Riassunto Economics of global trade prof. Gianfreda

CHAPTER 1 – CONSUMER PREFERENCES

Some time ago, General Mills introduced a new breakfast cereal. The new brand, Apple Cinnamon Cheerios,

was a sweetened and more flavourful variant on General Mills’ classic Cheerios product.

But before Apple-Cinnamon Cheerios could be extensively marketed, the company had to resolve an important

problem: How high a price should it charge? No matter how good the cereal was, its profitability would depend

on the company’s pricing decision. Knowing that consumers would pay more for a new product was not enough.

The question was how much more. General Mills, therefore, had to conduct a careful analysis of consumer

preferences to determine the demand for Apple-Cinnamon Cheerios.

General Mills’ problem in determining consumer preferences mirrors the more complex problem faced by the

U.S. Congress in evaluating the federal Food Stamps program. The goal of the program is to give low-income

households coupons that can be exchanged for food. But there has always been a problem in the program’s

design that complicates its assessment: to what extent do food stamps provide people with more food, as

opposed to simply subsidizing the purchase of food that they would have bought anyway? In other words, has

the program turned out to be little more than an income supplement that people spend largely on non-food items

instead of a solution to the nutritional problems of the poor? As in the cereal example, we need an analysis of

consumer behaviour. In this case, the federal government must determine how spending on food, as opposed to

spending on other goods, is affected by changing income levels and prices.

Solving these two problems—one involving corporate policy and the other public policy—requires an

theory of consumer behaviour:

understanding of the the explanation of how consumers allocate incomes to the

purchase of different goods and services.

CONSUMER BEHAVIOR

Consumer behaviour is best understood in three distinct steps:

1. Consumer Preferences: the first step is to find a practical way to describe the reasons people might prefer

one good to another.

2. Budget Constraints: of course, consumers also consider prices. In Step 2, therefore, we take into account the

fact that consumers have limited incomes which restrict the quantities of goods they can buy. What does a

consumer do in this situation? We find the answer to this question by putting consumer preferences and budget

constraints together in the third step.

3. Consumer Choices: given their preferences and limited incomes, consumers choose to buy combinations of

goods that maximize their satisfaction. These combinations will depend on the prices of various goods. Thus,

understanding consumer choice will help us understand demand—i.e., how the quantity of a good that

consumers choose to purchase depends on its price.

There are two types of determinants in consumer preferences:

Subjective determinants:

▪ tastes.

Objective determinants:

▪ budget and prices.

That’s the reason why it’s really complicated to study consumer preferences.

1.2. MARKET BASKETS

A market basket or a bundle is a list with specific quantities of one or more goods.

market basket

We use the term market basket to refer to such a group of items. Specifically, a is a list with

specific quantities of one or more goods. A market basket might contain the various food items in a grocery cart.

It might also refer to the quantities of food, clothing, and housing that a consumer buys each month. Many

economists also use the word bundle to mean the same thing as market basket.

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How do consumers select market baskets? How do they decide, for example, how much food versus clothing to

buy each month? Although selections may occasionally be arbitrary, as we will soon see, consumers usually

select market baskets that make them as well off as possible.

The number of food items can be measured in any number of ways: by total number of containers, by number of

packages of each item (e.g., milk, meat, etc.), or by number of pounds or grams. Likewise, clothing can be

counted as total number of pieces, as number of pieces of each type of clothing, or as total weight or volume.

Because the method of measurement is largely arbitrary, we will simply describe the items in a market basket in

terms of the total number of units of each commodity. Market basket A, for example, consists of 20 units of food

and 30 units of clothing, basket B consists of 10 units of food and 50 units of clothing, and so on.

To explain the theory of consumer behaviour, we will ask whether consumers prefer one market basket to

another. Note that the theory assumes that consumers’ preferences are consistent and make sense.

1.3. BASIC ASSUMPTIONS

The theory of consumer behaviour begins with three basic assumptions about people’s preferences for one

market basket versus another. We believe that these assumptions hold for most people in most situations.

1. Completeness: Preferences are assumed to be complete. In other words, consumers can compare and rank all

possible baskets. Thus, for any two market baskets A and B, a consumer will prefer A to B, will prefer B to A, or

will be indifferent between the two. By indifferent we mean that a person will be equally satisfied with either

basket. Note that these preferences ignore costs. A consumer might prefer steak to hamburger but buy hamburger

because it is cheaper.

2. Transitivity: Preferences are transitive. Transitivity means that if a consumer prefers basket A to basket B and

basket B to basket C, then the consumer also prefers A to C. For example, if a Porsche is preferred to a Cadillac

and a Cadillac to a Chevrolet, then a Porsche is also preferred to a Chevrolet. Transitivity is normally regarded

as necessary for consumer consistency.

3. More is better than less: Goods are assumed to be desirable—i.e., to be good. Consequently, consumers

always prefer more of any good to less. In addition, consumers are never satisfied or satiated; more is always

better, even if just a little better. This assumption is made for pedagogic reasons; namely, it simplifies the

graphical analysis. Of course, some goods, such as air pollution, may be undesirable, and consumers will always

prefer less. We ignore these “bads” in the context of our immediate discussion of consumer choice because most

consumers would not choose to purchase them.

These three assumptions form the basis of consumer theory. They do not explain consumer preferences, but they

do impose a degree of rationality and reasonableness on them.

CONSUMER PREFERENCES

1.4. INDIFFERENCE CURVES indifference curve

We can show a consumer’s preferences graphically with the use of indifference curves. An

represents all combinations of market baskets that provide a consumer with the same level of satisfaction.

That person is therefore indifferent among the market baskets represented by the points graphed on the curve.

Given our three assumptions about preferences, we know that a consumer can always indicate either a preference

for one market basket over another or indifference between the two. We can then use this information to rank all

possible consumption choices. In order to appreciate this principle in graphic form, let’s assume that there are

only two goods available for consumption: food F and clothing C. In this case, all market baskets describe

combinations of food and clothing that a person might wish to consume. As we have already seen, Table 3.1

provides some examples of baskets containing various amounts of food and clothing.

In order to graph a consumer’s indifference curve, it helps first to graph his or her individual preferences. Figure

3.1 shows the same baskets listed in Table 3.1. The horizontal axis measures the number of units of food

purchased each week; the vertical axis measures the number of units of clothing. Market basket A, with 20 units

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of food and 30 units of clothing, is preferred to basket G because A contains more food and more clothing (recall

our third assumption that more is better than less). Similarly, market basket E, which contains even more food

and even more clothing, is preferred to A. In fact, we can easily compare all market baskets in the two shaded

areas (such as E and G) to A because they contain either more or less of both food and clothing. Note, however,

that B contains more clothing but less food than A. Similarly, D contains more food but less clothing than A.

Therefore, comparisons of market basket A with baskets B, D, and H are not possible without more information

about the consumer’s ranking. FIGURE 3.1

This graph represents different market baskets (combinations of two types of goods, clothes and food). Each

letter represents a market basket.

Based on assumption 3, we can say that all the combinations in the red zone are preferred to A because

quantities of both goods are higher than in A. In contrary, all the baskets in the blue zone are not preferred to A

because quantities of both goods are lower than in A.

However, A can’t be easily compared with B, D or H. To know what are the preferences between these market

baskets, we have to ask the consumer.

From each basket, we can divide the graph in four quarters and have the same reasoning than in A.

This additional information is provided in Figure 3.2, which shows an indifference curve, labelled U

1, that

passes through points A, B, and D. This curve indicates that the consumer is indifferent among these three

market baskets. It tells us that in moving from market basket A to market basket B, the consumer feels neither

better nor worse off in giving up 10 units of food to obtain 20 additional units of clothing. Likewise, the

consumer is indifferent between points A and D: He or she will give up 10 units of clothing to obtain 20 more

units of food. On the other hand, the consumer prefers A to H, which lies below U 1.

Note that the indifference curve in Figure 3.2 slopes downward from left to right. To understand why this must

be the case, suppose instead that it sloped upward from A to E. This would violate the assumption that more of

any commodity is preferred to less. Because market basket E has more of both food and clothing than market

basket A, it must be preferred to A and therefore cannot be on the same indifference curve as A. In fact, any

market basket lying above and to the right of indifference curve U in Figure 3.2 is preferred to any market

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basket on U 1.

An indifference curve is a curve representing all combinations of market baskets that provide a consumer with

3 An indifference curve is totally personal and subjective, each consumer has

the same level of satisfaction.

his own indifference curves.

In this example, we observe that market baskets A, B and D give the same level of satisfaction to the consumer

because these points are on the same indifference curve U 1.

However, basket E is preferred to A, B and D because this basket is above indifference curve U 1.

In contrary, baskets H and G are less preferred to A, B and D because they are below indifference curve U 1.

The indifference curve U that passesthrough market basket A shows allbaskets that give the consumer the 20

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same level of satisfaction as does market basket A; these include baskets Band D. Our consumer prefers basketE,

which lies above U 1, to A, but prefers A to H or G, which lie below U

1.

1.5. INDIFFERENCE MAP

To describe a person’s preferences for all combinations of food and clothing, we can graph a set of indifference

indifference map.

curves called an

An indifference map is a graph containing a set of indifference curves showing the market baskets among which

a consumer is indifferent. In other words, an indifference map contains all the indifference curves of a particular

consumer. That’s why all the baskets on indifference curve U3

The higher is an indifference curve, the preferred it is.

U2. In the same way, all the baskets on indifference curve U2 are

are preferred to all the baskets on indifference curve

preferred to the baskets on indifference curve U1.

4 right of indifference curve U1 is preferred to any market basket on

In fact, any market basket lying above and to the

U1.

1.6. PROPERTIES OF INDIFFERENCE CURVES

Indifference curves have 3 properties:

1. Indifference curves are negatively sloped.

2. In most cases, the slope of the indifference curves is decreasing (= convexity).

3. Two indifference curves can’t intersect.

If indifference curves U1 and U2 intersect, one of the assumptions of consumer theory is violated.

According to this graph, consumer should prefer B to D because in D, quantities of both goods are higher.

But A is on the same indifference curve than B, which means that in A and B the consumer has the same level of

satisfaction. A is also on the same indifference curve than D. In other words, D and B give the same level of

satisfaction to the consumer, which doesn’t respect assumption 3 (more is better than less). That’s why

indifference curves can’t intersect.

Because A and B are both on indifference curve U

1, the consumer must be indifferent between these two market

baskets. Because both A and D lie on indifference curve U

2, the consumer is also indifferent between these

market baskets. Consequently, using the assumption of transitivity, the consumer is also indifferent between B

and D. But this conclusion can’t be true: market basket B must be preferred to D because it contains more of

both food and clothing.

Thus, intersecting indifference curves contradicts our assumption that more is preferred to less.

Of course, there are an infinite number of nonintersecting indifference curves, one for every possible level of

satisfaction. In fact, every possible market basket (each corresponding to a point on the graph) has an

indifference curve passing through it.

1.6.1. NEGATIVE SLOPE

The higher is an indifference curve, the preferred it is. That’s why all the baskets on indifference curve U 3

are preferred to all the baskets on indifference curve U 2. In the same way, all the baskets on indifference curve

U2 are preferred to the baskets on indifference curve U 1.

In fact, any market basket lying above and to the right of indifference curve U is preferred to any market basket

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on U1.

5 FIGURE 3.2

If a consumer increases the quantity of a good without decreasing the quantity of the other good, his satisfaction

would increase.

To maintain the same level of satisfaction, consumer must decrease the quantity of one good if he increases the

quantity of the other good.

That’s why the indifference curve slope is negative.

Because market basket E has more of both food and clothing than market basket A, it must be preferred to A and

therefore cannot be on the same indifference curve as A. In fact, any market basket lying above and to the right

of indifference curve U1 is preferred to any market basket on U1.

In other words, if a consumer increases the quantity of a good (food) without decreasing the quantity of the other

goods, her satisfaction would change (increase); however, the level of utility along the curve is unchanged.

∆�

�� = − �

∆� = - variazione y / variazione x

The shape of the indifference curve: convexity (the slope is decreasing)

THE MARGINAL RATE OF SUBSTITUTION

Recall that indifference curves are all downward sloping. In our example of food and clothing, when the amount

of food increases along an indifference curve, the amount of clothing decreases. The fact that indifference curves

slope downward follows directly from our assumption that more of a good is better than less. If an indifference

curve sloped upward, a consumer would be indifferent between two market baskets even though one of them had

more of both food and clothing.

The magnitude of the slope of an indifference curve measures the consumer’s marginal rate of

substitution (MRS) between two goods.

As said before, the slope of the indifference curve is decreasing. This slope is called the marginal rate of

substitution (MRS).

The MRS is the maximum amount of a good that a consumer is willing to give up in order to obtain one

additional unit of another good.

In this figure, the MRS between clothing (C) and food (F) falls from 6 (between A and B) to 4 (between B and

D) to 2 (between D and E) to 1 (between E and G).

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s FIGURE 3.5

The MRS is equal to 6 between A and B. What does it mean? It means that the consumer is willing to give up 6

units of clothing to obtain 1 more unit of food.

∆�

�� = − �

∆�

The formula of MRS is

MRS is always positive because the numerator is always negative.

The shape of an indifference curve describes how a consumer is willing to substitute one good for another.

Look, for example, at the indifference curve in this Figure. Starting at market basket A and moving to basket B,

we see that the consumer is willing to give up 6 units of clothing to obtain 1 extra unit of food. However, in

moving from B to D, he is willing to give up only 4 units of clothing to obtain an additional unit of food; in

moving from D to E, he will give up only 2 units of clothing for 1 unit of food. The more clothing and the less

food a person consumes, the more clothing he will give up in order to obtain more food. Similarly, the more food

that a person possesses, the less clothing he will give up for more food.

To quantify the amount of one good that a consumer will give up to obtain more of another, we use a

measure called the marginal rate of substitution (MRS). The MRS of food F for clothing C is the maximum

amount of clothing that a person is willing to give up to obtain one additional unit of food. Suppose, for

example, the MRS is 3. This means that the consumer will give up 3 units of clothing to obtain 1 additional unit

of food. If the MRS is 1/2, the consumer is willing to give up only 1/2 unit of clothing. Thus, the MRS measures

the value that the individual places on 1 extra unit of a good in terms of another.

Look again at Figure 3.5. Note that clothing appears on the vertical axis and food on the horizontal axis. When

we describe the MRS, we must be clear about which good we are giving up and which we are getting more of.

To be consistent throughout the book, we will define the MRS in terms of the amount of the good on the vertical

axis that the consumer is willing to give up in order to obtain 1 extra unit of the good on the horizontal axis.