SM 300

Engineering Economics
 Consumer Behavior
(Source: Pindyck and Rubinfeld, Microeconomics)
Theory of Consumer Behavior deals with the explanation of how
consumers allocate incomes to the purchase of different goods
and services.
Consumer Behavior can be understood in three distinct steps
1. Consumer preferences
Find a practical way to describe the reasons people might prefer one
good over another.
2. Budget constraints
Take into account the fact that consumers have limited incomes
which restrict the quantities of goods they can buy.
3. Consumer choices
Given their preferences and limited incomes, consumers choose to
buy combinations of goods that maximize their satisfaction.
 Consumer Preferences
Concept of Market Basket or Market Bundle:
It is a list with specific quantities of one or more goods. Eg.

To explain the theory of consumer behavior, we have to ask whether

consumers prefer one market basket to another.
 Consumer Preferences (contd.)
Basic Assumptions about Preferences: These hold true for most
people in most situations… thus imposing degree of Rationality
and Reasonableness on Consumer preferences for analysis
1. Completeness
• Preferences are assumed to be complete… Consumers can
compare and rank all possible baskets.
• Thus, given 2 market baskets A and B, a consumer will
– Prefer A to B or
– Prefer B to A or
– Be indifferent between the two, where indifferent  the
person will be equally satisfied with either basket.
When can the above assumption fail?
Note: These preferences ignore costs. A consumer might prefer
pizza to burger but buy burger because it is cheaper.
 Consumer Preferences (contd.)
Basic Assumptions about Preferences (contd.)
2. Transitivity
• Preferences are assumed to be transitive
• If consumer has preference such that
Basket A > Basket B > Basket C (where > means “preferred over”)
Basket A > Basket C [i.e. No Cycles in preferences]
Transitivity assumption is necessary for consumer consistency

3. More is Better than Less

Goods are assumed to be desirable i.e. to be “Good”
Hence, consumers always prefer more of any good to less
Also it is assumed that consumers are never satisfied… more is
always better even if a little better.
Thus “bads” like pollution are ignored in this analysis.
 Consumer Preferences (contd.)
Indifference Curves
• It is used to show a consumer’s preferences graphically
Indifference Curve represents all combinations of market baskets
that provide a consumer with the same level of satisfaction
Describing Individual
Preferences
Since more is preferred to less,
comparison of baskets in the
shaded areas easy… 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.
 Consumer Preferences (contd.)
Indifference Curves (Contd.)
• Additional information about the preferences is obtained when an
indifference curve is plotted… Eg. U1 in the below figure
An Indifference Curve
What can you say more about
preferences between various
baskets?

It is now clear that B, A and D

are on same indifference curve
 Indifference between the
combinations…

However, this consumer

prefers A to both H and G since
U1 is above those points.
 Consumer Preferences (contd.)
Indifference Maps
Graph containing a set of indifference curves showing the market
baskets among which a consumer is indifferent
An Indifference Map
Figure shows three
indifference curves that
form part of an indifference
map.

The entire map includes an

infinite number of such
curves.
 Consumer Preferences (contd.)
Indifference Curves Cannot Intersect

This is Not Possible… Why?

Here, consumer is
indifferent between A, B
and D baskets…

However, as per the

assumptions, B should be
preferred over D since it has
more of both Food and
Clothing  Violation of
assumption… therefore not
possible
 Consumer Preferences (contd.)
Indifference Curves Are Downward Sloping
• This follows from the assumption that more of the good is always
better than the less…
• If indifference curve sloped upwards… then there would exist a
point on the curve where the consumer would be indifferent
between the baskets even if he/she is getting more of both the
goods.

VS
 Consumer Preferences (contd.)
Indifference Curves Are Convex
• This is another important assumption regarding Indifference
Curves for “Goods”… Is it meaningful?
• Yes… As more and more of one good is consumer, we can expect
the consumer will prefer to give up fewer and fewer units of a
second good to get additional units of the first one!
 Consumers generally prefer balanced market baskets

Increased
Increased
Preference
Preference
VS

Note: For analysis “Bads” can be redefined into “Goods” Eg. “No Smog” is “good”