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Consumer Behavior 4
Chapter Outline
4.1 The Consumer’s Preferences
and the Concept of Utility
4.2 Indifference Curves
4.3 The Consumer’s Income and the

Budget Constraint
4.4 Combining Utility, Income, and

Prices: What Will the Consumer
Consume?
4.5 Conclusion
Copyright © 2013 Worth Publishers, All Rights Reserved Microeconomics Goolsbee/Levitt/ Syverson 1/e 4-1
Introduction 4
How do consumers make purchases?
• This chapter introduces a theory of consumer behavior
• The theory is used to investigate why consumers make purchases
• Ultimately, consumers are assumed to “optimize” their utility
given scarce resources
• Consumer theory is the basis for the “demand” side of the supply
and demand model
4.1 The Consumer’s Preferences and the
Concept of Utility 4
Economists assume consumers are rational and able to “optimize”
consumption decisions given scarce resources
Four assumptions over consumer preferences
1. Completeness and rankability
• Consumers can compare bundles of goods and rank them
2. For most goods, more is better than less
• Non-satiation and “free disposal”
3. Transitivity
• Imposes consistency on rankings
4. The more a consumer has of a particular good, the less she is willing
to give up of something else to get even more of that good
• Referred to as “diminishing marginal utility”
The Concept of Utility
Utility is a measure of how “satisfied” consumers are
• A measure of happiness or satisfaction
• Provides a theoretical basis for decision theory
A utility function describes the relationship between what consumers
actually consume and their level of well-being
• Common assumptions: continuous, differentiable, concave
Consider the utility someone enjoys from seeing a movie in a theater vs.
watching a DVD
U = U (T, D)
where T is the number of movies “consumed” at the theater, and D is
the number of DVDs consumed at home. Utility might be represented by
U = T 0.8 D 0.2
In general, movies consumed in the theater add more utility than those
consumed at home (* this particular functional form is referred to as
“Cobb–Douglas”)
Utility is a measure of how “satisfied” consumers are
• A measure of happiness or satisfaction
• Provides a theoretical basis for consumer theory
A utility function describes the relationship between what consumers
actually consume and their level of well-being
• Common assumptions: continuous, differentiable, concave
Marginal utility is the additional utility a consumer receives from an
additional unit of a good or service.
Continuing the previous example: the marginal utility of theater-movies for this
consumer is given by
ΔU (T, D) dU (T, D )
MUT = =
ΔT dT
or, with the prescribed parameters
MUT = 0.8T −0.2 D 0.2
Comparing consumption outcomes
The “rules” for utility allow for an ordinal ranking of consumption
bundles
• An ordinal ranking implies bundles can be ranked from best to worse
• A cardinal ranking would allow a person to determine how much better one
bundle is, compared to another
Why not cardinal?
• Many questions can be answered with only an ordinal ranking (predicting
what will be consumed)
• Consumers differ in preferences (both between consumers and over time)
4.2 Indifference Curves 4
Ordinal rankings mean we care about relative outcomes
• Some bundles are better than others, some are worse
• Start by considering bundles that are relatively equal
A consumer is indifferent between bundles when he or she
derives the same utility level from two or more bundles.
An indifference curve plots out all of the consumption bundles
that provide a consumer with the same level of utility.
Figure 4.1 Building an Indifference Curve
Numbe
ofr
living
friends
buildin
in
g A
10
B
5
C
3
Indifference
curve
U
0 500 750 1,000
Apartment size (square feet)
Figure 4.2 A Consumer’s Indifference Curve
Number
of U2 has a
living in
friends greater utility
building
than U1
5
U
2
U
1
0
500 1,000
Characteristics of indifference curves
1. They can be drawn
• Completeness and rankability
2. Curves further from the origin represent higher utility
• More is better
3. Curves never cross
• Transitivity
4. Convex to the origin
• Diminishing marginal utility
Indifference curves can never cross
Call our movie watcher, Joe
Movies at the
theater To see why indifference curves cannot cross,
consider bundles D and F
• These bundles are on the same curve; Joe must be
indifferent between them
F Now, draw another indifference curve through

E bundle F
• Implies Joe is also indifferent between points E and F
• Why must Joe prefer bundle E to bundle F?
D
DVDs
Figure 4.4 Tradeoffs Along an Indifference Curve
As apartment size gets larger,
Michaela
Numbe is less willing to trade off the number
ofr of friends for additional apartment
living
friends A size.
buildin
in
g
5
C
U
1
0 500 1,000
The Marginal Rate of Substitution
Indifference curves describe tradeoffs
• How much of one good are you willing to give up for one more unit of
another good
• The slope of the indifference curve captures this tradeoff
We call this slope the marginal rate of substitution
ΔY
MRS XY = −
ΔX
Describes the rate at which one is willing to trade X for Y, and be

equally well off
Figure 4.5 The Slope of an Indifference Curve is the Marginal
Rate of Substitution
T-
shirts As you move down an indifference
curve, you experience a
diminishing
A marginal rate of substitution
Slope = –2
B
Slope = –0.5 U
Pairs of
Copyright © 2013 Worth Publishers, All Rights Reserved Microeconomics socks
Goolsbee/Levitt/ Syverson 1/e 4-16
The Marginal Rate of Substitution and Marginal Utility
Consider point A from the previous figure
ΔY ΔQt-shirts
MRS XY = − =− =2
ΔX ΔQsocks
Sarah is willing to give up two t-shirts for one pair of socks; what does this
mean in terms of the change in Sarah’s level of utility?
ΔU = MU socks × ΔQsocks + MU t-shirts × ΔQt-shirts = 0
But the change in utility is zero... she is just as well off! Rearranging,
− MU t-shirts × ΔQt-shirts = MU socks × ΔQsocks
and finally: ΔQt-shirts MU socks

− =
ΔQsocks MU t-shirts
The Marginal Rate of Substitution and Marginal Utility
The MRS between two goods is equal to the inverse of the goods’ marginal
utilities:
Δ [Qt-shirts ] MU socks
MRS XY = − =
Δ [Qsocks ] MU t-shirts
Observing the tradeoffs that consumers make provides insight as to the relative
marginal utilities of goods!
What does it mean if the slope of an indifference curve is steeper? Flatter?
• Steeper curves imply the consumer is willing to give up a lot of Y for a little of X
• Flatter curves imply the consumer is not willing to give up a lot of Y for a little of X
Figure 4.6 The Steepness of Indifference Curves
Application 4
Valuing the Risk of Death
One of the most controversial roles of economists is
determining how to value changes to the risk of human
mortality or morbidity.
Yet this is an important question for policymakers
• Industrial production comes with associated risks (e.g., pollution);
how to balance costs with health protection?
• Many products carry risks (e.g., automobiles); how to balance
affordability/ease of use with safeguards?
So, we need a measure... what should it be based on?

• Lost earnings?
• Health costs? Images: FreeDigitalPhotos.net
Citation: Viscusi, W. K. 2009. “Valuing Risks of Death from Terrorism and Natural Disasters.” Journal of Risk and Uncertainty
38: 191–213.
Application 4
Most economists believe value is subjective
• The value of a reduction in risk is equal to what a consumer is
willing to give up for that reduction (e.g., wage–risk tradeoff)
• A more recent question: do we value reductions in certain categories
of risk more than others?
Viscusi (2007) investigates how people value the risk of Images: FreeDigitalPhotos.net
mortality from terrorism and natural disasters vs. the baseline

of a car accident; he uses a survey approach to elicit consumer
preferences regarding risk
• Risk of terrorism and traffic deaths are similarly valued, risk
reductions valued higher for those who perceive greater risk
• Natural disaster risk reductions valued at about half
Value of statistical life is generally assumed to be $1–10

million
Citation: Viscusi, W. K. 2009. “Valuing Risks of Death from Terrorism and Natural Disasters.” Journal of Risk and Uncertainty
38: 191–213.
Movie Theater vs. DVDs figure it out
Assume Joe’s utility function for movies at the theater (T ) and

DVDs watched at home (D ) is given by
U = 4T 2 + D 2 (MU T = 8T ; MU D = 2 D )
Answer the following questions:

1. Write an equation for MRSTD
2. Would bundles of (T = 2 and D = 2) and (T = 1 and D = 4) be
on the same indifference curves?
3. Are Joe’s indifference curves convex? (Does MRSTD fall as T
rises?)
1. Using the equation for MRS
Δ [QDVD ] MU theater 4T
MRSTD = − = =
Δ [Qtheater ] MU DVD D
2. For bundles to lie on the same indifference curve, they must provide
the same level of utility
For the first bundle: 2 2
U (T = 2; D = 2 ) = 4(2 ) + (2 ) = 20
and the second:

2 2
U (T = 1; D = 4 ) = 4(1) + (4 ) = 20
The bundles provide the same level of utility; thus, they must lie on the same
indifference curve
1. To answer this question, calculate MRS at each of the bundles;
remember
Δ [QDVD ] MU theater 4T
MRSTD = − = =
Δ [Qtheater ] MU DVD D
At the second bundle (theater movies are on the x-axis):

MU theater 4 (1)
MRSTD (T = 1; D = 4 ) = = =1
MU DVD 4
and at the first MU theater 4 (2 )

MRSTD (T = 2; D = 2 ) = = =4
MU DVD 2
So Joe is willing to trade more DVD watching for less theater tickets as he
consumes more theater movies... What does this mean?
• Indifference curves are actually concave, not convex
• Violates the fourth characteristic of indifference curves!
The Curvature of Indifference Curves: Substitutes and
Complements
The shape of indifference curves reveals information about the relationship
between products
• Relatively straight indifference curves describe goods that are more easily
substitutable for one another
• Indifference curves that are more convex to the origin describe goods that are more
complementary to one another
To illustrate, consider extreme cases

• Perfect substitutes are goods that the consumer will trade at a fixed rate and receive
the same level of utility (MRS is constant)
Perfect substitutes
2-liter bottles of
Consider a typical consumer’s preferences for
root beer 1- and 2-liter soda bottles
This consumer should be willing to trade one
4
2-liter bottle for two 1-liter bottles no matter
3
how much of each he or she has
MRS is constant in this case
2
U U U U
0 1 2 3 4
2 4 6 8 1-liter bottles of
root beer
The Curvature of Indifference Curves: Substitutes and
Complements
The shape of indifference curves reveals information about the relationship
between products
• Relatively straight indifference curves imply that the two goods being considered
are substitutable to some degree
• Indifference curves with significant curvature imply a degree of complementarity
To illustrate, consider extreme cases
• Perfect substitutes are goods that can trade with another good in fixed units and
receive the same level of utility (constant MRS)
• Perfect complements are goods that the consumer must consume in a fixed
proportion
Figure 4.8 The Curvature of Indifference Curves
Perfect complements
Alternatively, consider preferences for
hotdogs and hotdog buns
Hotdogs
Most consumers will prefer to consume these
goods in constant proportion
C
3 U Consider point A ; this consumer has two
3 hotdogs and two buns
A B
2 U Adding another hotdog bun (bundle B ) will
2
not increase utility
1 U
1 The consumer needs another hotdog as well
(bundle C ) if utility is to increase
0 1 2 3 Hotdog buns
4.11 The Same Consumer Can Have Indifference Curves with
Different Shapes
Television Choices figure it out
Patrick can watch reruns of The Bachelor (TB, in hours) or back to

back NFL (American football) games (NFL, in hours). Watching
The Bachelor makes Patrick happy, but he really does not care about
football.
Draw a diagram showing a set of Patrick’s indifference curves for B
and N (put B on the horizontal axis). What is Patrick’s MRSBN when
he is consuming one hour of each show?
Patrick’s preferences for NFL hours and The Bachelor are shown in the
graph below:
Since Patrick is indifferent to

hours of NFL, bundles A, B, and C
NFL (hours) all offer the same level of utility
U
To improve his utility, he must
1 U watch another hour of The
3 C 2 Bachelor
2
Because the slope of the
B E indifference curve is infinite,
MRSBN is also infinite; Patrick is
1 willing to give up an infinite
A D
number of hours of NFL for one
0
more hour of The Bachelor
1 2 3 TB (hours)
Application 4
Illegal music downloads and album sales
Illegal file sharing on peer-to-peer (P2P) networks is considered a
major threat by industry groups (notably, the Recording Industry
Association of America, or RIAA)
• CD shipments to the U.S. have declined from over 900 million units in
2000 to about 250 million in 2011 (2011 RIAA year-end shipment
statistics)
Images: FreeDigitalPhotos.net
• The RIAA has instigated numerous lawsuits aimed at individuals who

illegally share music files
• Additionally, the industry has attempted to hold P2P network operators
liable, and won a Supreme Court decision in 2005 based on the
contention of “market harm”
•Is illegal music downloading bad for the music industry?

• Specifically, are downloaded albums/songs substitutes for legally
purchased in all cases?
Citation: Oberholzer-Gee, F and K. Strumpf. 2007. “The Effect of File Sharing on Record Sales: An Empirical Analysis.” The
Journal of Political Economy 115(1): 1–42.
Application 4
Oberholzer-Gee and Strumpf (2007) find different results, using a
unique dataset
• Four months of download data from 2002 (1.75 million transfers)
matched to sales of representative albums
• Multiple empirical approaches reveal no statistically significant impact
of illegal downloads on record sales
At max, downloads reduced contemporaneous sales by 6 million Images: FreeDigitalPhotos.net
units in 2002 (total decline of 80 million); so what caused the

broader decline?
• Substitution of other forms of entertainment by consumers
• Proliferation of cell phones among young adults, reducing disposable
income
• Shift in sales to more efficient retailers (e.g., Walmart), reducing
inventory requirements (and thus shipments)
Citation: Oberholzer-Gee, F and K. Strumpf. 2007. “The Effect of File Sharing on Record Sales: An Empirical Analysis.” The
Journal of Political Economy 115(1): 1–42.
Budget Constraint 4
The budget constraint for two goods is plotted alongside indifference curves;
mathematically,
Income = PX Qx + PY QY
To find the slope of the budget constraint, solve for QY
Income PX
QY = − Qx
PY PY
Returning to the socks/t-shirts example, and setting income to $50, the price of
socks to $5, and the price of t-shirts to $10 yields
1
QY = 5 − Qx
Or, graphically, 2
Budget Constraint 4
Figure 4.14 The Budget Constraint
T-
shirts
I =5 B
P Slope is negative because
y purchasing more socks means
4 less income for t-shirts.
Infeasible
C
3
2 P Why does the

Slope = - x = −5/10= − 1/2
Feasibl
P budget constraint
y
1 e slope downward?
A
0 I Pairs of
2 4 6 8 = 10
P socks
x
Budget Constraint 4
Factors that Affect the Budget Constraint’s Position
The slope and position of the budget constraint are a function of two factors:
income and relative prices
• Changes in income shift the budget constraint by changing the intercept
• Changes in the price of one good pivots the budget constraint by changing the slope
Consider again the budget constraint for socks and t-shirts
Budget Constraint 4
Figure 4.15 The Effects of Price or Income Changes on the
Budget Constraint
(a) (b) (c)
T-shirts T-shirts T-shirts

B Old B Old B Old
5 constraint
budget 5 constraint
budget 5 constraint
budget
New budget New budget
constraint with constraint with 4 New budget
4 4
price for
higher price for t -
higher constraint
socks lower income
with
shirts
3 3 3
Loss of B Loss of B Loss of
bundle
feasible ' bundle
feasible ' bundle
feasible
2 2 2
s s s
1 1 1
Feasibl Feasibl Feasibl
bundle
e bundle
e ebundle
A A A A A
s s s
0 ' 0 0 '
2 4 6 8 10 2 4 6 8 10 2 4 6 8 10
Pairs of Pairs of Pairs of
socks socks socks
James has $40 per week he can spend on movie tickets (M) at $10
dollars each or burritos (B) at $5 each.
a. Write an equation for James’s budget constraint and draw it on
a graph that has burritos on the horizontal axis
b. Suppose the price of burritos rises to $8. Draw James’s new
budget constraint
The budget constraint represents bundles
James can feasibly purchase, and takes the
form:
Income = PB B + PM M
Movie tickets 40 = 5 B + 10 M
Since we are putting burritos on the
4 horizontal axis, we want to find an equation
for M as a function of B, or
3 10 M = 40 − 5 B
M = 4 − 0 .5 B
2
To find the new budget constraint, simply
1 change the price of burritos to $8
Since the price of movie tickets has not

BC BC changed, we know the budget constraint will
0 2 1
2 4 6 8 Burritos pivot inward, to a new horizontal intercept of
5 burritos
Budget Constraint 4
Nonstandard Budget Constraints
Quantity discounts
• Sometimes, consumers may secure a discounted price if a minimum quantity of a
good is purchased (e.g., buy two, get one free)
• This results in a kink in the budget constraint
Budget Constraint 4
Figure 4.16 Quantity Discounts and the Budget Constraint
Phon
minutee
s
1,400
5 cents/minute
Infeasible
1,000 Feasibl
e
600
10 cents/minute
Feasibl
e
0
4 10
Pizza
Copyright © 2013 Worth Publishers, All Rights Reserved Microeconomics s
Budget Constraint 4
Nonstandard Budget Constraints
Quantity discounts
• Sometimes, consumers may secure a discounted price if a minimum quantity of a
good is purchased (e.g., buy two, get one free)
• This results in a kink in the budget constraint
Quantity limits
• Alternatively, there may be limits on how much of a good can be purchased (e.g.,
gasoline in the 1970s)
Budget Constraint 4
Figure 4.17 Quantity Limits and the Budget Constraint
Phon
minutee
s
1,400
5 cents/minute
Infeasible
1,000 Feasibl
e
600
10 cents/minute
Feasibl
e
0
4 10
Pizza
Copyright © 2013 Worth Publishers, All Rights Reserved Microeconomics s
4.4 Combining Utility, Income, and Prices:
What Will the Consumer Consume? 4
The concepts of utility and indifference curves describe consumer preferences;
the budget constraint describes which bundles are feasible
Combining these concepts, we can begin to understand consumer choices
Solving the Consumer’s Optimization Problem
Consumers face a constrained optimization problem
• Maximize utility, subject to income and market prices
The optimal choice can be interpreted most easily using a graph
(a) Utility Maximization
Good Y
With one budget constraint,
search for indifference curve
that maximizes utility
A
U
2
U
*
U
1
BC
*
Good X
Tangency is the key to finding the optimal bundle, and occurs
• where the slope of the indifference curve is equal to the slope of the budget
constraint
• when the marginal rate of substitution is equal to the price ratio
Mathematically,
Slope of indifference curve = Slope of budget constraint
MU X P
− MRS XY = − =− X
MU Y PY
MU X PX
=
MU Y PY
What does this imply? Rewriting the tangency condition yields
MU X PX MU X MU Y
= ⇒ =
MU Y PY PX PY
The consumer finds the consumption bundle that provides the most benefit on a
cost-adjusted basis
• Occurs when marginal utility per dollar spent is equalized across all products
MU X MU Y
• What does it imply if > ?
PX PY
Utility Maximization figure it out
Sarah gets utility from soda (S ) and hotdogs (H ); her utility

function is given by
U = S 0.5 H 0.5 (MU S = 0.5S −0.5 H 0.5 ; MU H = 0.5S 0.5 H −0.5 )
Sarah’s income is $12, and the prices of sodas and hotdogs are $2
and $3, respectively
What is Sarah’s utility-maximizing bundle of sodas and hotdogs?
The tangency condition for maximization is

MU S P
= S
MU H PH
Subbing in the parameters yields
MU S PS 0.5S −0.5 H 0.5 2 H 2
= ⇒ = ⇒ =
MU H PH 0.5S 0.5 H −0.5 3 S 3
So, the ratio of hotdogs to sodas in the optimal bundle should be

equal to 2/3, or 2
H= S
3
To find the exact quantities, use the budget constraint
The budget constraint is given by

Income = PS S + PH H ⇒ 12 = 2 S + 3H
Rearranging, Income PH
S= − H ⇒ S= 6 − 1.5 H
PS PS
2
Subbing in H = S
3 yields
⎛2 ⎞
S= 6 − 1.5⎜ S ⎟ ⇒ 2 S = 6 ⇒ S = 3
⎝3 ⎠
Sarah consumes 3 sodas and 2 hotdogs, and she uses all of her
income ($12)
Implications of Utility Maximization
What if two consumers have different preferences? Will they have the same
MRS at their optimal bundles?
Yes! Because they face the same ratio of prices!
Figure 4.18 The Consumer’s Optimal Choice
Jack prefers
gum over iTunes
Gu
m
U
M
J
U
J
Meg prefers
iTunes over
Budget gum
M
constraint
iTunes
An Alternative Approach: Expenditure Minimization
As an alternative to utility maximization, some consumers may instead attempt
to minimize expenditures with respect to a fixed utility
• For instance, find the cheapest meal that will fill you up
• This is the dual problem to that of utility maximization
• You get the exact same result!
Figure 4.23 Utility Maximization Versus Expenditure
Minimization
(a) Utility Maximization (b) Expenditure Minimization
Good Y Good Y
With one budget constraint, With one indifference curve,
search for indifference curve search for budget constraint
that maximizes utility that minimizes expenditure
A A
U
2
U U
* *
U
1BC BC BC BC
* A * B
Good X Good X
4.5 Conclusion 4
This chapter introduced the underlying mechanisms behind consumer
choice
• Preferences
• Prices and income
In Chapter 5, we make the link between consumer behavior and
individual and market demand

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Consumer Behavior 4

4.2 Indifference Curves

4.3 The Consumer’s Income and the

4.4 Combining Utility, Income, and

F Now, draw another indifference curve through

Describes the rate at which one is willing to trade X for Y, and be

and finally: ΔQt-shirts MU socks

So, we need a measure... what should it be based on?

mortality from terrorism and natural disasters vs. the baseline

Value of statistical life is generally assumed to be $1–10

Assume Joe’s utility function for movies at the theater (T ) and

Answer the following questions:

and the second:

At the second bundle (theater movies are on the x-axis):

and at the first MU theater 4 (2 )

To illustrate, consider extreme cases

Patrick can watch reruns of The Bachelor (TB, in hours) or back to

Since Patrick is indifferent to

• The RIAA has instigated numerous lawsuits aimed at individuals who

•Is illegal music downloading bad for the music industry?

At max, downloads reduced contemporaneous sales by 6 million Images: FreeDigitalPhotos.net

units in 2002 (total decline of 80 million); so what caused the

2 P Why does the

Consider again the budget constraint for socks and t-shirts

T-shirts T-shirts T-shirts

Since the price of movie tickets has not

The optimal choice can be interpreted most easily using a graph

Sarah gets utility from soda (S ) and hotdogs (H ); her utility

The tangency condition for maximization is

So, the ratio of hotdogs to sodas in the optimal bundle should be

The budget constraint is given by

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