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Consumer Demand Analysis

Learning Objectives

A�er reading this chapter, you should be able to:

Understand that indifference curves can depict the consumer’s tastes and preferences in product space
and predict the consumer’s reac�on to changes in price, income, and other variables that enter the
consumer’s decision func�on.
Explain that the price effect is always nega�ve, such that demand curves slope downwards.
Dis�nguish between the income and subs�tu�on effects of a price change, and explain why the income
effect is posi�ve for superior goods and nega�ve for inferior goods.
Dis�nguish between changes in demand (i.e., shi�s of the demand curve) and changes in quan�ty
demanded (i.e., movements along a demand curve).
Explain that choice between compe�ng brands can be modeled as deriving from the different a�ribute
combina�ons inherent in differen�ated products.
Discuss how the firm can increase its value proposi�on to consumers by changing one or more of the
four “P” marke�ng variables.

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A consumer’s preference for Coca-Cola over Pepsi can be be�er
understood through brand-based analysis, which evaluates
consumer reac�on to changes in product design, promo�on, place
of sale, and packaging and service quality.

Introduction

Managers make many of their decisions based on what they expect their customers to do. By tradi�on, economists call these customers consumers,

meaning the ones who purchase (and typically also consume)1 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch03introduc�on#ch03txt1) the firm’s products.2

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch03introduc�on#ch03txt2) Managers can influence the purchasing behavior of consumers by adjus�ng one or more
of the variables that enter the consumer’s decision purchasing process—these variables are known as decision variables and include product price, product
design and packaging, product availability, and product promo�on. It is important for managers to understand how consumers are likely to respond to
changes in these variables because changes cost money to implement and have subsequent cost and revenue impacts. In this chapter, we examine
consumer decisions using a predic�ve model that indicates how consumers are likely to react to changes in both a firm’s controllable decision variables, such
as those men�oned above, as well as to changes in uncontrollable variables, or variables that are not controlled by the firm, such as consumer income
levels and changes in compe��ve behavior by rival firms.

Consumers make choices within product categories (between different brands of so� drinks)
and between product categories (between taking a vaca�on or buying a new car). Within
product categories the products are close subs�tutes, meaning they are differen�ated but
qualita�vely similar, and the customer will choose one brand in preference to the other
brands. Across different product categories, the products are dissimilar but are gross
subs�tutes, meaning that if one buys one product this limits the amount of money le� to buy
products in other categories. In this chapter we will consider the consumer’s decision problem
in both scenarios. We first consider the consumer’s choice problem in the context of different
product categories For example, the consumer is choosing between his or her preferred so�
drink (Coca-Cola) and his or her preferred brand of cheese (Swissco’s Gruyere). In this context,
we will examine the impact on quan�ty demanded of these two products for changes in
prices and consumer incomes. The main issue here is to understand how consumers, with
limited income and unlimited wants and needs, allocate that limited income among the
available product and service categories such that they maximize their u�lity.

In the la�er half of this chapter we ask what is it about products that cause the consumer to
want to buy a par�cular brand within a product category. Thus, we will shi� our level of
analysis from between products to within products to consider what characteris�cs of a brand are desirable to the consumer. So, whereas our analysis is
ini�ally product category based—the choice of so� drinks versus cheese—we shi� to brand-based analysis within a par�cular category—the choice of Coca-
Cola versus Pepsi. This allows us to consider the consumer’s reac�on to changes in the firm’s controllable decision variables such as changes in product
design, promo�on, place of sale, packaging, and service quality. For example, one brand may gain sales by improving the quality of its product, adver�sing
more, offering it for purchase online, and so on. You may note that these are tradi�onally considered marke�ng decisions, and indeed we want to examine
the underlying economics of these marke�ng decisions in the context of managerial economics, as an aim of this book is to integrate managerial economics
with other business disciplines.

1. In some cases the purchaser of the firm’s product buys it for someone else to consume, such as dog food or children’s clothes, in which case we say there is indirect demand for the
firm’s product from the end consumer (i.e., the dog or the child). In other cases of indirect demand, such as in business-to-business (B2B) retailing, one firm buys the firm’s products in
order to re-sell them to the end consumer. In general, the purchaser buys the product expec�ng to best serve the end consumer’s wants and needs. [return
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch03introduc�on#return1) ]

2. We use the term “product” to mean the outcome of the firm’s produc�on process. Thus “products” might mean either goods or services, and indeed are generally a combina�on of
the two, such as a haircut with fla�ery, a meal with a�en�ve service, or a baseball game with a hotdog. [return
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/ch03introduc�on#return1) ]

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3.1 Consumer Choice Between Product Categories

The model we will use to predict consumer behavior is the u�lity-maximizing model. This is the same model that was introduced in Chapter 2 to explain
how managers make decisions that include risk and uncertainty. The u�lity-maximizing model of consumer behavior says that individual consumers make
decisions to buy products based on the expecta�on that the purchase will allow them to gain the most psychic sa�sfac�on, or u�lity, from their limited
incomes. In Chapter 2, we saw that the individual’s u�lity can be depicted by indifference curves, which are curves joining combina�ons of items that give
equal u�lity to the individual. In Chapter 2, we considered indifference curves in risk and return space, where the individual gained u�lity from return and
disu�lity (i.e., nega�ve u�lity) from risk. In the risk–return applica�on, the indifference curves were posi�vely sloping because, to stay at the same level of
total u�lity, a combina�on that had more risk must also have more return. However, when we analyze consumer choice in product space we generally

consider only items that give the consumer u�lity, since people would not willingly purchase products that would give them disu�lity (such as garbage).3

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#ch03txt3) When both the items under considera�on generate u�lity, we will have nega�vely-sloping
indifference curves, since there must be reduced consump�on of one item to stay at the same level of total u�lity when consump�on of the other is
increased. Indifference curve analysis allows us to predict the choices that a consumer will make in response to changes in product prices and consumer
incomes, as we shall see.

Let us illustrate this in the context of Bob Goodguy, who likes to spend his discre�onary income (what is le� from his pay check a�er paying for his
necessary expenditures, such as accommoda�ons, food, and commu�ng expenses) on entertainment. He loves to go to baseball games and watch new
movies in the theater. Using indifference curve analysis we can plot out his preferences in baseball–movie space, as shown in Figure 3.1. The number of
movies is shown on the ver�cal (or Y) axis and the number of baseball games is shown on the horizontal (or X) axis. Each indifference curve shows
combina�ons of baseball and movies that Bob considers equivalent in terms of total u�lity.

Figure 3.1: Indifference curves in product space

In Figure 3.1, point A represents 5 movies and 2 baseball games. Because point A and point B are on the same indifference curve (I3), Bob must consider 5

movies and 2 games to be equally sa�sfying as 4 movies and 3 games. Note that point C, represen�ng about 2.6 movies and 3 baseball games, offers less

total u�lity than point B since it has the same number of games but fewer movies.4 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#ch03txt4) Also note
that point C offers more u�lity than point D since it has the same number of movies but more games. Finally, note that since points A, B, and E are superior
to point C, and since point C is superior to point D, then points A, B, and E must also be superior to point D.

Indifference curves depict the preference structure of the individual—that is, what products the person likes and how much they like the various products.
Indifference curves show what combina�ons of two products are considered equal to, inferior to, or superior to any other combina�on. Figure 3.1 shows the
indifference map for Bob Goodguy in baseball–movie space, but necessarily shows only a few of his indifference curves. Because every point in the space
would have an indifference curve passing through it, the complete indifference map showing every indifference curve would totally black out the space and
we would see nothing, so we show only selected indifference curves to illustrate the consumer’s choice problem that we wish to explain.

It is important to note four specific proper�es of indifference curves. First, points on higher curves are preferred to lower curves, because we assume that,
all other things being equal, consumers always prefers more rather than less of any product. Second, indifference curves in product space are nega�vely
sloped throughout, because we assume that the consumer always gains posi�ve u�lity from both goods. Giving up one unit of product Y (in this case
movies) must require gaining more of product X (baseball games) to stay at the same level of total u�lity. Third, indifference curves neither meet nor
intersect, due to the assump�on of transi�ve preferences. For example, in Figure 3.1, if B is preferred to C, and C is preferred to D, then B must be preferred
to D. Fourth, indifference curves are convex from below. Convexity means that the slope of the indifference curve becomes increasingly fla�er as we move
down that indifference curve. This convexity is due to the phenomenon of diminishing marginal u�lity.

Diminishing Marginal Utility

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Diminishing marginal u�lity is commonly
observed for virtually all goods and
services including water. Economists
assume that marginal u�lity decreases for
all products for all people.

In Figure 3.1 we see that the consumer is willing to subs�tute movies for baseball games, or vice-versa, to stay at the same level of u�lity on a par�cular
indifference curve. The rate at which Bob Goodguy subs�tutes movies for baseball games can be seen in Figure 3.1—moving from point A to B, he gives up
one movie for one addi�onal baseball game (ra�o 1:1), but moving from point B to point E he gives up 1.4 movies (from 4 movies to 2.6 movies) for an
addi�onal 1.7 baseball games (from 3 games to 4.7 games) which is a ra�o of 0.8235:1. It is clear that the rate at which he is willing to subs�tute movies for
games changes as he sees fewer movies and more games. We call this rate the marginal rate of subs�tu�on (MRS), which is defined as the amount of
product Y (movies in this example) that the consumer will be willing to give up for one more unit of product X (baseball games) while remaining at the
same level of total u�lity. The s�pula�on that the consumer remains at the same level of total u�lity makes it clear that we are talking about a movement
along a par�cular indifference curve and by conven�on we define the MRS for a movement down a par�cular indifference curve. Since a movement down
an indifference curve must follow the slope of that indifference curve, it is clear that the MRS is equal to the slope of the indifference curve at any point.
Because we have drawn the indifference curves to be convex to the origin, the slope becomes increasingly fla�er as we move down an indifference curve,
illustra�ng that the MRS declines as we move down an indifference curve.

As indicated above, the convexity of an indifference curve is due to the assump�on of diminishing marginal u�lity.
The marginal u�lity (MU) of a product is defined as the change in total u�lity that is due to the consump�on of
one more unit of that product, holding constant the consump�on of all other products (i.e., with all other things
being equal). Consumers normally find that their perceived MU declines progressively as consump�on of any
par�cular product increases, other things being equal. For example, suppose you have just finished exercising and
really want a drink of water. You might expect to gain a lot of u�lity, say, 20 u�ls (i.e., 20 units of u�lity) from that
bo�le of water. Suppose a�er you drink this bo�le you then consider drinking another bo�le. You might s�ll be
quite thirsty but would certainly expect to gain less u�lity from the second bo�le than from the first, say 10 u�ls.
A third bo�le is likely to promise even less u�lity, say 5 u�ls, and a fourth bo�le only 2 u�ls, and so on. Note that
addi�onal bo�les of water would make you feel uncomfortable or sick and we assume that people stop
consuming a product before MU becomes nega�ve. Diminishing marginal u�lity is commonly observed for virtually

all goods and services, so economists assume that MU decreases for all products for all people.5

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#ch03txt5)

To understand why diminishing marginal u�lity causes indifference curves to be convex, note that moving down an
indifference curve means the consumer is consuming more of product X and less of product Y but total u�lity is
not changing. Thus, the loss in total u�lity due to giving up units of Y must be equal to the gain in total u�lity
from the addi�onal units of X as the consumer moves along the indifference curve. Since the consumer is giving
up units of Y, the MU of the units of Y being given up must be ge�ng progressively higher, and conversely, since
the consumer is gaining units of X, the MU of these units of X must be ge�ng progressively lower. So to remain
at the same level of total u�lity the amount of product Y must be decreasing and the amount of product X must

be increasing, and thus the indifference curve is convex.6

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The Consumer’s Budget Constraint

Using indifference curves, we have modeled the consumer’s preferences, so we now know what the consumer wants. Next we have to consider what the
consumer can afford. For simplicity we will assume that the consumer earns a salary each week and can spend that money on goods and services. This
analysis is easily extended to recognize credit cards, bank loans, and previously accumulated wealth on the one hand, and nondiscre�onary expenditures on
the other, but a simple introduc�on is provided by assuming that the consumer has a limited budget equal to his or her weekly wage or salary income.

How far will the consumer’s income stretch? That depends on the prices, of course. Let’s go back to Bob Goodguy and assume that Bob’s budget is $120 per
week, that the price of a baseball game is $20, and the price of a movie is $23 (these prices include extra items like a hotdog at the baseball game and
popcorn at the movies). If Bob spent all $120 on baseball games, he could afford to go to 6 games a week (120/20 = 6), or if he spent the en�re $120
budget on movies he could go to 5.22 movies a week (120/23 = 5.22). While diminishing marginal u�lity suggests he will not want to do either of these two
extreme budget alloca�ons, these boundaries define the points where the budget constraint line intercepts the X and Y axes, at 6 baseball games and 5.22
movies, respec�vely, as shown in Figure 3.2. A straight line drawn between these points joins all the combina�ons of baseball and movies that will cost $120
in total.

In Figure 3.2, we see that Bob’s u�lity-maximizing combina�on of these two products is to a�end baseball games at the rate of 3 per week and movies at
the rate of 2.6 per week. Any combina�ons that offer more total u�lity must lie on indifference curves that lie above I2 and are not affordable given Bob’s

budget constraint. The u�lity-maximizing combina�on of products that the consumer can afford is thus found at the point of tangency between the budget
line and the highest a�ainable indifference curve. Any lower indifference curve would cut the budget line twice and points on that curve would be an
inefficient way to spend his income. Any combina�on that lies on a higher indifference curve would not touch the budget line at all, and thus would be
unaffordable. Thus, the model predicts that Bob will allocate his income between baseball and movies such that he maximizes u�lity from his limited

income.7 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#ch03txt7)

Figure 3.2: The u�lity-maximizing combina�on of products given
a budget constraint

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When baseball club management wants to increase profits they
need to know whether raising prices to get more money from
those who already come to the games or reducing prices to en�ce
more people to a�end the games will generate greater profits.

Price Changes and the Individual’s Demand Curve

The consumer’s demand curve shows how much the consumer will demand at various prices that the firm might set. Managers o�en consider changing
their prices to gain more profit, and they would like to know by how much individuals would change their quan�ty demanded as a result of the change in
price. We know that the consumer’s budget constraint line is located according to his or her budget constraint and the prices of the two products.
Accordingly, we should expect that if any one of these three variables changes, the budget line must change and a new combina�on of the two products
will become u�lity-maximizing. We shall illustrate with the price of baseball �ckets. Suppose a baseball club’s management is trying to increase profits so
they can buy be�er pitchers for the team. They first need to know whether they should raise �cket prices (to get more money from those who already
come to the games) or reduce prices (to en�ce more people to come to the games). Suppose they start doing market research and interview our typical
baseball fan, Bob Goodguy. They ask Bob how many �mes a week he would come to the games if the �cket price (including Bob’s hot dog and other
incidentals) were $10, $15, $20, and $30, respec�vely. To predict Bob’s answers, we can look at his preference map and the impact of the price changes on
the affordability of the baseball games at these four different prices, as shown in Figure 3.3.

As you can see in the upper half of Figure 3.3, we have rotated the budget line around to the
right to reflect the four different price levels, while holding the price of movies the same as
before. The intersec�on points on the horizontal axis must be the income constraint ($120)
divided by the price of baseball games in each case, and so are 120/30 = 4 (for the steepest
budget line); then 120/20 = 6; then 120/15 = 8; and finally 120/10 = 12 (for the fla�est
budget line shown), respec�vely. Note that one of Bob’s indifference curves is tangent to each
of these budget lines, indica�ng that Bob would maximize u�lity if he consumed 1.5, 3, 4.5,
and 6 baseball games per week under each of the different price scenarios, respec�vely. Note
that the number of movies chosen varies according to the price of the baseball �ckets as well.
It does not follow that Bob will necessarily choose more movies when the price of baseball
rises; it also depends on the MRS at various levels of consump�on of the two products.

Figure 3.3: The price effect and the consumer’s demand curve

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Now, look at the lower part of Figure 3.3 where we have plo�ed the price of the baseball games on the ver�cal axis but retain the same horizontal axis
showing the quan�ty of baseball games per week that Bob could a�end. The line joining the price–quan�ty combina�ons, labeled d, is Bob’s demand curve
for baseball games, other things (including his income, his preference structure, and the prices of other products) being constant.

Thus, the individual’s demand curve demonstrates the price effect, that is, when price is higher, the individual will demand fewer units of the product, and
conversely, when price is lower, the individual will demand more units of the product. The price effect will differ across individuals and across different
products because people have different incomes and different preferences.

The Income Effect

Managers must also be aware that changes in consumer incomes will change the demand for their products. Generally, when consumers have more income,
they will buy more of the focal product (i.e., the product we are focusing on). In those cases where consumers buy more units of a product as their incomes

rise, we say that the product is a superior good.8 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#ch03txt8) In some cases, however, the consumer will
buy less of the focal product when incomes rise because the consumer can now afford a be�er product, and in this case the focal product is called an
inferior good. It is important for managers to know whether their products are generally considered superior or inferior goods because changes in consumer
income may happen suddenly and are outside their control. Such changes might occur due to an economic downturn, a natural disaster, a global financial
crisis, changes in foreign exchange rates, or because some of the firm’s customers have lost their jobs, for example.

When the consumer’s income increases, the budget line will shi� outward in a parallel fashion; that is, its slope will stay the same. The slope of the budget
line does not change because its slope is equal to the ra�o of the two prices and those prices have not changed. Note that the ver�cal intercept of the
budget line is the number of units of product Y that can be afforded, so it is equal to the budget (B) divided by the price of product Y, or B/PY. Similarly, the

horizontal intercept is equal to the budget divided by the price of product X, or B/PX. Since the slope of any line is equal to the rise over the run, the slope

of the budget line is equal to −B/PY (the “rise,” with the nega�ve sign reflec�ng the fact that the “rise” is actually a fall) over B/PX (the run) which simplifies

to −PX/PY, or the nega�ve ra�o of the two prices. Thus, when the consumer’s income increases, with prices unchanged, the budget line has a new higher

intercept on each axis (because B increases) and the slope is unchanged. Accordingly, we can say that the budget line shi�s outward in a parallel fashion,
meaning that the consumer is able to buy more of both products X and Y.

In Figure 3.4 we show a budget increase for two other consumers who have different indifference maps reflec�ng their differing preferences for movies and
baseball. On the le�-hand graph we show a person who regards both products as superior goods, and thus the move from point a to point b illustrates an
increase in purchasing both products when income is increased. On the right-hand graph we show a different person who regards baseball as an inferior
good, and so the move from point aʹ to point bʹ illustrates a decrease in purchasing baseball �ckets (product X) when his income increases. With greater
income this person decides to shi� expenditure away from baseball and towards other products that he views as more consistent with a higher income
lifestyle. This is easier to understand if we view product Y on the ver�cal axis not as single product but as represen�ng a “basket of all other goods” and

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Real income is the purchasing power of
monetary income and is equal to
monetary income divided by some
measure of the price level.

that this basket includes, for example, caviar. At a higher income level the consumer might want to shi� expenditure away from baseball �ckets and towards

caviar as part of adop�ng a more “refined” lifestyle.9 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#ch03txt9)

Figure 3.4: The income effect for superior and inferior goods

Conversely, the demand for inferior goods will increase when income levels fall. This is because people shi� their consump�on expenditure from higher
quality goods (steak) to lower quality goods (sausages) when incomes fall and they are unable to afford to maintain the consump�on pa�ern associated
with their former standard of living. Similarly, people might switch from used cars to new cars when incomes increase, but later revert to buying a used car
if they experience a fall in their income. It is important for managers to understand whether their products are generally regarded as superior or as inferior
goods so they will know which way the demand for their product will go in the event of a change in consumer incomes. For example, a food store in a
suburban area that is currently undergoing gentrifica�on—meaning that higher income people are moving in and renova�ng the houses—might increase its
sales and profit by stocking food items that are considered “higher class,” such as grass-fed steaks and caviar, since the newer residents are likely to
subs�tute these superior goods for cheaper cuts of meat and regular snacks.

The Income and Substitution Effects of a Price Change

We have seen that the demand for a product will increase (1) when its price is reduced (the price effect); (2) when consumers’ incomes rise (if the focal
product is a superior good); and (3) when the price of an inferior subs�tute good increases. What we are seeing is a combina�on of income and subs�tu�on
effects. The income effect, as we have just learned, is either posi�ve or nega�ve depending on whether the focal product is a superior or inferior good, and
is equal to the change in the demand for the focal product that is due only to the change in income. The subs�tu�on effect is always nega�ve, and is due
to the change in the demand for the focal product that is due only to the change in its own price. We will see that the price effect (i.e., the change in
consumer demand due to a change in the price level) is made up of two separate effects—an income effect and a subs�tu�on effect.

To be�er understand the income effect component of the price effect we must dis�nguish between monetary
income and real income. Monetary income, also known as nominal income, is the face value of the consumer’s
income, for example Bob Goodguy’s earnings of $120 per week. Real income is the purchasing power of the
monetary income and is equal to monetary income divided by some measure of the price level. In our simple
two-product model there are only two prices, and when one of them changes, real income must change. From
the preceding analysis we know that if the price of one product rises, the consumer can afford fewer units of one
or both products, and so the purchasing power of monetary income (i.e., real income) has gone down. Conversely,
if a price falls, the consumer will buy more of at least that product and may also buy more of the other product
(or “all other products” in a mul�product model) because his or her real income has increased.

So the income effect component of the price effect is due to the consumer’s real income either going up or going
down, and, as we have seen, this income effect might be either posi�ve (for superior goods) or nega�ve (for
inferior goods). For a price reduc�on for product X (causing an increase in real income), we expect the income
effect—the change in the consump�on of product X divided by the change in real income—to be posi�ve (i.e.,
both consump�on and income move in the same direc�on, or +/+) if X is a superior good, but nega�ve (i.e.,
consump�on and income move in opposite direc�ons, or –/+) if X is an inferior good. Similarly, for a price increase
for product X (causing a reduc�on in real income), the income effect will be posi�ve (–/–) if X is a superior good

and nega�ve (+/–) if X is an inferior good.

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The other component of the price effect is the subs�tu�on effect, which is due to the change in rela�ve prices, other things being equal. One of the other
things that must remain equal is real income, so, to find the subs�tu�on effect we must (theore�cally) adjust monetary income to keep real income
constant. For example, if the rent on your apartment went up by $100 a month, you would stay at the same real income level if your money income was

also raised by $100 a month.10 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#ch03txt10) The subs�tu�on effect is always nega�ve; that is, if PX goes

down rela�ve to PY, the quan�ty demanded of X will go up and, oppositely, if PX goes up rela�ve to PY the quan�ty demanded of X will go down. Since the

price effect is always nega�ve (i.e., the quan�ty demanded always moves in the opposite direc�on to price), the income effect moves in the same direc�on
as, or reinforces, the subs�tu�on effect for superior goods. However, it moves against, or par�ally offsets, the subs�tu�on effect for inferior goods.

A rela�vely simple diagram showing the separa�on of the income and subs�tu�on effects will help to explain the two component parts of the price effect.
Because the price effect contains both the income effect and the subs�tu�on effect, we can find one simply by subtrac�ng the other from the price effect.
In Figure 3.5 we show the indifference curves for a par�cular consumer and an ini�al budget line (drawn as the line AB) stretching between the ver�cal axis
and the horizontal axis with slope –PX/PY. The consumer maximizes u�lity on indifference curve I1 at point a by choosing to consume X1 units of product X

and Y1 of product Y. Now consider a price reduc�on for product X, which causes the price ra�o –PX/PY to fall, causing a fla�er slope of the budget line,

which rotates from AB to AC. This allows the consumer to reach the higher indifference curve I2 which is tangent to budget line AC at point b, where it can

be seen that the consumer now consumes X2 units of product X and Y2 units of product Y. Thus, the price effect is the total change in the quan�ty

demanded of product X (from X1 to X2) and within that price effect we need to separate the income effect from the subs�tu�on effect.

Figure 3.5: Income and subs�tu�on effects when X is a superior
good

So, to find the income effect, we would perform a hypothe�cal income adjustment by shi�ing the budget line outwards (from AB to DE), keeping constant
the ini�al price ra�o un�l it is just tangent to the higher indifference curve I2 at point c. This new hypothe�cal budget line (DE) shows how much addi�onal

income would have been necessary to allow the consumer to reach indifference curve I2 if there had been no price change. Thus, the income effect is the

change in quan�ty demanded from X1 to Xʹ. This leaves the subs�tu�on effect as the movement from Xʹ to X2, and as you can see, it is effec�vely the

movement along indifference curve I2 from point c to point b. Note that the real income is effec�vely proxied by the level of u�lity the consumer can gain

from his or her monetary income and it is necessarily the same at all points on the same indifference curve (I2). The heavy arrows show that the income

effect is addi�ve to the subs�tu�on effect because X is regarded as a superior good by this par�cular consumer.

Conversely, if X is regarded as an inferior good by a different consumer, the income effect will be in the opposite direc�on to the subs�tu�on effect and thus
partly offset it, causing the price effect to be much smaller. In Figure 3.6 we show the case where a different consumer regards product X as an inferior

good and thus the indifference map is different from the previous case.11 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#ch03txt11) No�ce that the
indifference curves are not approximately parallel as before but tend to flare out as more and more of product X is included in this consumer’s profit-

maximizing combina�on of the two products.12 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#ch03txt12)

Figure 3.6: Income and subs�tu�on effects when X is an inferior
good

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In Figure 3.6 we see that for a price reduc�on of product X, the budget line rotates from AB to AC as before, and thus causes this different consumer to
shi� from the ini�al u�lity-maximizing product combina�on at point a to the product combina�on at point c. The price effect is again nega�ve (i.e., more of
product X is demanded when its price falls) but note that the income effect (the change in demand for X due to an increase in real income, from X1 to Xʹ) is

nega�ve in this case, confirming that this consumer regards X as an inferior good. This consumer nonetheless buys more of product X because the

subs�tu�on effect (from Xʹ to X2) is posi�ve and outweighs the income effect.
13 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#ch03txt13)

Changes in Demand Versus Changes in Quantity Demanded

In the previous explana�ons, we have been talking about the change in quan�ty demanded by an individual consumer. Such changes have been in response
to a change in the price level of the focal product (product X) or, in the case of changes in the quan�ty demanded of product Y, were due to the change in
the price of an alterna�ve product (i.e., product X). We saw in Figure 3.2 that the consumer has a demand curve for product X that summarizes the quan�ty
demanded of X at any price for product X, assuming monetary income and the price of product Y, and indeed all other influences on the demand for
product X, remain constant. Thus, a demand curve is applicable only if all other things are the same.

If there is a change in any of the other variables that influence the demand for product X, there will be a shi� of the demand curve. For clarity of discussion
we say that a shi� of the demand curve is a change in demand, as dis�nct from a change in the quan�ty demanded (which is due to a change in the price
of X). Thus, a change in its own price causes a movement along the demand curve for product X, and a change in any one of the other determining
variables causes a shi� of the demand curve for product X. The demand curve must shi� to reflect the changed quan�ty demanded at the same price level
due to the new level of the variable that caused it to shi�.

In Figure 3.7 we show shi�s of the consumer’s demand curve for product X at three different points in �me. Quan�ty demanded at price PX on the ini�al

(�me t1) demand curve dt1 is equal to Xt1. We suppose that subsequently some other variable (that influences demand for X) changes and causes the

quan�ty demanded to increase to Xt2 (at the same price PX) and thus the demand curve must have shi�ed outwards to dt2. S�ll later, one or more variables

change such that the quan�ty demanded at price PX falls to Xt3, and thus the demand curve has shi�ed back to the le� to the point shown as dt3.

Figure 3.7: Shi�s of the demand curve

Variables That Shift the Consumer’s Demand Curve

The variables that cause the consumer’s demand curve for a product to shi� are immensely important to the manager trying to maximize profits. Changes in
the “other things” that influence demand will mean that more (or less) of the product will be demanded at the exis�ng price. Consequently, the profit-
maximizing price will usually need to be changed, and the manager needs to know whether to change price up or down, and by how much.

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Complements are products that typically go together such as
toothbrushes and toothpaste. If the price of a complement
increases, consump�on is expected to decrease not only for the
product whose price went up but also for its complement.

Marke�ng Strategies

Changes in Monetary Income

From the foregoing analysis you already know that a change in the consumer’s monetary income will cause a change in demand (i.e., a shi� in the demand
curve). Within Figures 3.5 and 3.6 (and ignoring the change in the price of X in both cases) we can see the impact of a change in monetary income. In the
case of Figure 3.5, we saw that the quan�ty demanded for a superior good (holding constant the price of X) increased from X1 to Xʹ when addi�onal

monetary income was hypothe�cally given to the consumer. We can also see that the quan�ty demanded of Y increased while holding constant the price of
Y, due only to the change in monetary income. In the case of the consumer who regards X as an inferior good (see Figure 3.6), quan�ty demanded of X
decreases while the quan�ty of Y increases (at constant prices) when addi�onal monetary income is hypothe�cally received. Thus, we can see that changes
in monetary income will shi� the consumer’s demand curve to the right when the product is regarded as a superior good, or to the le� when it is regarded
as an inferior good.

Changes in the Price of Related Goods

The second variable that will shi� the demand curve for a product is the price of related goods. We saw already that changes in the price of X caused the
consumer to change the quan�ty demanded of product Y—this will change by a larger amount if X is an inferior good and Y is a superior subs�tute, as was
inferred earlier. What do we mean by related goods? We have already men�oned subs�tutes—these are alterna�ves in consump�on, you choose one at
the expense of the other, such as the choice between an orange drink and a cranberry drink, or between Coca-Cola and Pepsi. Marketers call these rival
products within their respec�ve product categories. Within product categories the products will tend to be rela�vely close subs�tutes and across categories
the products (e.g., orange drink and Coca-Cola) are usually considered distant subs�tutes—although these drinks are quite different they can both be used
to sa�sfy your thirst. Many other product categories, such as music or sports, are unrelated to either of the fruit drink or cola product categories and are
said to be nonsubs�tutes (or gross subs�tutes as men�oned at the beginning of the chapter). It will make sense to you that the quan�ty demanded of a
product will increase (and thus the demand curve will shi� to the right) when a subs�tute product’s price increases, or conversely, the demand curve will

shi� to the le� when a subs�tute’s price is reduced, because in both cases the consumer will tend to switch to the cheaper subs�tute.14

(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#ch03txt14)

The other category of related goods is complements. These are products that typically go
together, that complement each other in use, such as bu�er and toast, or food and drink,
respec�vely. Logic suggests that since they complement each other their consump�on will be
posi�vely related to each other; for example, the more toast you eat the more bu�er you will
eat. But if the price of a complement goes up, your real income will decrease, so you will
tend to reduce consump�on not only of the product whose price went up (the price effect)
but also of its complement (due to an income effect). Oppositely, if the price of a complement
goes down there will be a nega�ve price effect for that product and a posi�ve income effect
for its complement. Thus, the demand curve for a product will shi� to the right when the
price of a complementary good decreases, or conversely, the demand curve will shi� to the
le� when the price of a complementary good increases.

Accordingly, managers of firms need to keep an eye on the prices of both subs�tute goods
and complementary goods since changes in these prices will shi� the demand curve for the
firm’s product and necessitate a price adjustment for that product if the firm is to maximize
its profits.

Changes in Marke�ng Variables

Marketers have tradi�onally talked about the “four Ps” that influence the quan�ty demanded of their products—these are price, product design, promo�on,
and place of sale (or distribu�on system). These four variables are the “control levers” that marke�ng managers can use strategically to increase or reduce

demand for their products.15 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#ch03txt15) Of these four Ps we have so far considered only price. We have
seen that changes in a product’s price will cause a movement along the demand curve, while a change in the price of a related good will cause a shi� of the
demand curve, other things being equal. Changes in the other three Ps controlled by the firm will cause a shi� of the demand curve as well, as these
change the amount that the consumer will want to purchase at any par�cular price level.

Product design is about the quality of the product. Product design reflects a series of decisions
that are made about which component materials, what process of manufacturing, what shapes
and colors will be used, and so on. But note that one person’s quality (e.g., purple shag wool
carpets) might be another person’s aesthe�c nightmare. Accordingly, quality is as perceived by the
target customer. If a firm redesigns its product to be perceived as higher quality by its target
customers (like the latest version of the iPad), we expect those customers to want to buy more of
that product at any price, and so the demand curve for that product will shi� to the right.
Oppositely, changes in design that reduce the perceived quality (like the unpopular design of the
Ford Edsel in the late 1950s; or Coca-Cola’s changing the formula for its “New Coke” in 1985; or
cell phones made larger and heavier by the addi�on of flip-down keyboards early in this century)
will cause a reduc�on in demand such that the demand curve shi�s back to the le�. Note that

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Internet-based firms such as Amazon.com o�en offer lower prices
and a�ract customers who may have previously visited retail stores
to see the product in person.

changes in quality percep�ons may be outside the control of the firm; for example, the release of
new medical evidence that a par�cular food prevents (or causes) cancer will raise (or reduce) the
perceived quality of that food and shi� the demand curve to the right (or the le�).

Product design includes packaging, or the way the product is presented to the poten�al customer
at the place of sale. Packaging might include a cardboard box with artwork depic�ng the product
and how to use it. Protec�ve padding inside the box might ensure that the product will not be
scratched or broken in transit. Packaging might include a user’s manual and instruc�ons for
assembly. All of these things increase the customer’s apprecia�on of the product, or put another
way, raise the u�lity of the product to the consumer and increase the likelihood that the
consumer will want to buy the product. Thus, be�er packaging is expected to shi� the demand
curves to the right for at least some consumers and increase market demand. Conversely demand
curves may shi� to the le� for changes to packaging that are perceived to be worse than the
former standard of packaging, such as the use of nonbiodegradable materials in an
environmentally conscious world.

Product design also includes the quality of service that accompanies the sales or delivery of the product to the consumer. The salesperson can provide
friendly and a�en�ve service, informa�on, fla�ery, free food and beverages, and other benefits that provide u�lity to the consumer, and thus increase
consumer demand for the product at any par�cular price level. The demand curves of at least some individuals (others may not care) will shi� to the right if
the quality of service is increased, and the firm will expect its demand curve to also shi� to the right. Conversely, a reduc�on in service quality is likely to
reduce demand from at least some consumers and for the market in aggregate.

Promo�on is about efforts made by the firm to inform poten�al customers about, and persuade them to buy, the firm’s product. It may take the form of
adver�sing, website development, point-of-purchase displays, direct-selling efforts, and so on. It serves to raise both customer awareness and apprecia�on of
the product, targe�ng either or both poten�al customers and repeat customers to build their interest or loyalty. Increased promo�on efforts (unless done
badly) will cause an increase in the quan�ty demanded by at least some consumers and so their demand curves will shi� to the right. Reduced spending on
promo�on (or offensive or annoying promo�on) by the firm will reduce at least some customers’ awareness and apprecia�on of the product, par�cularly if
rival products are being adver�sed vigorously. Consequently, the firm should expect the market demand for its product to shi� to the le�. As with product
design, note that external forces can have posi�ve or nega�ve promo�onal influence on the firm’s demand. For example, good (bad) publicity for the firm or
for the firm’s country of origin effec�vely helps (hurts) customer awareness or apprecia�on of the product and shi�s the demand curve to the right (le�).

Place of sale is about where the customer can gain access to and purchase the product and is thus part of what marketers call the distribu�on system. This
could be direct from the firm to the customer—like door-to-door sales, telemarke�ng, and Internet sales—or indirect via a hierarchy of wholesalers and
retailers. Customers o�en want to see and touch products before purchasing them, so a network of showrooms may be necessary for displaying those
products. Showrooms need to be geographically dispersed to make it more convenient for poten�al customers to gain first-hand impressions and experience
with the product before they make the final decision to purchase. Such brick-and-mortar facili�es allow the firm to iden�fy poten�al customers with at least
some interest in the product and perhaps a predisposi�on to purchase and also provide the opportunity for sales staff to persuade these poten�al
customers to make the purchase decision.

Access to the Internet and the development of more sophis�cated websites has meant that poten�al customers can become fully informed about the
product and also learn about the experience of previous buyers with that product without visi�ng any store. For established products that are well known to
the customer due to repeat purchase (like groceries, hardware items, household appliances, parts for cars, etc.) many Internet-based firms choose to have
no physical store at all, with all sales taking place via the Internet. Indeed, due to the costs savings associated with having li�le or no physical store and few
salespeople, Internet-based firms can offer lower prices and a�ract customers who may have visited retail stores to gain informa�on and to see and touch
the product but subsequently choose to buy online.

So, if the firm expands its distribu�on network, it might expect to sell more product at
the exis�ng price level. This would cause the demand curves of at least some consumers
to shi� to the right and thus, the market demand curve (being the aggrega�on of all
consumers’ demands) would shi� to the right as well. Conversely, if a firm closes down
some retail sites it will be less accessible to some consumers who will then stop buying
or demand fewer units of the product in favor of buying a more accessible rival product.

Note that all firms have the four “P” variables to control the demand curves for their
own products. Those other firms that produce related goods, that is, either subs�tutes or
complements, will cause an impact on the demand curves for the focal firm’s product if
they change any of their four Ps. We have already seen that there will be a shi� of the
demand curve for the focal firm’s product when either subs�tutes or complements
change their prices. For a subs�tute product, changes in any of the four Ps that increase
demand for that subs�tute product will decrease the demand for product X, and vice
versa. For complementary products, changes in any of the four Ps that increase demand
for the complementary product will increase the demand for product X. Oppositely,

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changes to any of the four Ps by firms producing complementary goods that reduce demand for those goods will cause reduced demand, and thus a shi� to
the le� of the individual or the market demand curves for product X.

Changes in Expecta�ons

Finally, we consider changes in consumer expecta�ons with regard to the future values of variables that influence the quan�ty demand of product X.
Star�ng with the four Ps, you will understand that if consumers expect that future prices will be lower, future quality will be higher, future promo�onal
campaigns will offer be�er ancillary benefits to purchasers, or future accessibility to the distribu�on system will be more convenient, then consumers might
decide to delay purchase from the current period and shi� their demand into a future period. For example, news of a new version of the iPad to be
released will cause the current period demand curve to shi� to the le�, as many consumers will delay their purchase of the iPad un�l the new version is
available. Conversely, if the four Ps in the future are expected, on balance, to be worse than they are today, consumers may be able to shi� their demand
from a future period to the current period. For example, car manufacturers offer 0% APR financing on new vehicles for a limited �me, causing the current
period demand curve to shi� to the right. Now you can see that a product can be a subs�tute for itself across �me periods. If consumers decide to defer
purchase of product X into a future period, the demand curves for X in the current period must shi� to the le�; and conversely, if they decide to shi�

demand from a future period back into the current period, the current period demand curve must shi� to the right.16

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As well as expecta�ons about the future value of the four Ps, expected changes in income will have an impact on consumer quan�ty demanded in the
present and future periods as consumers react by switching demand from one �me period to another. If consumers expect their income in a future period
to be higher they may defer purchase of a product into a future period, or conversely buy the product in the current period because they expect they will
be unable to afford it in the future.

The final change in expecta�ons that we will introduce is a change in the u�lity that the consumer expects to derive from consump�on of the focal product
—economists call this a change in consumer tastes and preferences. It is usually preceded by the receipt of new informa�on that causes the consumer to
re-evaluate his or her apprecia�on of the product in comparison to its subs�tute products. For example, medical research showing that carrots are
sta�s�cally related to the avoidance of cancer would cause many people to expect to gain more u�lity from carrot juice and, subsequently, to want to
consume more carrot juice at the expense of other juices. Similarly, new informa�on about a complementary product, such as medical results indica�ng
bu�er is a major contributor to obesity, may cause many consumers to use less or no bu�er on their toast and, expec�ng to enjoy ea�ng toast less, they
will reduce their demand for toast as well.

Typically, a change in consumer tastes and preferences for a product is due to the consumer’s changed apprecia�on for a specific a�ribute of a mul�-
a�ribute product (e.g., carotene in carrots, or animal fat in bu�er) within a product category, so we will defer discussion of the impact of changed consumer
tastes into the following sec�on where we focus on the consumer’s choice between subs�tute products within a product category, where consumers
compare specific a�ributes of rival products to determine which of those products they will purchase.

3. Economists talk about goods, which give the consumer u�lity, and bads, which give the consumer disu�lity (such as risk). Some�mes we have to buy bads even though we don’t want
to, like parking �ckets or speeding fines. We do this because it is be�er than the alterna�ve, that is, what would happen if we don’t buy the bad. [return
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return3) ]

4. Don’t worry about these frac�onal amounts—by considering a longer �me period they will even out. For example by going to the movies at the rate of 2.6 �mes per week, the
consumer would consume 26 movies over a 10-week period. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return4) ]

5. Even addic�ve products, such as cigare�es, alcohol, and other drugs, give diminishing marginal u�lity if you keep taking more of the product at any one si�ng. While addic�on
increases one’s desire for taking the drug at a later point in �me, on any one occasion the MU of successive doses of the drug declines, other things being equal. [return
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return5) ]

6. Here is the proof that indifference curves must be convex due to diminishing marginal u�lity. The change in total u�lity (TU) due to a change in Y is equal to ΔY.MUY (that is the change

in consump�on of product Y �mes the MU associated with the last unit of Y) and the change in TU due to a change in consump�on of X is equal to ΔX.MUX (that is the change in

consump�on of product X �mes the MU associated with the last unit of X) and these changes in TU are equal in magnitude, so ΔY.MUY = ΔX.MUX. The le�-hand side of this equa�on

measures how much u�lity is lost by giving up ΔY, and the right-hand side measures how much total u�lity is gained by ge�ng an extra amount of X. By rearranging this equa�on we
get ΔY/ΔX = MUX/MUY. We already know that MRS = ΔY/ΔX, so subs�tu�ng for MRS we find MRS = MUX/MUY. So, the MRS is equal to the ra�o of the marginal u�li�es and is also

equal to the slope of the indifference curve. Since MUX is posi�ve (and declining) while the MUY is nega�ve (and increasing in absolute magnitude) as we move down the indifference

curve, the MRS (and therefore the slope of the indifference curve) must be declining. Thus convexity of indifference curves is due to the assump�on of diminishing marginal u�lity for
every product. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return6) ]

7. As indicated earlier, this is a predic�ve model without necessarily explaining Bob’s thought processes as he allocates his income. Most likely Bob just does what feels right for him, and
his a�empts to maximize the sa�sfac�on that he gets from his limited income cause him to make choices that are usually quite well predicted by the u�lity-maximizing model of
consumer behavior. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return7) ]

8. Superior goods are o�en called normal goods because normally consumers will buy more of them when incomes increase and less of them when incomes fall. [return
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return8) ]

9. We could alterna�vely have started the en�re analysis with the assump�on that the ver�cal axis represented “All Other Goods” but that would have introduced the difficult problems
of (1) how to measure the quan�ty of, and (2) how to represent the price level for, a basket of dissimilar goods and services. In a more complex (mathema�cal) mul�product model we
could represent all other products separately and show which products the consumer shi�s in favor of when he or she treats one or more products as inferior goods. [return
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return9) ]

10. This $100 compensa�on for the price increase is a simple case where the price effect is not immediate because the quan�ty demanded of your accommoda�on is fixed in the short
term. You cannot reduce the quan�ty demanded of your par�cular apartment immediately, although you may want to hunt around for a cheaper place to live and subsequently move
to a cheaper place. More likely the increased price of your rental accommoda�on will force you to cut back on dining out and other discre�onary expenditures. [return
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return10) ]

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11. Alterna�vely it could be the same consumer but a different product X—one that our consumer regards as an inferior good [return
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return11) ].

12. Since indifference curves pass through every point in product space, it might seem that if we did show all the indifference curves passing through the rela�vely wide spaces between
the indifference curves that are shown on the right-hand side of the indifference map, that all those curves could not possibly fit through the rela�vely narrow spaces between the
curves that are shown on the le�-hand side of the indifference map. But indeed they can, because product X and Y are infinitesimally divisible and so the indifference curves are really
infinitely narrow. We just show them as rela�vely thick lines so that we can see them! [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return11) ]

13. It is conceivable that for very large changes in the price of an inferior good, and for individuals who have extreme preferences for an alterna�ve product in place of X, the income effect
could outweigh the subs�tu�on effect and consequently that the price effect could be posi�ve (i.e., less would be demanded) for some people. But as you can deduce from Figure 3.6
the price of X fell to less than half of its original level and the price effect is s�ll nega�ve for the consumer depicted. When considering all consumers in the market for product X, as we
shall in Chapter 4, it is considered unlikely for the price effect to be posi�ve in aggregate—indeed such a product would not be produced by a profit-maximizing firm if incomes were
expected to con�nue to rise. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return13) ]

14. You might say that you prefer, say, Coca-Cola, and would not switch to Pepsi when the price of Pepsi is reduced, and I would believe you for rela�vely small reduc�ons in the price of
Pepsi (or small increases in the price of Coke). Most consumers will s�ck to their preferred brand within a limited range of price reduc�ons for subs�tutes but at some larger price
differen�al they will concede that their favorite brand is too expensive and will make the switch. This consumer loyalty for par�cular brands is cul�vated by firms as it restricts the
ability of rival products to steal sales by making small price changes. As we shall see in later chapters, it depends on both the degree of product differen�a�on the firm is able to
achieve and also the consumer’s switching costs. Although individual consumers will demonstrate reluctance to switch for small price changes, when consumers are aggregated to
form the market demand for the product there is always some customers who will switch as the price differen�al goes beyond the limit of their loyalty to their preferred brand. [return
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return14) ]

15. Note that more demand is not necessarily be�er. For example, if the firm’s per unit cost of produc�on is rising when its demand increases this may cause the unit cost of the product
to rise above the price level, which would reduce the firm’s profit. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return15) ]

16. Note that we divide �me into the “current” period and various future periods, and are careful to emphasize that the horizontal axis measures quan�ty per �me period (Q/t), such as
per week or per month. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.1#return16) ]

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Demand for cars is derived from the demand for the a�ributes that
the car supplies such as comfort, pres�ge, security, and privacy, not
for its physical composi�on of metal, plas�c, and glass.

3.2 Analysis of Consumer Choice Within Product Categories

The tradi�onal model of consumer behavior dates back well over a century, before branding of products became widespread and before differen�a�on of
products was widely understood to be a good way to increase business profitability (Marshall, 1890). These days, marke�ng managers want to know a lot
more about their products than the price effect and the income effect. Why do some consumers prefer the brand A product while others prefer the brand B
product (in the same product category)? How can we improve the design of brand A so that more consumers will prefer it? What benefits offered by brand
A should we stress in our adver�sing to gain the most impact from our promo�onal dollar? Is our product vulnerable to the invasion by a new product that
offers other benefits that our product does not?

To answer these ques�ons we must restate the theory of consumer demand in terms, not of
products, but of characteris�cs or a�ributes of the products. The a�ribute theory of demand
argues that consumers buy products because of the product a�ributes, that is, the benefits
consumers perceive to be delivered by those products (Lancaster, 1966, 1971). For example, a
car is desired not for its physical composi�on (of metal, plas�c, and glass) but instead for the
services it provides, such as transporta�on, comfort, pres�ge, security, and privacy. Demand
for cars is, thus, derived from the demand for the a�ributes that the car supplies. Similarly, a
meal in a quality restaurant is not purchased simply to fill one’s stomach, but also to enjoy
pleasant surroundings, courteous service, exo�c food, good company, and no mess to clean
up. Viewing consumer demand as demand for specific a�ributes allows managers to see why
some products in a category sell more than others, and how managers might redesign their
product to make it more compe��ve by adding desired a�ributes or dele�ng undesirable
a�ributes. Marke�ng managers, and par�cularly their brand managers, are always looking for
ways to sell more products, and will find the answer lies in modifying the a�ributes offered by
their products.

Depicting Products in Attribute Space

Because our graphs are two-dimensional we will assume that only two a�ributes are important to the consumer. Although this may seem overly simplis�c,
many consumer decisions are made on the basis of two main a�ributes, and in any case this analysis could be performed using mathema�cs when more
than two a�ributes enter the consumer’s decision func�on. Our purpose here is to gain a conceptual understanding of the way consumers dis�nguish
between rival products in a product category so we will confine ourselves to the two-a�ribute case.

Consider Mr. Magnus Corpus, who likes to dine out once a week and who makes his choice among restaurants based on his percep�on of the “exo�c
atmosphere” and the “haute cuisine” offered by those restaurants. This immediately rules out fast-food restaurants, of course, but he has iden�fied six
restaurants that do offer these two a�ributes. Using the Internet to view their menus and promo�onal photos, and to find other peoples’ ra�ng of these
restaurants, we suppose that he rates each restaurant on a scale of 0–100 on each a�ribute, as shown in Table 3.1. For simplicity we assume that the
restaurants have set the same price ($100) for essen�ally the same three-course meal, and that Magnus has an income that is sufficient to allow him to
dine at one of these restaurants each week and also to buy other things he needs. A�er we find out which is his preferred restaurant we could revert to the
“between product” alloca�on problem (as in sec�on 3.2 above) to examine the alloca�on of his limited income between his chosen restaurant and all other
goods and services.

Table 3.1: A�ributes and prices in six restaurants
Restaurant Exo�c Atmosphere (EA) Haute Cuisine (HC) Ra�o of EA to HC Price of a similar three-course meal

A 90 20 4.5 $100

B 80 55 1.45 $100

C 72 70 1.03 $100

D 60 80 0.75 $100

E 30 97 0.31 $100

F 15 100 0.15 $100

You will note that the restaurants differ in their a�ribute mix and thus the ra�o of exo�c atmosphere to haute cuisine also differs—some offer a high score
on one and a low score on the other, and some achieve a high or moderate score on both a�ributes. It is clear that on the single criteria of atmosphere,
restaurant A would be the winner, while on the single criteria of cuisine, restaurant F would be the winner. But how will Magnus, who likes both
atmosphere and cuisine, choose among these restaurants? It will depend on his marginal rate of subs�tu�on between atmosphere and cuisine, as we shall
see.

In Figure 3.8, we show the six restaurants in a�ribute space as the rays labeled A to F—the slope of each ray is equal to the ra�o of atmosphere to cuisine,
from Table 3.1. To understand each ray, think about buying the meal in each restaurant. In restaurant A, for example, spending $100 would allow the

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consumer to “travel” out along the ray to a point in a�ribute space that has the coordinates 90 units of exo�c atmosphere and 20 units of haute cuisine,
the slope of which is (rise) 90 units of atmosphere for (run) of approximately 20 units of cuisine (slope equals 90/20 = 4.5 to 1). Similarly, for each of the
other restaurants, the consumer would travel out through a�ribute space at the slope of the a�ribute ra�o provided by that restaurant, and the length of
the ray will depend on the price of the meal in that restaurant. The heavy kinked line joining the points abcdef in Figure 3.8 that joins each of the product
rays at the point represen�ng the full meal in each restaurant is called the efficiency fron�er. This line shows the maximum combina�on of the two
a�ributes that can be obtained at each restaurant (for a given meal and the price of that meal).

Figure 3.8: The consumer’s choice of product in a�ribute space

Now, since Magnus Corpus likes both atmosphere and cuisine, he will have an indifference curve map in atmosphere–cuisine space and there will be
combina�ons of exo�c atmosphere and cuisine that he considers superior, equivalent, or inferior to other combina�ons. In Figure 3.8 we have shown only
one of these indifference curves, namely I*, this being the highest a�ainable indifference curve given the a�ributes and prices set by the six restaurants.
Note that Magnus should choose restaurant D because it offers the a�ributes in the ra�o that allows him to get onto the highest a�ainable indifference
curve in the context of his choice between restaurants. Each of the other restaurants would see Mr. Corpus on a lower indifference curve, and would
represent an inefficient alloca�on of his income (i.e., the indifference curves [not shown] that pass through points a, b, c, e, and f must lie below I*).

The Price Effect in Attribute Space

We can easily show the price effect using the a�ribute approach. Suppose the manager of restaurant C decides to cut menu prices to increase sales at her
restaurant. We suppose she cuts menu prices (or includes dessert for free) such that the similar meal now costs only $90 in restaurant C. This means that
for $100, Magnus Corpus can now get more exo�c atmosphere and haute cuisine than before at restaurant C (by ea�ng there at the rate of 1.111 �mes per
week, i.e., 10 �mes over 9 weeks). Thus, the quantum of exo�c atmosphere would be 72 × 1.111 = 80 per week and the quantum of haute cuisine would
be 70 × 1.111 = 77.8 per week. The new coordinates (80; 77.8) for the meal at restaurant C are thus shown in Figure 3.9 as point cʹ, and the new efficiency

fron�er is the kinked line ac’ef and you will note that it effec�vely eclipses restaurants B and D.17

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So, Magnus Corpus now eats at restaurant C, and so do others who previously dined at restaurants B and D, since restaurant Cʹs new price and quality offer
dominates that of these other two restaurants—anyone who previously dined there would find themselves on a higher indifference curve at point cʹ by
dining at restaurant C. So the only people ea�ng at restaurants B and D will be either those who have not done their homework to find out the ra�ngs of
the restaurants in atmosphere–cuisine space, or they choose those restaurants based on other a�ributes, such as convenient loca�on and friendly service,
which are not included in our simple model.

Figure 3.9: The price effect in a�ribute space

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In a first class airline, adding more of a desirable a�ribute such as
larger seats and reducing the quantum of an undesirable a�ribute
such as noise should make first class �ckets more desirable to more
consumers.

The Value Proposition and Market Niches

In effect, restaurant C has significantly increased its value proposi�on to Magnus Corpus and to people like him who have similar tastes and preferences.
We can think of the value proposi�on as quality divided by price, or

VX = KX/PX (3-1)

where VX is some measure of value to the consumer, KX is the perceived quality of product X, and PX is the price of the product. A measure of value is the

total u�lity derived from the product (i.e., I** in Figure 3.9) and the relevant measure of quality is the quantum of the a�ributes that enter the consumer’s
decision func�on—in this case exo�c atmosphere and haute cuisine. Restaurant C offers more quality per dollar, or as some might say, more “bang for the
buck,” than either restaurant B or D when it comes to these two a�ributes and for people whose tastes are similar to that of Mr. Corpus. People who have
similar tastes and preferences collec�vely cons�tute a market niche and this par�cular market niche is characterized by people who want exo�c
atmospheres and haute cuisine as the main benefits associated with dining out, and who have marginal rates of subs�tu�on (MRS) between these that
might be called “moderate.” Others, who have substan�ally lower MRS between these two a�ributes (fla�er indifference curves) will prefer restaurant A,

while others, with substan�ally higher MRS (steeper indifference curves) will prefer restaurants E and F.18

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Changes in Product Quality

From the previous explana�ons, it is clear that a change in product quality must entail a
change in quantum of a�ributes offered by that product. Adding a new a�ribute that is
thought to be desired by consumers changes the quantum from zero to some new level.
Adding more of a desirable a�ribute should make the product more a�rac�ve to more
consumers, and reducing the quantum of an undesirable a�ribute (e.g., noise) should
make the product more desirable to more consumers. Rather than add yet another
diagram to illustrate this, look again at Figure 3.9 and assume that instead of reducing
price, restaurant C ramped up the exo�c atmosphere and the haute cuisine to the new
levels shown while maintaining the $100 meal price. In this scenario, Magnus Corpus and
customers like him who have similar MRS between exo�c atmosphere and haute cuisine,
along with customers who previously preferred restaurant B and D, would have found
restaurant C’s new offer to be a be�er value proposi�on that allows them to a�ain a
higher indifference curve represen�ng a higher level of total u�lity.

Looking at Figure 3.9 through the lens of an increase in product quality you will see that
the extension of the ray (0C to 0Cʹ) represen�ng product C assumes that both a�ributes
would be increased in the same ra�o—this is not necessarily the case, of course. A
restaurant might hire a new chef, and increase haute cuisine while holding exo�c
atmosphere constant, and thus the ra�o of the two a�ributes would change (and the ray
represen�ng the product in atmosphere–cuisine space would become fla�er). Again this
reposi�oning of the product is likely to capture sales from consumers who include haute
cuisine in their decision func�on (in conjunc�on with whatever other a�ributes are
offered by restaurants) for choosing between restaurants, since it will shi� out the

efficiency fron�er and thus push through the consumer’s previously highest a�ainable indifference curve to reach a new and higher indifference curve.

Changes in Promotion Leading to Changes in Consumer Preferences

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We saw earlier that the firm has four main levers to control the quan�ty demanded of its product. Now let us consider the impact on consumer demand of
increased promo�on for a firm’s product. Suppose the manager decides to mount an adver�sing campaign. The effec�veness of this promo�onal effort will
depend on what a�ributes of the product the adver�sing focuses on and what a�ributes does the consumer care about! Adver�sing will only increase
demand for the product if it increases the customer’s awareness of the existence of the a�ributes that are contained in the product (i.e., informa�ve
adver�sing) or increases the customer’s apprecia�on for some aspect of the exis�ng product (i.e., persuasive adver�sing), or some combina�on of the two.
In the case of purely informa�ve adver�sing, consumers may gain new informa�on from the adver�sing (that the product contains more of a�ribute X than
it did previously, or more than they previously thought it did). If customers become aware of the product for the first �me, they may subsequently admit
that product into their “choice set” (e.g., the six restaurants in Figure 3.9) and would become customers of that firm for the first �me if the new
combina�on of a�ributes and its price represents a superior value proposi�on (and allows consumers to reach a higher indifference curve). If customers
were previously aware of the product but are now informed that it contains more of a desirable a�ribute (or less of an undesirable a�ribute) than they
thought before, this will shi� the product’s ray in a�ribute space and poten�ally cause the efficiency fron�er to move outward and allow a�ainment of a
higher indifference curve.

When the firm’s promo�on has a persuasive effect, it will cause consumers to re-evaluate the u�lity they expect to get from the product because they
expect to gain more or less u�lity from one or more of the a�ributes of that product. Suppose that a firm adver�ses that sugar is a major cause of obesity
and that its cookies have very low sugar content. We will demonstrate the impact of this in Figure 3.10 for consumers who desire both sweetness and
crunchiness in their cookies. The target consumer will s�ll like the sweetness delivered by sugar but now knows that sugar is bad for his or her health, so he
or she will like it somewhat less than before. This means that the marginal u�lity of sugar, and thus the MRS between sugar and any other a�ribute, will
decline for all levels of sugar consump�on, and so the consumer’s indifference curves in “sweet and crunchy” a�ribute space will be fla�er than before. In
effect, the consumer’s indifference curve map rotates in a�ribute space such that each indifference curve will be fla�er than before.

In Figure 3.10 we show three firms, A, B, and C, who offer chocolate chip cookies that are differen�ated only by their sweetness and crunchiness. Firm A
offers a cookie that has a rela�vely high ra�o of crunchiness to sweetness; firm B offers a cookie that is moderately sweet and moderately crunchy; and firm
C offers a cookie that is rela�vely low on crunchiness but rela�vely high on sweetness. We show one indifference curve rela�ng to the consumer’s tastes
before the impact of the adver�sing campaign (i.e., the rela�vely steep indifference curve I* drawn with a solid line). Under this taste pa�ern the consumer
will prefer cookie C, since it puts him on the highest a�ainable indifference curve. A�er the impact of the adver�sing campaign the highest a�ainable
indifference curve with the new taste pa�ern is represented by the rela�vely flat indifference curve shown by do�ed line labeled Iʹ and we see that the
consumer will have switched from brand C to brand A to maximize his or her u�lity.

Figure 3.10: Brand switching due to changed consumer tastes

Note that the levels of total u�lity represented by the curves I* and Iʹ are not comparable with each other. We cannot tell whether the consumer gets more
total u�lity from cookie A before the change in tastes or from cookie C a�er the change in tastes. All we can say is that given the change in tastes, he or
she gets more u�lity from A than he or she would from C, and, in our example, he or she was induced to switch from brand C to brand A by the persuasive
impact of the promo�onal campaign conducted by firm A.

Other Changes That Impact Quantity Demanded

You will readily understand how a change in the place of sale variable will impact the consumer’s quan�ty demanded. This controllable variable can be
regarded as an a�ribute of the product because it provides a benefit to customers, namely convenience of purchase. Accordingly, we could subs�tute this
a�ribute into the figures above and analyze the impact of changing place of sale on the quan�ty demanded by par�cular consumers for whom convenience
of purchase is one of the two main a�ributes. We should expect to find that more convenient loca�ons of the firm will cause some consumers to switch to
buy from the focal firm, other things being equal.

Changes in consumer income are easy to show in the a�ribute approach—note that the length of the ray for each product in a product category reflects the
consumer’s budget divided by the price of each product. We saw earlier in the case of the price reduc�on by restaurant C that this caused the length of C’s
product ray in a�ribute space to lengthen. Conversely, if all prices had stayed the same and instead the consumer’s income had risen, the length of the

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When a consumer decides to change
products, such as trading in a Blackberry
for an iPhone, switching costs are
incurred. These include search,
transac�on, learning, and conversion
costs.

product rays would have all increased commensurately. As we have seen previously in the “between product categories case,” we expect that the consumer
would con�nue to buy the same product in each category as before, but would buy more of it (in each �me period) if it is regarded as a superior good, or

less of it (per �me period) if it is regarded as an inferior good.19 (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.2#ch03txt19)

Switching Costs

Switching costs are the costs that would be incurred by the consumer in switching from one brand to another. They
include the search costs of finding and comparing the informa�on about the quality (i.e., the composi�on of
a�ributes) of the products in a product category; the transac�on costs associated with actually buying and taking
possession of a different product; the learning costs associated with learning how to use the unfamiliar new product
rather than the familiar old product; conversion costs associated with making other products interact with the newly
purchased product; and the loss of salvage value associated with inability to sell the unused inventory of goods or
services involved in the product to be replaced.

For example, suppose I have an old plasma TV and think that a new LED TV would give me more u�lity. Before
switching, however, I must incur �me and money to find out if indeed the picture and performance of the LED TV is
be�er than my plasma TV (search costs); I would have to drive to the appliance store and spend �me actually
buying the new TV (transac�on costs); I would have to spend �me connec�ng the new TV to my old DVD and sound
system and have to buy a wider table for the new TV to stand upon (conversion costs); I would have to spend �me
reading the manual to learn how to get the most out of the extra capabili�es of the new TV (learning costs); I would
incur a fee for termina�ng my lease agreement with the rental company from which I currently lease my plasma TV
(contractual costs); and I would not be able to sell my old TV table because nobody wants old-fashioned TV tables
like that anymore (loss of salvage value).

Adding up all of these switching costs might make me decide that it is not worthwhile to make the switch, at least
not yet, un�l some of the above switching costs fall. You should note that the preceding analysis silently assumed
zero switching costs and that switching would only take place when a subs�tute product offers a be�er deal, that is,
more total u�lity to the consumer. In prac�ce, switching costs will inhibit consumers from switching to a subs�tute product un�l there is enough difference
in expected u�lity (between the two alterna�ves) to compensate for the disu�lity of the switching costs.

17. Note that no one will dine at restaurants B and D (assuming they only want exo�c atmosphere and haute cuisine, and that they have full informa�on about quality and prices) un�l
these restaurants either reduce their prices or increase their quality significantly. But in reality other diners seeking different a�ributes (e.g., service quality) may patronize restaurants
B and D. But if restaurant C’s price reduc�on does cause a substan�al loss of business for these other two restaurants, price reduc�ons might be expected and again Mr. Corpus and
people like him would need to re-evaluate their purchases accordingly. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.2#return17) ]

18. Market niches can be defined narrowly in terms of customers with similar MRS values, as above, or more broadly, in terms of customers seeking similar bundles of a�ributes, in which
case all six restaurants would be considered as serving the same market niche. Also note that where products contain more than two a�ributes firms may serve more than one market
niche at the same �me, as in the above example where people seeking convenient loca�on and good service could also choose to dine at one or other of these restaurants. [return
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.2#return18) ]

19. Although we will not go into it here, the a�ributes of a product may be regarded by consumers as inferior or superior. For example, new houses might be characterized by the
a�ributes “insula�on efficiency” and “interior brightness” and some building companies might offer house designs with fewer and smaller windows while others offer house designs
with more and larger windows. At a rela�vely low income the new-home purchaser might prefer a house with rela�vely few and smaller windows to allow savings on energy needed to
heat and cool the house, but at a higher income this same person might prefer the extra brightness during daylight hours of more and larger windows, because at the higher income
they can afford to pay for the extra energy consumed. Thus for increases in income, with other things being equal, the consumer would reduce demand for solid wall area with be�er
insula�on and increase demand for glass wall area with less-effec�ve insula�on. For this to happen the indifference curves in a�ribute space would not be parallel but would “flare
out” at higher levels of the a�ributes, just as they did for inferior products in Figure 3.6 above. [return (h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/sec3.2#return19) ]

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Summary

In this chapter we inves�gated the underpinnings of consumer demand for goods and services. Managers need to know what mo�vates customers to buy
more or less of their products at different �mes and in response to changes in variables that are both within and outside their control. Managers have four
main controllable variables they can use to influence the quan�ty demanded by consumers, namely price, product design, promo�on, and place of sale,
otherwise known as the “four Ps” of marke�ng. Uncontrollable variables that impact on consumer demand for the firm’s product include the four Ps of
other firms producing related goods (either subs�tutes or complements) and the consumer’s income level and expecta�ons. We saw that each consumer
will (no�onally at least) have a demand curve for each product and argued that the aggrega�on of these will cons�tute the market demand for the firm’s
product. Changes in the firm’s own price will cause a movement along the demand curve, while changes in any of the other variables that influence
consumer demand will cause a shi� of the demand curve.

The direc�on of the shi� of the demand curve for the focal firm’s product caused by changes in a related firm’s controllable variables will vary depending on
the type of product the focal firm produces. If the focal firm’s product is a subs�tute for the other product, the demand curve will shi� back to the le� as a
result of any change that causes the other firm’s demand to increase, such as a price reduc�on, enhancement of product design, increase in promo�on, or
improved distribu�on system (and oppositely for changes that cause the demand for the subs�tute product to decline). If the focal firm’s product is a
complement for the other firm’s product, the shi� of the focal firm’s demand curve will be in the opposite direc�on, compared to subs�tute products.
Similarly, changes in consumer incomes will cause a shi� outward of the consumers’ demand curves for the focal product if it is regarded as a superior
good, or inwards if it is regarded as an inferior good.

To arrive at these predic�ons we u�lized u�lity theory and assumed that individuals choose the products they consume to maximize their psychic
sa�sfac�on. We used indifference-curve analysis and noted the consumer’s u�lity-maximizing changes to quan�ty demanded as we varied the firm’s own
price, the prices of related products, other controllable and uncontrollable variables, and the consumer’s income. This analysis took place in the context of
consumer choices between product categories. In the second half of the chapter we focused on the consumer’s choice within a product category, examining
the consumer’s choice among subs�tute products within a par�cular product category, that is, among the products that managers usually think of as the
compe��on.

To achieve this we looked at the product a�ributes, that is, the benefits provided by products that are of interest to the consumer. We saw that when
consumers view products in terms of the a�ributes provided by those products, they will differen�ate between these products and select the brand that
offers the desired a�ributes in the ra�o, and at the price, that allows the consumer to maximize u�lity from that product. We noted that to gain the
customer’s business the firm must offer the best value proposi�on, where value is measured by quality over price. The best value proposi�on will be the
one that allows the customer to maximize u�lity, and that will occur when the product offers the a�ributes in the ra�o and at the price level that allows the
consumer to reach the highest a�ainable indifference curve in a�ribute space.

We also considered changes in consumer tastes, as triggered by the firm’s promo�onal efforts, but of course tastes could change for a variety of other
reasons as well, such as via social networking, exposure to new informa�on, re-evalua�on of personal goals, and so on. If the consumer’s tastes change
away from a par�cular a�ribute of the product (e.g., its carbon footprint) we expect the consumer to shi� demand toward subs�tute products that include
less of that a�ribute in their makeup. Alterna�vely, if tastes change in favor of a par�cular a�ribute (e.g., carotene in foods), we expect consumers to switch
to products that contain more of that a�ribute. We noted that consumers are likely to face switching costs and that these will delay or prevent the switch in
prac�ce un�l either switching costs fall or the u�lity expected from the alterna�ve product increases significantly.

Armed with this knowledge about the behavior of individual consumers we are now ready to move on to Chapter 4 where we consider the market demand
for a firm’s product, this being the aggrega�on of the individual consumers’ demand curves. Managers must consider the market as a whole, since individual
consumer differences mean that some consumers will react to changes in the firm’s controllable variables while others will not, and those that do react will
react to different degrees—it is the overall impact on the firm’s demand that is of most interest to the manager.

Ques�ons for Review and Discussion

Click on each ques�on to reveal the answer.

1. Some of the determinants of consumer demand are controllable by managers while others are uncontrollable by managers. Discuss.
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The determinants of consumer demand are things that cause or induce the consumer to buy more or less of the product in ques�on. The firm may
adjust its strategic (4P) variables of price, product design (including packaging and service levels), promo�onal efforts, and place of sale, in an a�empt
to influence customer purchases. Other determinants of consumer demand are uncontrollable, including consumer incomes, tastes, and expecta�ons;
the four Ps of rival and complementary firms; and external business environment variables such as interest, exchange, and unemployment rates.

2. State and explain why the four proper�es of indifference curves are important for the logical analysis of consumer behavior.
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Indifference curves are constructed to model ra�onal behavior of the individual. Higher curves are preferred to lower curves to reflect the general
presump�on that consump�on of more items is preferable to consump�on of fewer items. Indifference curves are nega�vely sloped to reflect the
trade-off between things that are valued by the consumer—to remain at the same level of u�lity as one product is increased requires fewer units of
the other item. Indifference curves not intersec�ng or crossing reflects the transi�vity (or consistency) of consumer preferences. The convexity of
indifference curves reflects diminishing marginal u�lity for any par�cular product, which is generally observed.

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3. What is the marginal rate of subs�tu�on (MRS) and why does it diminish as the consumer con�nues to subs�tute one product for another?
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The marginal rate of subs�tu�on (MRS) is the rate at which a person would be willing to give up units of one product (X) in return for addi�onal units
of another product (Y) such that the person’s total u�lity remains the same. It is equal to the ra�o of the marginal u�li�es (MU) of the two products.
The MRS declines because of the assump�on of diminishing marginal u�lity for all products and services. It diminishes as the consumer con�nues to
increase consump�on of product Y while decreasing consump�on of product X, because the MU of product Y is falling (as more units are consumed)
and the MU of product X is decreasing is rising (as fewer units are consumed). The value of a ra�o for which the numerator is declining and the
denominator is increasing must necessarily increase.

4. Define the consumer’s budget constraint line, and explain what causes it to (a) shi� outward in a parallel fashion, and (b) change its slope.
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The consumer’s budget constraint is a line joining combina�on of goods and services that all cost the same amount, that amount being equal to the
consumer’s income. It intercepts the ver�cal axis at the value equal to income divided by the price of product Y, and it intercepts the horizontal axis at
the value equal to income divided by the price of product X. For example, if Px = $4 and Py = $2 and the budget is $20, the ver�cal intercept will be
20/2 = 10, and the horizontal intercept will be 20/4 = 5. The slope of the budget line will be the rise (10) over the run (5) equals 2. Its slope is equal to
the ra�o of Px /Py = 4/2 = 2. Thus, if income increases, the intercept points each increase and the budget line shi�s outward, and if the slope changes
only if the price of either product changes.

5. Dis�nguish between superior goods and inferior goods. If an economy goes into a recession, which of these would suffer a reduc�on in consumer
demand, and why?
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The demand for superior goods increases when consumer incomes increase, and the demand for inferior goods decreases when incomes increase
(because consumers are able to afford a be�er quality subs�tute product). Conversely, when consumer incomes decrease, as in a recession, demand for
superior goods will decline as consumers subs�tute towards cheaper inferior goods to sa�sfy their needs.

6. Dis�nguish between the income effect and the subs�tu�on effect of a price change, and compare these for superior and inferior goods.
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The income effect of a price change is the change in quan�ty demanded that is due to a change in real income, holding constant prices of all products.
The subs�tu�on effect of a price change is the change in quan�ty demanded that is due to the change in rela�ve prices, holding real income constant.
For superior goods, the income and subs�tu�on effects move in the same direc�on (e.g., both posi�ve for a price reduc�on) whereas for an inferior
good these effects move in opposite direc�ons (e.g., income effect nega�ve and subs�tu�on effect posi�ve for a price reduc�on).

7. Explain why a price increase for a complementary good causes a shi� of the demand curve for the focal product.
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A price increase for any product causes decreased demand for that product. This induces a decrease in the demand for any products that are
complementary in consump�on, such as popcorn sales at the movies—fewer people going to the movies buy less popcorn although the price of
popcorn has not changed. This would occur for any price of popcorn, so the demand curve for popcorn must shi� to the le� because of the price
increase for movies.

8. What a�ributes do you think are being sought by a consumer who chooses to fly to Las Vegas for a vaca�on compared to another consumer who prefers
to drive to Las Vegas for a vaca�on?
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The “flyer” might enjoy flying, and enjoy spending �me in Las Vegas more than spending �me driving. The “driver” might enjoy driving (or hate flying),
and enjoy the solitude of driving rather than the hec�c pace of life in Las Vegas. The driver might prefer the convenience of having a car to get around
in, rather than take cabs or hire a car while in Las Vegas (and the flyer might prefer the opposite).

9. Dis�nguish between a change in consumer percep�ons and a change in consumer preference.
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A change in consumer percep�ons is a change in the a�ributes perceived within a product, induced by adver�sing or by other forms of informa�on
provision, including consump�on experience. A change in consumer preferences is a change in the u�lity the consumer expects to derive from the
a�ributes within the product, again induced by new informa�on or consump�on experience. For example, informa�on that sugar contributes to weight
gain may cause a person to ques�on how much sugar is in a food product and simultaneously to cause the consumer to enjoy that product less
because it contains a substan�al amount of sugar.

10. Reconcile the consumer’s choice of the best value proposi�on (V = K/P) with the u�lity-maximizing choice of brand within a product category. What
happens if there are significant switching costs for the consumer wan�ng to change brands to maximize u�lity?
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The value proposi�on is quality over price, where quality is effec�vely measured as the perceived (marginal) u�lity from one (more) unit of the product.
The u�lity-maximizing rule can be expressed as choosing the product for which the ra�o of MU/P is highest and con�nuing to do so un�l the budget is
all spent. This is consistent with choosing the best value proposi�on in each product category and buying more than one unit is some product
categories (and none in others because they do not offer a superior value proposi�on). Switching costs effec�vely add to the price of the subs�tute
product that may offer a superior value proposi�on if switching costs are ignored, but if considered prevent that product from being the superior value
proposi�on.

Decision Problems

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1. Using indifference curves in one graph, show the effects of the following series of events: a price reduc�on for product X; followed by an increase in the
consumer’s income; followed by a change in the consumer’s tastes away from product X.

a. What happens to the quan�ty demanded when price is reduced, and why?
b. What happens to quan�ty demanded of X when income increases, and why? Does your graph depict superior or inferior goods?
c. What happens to quan�ty demanded when tastes change away from product X, and why?

2. Imagine two music lovers, Ms. Imogene Smith and Mr. Robert Brown, who have substan�ally different tastes in music. Ms. Smith loves classical music for its
subtlety, its nuances, and its intriguing build-ups to crescendos with subsequent a�enua�on to calming melodic sequences. She nonetheless also
appreciates country music and occasionally downloads an album of this genre. But Mr. Brown loves country music! He loves it for its hear�elt rendi�ons of
the human condi�on, for its emo�on-s�rring stories of love gained and lost, and its apprecia�on of the contribu�on made to our lives by dogs, horses, and
ca�le. Notwithstanding this Mr. Brown is no bumpkin; he also enjoys listening to the odd piece of classical music and occasionally downloads an album of
this genre.

a. Using indifference maps that you think are appropriate for each of these music lovers, derive their individual demand curves for each product category.
b. Aggregate their individual demands at each price to find their total demand for each genre of music at each of several price levels.

3. The Blushing Cheeks Company sells a cosme�c product that has several close subs�tutes. At its present price, however, this product is not selling enough to
be profitable, so the finance manager wants to increase its price substan�ally. The marke�ng manager wants to spend money on a promo�onal campaign
before the price is raised, but the finance manager says this expenditure is counter-produc�ve since the firm wants to maximize profits.

a. Explain the marke�ng manager’s reasoning using the a�ribute approach to consumer behavior.
b. Dis�nguish between the impact of informa�onal adver�sing and the impact of persuasive adver�sing on the quan�ty demanded of product X; that is,

which lines or curves in your a�ribute analysis of the problem are impacted by adver�sing of these two types?

4. In a par�cular city two brands of beer, EasyLite and ThirstBuster, account for the great majority of beer sold in that city, each having about 45% share of the
market. Norbert Brewing Company is considering entering that market with a new brew that it calls Lifestyle beer. Norbert’s market research indicates that
the choice of beer brand in that city is typically based on two main a�ributes, these being lightness (low calories) and thirst-quenching (tangy hops).
EasyLite beer is perceived by the average consumer to contain 10 units of lightness and 5 units of thirst-quench, and costs $0.80 a bo�le. ThirstBuster is
perceived by the average consumer to contain 5 units of lightness and 10 units of thirst-quench, and costs $0.67 per bo�le. Norbert’s Lifestyle beer has been
designed to have 8 units of lightness and 7 units of thirst-quench. Research also shows that the average consumer spends about $10 per week on packaged
beer purchases.

a. What is the maximum price that might be charged for Lifestyle beer such that its ray in a�ribute space will reach the efficiency fron�er for the average
consumer with $10 to spend per week? (An approximate answer derived from your graph will suffice.)

b. Suppose Norbert’s average cost of produc�on is $0.50 per bo�le (and that this is about 50% higher than the produc�on cost of the other two beers).
What price do you suggest they set for Lifestyle beer, and why?

5. Richard Poirier has recently completed his MBA and upon receipt of his first paycheck began planning to buy a European sports car. He is considering four
major a�ributes in his choice among different sports cars: pres�ge, performance, reliability, and winter driving capability (i.e., trac�on in snow and icy
condi�ons). But the value he places on each a�ribute differs according to whether his employment remains in California or whether his employer transfers
him to upstate New York. If he remains in California, Richard considers performance to be twice as important as reliability; pres�ge to be three �mes as
important as reliability; and winter driving capability to be only half as important as reliability. If he is transferred to upstate New York where he expects
much colder winters, he considers winter driving capability to be three �mes as important as reliability; performance to be half as important as reliability;
and pres�ge twice as important as reliability. He is equally apprecia�ve of reliability whether he lives in California or upstate New York. Richard has found
two used European sports cars for sale, each costs $20,000, and they appear to be in equally good mechanical condi�on. He has rated each car on a scale of
100 for each of the four a�ributes, as follows:

A�ribute Car A Car B

Pres�ge 80 60

Performance 80 90

Reliability 70 90

Winter Driving Capability 80 60

a. Advise Richard which car he should buy if he is to remain in California. Hint: Don’t a�empt a graphical answer to this one! Calculate the u�lity “part-
worths” to find his total expected u�lity from each car.

b. Advise Richard which car he should buy if he is to live in upstate New York.
c. Which car should he buy if the probability of his being transferred to New York can be reliably es�mated as 0.7? Explain your reasoning.

Key Terms

Click on each key term to see the defini�on.

complements
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Products that are typically consumed together, and thus their demand curves are inter-related. For example, when the demand for one increases, demand
for the other one also increases.

consumers
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Individuals that purchase and use goods and services in an economy.

decision variables
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The variables that enter a consumer’s purchasing decision process, including the product’s price, design, packaging, place of sale (availability), and impact of
promo�onal efforts.

demand curve
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A line graph that demonstrates the nega�ve rela�onship between the price of a product and the quan�ty demanded of that product at various price levels.

discre�onary income
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The sum that remains in an individual’s budget a�er all expenses necessary for living have been purchased or deducted, which may be used for
discre�onary or nonvital expenses.

efficiency fron�er
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The line joining the points on the product rays represen�ng the maximum combina�on of the two a�ributes that can be obtained from each product given
the consumer’s income constraint.

expected changes in income
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The individual’s percep�on of the future level of his or her income, which has an impact on the quan�ty of goods and services demanded in the present
and future periods, as consumers react by switching demand from one �me period to another.

income effect
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The change in quan�ty demanded due to a change in the consumer’s income level, holding all other determinants of quan�ty demanded constant.

indifference map
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A system of curved lines that represents a person’s tastes and preferences between the variables depicted on the ver�cal and horizontal axes. Indifference
maps typically only show selected indifference curves to illustrate the focal consumer’s choice problem.

inferior good
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Goods that consumers tend to buy less of as their income increases.

marginal u�lity (MU)
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The change in total u�lity due to a one-unit change in consump�on of a par�cular product. Marginal u�lity is expected to diminish as a person consumes
progressively more units of any product.

market niche
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A subset of the total market for a product category comprising a group of consumers who have similar preferences and similar incomes, and who thus
confine their purchases to a subset of the brands available.

monetary income
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The face value of the consumer’s income from employment or investments over a given period of �me. Also known as nominal income, monetary income is
dis�nct from real income, which is the purchasing power of monetary income.

place of sale
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The loca�on where a transac�on takes place between the buyer and seller—it can be in a store, at the place of consump�on (e.g., door-to-door sales), or
over the Internet with subsequent delivery.

point of tangency
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The point at which a curved line touches but does not cross another line—the two lines converge towards the point of tangency and diverge a�er the point
of tangency.

preference structure
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A system of tastes and preferences exhibited by a person rela�ng to choices between products or other choice alterna�ves (e.g., risk and return). A
preference structure can be depicted by the indifference curves for a given individual.

price effect
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The change in the quan�ty demanded of a product due to the change in the price of that product with all other determinants of quan�ty demanded held
constant. It is demonstrated by the nega�ve slope of a demand curve. When the price is higher, fewer units of the product will be demanded, and
conversely, when price is lower the individual will demand more units of the product.

product a�ributes
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The perceived benefits contained within or delivered by products. Also known as product characteris�cs, they determine the consumers’ demand for a given
product.

product design
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The perceived characteris�cs (or a�ributes) of the product that define the quality of the product. Product design reflects a series of decisions made during
pre-produc�on about a�ributes such as component materials, the manufacturing or service process, and u�lized shapes and colors.

promo�on
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

Marke�ng communica�on ac�vi�es undertaken by the firm to provide informa�ve or persuasive messages to poten�al consumers. Promo�on is designed to
increase the overall sales of a product or service, including adver�sing, point-of-purchase displays, and other sales-enhancing tools.

real income
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The purchasing power of the consumer’s monetary income, equal to the face value of that income divided by an index of prices.

related goods
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

Products with demand curves that are inter-related to the demand for the focal firm’s product. They include subs�tutes and complements.

subs�tutes
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

Similar yet differen�ated products that serve the same consumer needs or wants. Subs�tutes are usually different brands within the same product category,
and range from very close subs�tutes (nearly iden�cal to each other, like brands of milk) to distant subs�tutes (substan�ally differen�ated, like brands of
cars).

subs�tu�on effect
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The tendency for the consumer to change from one product to a subs�tute product when the rela�ve prices of subs�tute products change, holding constant
all other determinants of quan�ty demanded including real income.

superior good
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A product for which quan�ty demanded will increase when real income increases and conversely decrease when real income decreases.

switching costs
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

Monetary and psychological costs consumers would suffer if they were to switch products, brands, or providers. They include search costs, transac�on costs,
learning costs, conversion costs, and the poten�al loss of salvage value.

9/17/2019 Print

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u�lity-maximizing model of consumer behavior
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A model that is used to depict human choice between alterna�ve items in terms of the psychic sa�sfac�on (u�lity) they expect to derive from those items.
These models can be solved graphically using indifference curves, or algebraically using equa�ons, to find the combina�on of items that maximizes psychic
sa�sfac�on for the person concerned.

u�ls
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

A numerical value given to units of psychic sa�sfac�on (u�lity) to theore�cally measure how much total or marginal u�lity the consumer expects to derive
from different product combina�ons.

value proposi�on
(h�p://content.thuzelearning.com/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AUBUS640.12.1/sec�ons/fm/books/AU

The ra�o of the perceived quality of a product (reflec�ng product a�ributes contained) to the price of that product, which the prospec�ve customer can
compare with the value proposi�ons of other products before choosing the one with the superior value proposi�on.

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