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“Consumer Behavior”
Reynolds I. Neoclassical economics assumes that individuals are “rational.”
A. Rational requires that individuals know their objective and all feasible alternatives. B. Individuals must establish criteria to evaluate each alternative with respect to the objective. C. Principle agent problem 1. When an agent acts on behalf of a principal, there may be imperfect information between the principal and agent. 2. The objectives of the agent may not be consistent with those of the p

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Reynolds-----EC303-------Consumer Behavior page 1
“Consumer Behavior”
ReynoldsI. Neoclassical economics assumes that individuals are “
rational
.”
A. Rational requires that individuals know their objective and all feasiblealternatives.B. Individuals must establish criteria to evaluate each alternative with respectto the objective.C. Principle agent problem1. When an agent acts on behalf of a principal, there may be imperfectinformation between the principal and agent.2. The objectives of the agent may not be consistent with those of theprincipal3. the principal-agent problem can be viewed as the process by whicha contract can be designed to motivate the agent to act in theprincipal’s interests.
II. Consumer choice is dependent on the set of possibilities and thepreferences of the individual.
A. The set of possible choices is defined by;1. The income or budget of the individual2. The prices of the set of goods (and services) available and relevantto the individual3. The budget constraint can be defined as:
M > P
X
Q
X
+P
Y
Q
Y
+. . . +P
N
Q
N
To simplify your life, consider two goods rather than Ngoods:M > P
X
Q
X
+P
Y
Q
Y
XXYY
Where:M = incomeP=PriceofgoodXQ=QuantityofgoodXP= PriceofgoodYQ=QuantityofgoodY
Problems:
1. If Q
X
= 16, How many units of good Y can be purchased?2. If Q
Y
= 24, How many units of good X can be purchased?
If income is $80 per month (M=80/m) while the price of good X is $4 (P
X
=4) and the price of good Y is $2.50(P
Y
=2.50), the budget constraint can be graphed,If the entire $80 is spent on good X, 20 units can bepurchased. This is shown as point A on the graph to theright, Q
X
= 20If the $80 is spent on good Y, the maximum amount of good Y is 32, Q
Y
= 32. This is shown as point B.Any combination of goods X and Y (called a “bundle ormarket basket”) that falls on the line AB requires anexpenditure of the entire $80. For example, a purchaseof Q
Y
=16 and Q
X
= 10 requires an expenditure of $80.This is the
budget constraint
or
budget line
. Allcombinations on or inside the constraint are
feasible
.Any combination that lies in the triangle OAB (in yellow)is feasible and requires an expenditure less than $80.Any combination that lies outside the line AB will costmore than $80. This is the infeasible set.
Q
Y
/ut
Q
X
/ut
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ABO
Reynolds-----EC303-------Consumer Behavior page 2
4. Note that the quantity and income is regarded as a “
flow
,” i.e. it ismeasured as an amount during a specific period of time.5. Summary:a) Bundles or market baskets that lie on the budget line orbudget constraint AB are feasible and require anexpenditure of exactly $M.b) Bundles that line inside the budget line cost less than $Mand are also feasible.c) Bundles that lie outside the budget constraint require anexpenditure of more than $M and are infeasible orunaffordable.6. Relative Prices and the slope of the budget constraint7. The equation for the budget constraint can be expressed:a)
XXYY
M=PQ+PQ
b)
Y
XXYY
PMQ=-QPP 8. A change in income (
∆
M) is shown by a parallel shift of the budgetconstraint.
The slope of the line AB can be described as “rise overrun,” which would be-32B4-==-=-1.6A202.5 Note that the X intercept (Q
X
=20) was calculated bydividing the budget (M) by the price of good X (P
X
),
X
Xintercept
MQ== run P
.The value of the Y intercept was calculated by thebudget (M) divided by the price of good Y (P
Y
),
YY
Yintercept
MQ=sothe rise PMfrompointBtoAis-P
,
.This makes the slope of the budget constraint
XY
P-P
Q
Y
/ut
Q
X
/ut
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AB
O
When M = $80, P
X
= $4 and P
Y
= $2.50 the budgetconstraint is AB.If M falls to M’ = $60 (
∆
M=-20,
and prices areunchanged) the new budget line becomes line GH. Adecrease in the budget shifts the budget constraint tothe left. The Q
Y
intercept (point G) will be
60= 242.5
, theQ
X
(point H) intercept is
M60==15P4X
An increase in the budget (with prices unchanged) willshift the budget to the right. If the income or budgetincreases to $112 (
∆
M=32) the budget constraint willshift to line RN.
Q
Y
/ut
Q
X
/ut
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AB
OGHRN
Reynolds-----EC303-------Consumer Behavior page 3
9. A change in relative prices can be shown by a rotation of the budgetline (i.e. its slope will change)10. An increase in the price of good X (
∆
P
X
>0) will rotate the budgetconstraint in along the X-axis. Let the price of good X increase to$5. What is the new Q
X
intercept? Draw in the new budgetconstraint. What has happened to the feasible set of bundles thatcan by purchased?11. If the price of good Y (P
Y
) changes while income (M) and the priceof good X (P
X
) remain constant, the budget constraint will rotatealong the Q
Y
axis. An increase in the price of good Y will rotate thebudget constraint in along the axis while a decrease will rotate itout. Raise the price of good Y to P
Y
’=$3 while M and P
X
areunchanged. What is the new Q
Y
’? What will happen if the
∆
P
Y
<0?
Problems
:1) Given an income of $120,P
X
=$5 and P
Y
=$10,construct the budgetconstraint.2) If the price of X (P
X
)increases to $8 (M=120,P
Y
=10), draw the newbudget constraint.3) If the income increases to$240 (M’) given P
X
’=8 andP
Y
=10, construct the budgetconstraint.4) With the income(M’=240) and P
X
’=8, Showan increase in the price of Y(P
Y
’=12) to $12.5) Given the budgetconstraint ZZ’ is whenM=$400, what are theprices of goods X and Y?
Given M = $80, P
X
=$4 and P
Y
=$2.50 the budgetconstraint is shown by line AB. If the price of X (P
X
)decreases the budget constraint will rotate outwardalong the X-axis. If the price of X changes (
∆
P
X
=-1, soP
X
’
= $3), the new Q
X
’
intercept will be
X-intercept
'80Q= = 26.673. The new budget constraint(given the new P
X
’
) is represented by the line BH.Note that income (M) remained at $80 and P
Y
is still$2.50. The reduction in the price of X changed the Q
X
-intercept.While the income (M) remains at $80, the reduction inthe price of good X (P
X
) has rotated out, there byincreasing the set of bundles that can be purchased withthe srcinal $80. The nominal income remains constantbut there is an increase in “real income.”
Q
Y
/ut
Q
X
/ut
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AB
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x/ut
Z
Z’
Reynolds-----EC303-------Consumer Behavior page 4
12. Budgets with more than two goods are in multidimensional spaceand are represented by a hyperplane. Three goods are in three-dimensional space, n-goods in n dimensional space.13. Pricing strategies such as quantity discounts, deductibles and co-payments may result in “kinked” budget constraints.
III. Consumer Preferences
A. Consumers are said to have a utility function, i.e. the satisfaction or utilitythat an individual has is dependent on a set of independent variables,
U
i
= f(Q
X
, Q
Y
,…Q
N
, Health, Attitude, etc…)Since health, attitude and that sort of thing are difficult if notimpossible to measure, neoclassical economics focuses on thequantities of goods and services (Q
X
, Q
Y
, Q
N
).
B. There are two approaches to explaining consumer choices (or behavior),one is with “marginal utility” analysis which requires cardinalmeasurement of utility. Cardinal utility measurement requires the agentto measure their satisfaction in numeric terms. A pizza gives me 16 utilsof satisfaction and a tofu burger gives me 8 utils, i.e. I like pizza twice asmuch as I like tofu burgers. The second approach is based on ordinalutility preferences. This approach presumes that the agent can ordertheir preferences, i.e. I like pizza more than I like tofu burgers. Thisapproach is referred to as “indifference analysis.” C. Indifference analysis presumes the agent can always identify theirpreferences. For any two bundles of goods (A and B) the consumer mustbe able to rank or give a preference ordering to all potential bundles of goods:1. I prefer A to B, i.e. A gives me more satisfaction than B, or2. I prefer B to A, or3. I am indifferent between A and B, i.e. A and B give me the samesatisfaction.D. Conditions required for indifference analysis1. Completeness – All combinations or bundles of goods can be rankordered. Clearly, lack of information about feasible alternatives canlead to problems.2. More is preferred to less – assumes that individuals derive utilityfrom the good. Note that many goods may yield negative utility atsome point. If goods have negative utility or disutility theindifference curves will not be “normally” shaped.3. Agents must maintain the conditions of transitivity. If you preferhamburgers to hotdogs and hotdogs are preferred to tofu burgersthen you must prefer hamburgers to tofu burgers.4. Frank argues that “convexity” is also required. This requirement isonly to insure the solution for utility maximization is determinant.It is possible that there may not be a single solution to optimize afunction.E. Indifference curves are like a topological or contour map. While the contourmap shows the topological features of a geographic area the indifferencecurves and indifference map shows the characteristics of an individual’sutility function. In Figure 1 there is a contour map. Each contour linerepresents an elevation. The lines are constructed at 500-foot elevationdifferences. The outside line represents all points that have an elevationof 500’. The second line has an elevation of 1000’, the third line anelevation of 1500’ and so forth. The contour lines represent a molehillwith an elevation of something over 2500’ and less than 3000’. Do notmake a mountain out of a molehill. An indifference map shows thefeatures of an individual’s preferences. Consider an indifference map fortwo goods (an indifference map for n goods will be in n-dimensionalspace), Q
X
and Q
Y
. The individual is endowed with Q
XA
=12 and Q
YA
=10.This is shown in Figure 2.
Fiure 1

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