Topic 5. The analysis of consumer behavior

1. Characteristics of consumer behavior.

2. Cardinal and ordinal approach to consumer behavior.

3. Changes in consumer equilibrium. Substitution and income effect.

-1-

Key Assumptions of Theory of Consumer Behavior:

1. Preferences are complete => Consumers can rank market baskets.

2. Preferences are transitive => If consumer prefers basket A to B and B to C then the consumer prefers A to C.

3. More of any good is always better.

Indifference Curve - Locus of points showing different combinations of goods to which the consumer is indifferent.

X

II I

a

III IV

b Y

Consumer starts with a of X and b of Y. Points in I => more satisfaction. Points is III => less satisfaction. Indifference curves must be in II and IV.

X Complements X Substitutes

Y Y

Y

Usual Case Utility along b > than along a

2

b

1 a

X

Indifference curves cannot cross unless there is a change in tastes.

-2-

Ordinal ranking => A is better than B but cannot tell by how much.

Cardinal ranking => Can tell how much better A is than B.

Slope of indifference curve measure marginal rate of substitution between goods. In terms of above example = .

At 1

At 2

=> along an indifference curve there is diminishing marginal rate of substitution.

Given you have relatively more X than Y => will give less Y for every additional X.

Budget line = locus of points showing different combinations of goods that can be bought given income. Where budget lines is tangent to highest indifference curve => desired point (a).

Y

A

a

3

2

1

B X

A = I / P_y, B = I / P_x. At a on highest indifference curve. MRS = Y/X =P_x / P_y

_{1 2}

if income increases budget line moves out.

If price of X falls budget line rotates

Y

a

I  => Budget line moves from 1 to 2 above

P_x => Budget line moves from ab to ac on left.

b c X

Total spending fixed along budget line. Object is to reach highest Indifference curve (not drawn).

Unless there is a corner solution, MRS = P_x / P_y. Of in words slope of the indifference curve = slope of budget line.

Corner solution => consume only one good

Utility = satisfaction one gets for consuming a good.

Marginal Utility declines as consumption of a good increases unless lumpiness problem (4 tires on a car).

MRS_xy = MU_x / MU_y

In equilibrium

MU_x / MU_Y = P_X / P_Y

MU_x / P_X = MU_Y / P_Y

(MU_x / P_X) > (MU_Y / P_Y) => Have too much Y relative to X

Marginal utility per dollar last dollar spent must be the same for all goods.

-4-

As price of X falls there is a substutution effect that is due to the relative price change and an income effect which is due to the increase in real income due to the price decrease. If the price of X falls, the consumption of Y can increase, or decrease.

Income Consumption Curve Traces out points of consumption of X and Y that occurs as income increases.

If X and Y are both superior goods, as I increases the consumption of X and Y increases. => Demand curves for both goods shift right.

Y

ICC

X

Here X is inferior at high income = > as I increases, consumption of X eventually falls.

Y

3

2

1

X

As Income rises X consumption first increases, then falls. As income rises the consumption of Y increases.

Y is a normal good. X is a normal good for low incomes, an inferior good for high prices.

In an N good world all goods can be normal goods. As a upper limit only N-1 can be inferior. => In a 2 good world cannot have two inferior goods.

Income and substitution effects can be drawn 4 ways for a price fall and 4 ways for a price rise assuming normal goods. For the inferior not giffen and inferior giffen there are 8 other ways each. Total number of cases = 24.

Inferior not Giffen = > good is inferior but not so inferior that the income effect out weighs substitution effect.

Four ways to draw cases:

Hicks method (American assumptions). => Assume base case. Prices change causing the budget line to rotate (See figure 4.6). Helping budget line drawn tangent to old indifference curve but parallel to new budget line.

Slutsky method (American assumptions) => Assume base case. Prices change causing the budget line to rotate . Helping budget line drawn through old basket but parallel to new budget line.

Hicks method (European Assumptions). => Assume base case. Prices change causing the budget line to rotate . Helping budget line drawn tangent to new indifference curve but parallel to old budget line.

Slutsky method (European Assumptions) => Assume base case. Prices change causing the budget line to rotate . Helping budget line drawn through new basket but parallel to old budget line.

For a price fall Hicks (Slutsky) method with American assumptions looks like a price increase for Hicks (Slutsky) with European assumptions.

Define AB = substitution effect using Hicks

AB^* = substitution using Stutsky

BC = income effect using Hicks

B^*C = income efffect using Stutsky

AC = Total Effect

Assume P X falls.

Normal good = > ABB^*C

Inferior not Giffen => ACB^*B

Inferior Giffen -> CB^*BA

Y

a

2

1

II III

I

A B B^* C c d

X

We assume income is fixed. Original budget line is ac. Consumer consumes A of X. Price falls => budget line shifts out to ad. Consumer now obtains C of X.

Hicks method draws helping budget line 1 tangent to old indifference curve I but parallel to new budget line. AC broken into AB (Hicks substitution effect) and BC Hicks income effect.

Slutsky method draws helping budget line 2 through old point. Consumer is overcompensated and substitution effect is now AB^* and income effect B^*C.

Bandwagon effect => You like the good better if others get it. Bandwagon effect makes market more elastic. Retail marketing based on creating bandwagon effect. MJ paid to wear a special shoe.

Snob Effect => You like the good less the more others have it. Snob effect makes market demand less elastic.