Chapter 7 Consumer Behavior Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. What will you learn in this chapter? • How revealed preferences relate to utility. • How budget constraints affect utility maximization. • How income affects consumption choices. • How prices affect consumption choices and how to distinguish between income and substitution effects. • How utility is influenced by outside perceptions, and how people get utility from altruism and reciprocity. 7-2 Utility basics • Utility is a measure of the amount of satisfaction a person derives from something. – Incorporates emotions and sensations. – Universal measure (or yardstick) that allows individuals to compare choices. – Not typically comparable across individuals. • Rational individuals maximize utility when making choices. – For example, if playing soccer for the next hour yields more utility than playing baseball, rational individuals will play soccer. 7-3 Revealed preferences • Utility is hard to measure. • How can anything meaningful be said about the utility people experience? – Observe what people actually do. • The principle of revealed preference is that people’s preferences can be determined by observing their choices and behavior. • Unique to a specific choice of a particular person at one date. 7-4 Utility functions • The principle of revealed preferences isn’t feasible for analyzing how people make choices. • Instead, a more formal method is required. • Utility functions aid in systematically analyzing choices. – A utility function is a formula for calculating the total utility that a particular person derives from consuming a combination of goods and services. • A bundle is a unique combination of goods and services that a person could choose to consume. 7-5 Utility functions • Utility functions quantify preferences. • Utility measurements are relative, not absolute. • For example, suppose Sarah receives a utility of 3 for each serving of mac-n-cheese she eats, 2 for broccoli, and 8 for ice cream. • If she eats 1 serving of mac-n-cheese, 2 servings of broccoli, and 2 of ice cream, then: total utility = (3 x 1) + (2 x 2) + (8 x 2) = 23 7-6 Marginal utility • When individuals continue to engage in an activity or consume more of one good or service, the utility from the next unit is not as great as the last unit. – Marginal utility is the change in total utility from consuming an additional unit of a good or service. – The principle of diminishing marginal utility is that the additional utility gained from consuming successive units of a good or service tends to be smaller than the utility gained from the previous unit or service. • Sometimes, marginal utility becomes negative. 7-7 Diminishing marginal utility The utility function and the marginal utility can be plotted. An individual maximizes utility when total utility is greatest or marginal utility is zero. Marginal utility per scoop Total utility 25 7 A 6 20 5 15 4 3 10 2 5 1 0 0 1 2 3 4 5 6 7 Scoops of ice cream 8 Total utility increases with each scoop of ice cream until point A, the seventh scoop, at which total utility is maximized. -1 A 1 2 3 4 5 6 7 Scoops of ice cream 8 Marginal utility measures the per unit utility from each scoop of ice cream. 7-8 Maximizing utility with constraints • People have many wants and are constrained by the time and money available to them. • Rational individuals maximize utility within those constraints by spending their resources on the bundle that yields the highest possible total utility. • A budget constraint provides all possible combinations of goods and services a consumer can buy for a given income. 7-9 The budget constraint The budget constraint for two goods is displayed using a movie ticket price of $15, a concert ticket price of $30, and an income of $120. Movie tickets 9 8 A Cody can buy 8 movie tickets for $120 … 7 6 5 …or 4 movie tickets and B 2 concert tickets … 4 3 2 1 C 0 1 2 3 Concert tickets 4 …or 4 concert tickets. • Point A: All income spent on movies (8 movie tickets). • Point B: Income spent on both goods (4 movie and 2 concert tickets). • Point C: All income spent on concerts (4 concert tickets). • Represents all feasible bundles. 5 7-10 Active Learning: The budget constraint Which bundle(s) are not within the following budget constraint? Movie tickets 9 E A G 4 I B 8 7 6 5 D 3 K 2 1 F H 0 1 2 3 Concert tickets C 4 J 5 7-11 Active Learning: The budget constraint Which bundle(s) are not within the following budget constraint? Movie tickets 9 E A G 4 I B 8 7 6 5 D 3 K 2 1 F H 0 1 2 3 Concert tickets C 4 J 5 7-12 Active Learning: The budget constraint • Find all feasible bundles using a movie ticket price of $15, a concert ticket price of $30, and an income of $120. • Is the bundle of 4 concert tickets and 1 movie ticket feasible? Bundle Concert tickets Movie tickets Total cost 7-13 Active Learning: The budget constraint • Find all feasible bundles using a movie ticket price of $15, a concert ticket price of $30, and an income of $120. • Is the bundle of 4 concert tickets and 1 movie ticket feasible? No Total cost Bundle Concert tickets Movie tickets A 0 8 120 B 1 6 120 C 2 4 120 D 3 2 120 E 4 0 120 F 4 1 135 7-14 Maximizing total utility Below are the associated utilities from consuming a specific number of concerts and movie tickets. Utility from concert tickets Utility from movie tickets Number of tickets Marginal utility Total utility Number of tickets Marginal utility Total utility 1 95 95 1 110 100 2 95 190 2 85 185 3 95 285 3 25 210 4 80 365 4 0 210 5 65 430 6 35 465 7 10 475 8 -10 465 Utility increases with each movie ticket until 7 tickets, at which total utility is maximized. Utility increases with each concert ticket until 3 tickets, at which total utility is maximized. 7-15 Maximizing total utility To maximize total utility, the total utility of each feasible bundle is identified and then compared to each other. Bundle Concert Utility from tickets concert tickets Movie Utility from tickets movie tickets Total utility A 0 0 8 465 465 B 1 100 6 465 565 C 2 185 4 385 570 D 3 210 2 190 400 E 4 210 0 0 210 • Bundle C with 2 concert tickets and 4 movie tickets has the highest total utility and is the preferred bundle. • Given this budget, a rational consumer spends all income on the combination of movie and concert tickets that maximizes utility. 7-16 Maximizing total utility Each bundle on the budget constraint has a corresponding utility. Movie tickets 9 8 A At point A, utility from concert tickets is 0 and utility from movie tickets is 465. Total utility is 465. 7 6 B At point B, utility from concert tickets is 100 and utility from movie tickets is 465. Total utility is 565. 5 C 4 3 At point C, utility from concert tickets is 185 and utility from movie tickets is 385. Total utility is 570. D 2 Budget constraint 1 0 1 2 3 Concert tickets At point D, utility from concert tickets is 210 and utility from movie tickets is 190. Total utility is 400. At point E, utility from concert tickets is 210 and E utility from movie tickets is 4 5 0. Total utility is 210. • Utility falls as one moves away from the preferred bundle, C. 7-17 Responding to changes in income • When a person’s income increases, more bundles of goods and services become affordable. • When income decreases, fewer bundles are affordable, and consumers will probably have to cut consumption of some things. • A change in income is represented by shifting the entire budget line outward. 7-18 The effect of an increase in income Suppose a person’s income increases from $120 to $180. Movie tickets • An increase in income allows individuals to afford more goods. • The entire budget line shifts outward. 14 12 1. An increase in income shifts the budget curve out. 10 8 New budget constraint 6 2. Cody can now afford as many as 12 movie tickets or 6 concert tickets. 4 2 0 1 2 3 4 Concert tickets 5 6 7-19 Active Learning: Effect of a decrease in income Suppose a mother decides to reduce her child’s movie and concert allowance. Graphically demonstrate the effect. Movie tickets 14 12 10 8 6 4 2 0 1 2 3 4 Concert tickets 5 6 7-20 Active Learning: Effect of a decrease in income Suppose a mother decides to reduce her child’s movie and concert allowance. Graphically demonstrate the effect. Movie tickets 14 12 1. A decrease in income shifts the budget curve in. 10 8 6 4 2 New budget constraint 0 1 2 3 4 Concert tickets 5 6 7-21 Responding to changes in prices • When prices change, an individual’s budget constraint is affected in two ways: – An income effect occurs as consumption changes from increased effective wealth due to a lower price. – The substitution effect is the change in consumption that results from a change in the relative price of goods. • The opportunity cost of consuming a good changes as prices change. • A price change causes the budget line to rotate. 7-22 The effect of a price change Suppose the price of a movie ticket decreases from $15 to $10. Movie tickets 14 • When the price of one good changes, the budget constraint rotates outward. • The new budget line demonstrates the new feasible bundles that are now available. • The change in the slope of the budget line reflects the change in the relative prices of the two goods. 12 movie tickets are now affordable. 12 10 A change in the price of one good rotates the budget curve. 8 6 4 New budget constraint 2 0 1 2 3 4 Concert tickets 5 6 7-23 Active Learning: The effect of a price change • Suppose that the price of a movie ticket increases from $15 to $30, while the price of a concert ticket and the consumer’s income stay the same at $30 and $120 respectively. • Find all feasible bundles of movie tickets and concert tickets. Bundle Concert tickets Movie tickets Total cost 7-24 Active Learning: The effect of a price change • Suppose that the price of a movie ticket increases from $15 to $30, while the price of a concert ticket and the consumer’s income stay the same at $30 and $120 respectively. • Find all feasible bundles of movie tickets and concert tickets. Total cost Bundle Concert tickets Movie tickets A 0 4 120 B 1 3 120 C 2 2 120 D 3 1 120 7-25 Utility and society • People gain utility from a variety of sources. – Outside perception: • What others think of your purchases. • How much others have. – Inward preferences: • How you prefer to spend your money. • Both outside perception and inward preferences contribute to decision making. 7-26 Utility, altruism, and reciprocity • Utility maximization encompasses individuals giving to others. – Altruism is a motive for action in which a person’s utility increases simply because someone else’s utility increases. – Altruistic and selfish or image-conscious motivations can coexist perfectly well. • Utility maximization suggests people gain utility by punishing bad behavior and rewarding good behavior. – Reciprocity is responding to another’s action with a similar action. 7-27 Summary • Economists assume that individuals seek to maximizes their utility within the limits of their available resources. • Individuals are constrained by their income and the prices of goods they desire to purchase. • A budget constraint shows all possible feasible consumption bundles available to an individual given a fixed budget. – An increase in income shifts the budget constraint outward. – An increase in price causes the budget constraint to rotate inward. 7-28 Summary • Economists generally assume that individuals’ preferences are demonstrated through the choices that they make, a concept known as revealed preference. • Individuals gain utility from a variety of sources. – Outside perception. – Inward preferences. • Utility maximization: – Individuals giving to others. – People gain utility by punishing bad behavior and rewarding good behavior. 7-29