Chapter 7 - Consumer behavior. In this chapter you will learn: 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.
Chapter7 ConsumerBehavior â2014byMcGrawHillEducation Whatwillyoulearninthischapter? ã Howrevealedpreferencesrelatetoutility ã Howbudgetconstraintsaffectutility 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 © 2014 by McGraw‐Hill Education 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 makingchoices Forexample,ifplayingsoccerforthenexthour yieldsmoreutilitythanplayingbaseball,rational individualswillplaysoccer â2014byMcGrawHillEducation Revealedpreferences ã 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 © 2014 by McGraw‐Hill Education 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 acombinationofgoodsandservices ã Abundle isauniquecombinationofgoodsand servicesthatapersoncouldchoosetoconsume â2014byMcGrawHillEducation Utilityfunctions ã Utilityfunctionsquantifypreferences • 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: totalutility=(3x1)+(2x2)+(8x2)=23 â2014byMcGrawHillEducation Marginalutility ã Whenindividualscontinuetoengageinanactivity orconsumemoreofonegoodorservice,the utilityfromthenextunitisnotasgreatasthelast 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 © 2014 by McGraw‐Hill Education 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 A 20 15 10 0 Scoops of ice cream Total utility increases with each scoop of ice cream until point A, the seventh scoop, at which total utility is maximized. -1 A Scoops of ice cream Marginal utility measures the per unit utility from each scoop of ice cream. â2014byMcGrawHillEducation Maximizingutilitywithconstraints ã Peoplehavemanywantsandareconstrained bythetimeandmoneyavailabletothem ã Rationalindividualsmaximizeutilitywithin thoseconstraintsbyspendingtheirresources onthebundlethatyieldsthehighestpossible totalutility ã Abudgetconstraint providesallpossible combinationsofgoodsandservicesa consumercanbuyforagivenincome â2014byMcGrawHillEducation 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 A Cody can buy movie tickets for $120 … …or movie tickets and B concert tickets … C Concert tickets …or 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 © 2014 by McGraw‐Hill Education 10 Active Learning: The budget constraint Which bundle(s) are not within the following budget constraint? Movie tickets E A G I B D K C F H © 2014 by McGraw‐Hill Education Concert tickets J 11 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 © 2014 by McGraw‐Hill Education Concert tickets Movie tickets Total cost 12 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 Number of tickets Total utility Marginal utility Total utility 95 95 110 100 95 190 85 185 95 285 25 210 80 365 210 65 430 35 465 10 475 ‐10 465 Utility increases with each concert ticket until 3 tickets, at which total utility is maximized Utility increases with each movie ticket until 7 tickets, at which total utility is maximized © 2014 by McGraw‐Hill Education 13 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 0 465 B 100 465 565 C 185 365 550 D 210 190 400 E 210 0 210 465 • Bundle C with 2 concert tickets and 4 movie tickets hasthehighesttotal utilityandisthepreferredbundle ã Giventhisbudget,arationalconsumerspendsallincomeonthe combinationofmovieandconcertticketsthatmaximizesutility â2014byMcGrawHillEducation 14 Maximizingtotalutility Eachbundleonthebudgetconstrainthasacorrespondingutility Movie tickets A At point A, utility from concert tickets is and utility from movie tickets is 465 Total utility is 465 B At point B, utility from concert tickets is 100 and utility from movie tickets is 465 Total utility is 565 C At point C, utility from concert tickets is 185 and utility from movie tickets is 365 Total utility is 550 D Budget constraint 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 Total utility is 210 ã Utilityfallsasonemovesawayfromthepreferredbundle,C â2014byMcGrawHillEducation 15 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 © 2014 by McGraw‐Hill Education 16 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 An increase in income shifts the budget curve out 10 New budget constraint Cody can now afford as many as 12 movie tickets or concert tickets 2 Concert tickets © 2014 by McGraw‐Hill Education 17 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 © 2014 by McGraw‐Hill Education Concert tickets 18 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 A decrease in income shifts the budget curve in 10 New budget constraint Concert tickets â2014byMcGrawHillEducation 19 Respondingtochangesinprices ã Whenpriceschange,anindividualsbudget constraintisaffectedintwoways: 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 ã Apricechangecausesthebudgetlinetorotate â2014byMcGrawHillEducation 20 Theeffectofapricechange Supposethepriceofamovieticketdecreasesfrom$15to$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 New budget constraint 2 Concert tickets © 2014 by McGraw‐Hill Education 21 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 © 2014 by McGraw‐Hill Education 22 Utility and society • People gain utility from a variety of sources – Outside perception: • What others think of your purchases • Howmuchothershave Inwardpreferences: ã Howyouprefertospendyourmoney ã Bothoutsideperceptionandinward preferencescontributetodecisionmaking â2014byMcGrawHillEducation 23 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 similaraction â2014byMcGrawHillEducation 24 Summary ã Economistsassumethatindividualsseekto maximizestheirutilitywithinthelimitsoftheir availableresources ã 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 – Anincreaseinpricecausesthebudgetconstraintto rotateinward â2014byMcGrawHillEducation 25 Summary ã Economistsgenerallyassumethatindividuals preferencesaredemonstratedthroughthe choicesthattheymake,aconceptknownas revealedpreference • 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 © 2014 by McGraw‐Hill Education 26 ... perfectly well • Utility maximization suggests people gain utility by punishing bad? ?behavior? ?and rewarding good behavior – Reciprocity isrespondingtoanothersactionwitha similaraction â2014byMcGrawHillEducation... Utility maximization: – Individuals giving to others – People gain utility by punishing bad? ?behavior? ?and rewarding good? ?behavior © 2014 by McGraw‐Hill Education 26 ... onthebundlethatyieldsthehighestpossible totalutility ã Abudgetconstraint providesallpossible combinationsofgoodsandservicesa consumercanbuyforagivenincome â2014byMcGrawHillEducation The budget constraint The budget constraint for two goods is displayed using a movie ticket