CONSUMER PREFERENCES
Overview
• Context: firms must have an idea of how consumers behave
• Concepts: utility function, indifference curves, demand function,
consumer surplus
• Plan: understand where consumer demand comes from /
characterize consumer demand / examples
Utility function
• Setting: Suppose we consume two goods, apples (quantity qA )
and bananas (quantity qB )
• Utility function, U(qA , qB ): how much we like various quantities of
the two goods
• If we prefer (q 0 , q 0 ) to (qA , qB ) (two different combinations), then
A
B
U(qA0 , qB0 ) > U(qA , qB )
• If two combinations are equally good, then
U(qA0 , qB0 ) = U(qA , qB )
Indifference curves
• We can represent preferences like a contour map: draw lines
representing specific levels of utility, U(qA , qB ) = constant
• We refer to these lines as indifference curves, since the consumer
is indifferent between the choices on it
• Analogous to contour lines on a map
Digression: topographic maps
Indifference curves
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increasing utility
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Shape of indifference curves
• Utility rises as you move NE (more is better)
• Negative slope: if you add more of one good, to keep me
indifferent you have to subtract some of the other good
• Convex shape (diminishing marginal benefit)
• Closer substitutes → flatter indifference curves
Budget line and budget set
• What choices can consumer afford? If total income is y and prices
are pA and pB , then the budget set is given by:
pA qA + pB qB ≤ y
• This is the area below the budget line:
qA =
y
pB
−
q
pA
pA B
Budget line and budget set
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qA =
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Changes in prices and income
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Increase in Y
Initial budget constraint
Increase in pB
b0
b
b 00
qB
Y
pB
Optimal choice
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increasing utility
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qB∗
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Effect of an increase in pB
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Effect of an increase in y
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Optimal choice
• The consumer chooses the combination (q ∗ , q ∗ ) on the budget set
A
B
that hits the highest indifference curve
• Optimal choice is on the budget line (why?)
• The number of apples consumed depends on:
− The price of apples
− The price of bananas
− Income
• In general, demand might depend on other factors (Examples?)
Demand curve
• Demand curve: quantity demanded at any given price
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It is a schedule (demand vs. quantity demanded)
Slope and shape depend on tastes
Normally downward sloping
Price on the vertical axis
Inverse demand: what would you be willing to pay for 1 apple, 2nd
apple, 3rd apple, etc.
• Law of Demand: quantity demanded falls as price rises
− Availability of substitutes
− Limited budget
Examples of demand curves
p
p
q
q
Linear demand
Constant elasticity
demand
Demand function
• Quantity demanded also depends on other factors:
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prices of substitutes or complements
population and income
advertising
lots of other things
• Important to distinguish between:
− movements along the demand curve (changes in price)
− shifts in the curve itself (changes in other factors)
Example: Coke
pC
E1 → E2 : increase in price of Coke
E2 → E3 : decrease in price of Pepsi
p2 = p3
p1
E3
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E2
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q1
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Consumer surplus
• Surplus generated for consumers by market transactions
• Difference between price and willingness to pay (inverse demand
curve)
• Consumer surplus and value-in-use are important measures of the
efficiency of an economic system (e.g., compare competition with
monopoly, impact of taxes/tariffs)
Example: slices of pizza
p ($)
3
p=1
.2
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q (# slices)
Example: slices of pizza
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q (# slices)
Example: slices of pizza
p ($)
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p=1
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Consumer surplus
p
surplus
p∗
expenditure
q
q∗
Example: water and diamonds
p
p
q
Water:
large surplus
small expenditure
q
Diamonds:
small surplus
large expenditure
Takeaways
• Consumers have preferences (utility, indifference curves); and a
limited income to spend (budget set, budget line)
• Optimization leads to demand function and demand curve (direct
and inverse)
• Consumer surplus: “profit” from consumption (willingness to pay
exceeds price actually paid)