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CH 3-Theory of Consumer Behaviour

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McGill University
Management Core
MGCR 293
Tariq Nizami

Chapter 3: Theory of Consumer Behaviour & Rational Choice The basic model of Consumer Behavior focuses on 2 important factors influencing consumer behavior.  First is the consumers’ preferences(willingness), or tastes over various combination of goods.  Second is the ability of consumers to acquire goods as determined by income and prices of the goods.  The theory follows directly from the theory of constrained maximization.  How do individual consumers form their demands for products?  We assume that our consumer is rational and wishes to maximize his/her well being which is a function of the goods he/she consumes.  However, the amount of goods she can consume will be constrained by her income, given the prices of goods, their tastes and preferences for goods and given their income.  We’ll develop the concepts of utility functions, indifference curves and budget lines and from this we’ll derive the consumer demand curve for a good.  We show how the consumer’s demand shifts when income changes.  The derivation of consumer’s demand curve is based on a model of Indifference Curves & budget lines.  Utility Function : Utility is the benefit or satisfaction consumers obtain from goods & services they consume.  A Utility Function is an equation that shows an individual’s perception of the level of utility that would be attained from consuming each conceivable bundle or combination of goods & services. U=f(X,Y).  It represents the preference ranking of the consumer regarding the goods a consumer is consuming. Indifference Curves  Consumers are willing to make tradeoffs or substitute among different goods.  This willingness to substitute is determined by the form of that person’s utility function. A fundamental tool for analyzing consumer behavior is an Indifference Curve. It is a locus of points representing different combos of good & services each of which provides an individual with the same level of utility. It shows the preferences of the consumer.  Properties of Indifference Curves  a)All combos of goods X & Y along the indifference curve I yield the consumer the same level of utility  b)An IC is downward sloping  c)ICs are convex The convexity of ICs implies a diminishing marginal rate of substitution .  Marginal Rate of Substitution. (MRS) The MRS measures the number of units of Y that must be given up per unit of X added so as to maintain a constant level of utility.  The MRS diminishes as we go down to the right along an Indifference Curve(IC). ICs generally reflect a declining MRS.  We therefore assume that ICs are convex to the origin, which implies that the consumer’s MRS declines as we move down any one of these curves.  Marginal Utility Interpretation of MRS MRS can be interpreted as the ratio of the MU of X divided by the MU of Y.  Thus MRS = -dY/dX = MUx/MUy.  Marginal Rate of Substitution(MRS) is discussed in this chapter to explain and understand what the slope of the indifference curve shows or represents. 1  d)Indifference Maps-ICs cannot intersect. An indifference map is made up of 2 or more ICs. An IC lying above and to the right of another represents a higher level of utility.  Also note that price and income has nothing to do with preferences.  Preferences is a theoretical concept about how people can rank bundles of goods.  The Budget Line - Consumer’s Budget Constraint Recall from ch 2 that demand functions indicate what consumers are both willing & able to do.  Because Indifference Curves are derived from the preference patterns of consumers, they show what consumers are willing to do.  Consumers are however constrained as to what they are able to do—what bundles of goods they can purchase is constrained by the market determined prices of the goods & by their incomes.  This is analysed by discussing the budget line .  A Budget Line is the locus of all combos or bundles of goods that can be purchased at given prices if the entire money income is spent.  Whether a particular indifference curve is attainable by a consumer depends on money income of the consumer and on commodity prices. The Budget Line reflects the ability of the consumer.  Suppose our consumer’s income is $600/week  1)Suppose the price of clothing is $60 and price of a pound of food is $3.  2)Then if she spent all her income she can buy 200 pounds of food and zero clothing per week or 10 pieces of clothing and zero of food per week.  3)Otherwise if she wished, buy some food and some clothing.  4)Each such combination can be represented by a point on the line as shown in Figure 3-4. in the text.  This is called a budget line.  A consumer’s budget line shows the market baskets that he or she can purchase, given the consumer’s income and prevailing market prices.  To obtain the equation for the consumer’s budget line, note that: YPf + XPc = I Equation.3.1 3Y+ 60X = 600 where Y is the amount she buys of food, X is the amount she buys of clothing, Pf is price of food, Pc is price of clothing and I is her income. Solving equation (3.1) for Y, we obtain: Y = I - PcX Pf Pf 3Y=600-60X Or Y=200-20X which is the equation for her budget line.  The
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