Principles of Economics
Session 3
Topics To Be Discussed
Consumer Preferences
Budget Constraints
Consumer Choice
Marginal Utility
Substitution and Income Effect
Topics to be Discussed
Market Demand
Consumer Surplus
Recognizing Lock-In
Steps of Studying
Consumer Behavior
Study consumer preferences

How and why do people prefer one good to another?
Study budget constraint

How are consumers constrained by their limited
incomes?
Combine consumer preferences and budget
constraints to determine consumer choices

What combination of goods will consumers buy to
maximize their satisfaction?
Market Basket
A market basket is a collection of one or
more commodities.
One market basket may be preferred
over another market basket containing a
different combination of goods.
Three Basic Assumptions
Preferences are complete.
Preferences are transitive.
Consumers always prefer more of any
good to less.
Consumer Preferences
Market
Basket
A
Units of
Food
20
Units of
Clothing
30
B
10
50
D
40
20
E
30
40
G
10
20
H
10
40
Indifference Curves
Indifference curves
represent all combinations
of market baskets that
provide the same level of
satisfaction to a person.
Consumer Preferences
 Combination B,A, & D
yields the same satisfaction
 E is preferred to U1
 U1 is preferred to H & G
Clothing
(units per week)
B
50
H
E
40
A
30
D
20
Indifference Curve
G
10
10
20
30
40
Food
(units per week)
Consumer Preferences
Clothing
(units per week)
50
B
40
H
The consumer prefers
A to all combinations
in the blue box, while
all those in the pink
box are preferred to A.
E
A
30
D
G
20
10
10
20
30
40
Food
(units per week)
Indifference Map
An indifference map is a set of
indifference curves that describes a
person’s preferences for all
combinations of two commodities.
Indifference Map
Clothing
(units per week)
 Market basket A is
preferred to B.
 Market basket B is
preferred to D.
D
B
A
U3
U2
U1
Food
(units per week)
Indifference Curves Can’t Cross
Clothing
(units per week)
U2
U1
A
The consumer should be
indifferent between A, B
and D. However, B
contains more of both
goods than D.
B
D
Food
(units per week)
Substitution
A
Clothing 16
(units
per week) 14
12
The amount of clothing
given up for a unit of food
decreases from 6 to 1
-6
10
B
1
8
-4
D
6
1
E
-2
4
G
1 -1
1
2
1
2
3
4
5
Food
(units per week)
Marginal Rate of Substitution
The marginal rate of substitution (MRS)
quantifies the amount of one good a
consumer will give up to obtain more of
another good.
 It is measured by the slope of the
indifference curve.
Diminishing MRS
A
Clothing 16
(units
per week) 14
12
MRS = 6
MRS   C
-6
10
B
1
8
F
-4
D
6
MRS = 2
1
-2
4
E
1 -1
2
1
2
3
4
G
1
5
Food
(units per week)
Perfect Substitutes and
Perfect Complements
Two goods are perfect substitutes when
the marginal rate of substitution of one
good for the other is constant.
 Two goods are perfect complements when
the indifference curves for the goods are
shaped as right angles.
Perfect Substitutes
Apple
Juice
(glasses) 4
3
2
1
0
1
2
3
4
Orange Juice
(glasses)
Perfect Complements
Left
Shoes
4
3
2
1
0
1
2
3
4
Right Shoes
Application of Consumer
Preferences
Automobile executives must regularly
decide when to introduce new models
and how much money to invest in
restyling.
An analysis of consumer preferences
would help to determine when and if car
companies should change the styling of
their cars.
Consumer Preferences
Styling
Consumers are
willing to give up
considerable
styling for additional
performance
MRS＞1
Performance
Consumer Preferences
Styling
Consumers are
willing to give up
considerable
performance for
additional styling
MRS＜1
Performance
Utility
Utility refers to numerical
score representing the
satisfaction that a consumer
gets from a given market
basket.
Utility Function
U=f(X1 , X2 , X3 , … Xn)
Assume the utility function for food
(F) and clothing (C)
U=f(F, C) = F + 2C
Market Baskets
F Units
C Units
Utils
A
8
3
8 + 2(3) = 14
B
6
4
6 + 2(4) = 14
C
4
4
4 + 2(4) = 12
The
consumer is indifferent to A & B
The
consumer prefers A & B to C
Utility Functions &
Indifference Curves
Clothing
(units
per week)
Assume: U = FC
C
25 = 2.5×10
A
25 = 5 ×5
B
25 = 10 ×2.5
15
C
10
U3 = 100 (Preferred to U2)
A
5
B
0
5
10
U2 = 50 (Preferred to U1)
U1 = 25
15
Food
(units per week)
Ordinal vs. Cardinal Utility
Ordinal Utility Function: places market
baskets in the order of most preferred to
least preferred, but it does not indicate
how much one market basket is preferred
to another.
 Cardinal Utility Function: utility function
describing the extent to which one
market basket is preferred to another.
Budget Constraints
Budget constraints limit an
individual’s ability to consume in
light of the prices they must pay
for various goods and services.
Budget Line
The budget line indicates all
combinations of two commodities
for which total money spent
equals total income.
Budget Line
 Let
F = amount of food purchased
C = amount of clothing purchased
Pf = Price of food
Pc = price of clothing
M = money income
 Then
M  Pf F  PcC
Budget Line
Market Food (F) Clothing (C) Total Spending
Basket
Pf=$1
Pc=$2
PfF+PcC=M
A
0
40
$80
B
20
30
$80
D
40
20
$80
E
60
10
$80
G
80
0
$80
Budget Line
Clothing
(units
per week)
(M/PC) = 40
Pc = $2
Pf = $1
M = $80
A
Budget Line F + 2C = $80
B
30
M / Pc
Slope  C / F  
M / Pf
D
20
1
  Pf / Pc  
2
E
10
G
0
20
40
60
Food
80 = (M/PF) (units per week)
Budget Line
 As
consumption moves along a
budget line from the intercept, the
consumer spends less on one item
and more on the other.
 The slope of the line measures the
relative cost of food and clothing.
Budget Line
 The
slope is the negative of the ratio
of the prices of the two goods.
 The slope indicates the rate at which
the two goods can be substituted
without changing the amount of
money spent.
Budget Line
The vertical intercept (M/PC),
illustrates the maximum amount of C
that can be purchased with income M.
 The horizontal intercept (M/PF),
illustrates the maximum amount of F
that can be purchased with income M.
Effect of Income Change
Clothing
(units
per week)
A increase in
income shifts the
budget line outward
80
60
A decrease in
income shifts the
budget line inward
40
20
L3
(M=
$40)
0
40
L2
L1
(M = $80)
80
120
(M = $160)
160
Food
(units per week)
Effect of Price Change
Clothing
(units
per week)
An increase in the price of food
to $2.00 changes the slope of the
budget line and rotates it inward.
A decrease in the price of food to
$.50 changes the slope of the
budget line and rotates it outward.
40
L3
L1
L2
(PF = 1)
(PF = 2)
40
80
(PF = 1/2)
120
160
Food
(units per week)
Consumer Choice
Consumers choose a combination
of goods that will maximize the
satisfaction they can achieve,
given the limited budget available
to them.
Conditions to Maximize Utility
 The choice must be located on the
budget line.
 The choice must give the consumer
the most preferred combination of
goods and services.
Consumer Choice
The MRS of an indifference curve is:
C
MRS  
F
The slope of the budget line is:
Slope  
Pf
Pc
Therefore, satisfaction is maximized where:
MRS 
Pf
Pc
Satisfaction Maximization
Satisfaction is maximized
when marginal rate of
substitution (of F and C)
is equal to the ratio of the
prices (of F and C).
Consumer Choice
Clothing
(units per
week)
Pc = $2
M = $80
Point B does not maximize
satisfaction because the
MRS (-10/10) = 1 is greater
than the price ratio (1/2).
40
30
Pf = $1
B
-10C
Budget Line
20
U1
+10F
0
20
40
80
Food (units per week)
Consumer Choice
Clothing
(units per
week)
Pc = $2
Pf = $1
40
M = $80
Market basket D
cannot be attained
given the current
budget constraint.
D
30
20
U3
Budget Line
0
20
40
80
Food (units per week)
Consumer Choice
Clothing
(units per
week)
Pc = $2
Pf = $1
M = $80
At market basket A the budget line
and the indifference curve are
tangent and no higher level of
satisfaction can be attained.
40
30
A
20
At A: MRS =Pf /Pc = .5
U2
Budget Line
0
20
40
80
Food (units per week)
Consumer Choice
Clothing
(units per
week)
Pc = $2
Pf = $1
M = $80
40
30
D
A
D is not available.
A offers less satisfaction than B.
B is the optimum choice.
B
20
U3
U2
U1
0
20
40
80
Budget Line
Food (units per week)
Marginal Utility and
Consumer Choice
Marginal utility measures the
additional satisfaction
obtained from consuming one
additional unit of a good.
Diminishing Marginal Utility
 The
marginal utility derived from
increasing from 0 to 1 units of food
might be 9
 Increasing
from 1 to 2 might be 7
 Increasing
from 2 to 3 might be 5
Principle of Diminishing MU
The principle of diminishing
marginal utility states that as more
and more of a good is consumed,
consuming additional amounts will
yield smaller and smaller additions
to utility.
Marginal Utility and
Indifference Curve
If consumption moves along an
indifference curve, the additional
utility derived from an increase in
the consumption one good, food (F),
must balance the loss of utility from
the decrease in the consumption in
the other good, clothing (C).
Marginal Utility and
Consumer Choice
MU F (F )  MU c (C )
F
MU c

C
MU F
F
PC
MRS 
 F
C
P
MU c
PC
 F
F
MU
P
Equation for Utility Maximization
P
P

MU F MU c
F
C
Equal Marginal Principle
The equal marginal principle
states that total utility is
maximized when the budget is
allocated so that the marginal
utility per dollar of expenditure is
the same for each good.
Equal Marginal Principle
Constraint=$20
Hot dog price=$2.5
MU of
Units per hot dogs
game
(MUH )
1
20
2
15
MUH /PH
8
6
Coke price=$2
MU of
Cokes
(MUc )
60
40
MUc /Pc
30
20
3
12.5
5
20
10
4
5
10
7.5
4
3
16
8
8
4
6
5
2
4
2
Equal Marginal Principle
P1
P2
P3
PN



...

MU1 MU 2 MU 3
MU N
Equal Marginal Principle
Budget=$2,000 TV ad price=$400 Radio ad price=$300
Number of ads
1
2
3
4
5
6
Increase in units sold
MBTV
MBRadio
400
360
300
270
280
240
260
225
240
150
200
120
Equal Marginal Principle
Budget=$2,000 TV ad price=$400 Radio ad price=$300
Number of ads
1
2
3
4
5
6
Increase in units sold
MBTV
MBRadio
400/400=1.00 360/300=1.20
300/400=0.75 270/300=0.90
280/400=0.70 240/300=0.80
260/400=0.65 225/300=0.75
240/400=0.60 150/300=0.50
200/400=0.50 120/300=0.40
Effect of a Price Change
Clothing
(units per
month)
M = $20
PC= $2
PF =$2, $1, $0.5
10
A
7
6
5
B
U1
D
U3
U2
3
8 10
20
Three separate
indifference curves
are tangent to
each budget line.
40
Food (units
per month)
Effect of a Price Change
Clothing
(units per
month)
The price-consumption curve
traces out the utility maximizing
market basket for the various
prices for food.
10
A
7
6
5
B
U1
D
U3
Price-consumption curve
U2
3
8 10
20
40
Food (units
per month)
Demand Curve
Clothing10
(units per
month) 7
6
5
A
B
U2
3 8 10
Price
of Food
D
U1
U3
20
40 Food (units per month)
$2.00
$1.00
Demand curve
$0.50
3 8
20
Food (units per month)
Effects of Income Changes
Pf = $1
Pc = $2
M = $10, $20, $30
15
Clothing
(units per
month)
10
Income-consumption
curve
7
D
5
U3
U2
B
3
U1
A
4
10
16
20
Food (units
30 per month)
Effects of Income Changes
Price
of
food
An increase in income,
from $10 to $20 to $30,
with the prices fixed,
shifts the consumer’s
demand curve to the right.
E
$1.00
G
H
D3
D2
D1
4
10
16
Food (units
per month)
Effects of Income Changes
 An
increase in income shifts the
budget line to the right, increasing
consumption along the incomeconsumption curve.
 Simultaneously, the increase in
income shifts the demand curve to
the right.
Normal Good vs. Inferior Good
Normal Good
 The
income-consumption curve has a
positive slope.
 The
quantity demanded increases with
income.
 The
income elasticity of demand is
positive.
Normal Good vs. Inferior Good
Inferior Good
 The
income-consumption curve has a
negative slope.
 The
quantity demanded decreases with
income.
 The
income elasticity of demand is
negative.
An Inferior Good
Steak 15
(units per
month)
Income-Consumption Curve
Both hamburger and steak behave as
a normal good, between A and B...
C
10
…but hamburger becomes an
inferior good when the income
consumption curve bends
backward between B and C.
U3
B
5
U2
A
U1
5
10
20
Hamburger
30 (units per month)
Income and Substitution Effects
Substitution Effect
Consumers will tend to buy more of the good
that has become relatively cheaper, and less of
the good that is now relatively more expensive.
 Income Effect
Consumers experience an increase in real
purchasing power when the price of one good
falls.
Income and Substitution Effects
Clothing
(units per
month) 20
Normal Good
M=$60, Pf = $3, Pc = $3
Decreased Pf = $2
Total Effect = 18.5
17
16
A
Income Effect = 4.5
Substitution Effect = 14
D
5
B
U2
Substitution
Effect
U1
Food (units
O
4
Total Effect
18 20
22.5 25.5 30
per month)
Income Effect
Income and Substitution Effects
Clothing
(units per
month) 20
M=$60, Pf = $3, Pc = $3
Inferior Good
Decreased Pf = $2
Total Effect = 6.5
17
16
A
Substitution Effect = 14
B
Income Effect = - 7.5
13
U2
D
5
Substitution
Effect
O
10.5
4
Total Effect
Substitution Effect ＞
Income Effect.
U1
25.5 30
18 20
Income Effect
Food (units
per month)
Income and Substitution Effects
Clothing
(units per
month) R
Giffen Good
The income effect may
theoretically be large enough
to cause the demand curve for
a good to slope upward. This
is of little practical interest
B
A
U2
D
Total Effect
O
U1
F2 F1
E
Income Effect
S
Substitution
Effect
T
Food (units
per month)
Market Demand
Price Individual A Individual B Individual C Market
($)
(units)
(units)
(units)
(units)
1
6
10
16
32
2
4
8
13
25
3
2
6
10
18
4
0
4
7
11
5
0
2
4
6
Market Demand Curve
Price
5
The market demand
curve is obtained by
summing the consumer’s
demand curves
4
3
Market Demand
2
1
0
DA
5
DB
10
DC
15
20
25
30
Quantity
Consumer Surplus
Willingness to pay is the maximum
price that a buyer is willing and able
to pay for a good.
It measures how much the buyer
values the good or service.
Consumer Surplus
Consumer surplus is the amount
a buyer is willing to pay for a
good minus the amount the buyer
actually pays for it.
Four Possible Buyers’
Willingness to Pay
Buyer
Willingness to Pay
John
$100
Paul
80
George
70
Ringo
50
Consumer Surplus
The market demand curve depicts
the various quantities that buyers
would be willing and able to
purchase at different prices.
Four Possible Buyers’
Willingness to Pay
Price
Buyer
Quantity
Demanded
More than $100
None
0
$80 to $100
John
1
$70 to $80
John, Paul
2
$50 to $70
John, Paul, George
3
$50 or less
John, Paul,
George, Ringo
4
Measuring Consumer Surplus
with the Demand Curve
Price of
Album
John’s willingness to pay
$100
Paul’s willingness to pay
80
70
George’s willingness to pay
Ringo’s willingness to pay
50
Demand
0
1
2
3
4
Quantity of
Albums
Measuring Consumer Surplus
with the Demand Curve
Price of
Album
Price = $80
$100
John’s consumer surplus ($20)
80
70
50
Demand
0
1
2
3
4
Quantity of
Albums
Measuring Consumer Surplus
with the Demand Curve...
Price of
Album
Price = $70
$100
John’s consumer surplus ($30)
80
70
50
Paul’s consumer surplus ($10)
Total
consumer
surplus ($40)
Demand
0
1
2
3
4
Quantity of
Albums
Measuring Consumer Surplus
with the Demand Curve
The area below the demand curve
and above the price measures the
consumer surplus in the market.
How the Price Affects
Consumer Surplus
Price
A
P1
P2
Initial
consumer
surplus
B
D
Additional
consumer
surplus to
initial
consumers
0
Consumer
surplus to new
consumers
C
E
F
Demand
Q1
Q2
Quantity
Paradox of Value
Nothing is more useful than water; but
it will scare purchase anything. A
diamond, on the contrary, has scarce
any value in use; but a very great
quantity of other goods may frequently
be had in exchange for it
－The Wealth of Nations, Adam Smith
Price and Usefulness
of Diamond
Price
P
Consumer Surplus
Demand
0 Q
Quantity
Price and Usefulness
of Water
Price
Demand
Consumer Surplus
P
0
Q Quantity
Consumer Surplus and
Economic Well-Being
Consumer surplus, the amount that
buyers are willing to pay for a good
minus the amount they actually pay
for it, measures the benefit that
buyers receive from a good as the
buyers themselves perceive it.
Consumer Surplus and
Importation
Price
Domestic
supply
Price before
trade
World
Price
Price after
trade
Imports
0
Domestic
quantity
supplied
Domestic
quantity
demanded
Domestic
demand
Quantity
Consumer Surplus and
Importation
Price
Consumer surplus
before trade
Domestic
supply
A
Price before
trade
Price after
trade
World
Price
Domestic
demand
0
Quantity
Consumer Surplus and
Importation
Price
A
Price before
trade
Price after
trade
0
B
Consumer surplus
after trade
D
Imports
Domestic
supply
World
Price
Domestic
demand
Quantity
Recognizing Lock-In
Recognizing Lock-In
Cost of switching
Compare

Ford v. GM

Mac v. PC
What’s the Difference?
Durable investments in complementary
assets



Hardware
Software
Wetware
Supplier wants to lock-in customer
Customer wants to avoid lock-in
Basic principle: Look ahead and reason
back
Small Switching Costs
Matter
Phone number portability
Email addresses
Hotmail (advertising, portability)
ACM, CalTech
Look at lockin costs on a per customer
basis
Classification of Lock-In
Contractual commitments: damages
Durable purchases and replacement:
declines with time
Brand-specific training: rises with time
Information and data: rises with time
Specialized suppliers: may rise
Search costs: learn about alternatives
Loyalty programs: rebuild cumulative usage
Contractual Commitments
“Requirements contract”:
Purchase supplies from one supplier
 Beware of “evergreen contracts”
Follow the Lock-in cycle
Brand Selection
Sampling
Lock-In
Entrenchment
Assignment
Review Chapter 5
Answer questions on P94
Preview Chapter 6
Thanks