Chapter 3 v2 - Consumer behaviour

Question 1

What is the million dollar question in regards to launching a new product?

Answer 1

How high a price should it be?

It is not enough to know that consumers are willing to pay more, we need to know HOW MUCH MORE.

The answer/solution is to conduct a consumer preference analysis to determine the demand. Given the demand, we can find a price.

Question 2

In broad terms, describe the meaning of consumer behavior

Answer 2

Consumer behavior refers to theories about how consumers allocate their incomes to purchase goods and services.

Question 3

Explain the three steps in understanding consumer behavior

Answer 3

1) consumer preferences
2) budget constraints
3) consumer choice

Consumer preferences: We want to find a way to describe and model the reasons why consumers prefer one good over another. Why is one preferred?

Consumer budget constraints is about the actual limit in income. Prices are the main driver in this regard. If prices are low, an income I can buy more. If prices are high, the same income can buy less. Consumers are price aware. The question then becomes, what will a consumer do when he is faced with choices in goods when he has limited income.

Consumers make choices based on their preferences and their budget constraints. We assume consumers make choices based on maximizing satisfaction. Consumer choice is the key to understanding demand.

Question 4

Elaborate on the assumptions we make regarding consumers

Answer 4

We make assumption on several factors, but many of them are hardly wrong. However, the most shady assumption is the assumption that consumers make choices in order to maximize their satisfaction based on income level. We know that this is not always true: for instance impulse purchases.

Question 5

Elaborate on market baskets

Answer 5

Market baskets refer to a group of items. It can consists of ex 2 types of items, more types etc.

Baskets are a way of describing goods.

Question 6

Regarding consumer preferences, what are the assumptions we make?

Answer 6

Completeness. This means that consumers are able to rank each basket. If a basket is equally preferred to another, we use the term indifference.

Transitivity. If a consumer prefer A to B, and B to C, then he MUST also prefer A to C.

More is better than less. We regard goods as something we like, therefore having more is better.

Question 7

Elaborate on indifference curves

Answer 7

Indifference curves are related to a level of satisfaction. All combinations of market baskets that yield the same level of satisfaction will be located on what we call an “indifference curve”. Each level of satisfaction will have an indifference curve, and there will be combinations of market baskets on these lines in which the consumer would be indifferent.

When we compare baskets, we look at the types of items in it, and figure out the combinations that yield indifference. We typically consider only baskets of 2 types of items, because this allows us to view the problem graphically. ex, consider a market basket consisting of clothes and food. Then we look at combinations of food and clothes that yield indifference to a consumer. A consumer might value 50 clothes and 10 food equally satisfactory as 10 clothes and 50 food etc.

Question 8

If we plot market baskets in a 2d plot, what can we do with this?

Answer 8

Such a plot will only list the combinations of goods in a basket. Therefore, we can only use the more is better principle to make conclusions about consumer preference. However, when this is not possible, we can’t say shit. We would then need more information about the ranking.

Question 9

In what way does the indifference curve slope, and why?

Answer 9

It slopes downward because of the more is better assumption. If the indifference curve were to slope up, it would indicate that a consumer is indifferent between a market basket A and a basket B that has the same as A but more… This doesn’t make any sense. Therefore it slopes down.

Question 10

What is an indifference map?

Answer 10

Set of all indifference curves

Question 11

What is the marginal rate of substitution?

Answer 11

The marginal rate of substitution is a measure of how much of one good we would want to sacrifice in order to receive an additional unit of some other good.

In terms of the 2D plots, we are looking at how many units of the good that is one the y axis are we willing to sacrifice for an additional unit of the good which is one the x-axis.

The marginal rate of substitution is equal to the derivative of the indifference curve. This means that MRS is related to a specific indifference curve.

Question 12

Is MRS a positive of negative number?

Answer 12

Negative, due to the downward slope of the indifference curve.

Question 13

What is regarded as the fourth assumption on consumer preferences?

Answer 13

Diminishing marginal rate of substitution.

The background on this is as follows:
When we, as a consumer, get a very large amount of one specific good relative to another, we start valuing the good that we dont have very much of more. This is not because the other good is more important, or grows more important, but rather because of the large amount of good A we have acquired. We simply don’t need another unit. So, if we have many of good on y-axis and small amount of x-axis good, then we are looking at quite large sacrifices in amount of y-good in order to get an additional x-good. As we move further along the x-axis, the opposite happens. We’ll see the indifference curve flatten hard. eventually it will grow to the point where we almost dont want to give anything for another unit.

Question 14

How does indifference curves and willingness relate to perfect substitutes and perfect complements?

Answer 14

First of all, indifference curves show the consumers’ willingness to substitute one good of another. What happens if we look at 2 goods that are perfect substitutes?

Because they are “perfect substitutes” it doesn’t matter at all to the consumer which of the units it has. Therefore, we would be equally willing to trade one for one at any time. This gives us an indifference curve that takes the form of a linear curve. The slope is equal to 1.

What about perfect complements?
Because they are perfect complements, one would generally not want to trade at all. Therefore they are represented by indifference curves that looks like right angles.

Question 15

elaborate on utility

Answer 15

Consumer theory relies only on relative rankings of market baskets, but sometimes it is useful to provide some actual numerical values to the baskets. We coin the term utility to refer to a measure of “satisfaction” that is achieved by a particular market basket. In such case, each indifference curve would have the same utility score.

To compute the utility we use a utility function. A utility function is a formula that maps the items to some real value. EX: u(F,C) = F + 2C

The utility function must work in accordance with the assumptions of consumer preference. For instance, transitivity. Also, of Course, if market basket A is preferred to B, then the utility function needs to output a value for A that is larger than the value for B.

Question 16

How can we find indifference curves?

Answer 16

we can use the utility function and find all combinations of good A and good B that gives a specific level of utility.

Question 17

Does the utility scores mean anything?

Answer 17

No not really.

Question 18

Explain ordinal vs cardinal utility

Answer 18

Ordinal refers to the way utility functions are personal and cannot be used for comparisons between consumers. In addition, ordinal utility functions doesn’t provide any information on how much more a consumer is satisfied by some increase in the utility score. It is just a function that provides relative measures for a consumer.

If we had a function that could be used for comparisons between consumers, it would be called cardinal utility.

Question 19

In one sentence, describe the budget line

Answer 19

The budget line is a function representing all possible combination of 2 goods when we are given the prices of those goods as well as an income level for the consumer.

Question 20

What are limitations of the budget line situation?

Answer 20

first of all, we assume that the entire income goes to spending. This eliminates saving. We could however, multiply the income by a number which automatically removes a certain percentage to be used for saving without altering the budget line too much.

In addition, it only considers 2 goods.

Question 21

What is the budget line (2d) in mathematical form?

Answer 21

P_{A}A + P_{B}B = I

Question 22

How do we find the budget line?

Answer 22

Assuming we know the prices and the income level:
We look at how many of good A we can buy if the entire income is allocated to good A. Then we do the same for good B. Then we mark those points and draw a straight line between them. This line will have the slope of -(y)/(x) = -(P_x)/(P_y)

Question 23

What happens to the budget line if the income of the consumer change?

Answer 23

If the income increase the entire budget line will shift outwards. The slope remains the same as the prices are still the same.

If the income decrease the entire budget line will shift inward.

Question 24

What happens to the budget line if the prices of goods change?

Answer 24

If one price change, it will change the slope. If both prices change the same, the slope remains the same, but curve shifts.

Question 25

Regarding consumer choice, we assume rationality in regards to the choice. What must a “maximizing market basket” satisfy?

Answer 25

There are 2 conditions that a maximizing market basket must satisfy in order to be regarded as rational choice:

1) It must be located on the budget line. this explains itself. If it is above the budget line, then the consumer cannot afford it. If it is beneath the budget line, the some of the income is not allocated, which means not maximized satisfaction.

2) It must give the consumer the most preferred combination of goods and services. This naturally refers to choosing the indifference curve that is as far out as possible.

Question 26

Graphically, what are we talking about when we talk consumer choice?

Answer 26

We are looking at the point where the budget line stands tangential to an indifference curve, at meets it at this point only.

Question 26

What is the key point from the result of the analysis regarding consumer choice?

Answer 26

key is the fact that we have the preferred choice at the point where Marginal rate of substitution is equal to the slope of the indifference curve.
This means that the marginal benefit (the benefit associated in consuming another unit of some good) is equal to the marginal cost ( the cost of the additional unit)

The marginal cost is measured by the budget line. The budget line clearly states how much it will cost us to get one more unit of the good on the x axis.
The marginal benefit is measured by the marginal rate of substitution. Meaning, the benefit a consumer would get from sacrificing some of Y to get one more of X is the same as the cost associated with doing this.

Question 27

Elaborate on corner solutions.

How do corner solutions affect the indifference curves?

Answer 27

Corner solutions are referring to cases where people do not consume anything of a particular good. Meaning, when we compare two goods, like food and clothing, a corner solution would refer to the extreme case of only consuming one of these goods.

Way say that the consumer is either unwilling or unable to make a trade off between goods.

When comparing only two goods, we will be located at one of the axes, which means only one product is consumed, and we/the consumer allocate the entire income to this good. Therefore, the budget line location WILL be on the axes (on of them), not where the indifference curve is tangential with the budget line.

Question 28

Elaborate on marginal cost

Answer 28

In consumer theory, marginal cost refer to the cost of consuming one additional unit. The book gives this cost in terms of amounts of units of the good we give up. For instance, the marginal cost of getting an additional unit of food could be 1/2 piece of clothes. Since we are working with linear budget lines, the marginal cost will remain constant. The marginal cost is always equal to the slope of the budget line.

THE REST OF THE ANSWER IS NOT REALLY NEEDED

Marginal cost is the additional cost incurred by producing one more unit of a good or service.

The term is used a little differently between producers and consumers. The main meaning is the same through. We are looking at the cost of acquiring an additional unit.

For producers, this is the production cost of increasing production by one unit.

For consumers, marginal cost refers to the price of buying an additional unit of some good or service. The budget line displays this cost. The slope is essentially the marginal cost.

Question 29

Elaborate on marginal benefit

Answer 29

In consumer theory, marginal benefit refers to the additional satisfaction, or utility, that a consumer get by consuming an additional unit of some good or service. The additional satisfaction or utility if often measured in terms of how many/much of the other good that the consumer is willing to give up to get the additional good.

Question 30

How do we figure out the slope of the budget line?

Answer 30

We start with the budget line on the form:
I = F_{C}C + F_{F}F

Then we transform this equation so that it takes the shape of
y = a + bx, where y is the good on the y axis.

C = I/(P_{C} - (P_{F}/{P_{C})*F

Here, C is the y variable, I/(P_{C}) is the “konstantledd”/intercept. -(P_{F}/P_{C}) is the slope, and F is the x variable.

Then, we can use this equation to find how many units of clothes we can buy if Food is 0, etc.

Question 31

Elaborate on marginal cost vs marginal benefit.

Answer 31

The willingness to sacrifice a number of goods (y axis) to get one additional of the x axis good. As long as the amount of Y we are willing to sacrifice for another unit of X is larger than the cost, then we go ahead. At some point, the amount we are WILLING to sacrifice to get an additional unit of X will be exactly the same as what it will cost. After this point, the cost is still the same, but the amount we are willing to sacrifice is now smaller than the cost. Meaning it is not worth it.

The marginal benefit is the additional utility or satisfactions that a consumer get by consuming an additional unit of some good.
The marginal cost is the additional cost of consuming one additional unit of some good.

In our examples, the marginal cost remains constant. However, the marginal benefit does not. Therefore, at one point, they will be the same. At this point, we get exactly as much extra satisfaction by consuming one more unit of a good as we pay.

Consider a budget line with slope -1 (prices are equal).
The indifference curve that intersect the budget line in only one point (and stands tangential to it in this point), has the following behavior:
Before the intersect point (above the budget line), the indifference curve will have a slope that is steeper than the slope of the budget line. This indicates that the consumer is willing to sacrifice more than 1 unit of A to get an additional unit of B. However, because of the constant marginal cost, they will not be the same.
As we get closer and closer to the intersect point, the additional benefit/satisfaction/utility becomes closer and closer to the marginal cost. For instance, if we happily want to trade 1.2 units of Clothes to get 1 unit of food, but the cost is only 1 unit, then we make this deal immediately.
But, when we get to the point where giving up 1 piece of clothes to get 1 unit of food, then we are at the goal.

Question 32

What could be the reason for corner solutions?

Answer 32

The income is too low relative to the prices. If you have a very limited income, you will most likely not buy shit you dont need. But if you have a lot of money, you dont have to be as restricted.

Question 33

Elaborate on revealed preference.

Answer 33

The basic idea: If a consumer chooses one market basket over another, and if the chosen market basket is more expensive than the alternative, the the consumer must prefer the chosen market basket.

We are also assuming rational consumers who seek to maximize satisfaction. Therefore, when a market basket is chosen on some budget line, then we know that the consumer prefers this market basket to all other possible baskets on the same budget line.

Question 34

What is the revealed preference procedure?

Answer 34

We start with a single budget line and a consumer choice. Because we assume rational maximization of utility, we assume that this choice represent maximized utility, meaning the indifference curve only scrape the budget line in a point representing consumer choice of market basket A.
Then we know that the indifference curve must be above the budget line and not inside the rectangle created by the “more is better” assumption regarding consumer preference (above and to the right of the consumer choice market basket).

Now, we need a new budget line, signaling new prices, that goes through point A. It is crucial that the new budget line goes through A, and we need to have a consumer choice given this new line as well. Then we can compare the new choice with the choice of market basket A. We also need the consumer choice to not be A, but some other point on the new budget line. Then, we can yet again use the more is better principle to draw/shade an area where the indifference curve cannot be in. At the same time, the new budget line offers another restriction due to the fact that the indifference curve must be convex.

We repeat this process until we get a satisfactory small area where we know the indifference curve lies within.

NOW, IF WE WANT TO FIND ANOTHER INDIFFERENCE CURVE, we need to to the same procedure but all the budget lines must go through another point.

Question 35

What are the “goals” of the chapter regarding consumer behavior?

Answer 35

We want to answer 2 questions/solve them:

1) Determine how much demand there is in a market for a certain product. The driver for this is being able to set a good price.

2) Determine how the spending on some good, ex food, as opposed to spending on another good, is affected by changing levels in income and price.

Both of these require understanding of consumer behavior.

Question 36

Is the assumption of rationality fair? Are there other theories out there?

Answer 36

Behavioral economics. Use psychology and other tools to better explain how consumers sometimes make irrational decisions.

Question 37

What are the 2 assumptions/requirements regarding consumer choice?

Answer 37

We assume that consumers allocate their entire income, which means that the market basket of choice but lie on the budget line.

Also, we assume consumers seek to always maximize their utility by their choices of market baskets. This means they reach the outmost indifference curve possible.

Question 38

What is marginal utility?

Answer 38

The additional satisfaction a consumer would get from consuming an additional unit of some good.

We assume diminishing marginal utility

Question 39

Explain diminishing marginal utility

Answer 39

Diminishing marginal utility refers to the fact that as we’re consuming more and more of the same good, the additional utility we get is smaller than before. u(n+1) < u(n), if u(x) describes the marginal utility

Question 40

What is the equal marginal principle?

Answer 40

it is a principle that says: Utility is maximized when the consumer has equalized the marginal utility per dollar of expenditure across all goods.

The result is like this mathematically:
MU_{F} / P_{F} = MU_{C} / P_{C}

What is the background for this?
The highest indifference curve has the highest level of utility. Therefore, finding the maximum utility subject to budget constraints is a way of re-casting the original problem of finding the highest indifference curve.
Recall we assume diminishing marginal utility (else consuming more of only one good would be better)

We consider a small movement on the indifference curve. The additional consumption of food, delta F, or dF, will generate marginal utility MU_{F}.
We then have increased TOTAL utility by MU_{F}*dF, or delta F. But, as we receive more utility for the consumption of food, we also give up utility from clothing. Since we are on an indifference curve, the total change must be 0.

0 = MU_{F}dF + MU_{C}dC

We can re arrange this:

-(dC/dF) = MU_{F} / MU_{C}

We notice VS is the MRS.

MRS = MU_{F} / MU_{C}

we also know that MRS = P_{F} / P_{C} when utility is maximized.

This gives us:
P_{F} / P_{C} = MU_{F} / MU_{C}

Finally, this gives us:

MU_{F} / P_{F} = MU_{C} / P_{C}

This equations says that utility is maximized whenever the marginal utility of a good per dollar of that good is equal to the same ratio of the other good.

Why is this? IF we would get more utility from consuming another unit of food, then we would do this. Say we do this: Then marginal utility will diminish as assumed. at the same time, since we are giving up one unit of clothes, clothes will do the opposite of diminish, since we are not getting more, but getting less. Therefore, marginal utility of food decrease, wihile marginal utility of clothes increase. When these MU/Price ratios meet,

Question 41

How can we recast the problem of “finding the highest indifference curve given a budget constrain” in regards to utility?

Answer 41

Consumers can maximize their utility given some budget constraint. The problem is therefore “maximizing utility based on a given budget”.

Question 42

Relate marginal utility to the problem of consumer’s utility maximization problem

Answer 42

Consider movement along some indifference curve. Small movement. The movement in the x-direction can be described as delta X.
The additional utility we’d get by consuming one more unit of X is called the marginal utility. Marginal utility is equal to MU_x.
Thus, the utility gain by this small movement along the indifference curve is:
MU_x * deltaX.

BUT, since we move along the indifference curve, utility cannot change. Therefore, the utility we give up in terms of the good on the Y axis must equal the utility gained.

MU_x * deltaX + MU_y * deltaY = 0

We can rearrange this:

MU_x / MU_y = - (deltaY/deltaX)
We could also use differential movement, in terms of dy/dx. Anyways, we recognize this result as the marginal rate of substitution.

MU_x / MU_y = MRS

We also know that the MRS is equal to the slope of the budget line. This slope is equal to the negative ratio of prices.

MU_x / MU_y = P_x / P_y

This gives:

MU_x / P_x = MU_y / P_y

This is called the equal marginal principle. The consumer has equalized the marginal utility per dollar of expenditure across all goods.

Question 43

What is the equalized marginal principle?

Answer 43

When the consumer has equalized the marginal utility per dollar of expenditure across all goods.

Question 44

Is CPI a good measure to use for pensions? Is it a good measure to use for anything?

Answer 44

This is a complex scenario. Difficult to answer. The root of the complexity stems from the fact that CPI is a total measure of the entire economy. It tries to be as general as possible. Therefore, there might be differences in inflation when you consider products typically used more by elderly and then by younger people. For instance, if the price of drugs increase more than CPI, this will affect the elderly in a larger way than it would on young people. Therefore, if the pension increase with CPI, they will actually experience a decrease in purchasing power.

Question 45

What is the Ideal-cost-of-living index?

Answer 45

Cost of attaining a given level of utility at the current prices relative to the cost of attaining the same utility at base-year prices.

Not practical, as it requires vast amount of information regarding preferences.

Question 46

What is a Laspeyres index?

Answer 46

A Laspeyres price index is an index that use a fixed-consumption bundle in the base period. Therefore, the Laspeyres index answers the following question:

“What amount of money is required to by the bundle we chose at some base-year divided by the price of the same bundle when purchased in the base-year?”.

Question 47

how do we calculate the laspeyres index?

Answer 47

We take the prices of a fixed bundle from the different years, current year at top, base year at bottom. Then we multiply by 100 to indicate percentage. This is only convention, not mandatory.

Question 48

What is the assumption of the Laspeyres index that is kind of wack?

Answer 48

Laspeyres index assumes that consumers do not alter their preferences when prices change.

Question 49

What is the Paasche index?

Answer 49

The same as Laspeyres, but instead of using a bundle from some base-year, it use a bundle from the current year, and divides by the cost of buying this bundle in the base year.