Chapter 3

Chapter 3
Consumer
Behavior
Topics to be Discussed
Consumer Preferences
Budget Constraints
Consumer Choice
Revealed Preferences
Chapter 3: Consumer Behavior Slide 2

Topics to be Discussed
Marginal Utility and Consumer Choices
Cost-of-Living Indexes

Consumer Behavior
Two applications that illustrate the
importance of the economic theory of
consumer behavior are:
Apple-Cinnamon Cheerios
The Food Stamp Program.

Consumer Behavior
General Mills had to determine how
high a price to charge for Apple-
Cinnamon Cheerios before it went to
the market.

Consumer Behavior
When the food stamp program was
established in the early 1960s, the
designers had to determine to what
extent the food stamps would provide
people with more food and not just
simply subsidize the food they would
have bought anyway.

Consumer Behavior
These two problems require an
understanding of the economic theory
of consumer behavior.

Consumer Behavior
There are three steps involved in the
study of consumer behavior.
1) We will study consumer preferences.

To describe how and why people prefer
one good to another.

Consumer Behavior
2) Then we will turn to budget

constraints.
People have limited incomes.

Consumer Behavior
3) Finally, we will combine consumer

preferences and budget constraints
to determine consumer choices.
What combination of goods will
consumers buy to maximize their
satisfaction?
Chapter 3: Consumer Behavior Slide

Market
Market Baskets
Baskets
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.

Market
Market Baskets
Baskets
Three Basic Assumptions
1) Preferences are complete.
2) Preferences are transitive.
3) Consumers always prefer more of

any good to less.

Market Basket Units of Food Units of Clothing
A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40

Indifference
Indifference Curves
Curves
Indifference curves represent all
combinations of market baskets that
provide the same level of satisfaction to
a person.

Clothing The consumer prefers
(units per week) A to all combinations
50 B in the blue box, while
all those in the pink
box are preferred to A.
40 H E
A
30
D
20 G
10
Food
10 20 30 40 (units per week)

Clothing Combination B,A, & D
(units per week) yield the same satisfaction
50 B E is preferred to U1
U1 is preferred to H & G
H
40 E
A
30
D
20 U1
G
10
Food

Indifference Curves
Indifference curves slope downward to the
right.
If it sloped upward it would violate the
assumption that more of any commodity
is preferred to less.

Indifference Curves
Any market basket lying above and to the
right of an indifference curve is preferred to
any market basket that lies on the
indifference curve.

Indifference
Indifference Maps
Maps
An indifference map is a set of

indifference curves that describes a
persons preferences for all
combinations of two commodities.
Each indifference curve in the map shows
the market baskets among which the
person is indifferent.

Indifference Curves
Finally, indifference curves cannot cross.
This would violate the assumption that
more is preferred to less.

Clothing
(units per week) Market basket A
is preferred to B.
Market basket B is
D preferred to D.
B A
U3
U2
U1
Food
(units per week)

Clothing Indifference Curves
(units per week) U1 Cannot Cross
U2
The consumer should

be indifferent between
A, B and D. However,
A B contains more of
both goods than D.
B
D
Food
(units per week)

Clothing 16 A Observation: The amount

(units of clothing given up for
per week) 14 a unit of food decreases
from 6 to 1
12 -6
10 B
1 Question: Does this
8 -4 relation hold for giving
D up food to get clothing?
6 1
-2 E
4 G
1 -1
2 1
Food
1 2 3 4 5 (units per week)

Marginal
Marginal Rate
Rate of
of Substitution
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.

Clothing 16 A
(units
MRS C
per week) 14 MRS = 6 F
12 -6
10 B
1
8 -4
D MRS = 2
6 1
-2 E
4 G
1 -1
2 1
Food
1 2 3 4 5 (units per week)

Marginal
Marginal Rate
Rate of
of Substitution
Substitution
We will now add a fourth assumption
regarding consumer preference:
Along an indifference curve there is a
diminishing marginal rate of substitution.
Note the MRS for AB was 6, while that
for DE was 2.

Marginal
Marginal Rate
Rate of
of Substitution
Substitution
Question
What are the first three assumptions?

Marginal
Marginal Rate
Rate of
of Substitution
Substitution
Indifference curves are convex because
as more of one good is consumed, a
consumer would prefer to give up fewer
units of a second good to get additional
units of the first one.
Consumers prefer a balanced market
basket

Marginal
Marginal Rate
Rate of
of Substitution
Substitution
Perfect Substitutes and Perfect
Complements
Two goods are perfect substitutes when
the marginal rate of substitution of one
good for the other is constant.

Marginal
Marginal Rate
Rate of
of Substitution
Substitution
Perfect Substitutes and Perfect
Complements
Two goods are perfect complements when
the indifference curves for the goods are
shaped as right angles.

Apple
Juice
(glasses) 4
Perfect
Perfect
Substitutes
Substitutes
3
Orange Juice
0 1 2 3 4 (glasses)

Left
Shoes
4
Perfect
Perfect
3
Complements
Complements
0 1 2 3 4 Right Shoes

BADS
Things for which less is preferred to more
Examples
Air pollution
Asbestos

What Do You Think?
How can we account for Bads in the
analysis of consumer preferences?

Designing
Designing New
New Automobiles
Automobiles (I)
(I)
Automobile executives must regularly
decide when to introduce new models
and how much money to invest in
restyling.

Designing
Designing New
New Automobiles
Automobiles (I)
(I)
An analysis of consumer preferences
would help to determine when and if car
companies should change the styling of
their cars.

Styling Consumer
Consumer
Preference
Preference A:
A:
High
HighMRS
MRS
These consumers are

willing to give up
considerable
styling for additional
performance
Performance

Consumer
Consumer
Styling
Preference
PreferenceB:
B:
Low
Low MRS
MRS
These consumers are
willing to give up
considerable
performance for
additional styling
Performance

Designing
Designing New
New Automobiles
Automobiles (I)
(I)
What Do You Think?
How can we determine the consumers
preference?

Designing
Designing New
New Automobiles
Automobiles (I)
(I)
A recent study of automobile demand in
the United States shows that over the
past two decades most consumers
have preferred styling over
performance.

Designing
Designing New
New Automobiles
Automobiles (I)
(I)
Growth of Japanese Imports
1970s and 1980s
15% of domestic cars underwent a style
change each year
This compares to 23% for imports

Utility
Utility:Numerical score representing the
satisfaction that a consumer gets from a
given market basket.

Utility
If buying 3 copies of Microeconomics
makes you happier than buying one shirt,
then we say that the books give you more
utility than the shirt.

Utility Functions
Assume:
The utility function for food (F) and clothing (C)
U(F,C) = F + 2C
Market Baskets: F units C units U(F,C) = F + 2C

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

Clothing Utility
UtilityFunctions
Functions&&Indifference
IndifferenceCurves
Curves
(units
per week) Assume: U = FC
Market Basket U = FC
15 C 25 = 2.5(10)
A 25 = 5(5)
C B 25 = 10(2.5)
10
A U3 = 100 (Preferred to U2)

5
B
U2 = 50 (Preferred to U1)
U1 = 25
Food

Ordinal Versus 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.

Ordinal Versus Cardinal Rankings
The actual unit of measurement for utility is
not important.
Therefore, an ordinal ranking is sufficient to
explain how most individual decisions are
made.

Budget Constraints
Preferences do not explain all of
consumer behavior.
Budget constraints also limit an
individuals ability to consume in light of
the prices they must pay for various
goods and services.

Budget Constraints
The Budget Line
The budget line indicates all combinations
of two commodities for which total money
spent equals total income.

Budget Constraints
The Budget Line
Let F equal the amount of food purchased,
and C is the amount of clothing.
Price of food = Pf and price of
clothing = Pc
Then Pf F is the amount of money spent on
food, and Pc C is the amount of money
spent on clothing.

Budget Constraints
The budget line then can be written:
PFF PCC I

Budget Constraints
Market Basket Food (F) Clothing (C) Total Spending
Pf = ($1) Pc = ($2) PfF + PcC = I
A 040 $80
B 2030 $80
D 4020 $80
E 6010 $80
G 800 $80

Budget Constraints
Clothing
Pc = $2 Pf = $1 I = $80
(units
per week)
A Budget Line F + 2C = $80
(I/PC) = 40
B 1
30 Slope C/F - - PF/PC
2
10
D
20
20
E
10
G Food
0 20 40 60 80 = (I/PF) (units per week)

Budget Constraints
The 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.
The slope is the negative of the ratio of the
prices of the two goods.

Budget Constraints
The Budget Line
The slope indicates the rate at which the
two goods can be substituted without
changing the amount of money spent.

Budget Constraints
The Budget Line
The vertical intercept (I/PC), illustrates the
maximum amount of C that can be
purchased with income I.
The horizontal intercept (I/PF), illustrates
the maximum amount of F that can be
purchased with income I.

Budget Constraints
The Effects of Changes in Income and
Prices
Income Changes
An increase in income causes the
budget line to shift outward, parallel to
the original line (holding prices
constant).

Budget Constraints
Prices
Income Changes
A decrease in income causes the budget
line to shift inward, parallel to the original
line (holding prices constant).

Budget Constraints
Clothing
(units A increase in
per week) income shifts
80 the budget line
outward
60
A decrease in
income shifts
40 the budget line
inward
20 L3
(I = L1 L2
$40) (I = $80) (I = $160)
Food
0 40 80 120 160 (units per week)

Budget Constraints
Prices
Price Changes
If the price of one good increases, the
budget line shifts inward, pivoting from
the other goods intercept.

Budget Constraints
Prices
Price Changes
If the price of one good decreases, the
budget line shifts outward, pivoting from
the other goods intercept.

Budget Constraints
Clothing
(units An increase in the
per week) price of food to
$2.00 changes
the slope of the
budget line and
rotates it inward.
A decrease in the
40 price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.
L3 L1 L2
(PF = 1) (PF = 1/2)
(PF = 2) Food

Budget Constraints
Prices
Price Changes
If the two goods increase in price, but
the ratio of the two prices is unchanged,
the slope will not change.

Budget Constraints
Prices
Price Changes
However, the budget line will shift inward
to a point parallel to the original budget
line.

Budget Constraints
Prices
Price Changes
If the two goods decrease in price, but
the ratio of the two prices is unchanged,
the slope will not change.

Budget Constraints
Prices
Price Changes
However, the budget line will shift
outward to a point parallel to the original
budget line.

Consumer Choice
Consumers choose a combination of
goods that will maximize the satisfaction
they can achieve, given the limited
budget available to them.

Consumer Choice
The maximizing market basket must
satisfy two conditions:
1) It must be located on the budget

line.
2) Must give the consumer the most

preferred combination of goods and
services.

Consumer Choice
Recall, the slope of an indifference curve is:
C
MRS
F
Further, the slope of the budget line is:
PF
Slope
PC
Consumer Choice
Therefore, it can be said that
satisfaction is maximized where:
PF
MRS
PC

Consumer Choice
It can be said that 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 Pc = $2 Pf = $1 I = $80
(units per
week) Point B does not
maximize satisfaction
40 because the
MRS (-(-10/10) = 1
is greater than the
B price ratio (1/2).
30
-10C
Budget Line
20
U1
+10F
0 20 40 80 Food (units per week)

Consumer Choice
(units per
week)
40
D Market basket D
30 cannot be attained
given the current
budget constraint.
20
U3
Budget Line

Consumer Choice
(units per
week) At market basket A
the budget line and the
40 indifference curve are
tangent and no higher
level of satisfaction
can be attained.
30
A
20 At A:
MRS =Pf/Pc = .5
U2
Budget Line

Consumer Choice
Designing
Designing New
New Automobiles
Automobiles (II)
(II)
Consider two groups of consumers,
each wishing to spend $10,000 on the
styling and performance of cars.
Each group has different preferences.

Consumer Choice
Designing
Designing New
New Automobiles
Automobiles (II)
(II)
By finding the point of tangency
between a groups indifference curve
and the budget constraint auto
companies can design a production and
marketing plan.

Designing New Automobiles (II)
Styling
$10,000 These consumers

are willing to trade
off a considerable
amount of styling
for some additional
performance
$3,000
$7,000 $10,000 Performance

Designing New Automobiles (II)
Styling
$10,000 These consumers

are willing to trade
off a considerable
$7,000 amount of
performance for
some additional
styling
$3,000 $10,000 Performance

Consumer Choice
Decision
Decision Making
Making &
& Public
Public Policy
Policy
Choosing between a non-matching and
matching grant to fund police
expenditures

Consumer Choice
Private Non-matching
Non-matching Grant
Grant
Expenditures ($)
Before Grant
Budget line: PQ
P A: Preference maximizing
market basket
Expenditure
OR: Private
A OS: Police
R
U1
Police
O S Q Expenditures ($)

Consumer Choice
Private Non-matching
Non-matching Grant
Grant
Expenditures ($)
T
After Grant
Budget line: TV
P B: Preference maximizing
market basket
Expenditure
U B OU: Private
A OZ: Police
R U3
U1
Police
O S Z Q V Expenditures ($)

Consumer Choice
Private Matching
Matching Grant
Grant
Expenditures ($)
T Before Grant
Budget line: PQ
A: Preference maximizing
P market basket
After Grant
C: Preference maximizing
market basket
W A Expenditures
R C OW: Private
U2 OX: Police
U1
O S X Q R Police ($)

Consumer Choice
Private Matching
Matching Grant
Grant
Expenditures ($)
T
Nonmatching Grant
Point B
P OU: Private expenditure
OZ: Police expenditure
Matching Grant
U B Point C
W A OW: Private expenditure
C U OX: Police expenditure
U2 3
U1
O Z X Q R Police ($)

Consumer Choice
A
ACorner
Corner Solution
Solution
A corner solution exists if a consumer
buys in extremes, and buys all of one
category of good and none of another.
This exists where the indifference curves
are tangent to the horizontal and vertical
axis.
MRS is not equal to PA/PB

A Corner Solution
Frozen
Yogurt
(cups
monthly) A A corner solution
exists at point B.
U1 U2 U3
B Ice Cream (cup/month)

Consumer Choice
A Corner Solution
At point B, the MRS of ice cream for frozen
yogurt is greater than the slope of the
budget line.
This suggests that if the consumer could
give up more frozen yogurt for ice cream he
would do so.
However, there is no more frozen yogurt to
give up!

Consumer Choice
A Corner Solution
When a corner solution arises, the
consumers MRS does not necessarily
equal the price ratio.
In this instance it can be said that:
MRS PIceCream / PFrozen Yogurt

Consumer Choice
A Corner Solution
If the MRS is, in fact, significantly greater
than the price ratio, then a small decrease
in the price of frozen yogurt will not alter
the consumers market basket.

Consumer Choice
A
ACollege
College Trust
Trust Fund
Fund
Suppose Jane Does parents set up a
trust fund for her college education.
Originally, the money must be used for
education.

Consumer Choice
A
ACollege
College Trust
Trust Fund
Fund
If part of the money could be used for
the purchase of other goods, her
consumption preferences change.

Consumer Choice
Other
A
ACollege
College Trust
Trust Fund
Fund
Consumption
($) A: Consumption before the trust fund
The trust fund shifts the budget line
B: Requirement that the trust fund
C
must be spent on education
P U3 C: If the trust could be spent on
B other goods
A U2
U1
Q Education ($)

Revealed Preferences
If we know the choices a consumer has
made, we can determine what her
preferences are if we have information
about a sufficient number of choices
that are made when prices and incomes
vary.

Revealed Preferences--
Two Budget Lines
Clothing l1 I1: Chose A over B
(units per A is revealed preferred to B
month)
l2: Choose B over D
l2 B is revealed preferred to D
B
D
Food (units per month)

Two Budget Lines
Clothing l1
(units per All market baskets
month) in the pink
shaded area are
l2 preferred to A.
B
D
B is preferred to
all market baskets
in the green area

Four Budget Lines
I3: E revealed preferred to A
Clothing
l3
(units per
month) All market baskets in the
pink area preferred to A
E
l1
l4
A
l2
B G
A: preferred to all I4: G revealed preferred to A
market baskets in
the green area

Revealed Preferences for Recreation
Other Scenario
Recreational Robertas recreation budget = $100/wk
Activities Price of exercise = $4/hr/week
($) Exercises 10 hrs/wk at A given U1 & I1
100 C
80
The rate changes to $1/hr + $30/wk
60 New budget line I2 & combination B
A
B Reveal preference of B to A
40 U1 U2
Would the Clubs
20 profits increase?
l1 l2
Amount of Exercise
0 25 50 75 (hours)

Marginal Utility and
Consumer Choice
Marginal
Marginal Utility
Utility
Marginal utility measures the additional
satisfaction obtained from consuming
one additional unit of a good.

Consumer Choice
Marginal
Marginal Utility
Utility
Example
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
Observation: Marginal utility is diminishing

Consumer Choice
Diminishing
Diminishing Marginal
Marginal Utility
Utility
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.

Consumer Choice
Marginal Utility and the 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).

Consumer Choice
Formally:
0 MUF(F) MUC(C)

Consumer Choice
Rearranging:
C / F MU F / MU C

Consumer Choice
C / F MU F / MU C
Because:
C / F MRS of F for C
MRS MUF/MUC
Consumer Choice
When consumers maximize satisfaction
the:
MRS PF/PC
Since the MRS is also equal to the ratio of the
marginal utilities of consuming F and C, it
follows that:
MUF/MUC PF/PC
Consumer Choice
Which gives the equation for utility
maximization:
MU F / PF MU C / PC

Consumer Choice
Total utility is maximized when the
budget is allocated so that the marginal
utility per dollar of expenditure is the
same for each good.
This is referred to as the equal marginal
principle.

Consumer Choice
Gasoline
Gasoline Rationing
Rationing
In 1974 and again in 1979, the

government imposed price controls on
gasoline.
This resulted in shortages and gasoline
was rationed.

Consumer Choice
Gasoline
Gasoline Rationing
Rationing
Nonprice rationing is an alternative to

market rationing.
Under one form everyone has an equal
chance to purchase a rationed good.
Gasoline is rationed by long lines at the
gas pumps.

Consumer Choice
Rationing hurts some by limiting the
amount of gasoline they can buy.
This can be seen in the following model.
It applies to a woman with an annual
income of $20,000.

Consumer Choice
The horizontal axis shows her annual
consumption of gasoline at $1/gallon.
The vertical axis shows her remaining
income after purchasing gasoline.

Consumer Choice
Spending
on other
goods ($) 20,000 A With a limit of
2,000 gallons,
18,000
D the consumer moves
C to a lower
15,000 indifference curve
(lower level of utility).
U1
U2
B
Gasoline
2,000 5,000 20,000 (gallons per year)

The CPI is calculated each year as the
ratio of the cost of a typical bundle of
consumer goods and services today in
comparison to the cost during a base
period.

What Do You Think?
Does the CPI accurately reflect the cost of
living for retirees?
Is it appropriate to use the CPI as a cost-
of-living index for other government
programs, for private union pensions, and
for other private wage agreements?

Example
Two sisters, Rachel and Sarah, have
identical preferences.
Sarah began college in 1987 with a $500
discretionary budget.
In1997, Rachel started college and her
parents promised her a budget that was
equivalent in purchasing power.

1987 (Sarah) 1997 (Rachel)

Price of books $20/book $100/book
Number of books 15 6
Price of food $2.00/lb. $2.20/lb
Pounds of food 100 300
Expenditure $500 $1,260

Sarah Expenditure
$500 = 100 lbs. of food x $2.00/lb. + 15 books x $20/book
Rachel Expenditure for Equal Utility

$1,260 = 300 lbs. of food x $2.20/lb. + 6 books x $100/book

The ideal cost-of-living adjustment for

Rachel is $760.
The ideal cost-of-living index is
$1,260/$500 = 2.52 or 252.
This implies a 152% increase in the cost
of living.

Books
(per quarter)
For Rachel to achieve
the same level of utility as
U1 Sarah, with the higher
25 prices, her budget must
be sufficient to allow her
20 to consume the bundle
shown by point B.
A
15
10
B
5
l2
l1 Food
0 50 100 200 250 300 350 400 450 500 550 600 (lb./quarter)

The ideal cost of living index represents

the cost of attaining a given level of utility
at current (1997) prices relative to the
cost of attaining the same utility at base
(1987) prices.

To do this on an economy-wide basis

would entail large amounts of information.
Price indexes, like the CPI, use a fixed
consumption bundle in the base period.
Called a Laspeyres price index

Laspeyres
Laspeyres Index
Index
The Laspeyres index tells us:

The amount of money at current year prices
that an individual requires to purchase the
bundle of goods and services that was
chosen in the base year divided by the cost
of purchasing the same bundle at base
year prices.

Calculating Rachels Laspeyres cost

of living index
Setting the quantities of goods in 1997
equal to what were bought by her sister,
but setting their prices at their 1997
levels result in an expenditure of $1,720
(100 x 2.20 + 15 x $100)

Her cost of living adjustment would now

be $1,220.
The Laspeyres index is:
$1,720/$500 = 344.
This overstates the true cost-of-living
increase.

Books
(per quarter)
Using the Laspeyres
index results in the
U1 budget line shifting
25 up from I2 to I3.
20
A
15
10
B
l3
5
l2
l1 Food
0 50 100 200 250 300 350 400 450 500 550 600 (lb./quarter)

What Do You Think?

Does the Laspeyres index always overstate
the true cost-of-living index?

Yes!
The Laspeyres index assumes that
consumers do not alter their consumption
patterns as prices change.

Yes!
By increasing purchases of those items that
have become relatively cheaper, and
decreasing purchases of the relatively more
expensive items consumers can achieve the
same level of utility without having to
consume the same bundle of goods.

The Paasche Index

Calculates the amount of money at current-
year prices that an individual requires to
purchase a current bundle of goods and
services divided by the cost of purchasing the
same bundle in the base year.

Comparing
Comparing the
the Two
Two Indexes
Indexes
Both indexes involve ratios that involve
todays current year prices, PFt and PCt.
However, the Laspeyres index relies on
base year consumption, Fb and Cb.
Whereas, the Paasche index relies on
todays current consumption, Ft and Ct .

Then a comparison of the Laspeyres and

Paasche indexes gives the following
equations:
PFt Ft PCt Ct
LI
PFt Ft PCt Ct
PFb Ft PCt Ct
PI
PFb Ft PCt Ct
Comparing
Comparing the
the Two
Two Indexes
Indexes
Suppose:
Two goods: Food (F) and Clothing (C)

Comparing
Comparing the
the Two
Two Indexes
Indexes
Let:
PFt & PCt be current year prices
PFb & PCb be base year prices
Ft & Ct be current year quantities
Fb & Cb be base year quantities

Comparing
Comparing the
the Two
Two Indexes
Indexes
Sarah (1990)
Cost of base-year bundle at current prices
equals $1,720 (100 lbs x $2.20/lb + 15 books
x $100/book)
Cost of same bundle at base year prices is
$500 (100 lbs x $2.00/lb + 15 books x
$20/book)

Comparing
Comparing the
the Two
Two Indexes
Indexes
Sarah (1990)
$1,720
LI 344
$500

Comparing
Comparing the
the Two
Two Indexes
Indexes
Sarah (1990)
Cost of buying current year bundle at current
year prices is $1,260 (300 lbs x $2.20/lb + 6
books x $100/book)
Cost of the same bundle at base year prices
is $720 (300 lbs x $2/lb + 6 books x $20/book)

Comparing
Comparing the
the Two
Two Indexes
Indexes
Sarah (1990)
$1,260
PI 175
$720

The
The Paasche
Paasche Index
Index
The Paasche index will understate the
cost of living because it assumes that the
individual will buy the current year bundle
in the base year.

In 1995, the government adopted the

chain-weighted price index to deflate its
measure of real GDP.
Developed to overcome problems that arose
when long-term comparisons of GDP were
made using fixed-weight price indexes and
prices were rapidly changing.

The
The Bias
Bias of
of the
the CPI
CPI
What Do You Think?
What is the impact on the Federal budget of
using the CPI (a Laspeyres index) to adjust
social security and other programs for
changes in the cost of living?

Summary
People behave rationally in an attempt
to maximize satisfaction from a
particular combination of goods and
services.
Consumer choice has two related parts:
the consumers preferences and the
budget line.

Summary
Consumers make choices by comparing
market baskets or bundles of
commodities.
Indifference curves are downward sloping
and cannot intersect one another.
Consumer preferences can be completely
described by an indifference map.

Summary
The marginal rate of substitution of F for
C is the maximum amount of C that a
person is willing to give up to obtain one
additional unit of F.
Budget lines represent all combinations
of goods for which consumers expend
all their income.

Summary
Consumers maximize satisfaction
subject to budget constraints.
The theory of revealed preference
shows how the choices that individuals
make when prices and income vary can
be used to determine their preferences.

End of Chapter 3
Consumer
Behavior

Chapter 3

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Chapter 3

Chapter 3: Consumer Behavior Slide 2

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1) We will study consumer preferences.

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2) Then we will turn to budget

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3) Finally, we will combine consumer

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1) Preferences are complete.

2) Preferences are transitive.

3) Consumers always prefer more of

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An indifference map is a set of

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The consumer should

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Clothing 16 A Observation: The amount

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These consumers are

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Market Baskets: F units C units U(F,C) = F + 2C

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A U3 = 100 (Preferred to U2)

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