APPLIED ECONOMICS FOR BUSINESS
MANAGEMENT
Lecture # 2
• Review
• Go over Homework Sets #1 & #2
• Consumer Behavior
Lecture Outline:
• Review
• Homework Sets #1 & #2
• Consumer Behavior
Consumer Behavior:
Recall from introductory economics, for competitive
markets, the interaction of demand and supply
determines market price.
Let’s examine demand first.
Consumer Behavior
3 Characteristics of Consumer Behavior:
(i) consumers spend everything they
earn on goods and services.
Note: savings and investments are considered to be goods
which provide services, such as, increasing one’s wealth or
taking precautions against future uncertainties.
Money income is spent on: food, clothing, shelter, medicine,
entertainment, savings,……….etc.
Consumer Behavior
3 Characteristics of Consumer Behavior:
(i) consumers spend everything they
earn on goods and services.
(ii) consumers prefer more to less.
However, consumers do not buy infinite quantities
of goods because they have a limited amount of
money income.
Consumer Behavior
3 Characteristics of Consumer Behavior:
(i) consumers spend everything they
earn on goods and services.
(ii) consumers prefer more to less.
So consumers have a constraint, an income or
budget constraint, which limits the number of
commodities/services they can purchase while
trying to maximize their utility or satisfaction
derived from these commodities/services.
Consumer Behavior
What is utility?
Utility is the satisfaction which a good or service yields.
Consumer Behavior
3 Characteristics of Consumer Behavior:
(i) consumers spend everything they
earn on goods and services.
(ii) consumers prefer more to less.
(iii) Another noticeable feature of consumer behavior
is that income is not spent on only a single item,
rather a variety of goods and services are purchased.
The reason for this behavior is the
law of diminishing marginal utility.
Consumer Behavior
Law of Diminishing Marginal Utility
The law of diminishing marginal utility states
that as individuals consume additional units
of a specific commodity, consumption of other
goods and services unchanged, the amount of
satisfaction derived from each additional unit
of that good decreases.
Note: total utility or satisfaction increases but the additional
utility (called marginal utility) declines.
Preferences
In a given time period, the individual or household will
consume a variety of commodities and will express a
preference in consuming these items.
The objective of the consumer is to maximize utility for a
given level of income. In order to attain this objective, the
consumer must be able to rank different commodity
bundles.
Preferences
Example:
Let A, B, and C represent different commodity bundles.
Notation:
A & B are indifferent.
Ordering Preferences
We have the following postulates (rules) for ordering
preferences:
(i) Consumers have the ability to rank commodities.
For any given set of commodities, the consumer is able
to determine which commodity bundle provides the
most satisfaction.
Ordering Preferences
We have the following postulates (rules) for ordering
preferences:
(i) Consumers have the ability to rank commodities.
(ii) Antisymmetry in ordering i.e., if
(iii) Transitivity in ordering i.e., if
Ordering Preferences
(i) Consumers have the ability to rank commodities.
(ii) Antisymmetry in ordering i.e., if
(iii) Transitivity in ordering i.e., if
These 3 postulates are the necessary and sufficient
conditions for the consumer to be able to order
preferences.
Utility Function
The analysis of consumer behavior is greatly facilitated by
the use of an utility function.
Consider the following utility function:
where U = utility
= commodities
Utility Function
We assume that the utility function is continuous.
This means that for any level of y1 and y2, we can
determine a level of utility or satisfaction.
Also, this utility function is twice differentiable,
i.e., first and second order direct and cross partials
exist
(need this to derive optimal consumption bundles).
Utility Function
If
(where utils is the measure of
satisfaction), this can be achieved by various
combinations of and .
For instance, if the exact utility function can be written as:
Utility Function
then
Indifference Curve
These combinations of
and
yield a given level of
satisfaction (i.e
). So the indifference curve for
can be graphed as follows:
An indifference curve is
a curve or a locus of point
which shows combination
of commodities that yield
the consumer the same
amount of satisfaction or
utility.
Indifference Curve
An indifference curve map can be shown as follows:
Commodity
combinations on
yield greater
satisfaction than any
combination on
.
Likewise any
combination on
yields greater utility
than any combination
on .
Indifference Curve
Characteristics of indifference curves:
1. Downward sloping to the right.
2. Convex to the origin (or concave upward).
3. Cannot intersect one another.
Indifference Curve
What does downward to the right imply? Examine the previous
graph: giving up
for more .
What about convex to the
origin?
Concave upward.
Concavity
This also shows that as
more
are given up, the
consumer must be
compensated with
increasing additions of .
Concavity
We often call this feature:
diminishing marginal utility
(MU).
Additional units of
are
worth less in terms of
.
So we have diminishing MU
of .
Concavity
If the indifference curve had this shape:
As more
are given up,
the consumer must be
compensated with less
.
So additional units
of
are worth more to
the consumer.
Indifference Curve
Indifference curves cannot intersect one another:
Cannot have this case.
Why?
Reason #1: For point
A, what level of
satisfaction?
22 or 25 utils?
Indifference Curve
Reason #2: Point C
has greater satisfaction
than point B,
however, point C
consumes less y2
than point B.
Utility Function
Let
Take total differential:
Indifference Curve
Recall for an indifference curve,
Note: points along this
indifference curve yield a
constant amount of
satisfaction


Gain in utility
from consuming
more
Loss in
utility from
giving up
RCS
gain = loss  keep utility constant
Also,
We call the slope of the indifference curve,
the rate of commodity substitution (RCS).
RCS
The RCS shows substitutability of
for
.
So
The RCS measures the substitution of
for
as we move down along the indifference curve.
or negatively sloped indifference curve.
The RCS is often called the marginal rate of substitution
(MRS).
and
are used interchangeably.
Budget Constraint
Money income is a constraint to consumer purchases – a consumer
has a limited amount of income.
In the sample case of two commodities, if the consumer spends
his/her income in purchasing
and , we have the following
budget line:
Budget Constraint
If income
and
and
then how are the axes point determined?
Another way of asking the question:
What are the maximum quantities of and
that can be purchased by this consumer given
commodity prices and his/her budget of $100?
By spending all his/her income on
,
,
Budget Constraint
Likewise if he/she spend all of the income on
then he/she could purchase
So we know two points on the
budget line
Budget Constraint
Using these two points, we can find the slope of the budget line:
Budget Constraint
Another way to show this:
Take total differential:
Note: Since and
are given,
Consumer Equilibrium
Consumer equilibrium occurs where the budget
constraint is tangent to the indifference curve.
At point E, the indifference curve
is tangent to the budget line,
i.e., the slope of the indifference
curve is equal to the slope of the
budget line.
Consumer Equilibrium
Another way of saying this is the rate at which the
consumer is willing to substitute
for
is equal
to the rate at which the market permits the
substitution of
for
.
In other words, E is where:
The rational consumer desires to purchase
and
such that his/her utility is maximized subject to his/
her income or budget constraint.
Consumer Equilibrium
Given
and
Max utility subject to the budget constraint:
where λ is the Lagrange multiplier
1st order condition:
Consumer Equilibrium
Rearranging terms:
Consumer Equilibrium
Recall
and
So
So the critical values are those values of
and
such that the indifference curve is tangent to the
budget constraint (i.e., point E or the consumer
equilibrium point)
Marginal Utility of Income
What is λ?
which is the change in utility due to a change in income.
So, λ is the marginal utility of income
(
)
For the 2nd order condition:
Example
Suppose that a consumer has the following utility function:
where
and
are two commodities
Assume also that the consumer has a budget of
$100 to spend on and .
The market prices for
and
and
are:
Find the consumer equilibrium point where he/she
maximizes utility subject to the budget constraint.
Solving these two equations for λ:
Also,
Substituting the value of
Or
critical values:
,
and
2nd order condition:
Expand by 1st row:
So what does the solution look like graphically….
and
So if all income is spent on
purchasing , the
maximum amount of
the commodity
purchased
=
If all income is spent on
purchases
, then the
maximum amount
purchased
=
The consumer maximizes
utility subject to his income
or budget constraint at
point E.
What is the level of
consumer satisfaction or
utility at point E ?
Now, suppose the increases to
,
ceteris paribus (all other things constant).
Determine the new consumer equilibrium level for
Redo the optimization procedure:
and
.
So critical values:
,
, and
.
2nd order conditions to verify utility max subject to
budget constraint
Expand by 1st row:
critical values represent a
rel max
Graphically, we can show what has happened.
increases from
to
If consumer spent all income on

If consumer spent all income on
