints. Specifically, we will examine the role prices and income play in budget set.
Budget constraints restrict consumers to the purchases that they can afford.
The
budget set
is a set of bundles of goods and/or services that a consumer can afford.
The
budget line
depicts combinations of a goods and/or services that can exhaust
consumers income.
To demonstrate how the presence of a budget constraint restricts the consumers choice, we need some additional shorthand notation. Let M represent the consumers income, which can be any amount.
Budget Set
By using M instead of a particular value of income, we gain generality in that the theory is valid for a consumer with any income level. We will let P underscore x and P underscore y represent the prices of goods X and Y, respectively. Given this notation, the opportunity set (also called the budget set) may be expressed mathematically as:
Budget Line
The budget set defines combinations of goods X and Y that the consumer can afford. The consumers expenditures on good X and their expenditures on good Y, do not exceed their income. Note that if the consumer spends their entire income on the two goods, this equation holds with equality. This relation is called the budget line and mathematically it can be shown as:
Budget Line Graph
Graphically, the budget line can be depicted as shown (refer to the image). If a consumer spent all their income on good X, expenditure on good X would be equal to:
The maximum quantity of good X that can be bought is:
Slope of the Budget
The slope of the budget, which is the market rate of substitution between goods X and Y, can be represented as P underscore x over P underscore y.
Point H is unattainable as it requires an expenditure that is greater than M.
All points below the budget line, like point G, are affordable. However, in the context of a consumer maximizing their benefits, points below the budget line are inefficient because a
consumer could increase their satisfaction (more is better) by consuming a combination of goods that is along their budget line, in order to maximize their satisfaction.
Changes in Income
When
income increases
without any change in prices, both the horizontal and vertical intercepts of the budget line
shift upward
since larger amounts of each good can be purchased at the higher income.
When
income decreases
without any change in prices, both the vertical and horizontal intercepts of the budget line
decrease
, because less of each good can be purchased at the lower income.
The figure here shows these movements graphically.
Changes in Prices
Suppose the
price
of good Y remains
unchanged
. Since the slope of the budget line is P underscore x over P underscore y, then a
drop
in P underscore x changes the slope, making the budget line
flatter.
A
reduction
in the
price
of good
X does not change
the
Y
intercept of the budget line. But the maximum amount of good
X
that can be bought at the lower price increase, shifting the
X
intercept.
A reduction in the price of good
X rotates
the budget line
counter clockwise
as seen in the figure here.
Check Your Understanding
Question 3
If a consumer has an income of $1,572.5, and if the price of good X is $8.5, what is the maximum number of units of good X a consumer can purchase?
Answer
Question 4
Which of the following is correct if B is greater than A and A is greater than C?
C is greater than B
B is greater than C
B is approximately equal to A
Answer
If B is greater than A and A is greater than C, then B is greater than C.
Consumer Equilibrium
Reaching A Balance
Consumers achieve equilibrium at a consumption bundle is the affordable bundle that yields the greatest satisfaction to the consumer. An important property of consumer equilibrium is that at the equilibrium consumption bundle, the slope of the indifference curve is equal to the slope of the budget line.
In the given figure, bundle C represents the consumers equilibrium choice. It is on the highest indifference curve; therefore, it represents the highest utility (compared to the other indifference curves) and since it is on the budget line, it is affordable.
Price Changes and Consumer Equilibrium
A price change will result in different equilibrium consumption bundle. A reduction in the price of good X leads to a counter clockwise rotation of the budget line. It expands a consumers opportunity set, allowing a consumer to achieve a higher level of satisfaction.
If X and Y are Substitutes
If goods X and Y are substitutes, an increase (or decrease) in the price of X leads to an increase (or decrease) in the consumption of Y; and a reduction in the price of X would lead a consumer to move from point A (in the above figure) to a point such as B, where less of Y is consumed than at point A.
If X and Y are Complements
If goods X and Y are complements, an increase (or decrease) in P underscore x leads to a decrease (or increase) in the Ys consumption; and a reduction in the price of X would lead the consumer to move from point A (in the above figure) to a point such as B, where more of Y is consumed than before.
Income Changes and Consumer Equilibrium
Changes in income either expand or contract the consumers budget constraint, and the
consumer, therefore, finds it optimal to choose a new equilibrium bundle.
When a consumers income increases, their budget line shifts out allowing them to achieve a higher level of satisfaction than before.
In the case of a price change, the exact location of the new equilibrium point will depend on consumer preferences.
Normal Good
If an increase (or decrease) in income leads to an increase or decrease in the consumption of good X, good X is a normal good; if good Y follows the same pattern, good Y is also a normal good.
Graphically, as shown in the figure, we would observe an increase in the consumption of both goods.
Inferior Good
If, the consumption of good X decreases or increases as income increases or decrease, then good X is an inferior good. If good Y is a normal good and good X is inferior, consumption of good X will increase and the of good Y will increase, as shown in the figure.
Substitution and Income Effects
The total effect of a price change is composed of substitution and income effects. Consider the figure shown here.
Suppose a consumer is initially at point A, and Px increases; resulting in a clockwise rotation of the budget line (from connecting point F and G to connecting points F and H). It is useful to isolate the two effects of a price change to see how each effect alters consumer choice individually. In particular, ignore for the moment the fact that the price increase leads to a lower indifference curve.
Now suppose that after the price increase, the consumer is given enough income to achieve the budget line connecting points J and I (shown in the figure). This budget line has the same slope as budget line F H, but it implies a higher income than budget line F H. The consumer does not actually face budget line J I when the price increases but instead faces budget line F H.
Given this budget line, the consumer will achieve equilibrium at point B, where less of good X is consumed than in the initial situation, point A. The movement from A to B is called the
substitution effect
; it reflects how a consumer will react to a different market rate of
substitution. The substitution effect is the difference between X to the power of zero and X to the power of M as shown in the figure.
Let us now take back the income we gave to the consumer to compensate for the price increase. When this income is taken back, the budget line shifts from J I to F H. This shift in the budget line reflects only a reduction in income; the slopes of budget lines J I and F H are identical.
This movement from B to C is called the
income effect
. The income effect is the difference X to the power of M and X to the power of 1 (as seen in the figure). It reflects the fact that when price increases, the consumers
real income
falls. Since good X is a normal good (in the figure), the reduction in income leads to a further reduction in the consumption of X.
Check Your Understanding
Question 5
Suppose income (M) increases from
and the optimal number units of good X for a particular consumer decreases, we can infer that:
Good X is a normal good.
The price of good X increased.
The consumer has a higher preference for good X over good Y.
None of the above.
Answer
If the income (M) increases from
and the optimal number units of good X for a particular consumer decreases, we can infer that
good X is an inferior good.
Question 6
What happens when goods X and Y are normal goods that are substitutes and income increases, while all else are constant?
Answer
When goods X and Y are normal goods that are substitutes and income increases, while all else are constant, the Y intercept becomes larger.
Applications of Indifference Curve Analysis: Choices by
Customers
The
buy one, get one free
marketing scheme is quite easy to analyze in our framework.
In the figure here, a consumer buys one large pizza at point D, but prefers the bundle that is on a higher indifference, such as point C.
With a
buy one, get one free
deal, that consumers budget line is now A D E F. If she buys more than one large pizza her budget line becomes D E F since she will have an extra pizza for free. The second free pizza means that between one and two large pizzas, the price of pizza is equal to zero and the budget line is thus horizontal between one and two large pizzas.
If a consumer buys more than two pizzas, their budget set is bound by A D E F, setting that consumer on a bundle on a higher indifference curve that their budget would not have otherwise allowed for without the
buy one, get one free
deal.
Applications of Indifference Curve Analysis: Cash Gifts, Certificates and In-kind Gifts
Lets suppose that Sam received a gift certificate. It is only good for $10 worth of merchandise
at store X, which sells good X.
By receiving a gift certificate, Sam cannot purchase any more of good Y that he could before he received the certificate, as the certificate is valid only for good X, in store X. But if he spends all his income on good Y, he can still purchase $10 worth of good X with that certificate.
And if he spends all his income on good X, he can purchase $10 more than he could before because of the gift certificate. In effect, the gift certificate is like money that is good only at store X.
To examine what happens to behavior when a consumer receives a gift certificate, lets suppose that the consumer is in equilibrium initially at point A as shown in the figure, spending $10 on good X. What happens if the consumer is given a $10 gift certificate good only for items in store X?
If both X and Y are normal goods, the consumer will desire to spend more on both goods as income increases. Thus, if both goods are normal goods, the consumer moves from A to C as seen in the figure. In this instance, the consumer reacts to the gift certificate just as she or he would have reacted to a cash gift of equal value.
Applications of Indifference Curve Analysis: Income Leisure
Choices
Most workers view both leisure and income as goods and substitute between them at a diminishing rate along an indifference curve. While workers enjoy leisure, they also enjoy income.
To induce workers to give up leisure, firms must compensate them. Worker behavior thus may be examined in much the same way we analyzed consumer behavior.
The worker attempts to achieve a higher indifference curve until he or she achieves one that is at a tangent to the opportunity set, for example, at point E shown in the figure here. In this instance, the worker consumes 16 hours of leisure and works 8 hours to earn a total of $80 per day.
Check Your Understanding
Question 7
Is the following statement true or false?
A gift certificate could allow a consumer to consume bundles beyond what their income would have otherwise allowed.
Answer
A gift certificate could allow a consumer to consume bundles beyond what their income would have otherwise allowed.
Question 8
Which of the following is not true about
buy one, get one free
marketing schemes?
They can induce consumers to buy more than they would have.
They only apply to normal goods and not inferior goods.
They could increase consumer satisfaction
They could change a consumers optimal consumption bundle.
Answer
Buy one, get one free marketing schemes do not apply only to normal goods. They apply to inferior goods also.
Concept Scenarios
Scenario 1
Jeff consumes two goods: good X and good Y.
He is currently consuming 20 units of good X and 10 units of good Y. Jeffs marginal rate of
substitution between good X and Y is 2.
If the price of good X is $12 and good Y is $6, is Jeff in equilibrium?
Tip 1
Edward Davies and Martha are your peers for this course.
Edward Davies: He is not in equilibrium because he is not consuming the same number of units for good X and Y.
Martha: Perhaps we should consider how many units of good X would he be willing to give up in order to get another unit of good Y and check how that relates to the price ratio.
Tip 2
Watch the instructional video,
Optimal point on budget line | Microeconomics by Khan Academy to help you find the solution.
Tip 3
Refer to the lecturette section on Constraints to help you find the solution.
Scenario 1: Solution
At equilibrium the price ratio = the marginal rate of substitution. Therefore, Jeff is in equilibrium since:
Scenario 2
Suppose the equation of the budget line for a particular consumer is:
If good X is a normal good and the price of good X increases from $8 to $10, how does that affect the equation of the budget line and the consumption of good X?
Tip 1
Edward
