Lectures 3 4 and 5

CHAPTER
3
Consumer
Behavior
Prepared by:
Fernando & Yvonn Quijano
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 8e.
CHAPTER 3 OUTLINE
3.1 Consumer Preferences
3.2 Budget Constraints
3.3 Consumer Choice

Chapter 3: Consumer Behavior
3.4 Revealed Preference
3.5 Marginal Utility and Consumer Choice
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 8e. 2 of 37
Consumer Behavior
● theory of consumer behavior Description of how

consumers allocate incomes among different goods and
services to maximize their well-being.
Consumer behavior is best understood in three distinct steps:
1. Consumer preferences
2. Budget constraints
3. Consumer choices
3.1 CONSUMER PREFERENCES
Market Baskets
● market basket (or bundle) List with specific quantities
of one or more goods.
TABLE 3.1 Alternative Market Baskets
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
To explain the theory of consumer behavior, we will ask

whether consumers prefer one market basket to another.
Some Basic Assumptions about Preferences
1. Completeness: Preferences are assumed to be complete. In

other words, consumers can compare and rank all possible
baskets. Thus, for any two market baskets A and B, a consumer
will prefer A to B, will prefer B to A, or will be indifferent between
the two. By indifferent we mean that a person will be equally
satisfied with either basket.
Note that these preferences ignore costs. A consumer might

prefer steak to hamburger but buy hamburger because it is
cheaper.
Some Basic Assumptions about Preferences
2. Transitivity: Preferences are transitive. Transitivity means that

if a consumer prefers basket A to basket B and basket B to
basket C, then the consumer also prefers A to C. Transitivity is
normally regarded as necessary for consumer consistency.
3. More is better than less: Goods are assumed to be desirable

—i.e., to be good. Consequently, consumers always prefer
more of any good to less. In addition, consumers are never

satisfied or satiated; more is always better, even if just a little
better. This assumption is made for pedagogic reasons;
namely, it simplifies the graphical analysis. Of course, some
goods, such as air pollution, may be undesirable, and
consumers will always prefer less. We ignore these “bads” in
the context of our immediate discussion.
Indifference curves
Figure 3.1
Describing Individual Preferences
Because more of each good is

preferred to less, we can
compare market baskets in the
shaded areas. Basket A is clearly
preferred to basket G, while E is
clearly preferred to A.
However, A cannot be compared
with B, D, or H without additional
information.
Indifference curves
● indifference curve Curve representing all combinations of market

baskets that provide a consumer with the same level of satisfaction.
Figure 3.2
An Indifference Curve
The indifference curve U1 that

passes through market basket A
shows all baskets that give the
consumer the same level of
satisfaction as does market

basket A; these include baskets B
and D.
Our consumer prefers basket

E, which lies above U1, to A,
but prefers A to H or G, which
lie below U1.
Indifference Maps
● indifference map Graph containing a set of indifference curves
showing the market baskets among which a consumer is indifferent.
Figure 3.3
An Indifference Map
An indifference map is a set of

indifference curves that
describes a person's
preferences.
Any market basket on

indifference curve U3, such as
basket A, is preferred to any
basket on curve U2 (e.g.,
basket B), which in turn is
preferred to any basket on U1,
such as D.
Indifference Maps
Figure 3.4
Indifference Curves Cannot Intersect
If indifference curves U1 and U2

intersect, one of the
assumptions of consumer
theory is violated.
According to this diagram, the
consumer should be indifferent
among market baskets A, B,

and D. Yet B should be
preferred to D because B has
more of both goods
The Marginal Rate of Substitution

● marginal rate of substitution Maximum amount of a good that a
consumer is willing to give up in order to obtain one additional unit of
another good.
Figure 3.5
The Marginal Rate of Substitution
The magnitude of the slope of an

indifference curve measures the
consumer’s marginal rate of
substitution (MRS) between two goods.
In this figure, the MRS between clothing

(C) and food (F) falls from 6 (between A
and B) to 4 (between B and D) to 2
(between D and E) to 1 (between E and
G).
Convexity The decline in the MRS
reflects a diminishing marginal rate of
substitution. When the MRS
diminishes along an indifference curve,
the curve is convex.
Perfect Substitutes and Perfect Complements
● perfect substitutes Two goods for which the marginal rate

of substitution of one for the other is a constant.
● perfect complements Two goods for which the MRS is

infinite; the indifference curves are shaped as right angles.
Bads
● bad Good for which less is preferred rather than more.

Figure 3.6
In (a), Bob views orange juice and In (b), Jane views left shoes and
apple juice as perfect substitutes: He right shoes as perfect complements:
is always indifferent between a glass An additional left shoe gives her no
of one and a glass of the other. extra satisfaction unless she also
obtains the matching right shoe.
Figure 3.7
Preferences for Automobile Attributes
Preferences for automobile attributes can be described by

indifference curves. Each curve shows the combination of
acceleration and interior space that give the same satisfaction.
Owners of Ford Mustang coupes are The opposite is true for owners of
willing to give up considerable interior Ford Explorers. They prefer
space for additional acceleration. interior space to acceleration.
Utility and Utility Functions

● utility Numerical score representing the satisfaction that a
consumer gets from a given market basket.
● utility function Formula that assigns a level of utility to individual

market baskets.
Figure 3.8
Utility Functions and Indifference Curves
A utility function can be

represented by a set of
indifference curves, each

with a numerical
indicator.
This figure shows three
indifference curves (with
utility levels of 25, 50,
and 100, respectively)
associated with the utility
function:
u(F,C) =
FC
Ordinal versus Cardinal Utility

● ordinal utility function Utility function that generates a ranking
of market baskets in order of most to least preferred.
● cardinal utility function Utility function describing by how much

one market basket is preferred to another.
Figure 3.9
Income and Happiness

A cross-country
comparison shows that
individuals living in
countries with higher
GDP per capita are on
average happier than
those living in countries
with lower per-capita
GDP.
3.2 BUDGET CONSTRAINTS
The Budget Line

● budget constraints Constraints that consumers face
as a result of limited incomes.
● budget line All combinations of goods for which the total

amount of money spent is equal to income.
TABLE 3.2 Market Baskets and the Budget Line
Market Basket Food (F) Clothing (C) Total Spending

A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
Market baskets associated with the budget line F + 2C = $80
The Budget Line

Figure 3.10
A Budget Line
A budget line describes the

combinations of goods that can be
purchased given the consumer’s
income and the prices of the goods.
Line AG (which passes through
points B, D, and E) shows the
budget associated with an income
of $80, a price of food of PF = $1

per unit, and a price of clothing of
PC = $2 per unit.
The slope of the budget line
(measured between points B and D)
is −PF/PC = −10/20 = −1/2.
The Effects of Changes in Income and Prices
Figure 3.11
Effects of a Change in Income on the
Budget Line
Income changes A change in

income (with prices unchanged)
causes the budget line to shift
parallel to the original line (L1).
When the income of $80 (on L1) is
increased to $160, the budget line

shifts outward to L2.
If the income falls to $40, the line
shifts inward to L3.
The Effects of Changes in Income and Prices
Figure 3.12
Effects of a Change in Price on the
Budget Line
Price changes A change in the

price of one good (with income
unchanged) causes the budget line
to rotate about one intercept.
When the price of food falls from
$1.00 to $0.50, the budget line

rotates outward from L1 to L2.
However, when the price increases
from $1.00 to $2.00, the line rotates
inward from L1 to L3.
What happens when price of both the goods double?

What happens when income and both prices double?
3.3 CONSUMER CHOICE
The maximizing market basket must satisfy two conditions:
1. It must be located on the budget line.
2. It must give the consumer the most preferred combination of
goods and services.
Figure 3.13
Maximizing Consumer Satisfaction
A consumer maximizes satisfaction

by choosing market basket A. At
this point, the budget line and
indifference curve U2 are tangent.
No higher level of satisfaction (e.g.,

market basket D) can be attained.
At A, the point of maximization, the
MRS between the two goods equals
the price ratio. At B, however,
because the MRS [− (−10/10) = 1]
is greater than the price ratio (1/2),
satisfaction is not maximized.
3.3 CONSUMER CHOICE
Satisfaction is maximized (given the budget constraint) at the

point where MRS = PF/PC.
● marginal benefit Benefit from the consumption of one

additional unit of a good.
● marginal cost Cost of one additional unit of a good.
Using these definitions, we can then say that satisfaction is

maximized when the marginal benefit—the benefit associated
with the consumption of one additional unit of food—is equal to
the marginal cost—the cost of the additional unit of food. The
marginal benefit is measured by the MRS.
3.3 CONSUMER CHOICE
Figure 3.14
Consumer Choice of Automobile Attributes
The consumers in (a) are willing to trade off a considerable amount of interior space
for some additional acceleration. Given a budget constraint, they will choose a car
that emphasizes acceleration. The opposite is true for consumers in (b).
3.3 CONSUMER CHOICE
Corner Solutions
● corner solution Situation in which the marginal rate of
substitution for one good in a chosen market basket is not
equal to the slope of the budget line.
Figure 3.15
A Corner Solution
When a corner solution arises,

the consumer maximizes
satisfaction by consuming only
one of the two goods.

Given budget line AB, the highest
level of satisfaction is achieved at
B on indifference curve U1, where
the MRS (of ice cream for frozen
yogurt) is greater than the ratio of
the price of ice cream to the price
of frozen yogurt.
3.3 CONSUMER CHOICE
Figure 3.16
A College Trust Fund
When given a college trust

fund that must be spent on
education, the student
moves from A to B, a corner
solution.
If, however, the trust fund
could be spent on other
consumption as well as
education, the student would
be better off at C.
3.4 REVEALED PREFERENCE
If a consumer chooses one market basket over another, and if
the chosen market basket is more expensive than the alternative,
then the consumer must prefer the chosen market basket.
Figure 3.17
Revealed Preference:
Two Budget Lines
If an individual facing budget line l1

chose market basket A rather than
market basket B, A is revealed to
be preferred to B.
Likewise, the individual facing

budget line l2 chooses market
basket B, which is then revealed to
be preferred to market basket D.
Whereas A is preferred to all market
baskets in the green-shaded area,
all baskets in the pink-shaded area
are preferred to A.
Figure 3.18
Revealed Preference:
Four Budget Lines
Facing budget line l3 the

individual chooses E, which is
revealed to be preferred to A
(because A could have been
chosen).
Likewise, facing line l4, the
individual chooses G which is

also revealed to be preferred to
A.
Whereas A is preferred to all
market baskets in the green-
shaded area, all market baskets
in the pink-shaded area are
preferred to A.
Figure 3.19
Revealed Preference for Recreation
When facing budget line l1, an

individual chooses to use a
health club for 10 hours per
week at point A.
When the fees are altered, she
faces budget line l2.
She is then made better off

because market basket A can
still be purchased, as can market
basket B, which lies on a higher
indifference curve.
3.5 MARGINAL UTILITY AND CONSUMER CHOICE
● marginal utility (MU) Additional satisfaction obtained

from consuming one additional unit of a good.
● diminishing marginal utility Principle that as more of a good is
consumed, the consumption of additional amounts will yield
smaller additions to utility.
0  MU (F )  MU (C )
F C
(C / F )  MU  MU (C )
F C
MRS  MU /MU (3.5)
F C
MRS  P / P (3.6)
F C
MU / MU  P / P
F C F C
MU / P  MU / P (3.7)
F F C C
● equal marginal principle Principle that utility is maximized
when the consumer has equalized the marginal utility per dollar of
expenditure across all goods.
3.5 MARGINAL UTILITY AND CONSUMER CHOICE
Figure 3.20
Marginal Utility and Happiness

A comparison of mean levels of satisfaction with life across income classes in the United
States shows that happiness increases with income, but at a diminishing rate.
* Some practice problems
1. Upon merging with the West German economy, East German consumers indicated a preference for
Mercedes-Benz automobiles over Volkswagens. However, when they converted their savings into
deutsche marks, they flocked to Volkswagen dealerships. How can you explain this apparent
paradox?
2. Based on his preferences, Bill is willing to trade 4 movie tickets for 1 ticket to a basketball game. If
movie tickets cost $8 each and a ticket to the basketball game costs $40, should Bill make the trade?
Why or why not?
3. Draw indifference curves that represent the following individuals’ preferences for hamburgers and
soft drinks. Indicate the direction in which the individuals’ satisfaction (or utility) is increasing.
(a) Joe has convex preferences and dislikes both hamburgers and soft drinks.
(b) Jane loves hamburgers and dislikes soft drinks. If she is served a soft drink, she will pour it
down the drain rather than drink it.
(c) Bob loves hamburgers and dislikes soft drinks. If he is served a soft drink, he will drink it to be
polite.
(d) Molly loves hamburgers and soft drinks, but insists on consuming exactly one soft drink for
every two hamburgers that she eats.
(e) Bill likes hamburgers but neither likes nor dislikes soft drinks
(f) Mary always gets twice as much satisfaction from an extra hamburger as she does from an extra
soft drink.
4. The price of DVDs (D) is $20 and the price of CDs (C) is $10. Philip has a budget of $100 to spend on
the two goods. Suppose that he has already bought one DVD and one CD. In addition there are 3
more DVDs and 5 more CDs that he would really like to buy.
a) Draw his budget line on a graph with CDs on the horizontal axis.
b) Considering what he has already purchased, and what he still wants to purchase, identify the
three different bundles of CDs and DVDs that he could choose.
•CHAPTER 4 OUTLINE
• 4.1 Individual Demand
• 4.2 Income and Substitution Effects

•4.1 INDIVIDUAL DEMAND
The Individual Demand Curve

Figure 4.1
Effect of Price Changes
A reduction in the price of food, with income and the

price of clothing fixed, causes the consumer to choose
a different market basket.
The utility maximizing combination of 6 units of clothing

and 4 units of food corresponds to a price of food equal
to $2.00.
In panel (a), as the price of food falls, the utility

maximizing combination changes.
The baskets that maximize utility for various prices

of food trace out the price-consumption curve.
As the price of food changes, the quantity

of food demanded changes. The
relationship between the price and the
quantity of food demanded, shown in panel
(b), traces the demand curve for food.
The Individual Demand Curve
• ● price-consumption
curve Curve tracing the
utility-maximizing combinations
of two goods as the price of
one changes.
• ● individual demand
curve Curve relating the
quantity of a good that a
single consumer will buy to its
price.
Income Changes
• Figure 4.2
• Effect of Income Changes
•An increase in income, with the

prices of all goods fixed, causes
consumers to alter their choice of
market baskets.
•In part (a), the baskets that
maximize consumer satisfaction
for various incomes (point A,
$10; B, $20; D, $30) trace out the

income-consumption curve.
•The shift to the right of the
demand curve in response to the
increases in income is shown in
part (b). (Points E, G, and H
correspond to points A, B, and D,
respectively.)
Normal versus Inferior Goods

• Figure 4.3
• An Inferior Good
•An increase in a person’s

income can lead to less
consumption of one of the
two goods being
purchased.
•Here, hamburger, though
a normal good between A
and B, becomes an
inferior good when the
income-consumption
curve bends backward
between B and C.
Engel Curves
• ● Engel curve Curve
relating the quantity of a good
consumed to income.
• Figure 4.4
•Engel curves relate the

quantity of a good consumed
to income.
•In (a), food is a normal good

and the Engel curve is
upward sloping.
•In (b), however, hamburger
is a normal good for income
less than $20 per month
•and an inferior good for
income greater than $20 per
month.
•If the market price were held

constant, we would expect to see an
increase in the quantity demanded as
a result of consumers’ higher incomes.
Because this increase would occur no
matter what the market price, the
result would be a shift to the right of
the entire demand curve.
•TABLE 4.1 Annual U.S. Household Consumer Expenditures

•INCOME GROUP (2005$)
• Expenditures Less than 10,000- 20,000- 30,000- 40,000- 50,000 70,000
• ($) on: $10,000 19,999 29,999 39,999 49,999 69,999 and
above
•Entertainment 844 947 1191 1677 1933 2402 4542
•Owned Dwelling 4272 4716 5701 6776 7771 8972 14763
•Rented Dwelling 2672 2779 2980 2977 2818 2255 1379
•Heath Care 1108 1874 2241 2361 2778 2746 3812
•Food 2901 3242 3942 4552 5234 6570 9247
•Clothing 861 884 1106 1472 1450 1961 3245
•Source: U.S. Department of Labor, Bureau of Labor Statistics, “Consumer Expenditure Survey, Annual Report 2005.”
• Figure 4.5
•Average per-household
expenditures on rented
dwellings, health care,
and entertainment are
plotted as functions of
annual income.
•Health care and

entertainment are normal
goods, as expenditures
increase with income.
•Rental housing,
however, is an inferior
good for incomes above
$35,000.
Substitutes and Complements
•Recall that:
•Two goods are substitutes if an increase in the price of one

leads to an increase in the quantity demanded of the other.
•Two goods are complements if an increase in the price of

one good leads to a decrease in the quantity demanded of
the other.
•Two goods are independent if a change in the price of one

good has no effect on the quantity demanded of the other.
•Relation with PCC
•4.2 INCOME AND SUBSTITUTION EFFECTS
•A fall in the price of a good has two effects::
1. Consumers will tend to buy more of the good that has

become cheaper and less of those goods that are now
relatively more expensive.
2. Because one of the goods is now cheaper, consumers

enjoy an increase in real purchasing power.
Substitution Effect
● substitution effect Change in consumption of

a good associated with a change in its price, with
the level of utility held constant.
• Income Effect
● income effect Change in consumption of a
good resulting from an increase in purchasing

power, with relative prices held constant.
•The total effect of a change in price is given theoretically by the

sum of the substitution effect and the income effect:
•Total Effect (F1F2) = Substitution Effect (F1E) + Income Effect (EF2)
• Figure 4.6
•Income and Substitution Effects:

Normal Good
•A decrease in the price of food

has both an income effect and a
substitution effect.
•The consumer is initially at A, on
budget line RS.
•When the price of food falls,
consumption increases by F1F2 as
the consumer moves to B.
•The substitution effect F1E

(associated with a move from A to
D) changes the relative prices of
food and clothing but keeps real
income (satisfaction) constant.
•The income effect EF2
(associated with a move from D to
B) keeps relative prices constant
but increases purchasing power.
•Food is a normal good because
the income effect EF2 is positive.
• Income Effect
• Figure 4.7
•Income and Substitution Effects:

Inferior Good
•The consumer is initially at A on
budget line RS.
•With a decrease in the price of food,
the consumer moves to B.
•The resulting change in food
purchased can be broken down into a
substitution effect, F1E (associated
with a move from A to D), and an

income effect, EF2 (associated with a
move from D to B).
•In this case, food is an inferior good
because the income effect is
negative.
•However, because the substitution
effect exceeds the income effect, the
decrease in the price of food leads to
an increase in the quantity of food
demanded.
• A Special Case: The Giffen Good
● Giffen good Good whose demand curve slopes upward
because the (negative) income effect is larger than the
substitution effect.
• Figure 4.8
•Upward-Sloping Demand Curve: The

Giffen Good
•When food is an inferior good,

and when the income effect is
large enough to dominate the
substitution effect, the demand

curve will be upward-sloping.
•The consumer is initially at point
A, but, after the price of food falls,
moves to B and consumes less
food.
•Because the income effect F2F1
is larger than the substitution
effect EF2, the decrease in the
price of food leads to a lower
quantity of food demanded.
• Figure 4.9
•Effect of a Gasoline Tax with a Rebate
•A gasoline tax is imposed when

the consumer is initially buying
1200 gallons of gasoline at point
C.
•After the tax takes effect, the
budget line shifts from AB to AD
and the consumer maximizes his
preferences by choosing E, with a
gasoline consumption of 900

gallons.
•However, when the proceeds of
the tax are rebated to the
consumer, his consumption
increases somewhat, to 913.5
gallons at H.
•Despite the rebate program, the
consumer’s gasoline consumption
has fallen, as has his level of
satisfaction.
* Some practice problems
1. Suppose that an individual allocates his or her entire budget between two goods, food and clothing.
Can both goods be inferior? Explain.
2. Draw the PCC and ICC for perfect substitutes and complements
3. An individual consumes two goods, clothing and food. Given the information below, illustrate both
the income-consumption curve and the Engel curve for clothing and food.
Price Price Quantity Quantity Income

Clothing Food Clothing Food
$10 $2 6 20 $100
$10 $2 8 35 $150
$10 $2 11 45 $200
$10 $2 15 50 $250
4. Judy has decided to allocate exactly $500 to college textbooks every year, even though she knows that
the prices are likely to increase by 5 to 10 percent per year and that she will be getting a substantial
monetary gift from her grandparents next year. What is Judy’s price elasticity of demand for
textbooks? Income elasticity?

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CHAPTER

3.1 Consumer Preferences

3.2 Budget Constraints

3.3 Consumer Choice

3.4 Revealed Preference

3.5 Marginal Utility and Consumer Choice

● theory of consumer behavior Description of how

Consumer behavior is best understood in three distinct steps:

TABLE 3.1 Alternative Market Baskets

Market Basket Units of Food Units of Clothing

To explain the theory of consumer behavior, we will ask

Some Basic Assumptions about Preferences

1. Completeness: Preferences are assumed to be complete. In

Note that these preferences ignore costs. A consumer might

Some Basic Assumptions about Preferences

2. Transitivity: Preferences are transitive. Transitivity means that

3. More is better than less: Goods are assumed to be desirable

more of any good to less. In addition, consumers are never

Describing Individual Preferences

Because more of each good is

● indifference curve Curve representing all combinations of market

The indifference curve U1 that

satisfaction as does market

Our consumer prefers basket

An indifference map is a set of

Any market basket on

If indifference curves U1 and U2

among market baskets A, B,

The Marginal Rate of Substitution

The Marginal Rate of Substitution

The magnitude of the slope of an

In this figure, the MRS between clothing

Perfect Substitutes and Perfect Complements

● perfect substitutes Two goods for which the marginal rate

● perfect complements Two goods for which the MRS is

Perfect Substitutes and Perfect Complements

Preferences for automobile attributes can be described by

Utility and Utility Functions

● utility function Formula that assigns a level of utility to individual

A utility function can be

indifference curves, each

Ordinal versus Cardinal Utility

● cardinal utility function Utility function describing by how much

Income and Happiness

The Budget Line

● budget line All combinations of goods for which the total

TABLE 3.2 Market Baskets and the Budget Line

Market Basket Food (F) Clothing (C) Total Spending

Market baskets associated with the budget line F + 2C = $80

The Budget Line

A budget line describes the

of $80, a price of food of PF = $1

Income changes A change in

increased to $160, the budget line

Price changes A change in the

$1.00 to $0.50, the budget line

What happens when price of both the goods double?

Maximizing Consumer Satisfaction

A consumer maximizes satisfaction