Chapter 4 – Theory of Consumer Behaviour
Consumer behaviour properties
1.
2.
3.
4.
Completeness

Consumer knows their preference or indifference among all bundles

Consumer is either indifferent 𝐴~𝐵,

𝑂𝑟 ℎ𝑒 𝑝𝑒𝑟𝑓𝑒𝑟𝑠 𝑏𝑢𝑛𝑑𝑙𝑒 𝐴 𝑚𝑜𝑟𝑒 𝑡ℎ𝑎𝑛 𝑏𝑢𝑛𝑑𝑙𝑒 𝐵, 𝑒𝑡𝑐 𝐴 > 𝐵, 𝐵 < 𝐴
More is Better

The assumption that more is better provides important info about consumer preferences but it does not
help us determine a consumer preference for all possible bundles. It does not reveal whether bundle A is
preferred to bundle B

Indifference curve defines the combinations of 2 goods that give a consumer the same level of
satisfaction. If bundles A, B, C were all on the same indifference curve, consumer would be indifference
among the 3 bundles

MRS – the rate at which a consumer is willing to substitute one good for another to maintain the same
level of satisfaction (absolute value of the slope of an indifference curve)

Indifference curve satisfies the property of the diminishing MRS
Diminishing Marginal Rate of Substitution

As a consumer obtains more of good X, the amount of good Y that they are willing to give up to obtain
another unit of good X decreases

Implies that indifference curves are concave from the origin
Transitivity

For any 3 bundles, A, B and C, if 𝐴 > 𝐵, 𝐵 > 𝐶, 𝑎𝑛𝑑 𝐴 > 𝐶, 𝑡ℎ𝑒𝑛 𝐴~𝐶

Implies that indifference curves do not intersect with each other

Curves further from the origin imply higher levels of satisfaction
Consumer Equilibrium
Objective of the consumer is to choose the consumption bundle that maximizes their satisfaction or utility
Consumer have no incentive to change to a different affordable bundle at this point
Slope of an indifference curve = slope of the budget line
Comparative Statics
Prices Changes and Consumer behaviour
A change in the price of a good will lead to a change in the equilibrium consumption bundle
Goods X and Y are substitutes if an increase (decrease) in the price of X leads to an increase (decrease) in the
consumption of Y

If price of Pepsi increased, most people would tend to consume more Coke
Goods X and Y are complements if an increase (decrease) in the price of X leads to an decrease ( increase) in the
consumption of Y
Income changes and Consumer behaviour
Change in income also leads to a change in consumption patterns of consumers
Good X is a normal good if an increase (decrease) in income leads to an increase (decrease) in the consumption of
good X
Good X is a inferior good if an increase (decrease) in income leads to an decrease (increase) in the consumption of
good X
Substitution and Income Effects
Substitution Effect
Movement along the indifference curve that results from a change in the relative prices of goods, holding real
income constant
Income Effect
Movement from one indifference curve to another that results from a change in real income caused by a price
change
Total Effect of a price
Composed of substitution effect (effect of a higher relative price of good X) and income effect (reduced real income
of the consumer)
Substitution effect reflects a movement along an indifference curve, isolating the effect of the relative price change
on consumption
Income effect reflects a parallel shift in the budget line, isolating effect of reduced “real income” on consumption
Total effect of a price is A-> C
Applications of Indifference Curve Analysis
Choices of Consumers
Buy one, get one free deal and cash gifts, gift certificates
Two important benefits that sells gift certificates
1. As a manger, you can reduce the strain on your refund department by refunding gift certificates to customers
looking for a gift (true for both normal and inferior goods)
2. If you sell an inferior good, offering to sell gift certificates to those looking for gifts may result in a greater
quantity sold than if customers resorted to giving cash gifts (assuming you do not permit individuals to
redeem gift certificates for cash)
Choices of Workers and Managers
Model of Income – Leisure choice
Most workers view both leisure and income as goods and substitute between them at a diminishing rate along an
indifference curve
To induce works to give up leisure, firms must compensate them
Ex: Suppose a worker is offered a wage of $5 per hour plus a fixed payment of $40. What is the equation for the worker’s
opportunity set in a given 24-hour day? What are the maximum total earnings the worker can earn in a day? The minimum?
What is the price to the worker of consuming an additional hour of leisure?
-
Total Earnings (E) of a worker who consumes L hours of leisure in a 24 hour day is E=40+$5(24-L), so the
combinations of earnings (E) and leisure (L) satisfy E=160 -$5L
Thus, the most a worker can earn in a 24 hr. day is $160 (by consuming no leisure)
Least that can be earned is $40 (by not working at all)
Price of a unit of leisure is $5 since the opportunity cost of an hour of leisure is one hour of work
Relationship between Indifference curve analysis and demand curves
-
Indifference curves along with price changes determine the individuals demand curves
Market demand is the horizontal summation of individuals demands
Problem Solutions
3.
In the text, we showed a situation in which a gift certificate leads to a consumer to purchase a greater quantity
of an inferior good than they would consume if given a cash gift of equal value.

This is not always the case because if the consumer was initially consuming more of the inferior good
than a gift certificate would purchase, then less of the inferior good will be consumed when given a gift
certificate
4.
Provide an explanation for why a “buy one, get one free” deal is not the same as a half-price?

A half price cuts the price of each and every unit in half

Buy one, get one free deal does not change the relative price of any units between 0 and 1 unit. It makes
the price of units purchased between 1 and 2 units purchased zero
5.
Consumer budget line is 400 = 100X + 200Y
a) Determine the prices of goods X and Y: X = $100, Y=$200
𝑀
400
b) How many units of product Y should be purchased at point A? 𝑌 = =
= 2 𝑢𝑛𝑖𝑡𝑠
c)
How many units of product X could be purchased at point B? 𝑋 =
𝑌
400
100
200
= 4 𝑢𝑛𝑖𝑡𝑠
d)
e)
f)
g)
How many units of product X could be purchased at point B? 1 unit since $100 gift certificate will
purchase exactly one unit of good X
𝑀+100
How many units of product X could be purchased at point F?
= 5 𝑢𝑛𝑖𝑡𝑠
𝑃𝑥
Based on this consumer’s preferences, rank bundles A, B, C and D in order from most preferred to most
prefer? D, B, C, A
Is product X a normal or an inferior good? Normal
6.
A consumer must spend all of her income on two goods (X and Y). In each of the following scenarios, indicate
whether the equilibrium consumption of goods X and Y will increase or decrease. Assume X is a normal good
and good Y is an inferior good
a) Income doubles: consumption of X will increase and consumption of Y will decrease
b) Income quadruples and all prices double: consumption 𝑜𝑓 𝑋 𝑤𝑖𝑙𝑙 ↑, 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑜𝑓 𝑌 𝑤𝑖𝑙𝑙 ↓
c) Income and all prices quadruple: nothing will happen to the consumption of either good
d) Income is halved and all prices doubled: 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑜𝑓 𝑋 𝑤𝑖𝑙𝑙 ↓ 𝑎𝑛𝑑 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝑜𝑓 𝑌 𝑤𝑖𝑙𝑙 ↑
7.
All properties hold except “Diminishing MRS and More is better”
8.
A worker views leisure and income as “goods” and has an opportunity to work at an hourly wage of $15 per
hour.
a) Worker opportunity set in a given 24-hour period? E=360 – 15L
b) Suppose the worker is always willing to give up $11 of income for each hour of leisure. Do her preferences exhibit
a diminishing MRS? How many hours per day will she choose to work?
- The worker indifference curve does not exhibit diminishing MRS of substitution
- The worker always trades between the two goods at the same rate. Since $11 is less than $15, the worker will
choose to work 24 hours.
11. These preferences do not exhibit a diminishing MRS since consumers are always willing to substitute the same
amount of store brand sugar for an additional pound of producer brand sugar. When store brand sugar is $1 per
pound and producer brand sugar is $3 per pound, the consumer will purchase 24 pounds of store level sugar and no
producer brand sugar. After the change, the consumer will purchase no store label sugar and 8 pounds of producer
brand sugar.
12. When there is no food stamp program, MRS is -0.33. The food stamp program leaves MRS unchanged and a
consumer can purchase $284 of food without spending her income. A dollar-for dollar exchange of food stamps for
money further expands a consumer’s opportunity set, making her better off
16. Under the existing plan, a worker that does not “good off” produces 3 copiers per hour and is paid $9 each hour. Under the
new plan, each worker would be paid a flat wage of $8 per hour. While it might appear on the surface that the company would
save $1 per hour in labour costs by switching plans, the flat wage would be a lousy idea, Under the current plan, workers get
paid $9 only if they work hard during the hour and produce 3 machines that pass inspection. Under the new plan, workers
would get paid $8 an hour regardless of how many units they produce. Since your firm has no supervisors to monitor the
workers, you should not favour the plan.
18. Yes, since pizza is an inferior good, if consumer is given $50 in cash, she will for sure spend it entirely on music downloads.
– just as she would if given a $50 gift certificate for music downloads
22. Gift cards are not merely a fad. Retailers experience significant benefits from a gift cards since they minimize product
returns; independent of whether the good is normal or inferior. Gift cards can also benefit customers. A gift card does not
impact the amount purchased for one good (good on Y axis) but shifts out the budget constraint for the other good (good on X
axis) by the face value of the gift card. The expanded budget constraint permits the consumer to reach a higher indifference
curve, resulting in greater utility.
24. The movement of selling 9 bottles of Coke to 7 bottles of coke is the change in sales due to the substitution effect. We know
this because it is determine by keeping the consumer on the same indifference curve, and comparing purchases at the two
difference prices. The price increase also has an income effect; since it is effectively lowers the consumer’s overall purchasing
power. Since coke is a normal good, this lowering of income results in lower sales. Adding this to the substitution effect means
that sale will be less than 7.
25. As shown in the book, we can determine aggregate demand by summing up quantity demanded for each individual at
every price. At a given price P, quantity demanded by a female customer is 24-2P and at that same price, quanity demanded by
a male customer is 27-P. Summing give us 24-2P+27-P=51-3P. So for any price P, the total demand is 51-3P. If we call total
demand QT, we have the aggregate demand equation QT=51-3P. We often want to graph demand using the iverse demand
function. P=17-1/3QT