Transcript Consumer Choice

Introduction
 Recall one of the Ten Principles from Chapter 1:
People face tradeoffs.
 Buying more of one good leaves
less income to buy other goods.
 Working more hours means more income and
more consumption, but less leisure time.
 Reducing saving allows more consumption today
but reduces future consumption.
 This chapter explores how consumers make
choices like these.
THE THEORY OF CONSUMER CHOICE
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Household Choice in Output Markets
Every household must make three basic decisions:
1.
How much of each product, or output, to demand
2.
How much labor to supply
3.
How much to spend today and how much to save
for the future
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Household Choice in Output Markets
The Determinants of Household Demand
Several factors influence the quantity of a given good or service
demanded by a single household:
 The price of the product
 The income available to the household
 The household’s amount of accumulated wealth
 The prices of other products available to the household
 The household’s tastes and preferences
 The household’s expectations about future income,
wealth, and prices
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Household Choice in Output Markets
The Budget Constraint
budget constraint The limits imposed on
household choices by income, wealth,
and product prices.
TABLE 6.1 Possible Budget Choices of a Person
Earning $1,000 Per Month After Taxes
Option
Monthly
Rent
Other
Food Expenses
Total
Available
?
A
$ 400
$250
$350
$1,000
Yes
B
600
200
200
1,000
Yes
C
700
150
150
1,000
Yes
D
1,000
100
100
1,200
No
choice set or opportunity set The set of options
that is defined and limited by a budget
constraint.
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Household Choice in Output Markets
Preferences, Tastes, Trade-Offs, and Opportunity Cost
FIGURE 6.1 Budget Constraint and
Opportunity Set for Ann and Tom
A budget constraint separates
those combinations of goods and
services that are available, given
limited income, from those that are
not. The available combinations
make up the opportunity set.
real income Set of
opportunities to purchase
real goods and services
available to a household as
determined by prices and
money income.
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HOUSEHOLD CHOICE IN OUTPUT MARKETS
The Equation Of The Budget Constraint
In general, the budget constraint can be written:
PXX + PYY = I,
where PX = the price of X, X = the quantity of X
consumed, PY = the price of Y, Y = the quantity
of Y consumed, and I = household income.
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The Budget Constraint:
What the Consumer Can Afford
 Example:
Hurley divides his income between two goods:
fish and mangos.
 A “consumption bundle” is a particular combination
of the goods, e.g., 40 fish & 300 mangos.
 Budget constraint: the limit on the consumption
bundles that a consumer can afford
THE THEORY OF CONSUMER CHOICE
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ACTIVE LEARNING
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Budget Constraint
Hurley’s income: $1200
Prices: PF = $4 per fish, PM = $1 per mango
A. If Hurley spends all his income on fish,
how many fish does he buy?
B. If Hurley spends all his income on mangos,
how many mangos does he buy?
C. If Hurley buys 100 fish, how many mangos can
he buy?
D. Plot each of the bundles from parts A – C on a
graph that measures fish on the horizontal axis
and mangos on the vertical, connect the dots.
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ACTIVE LEARNING
Answers
Quantity
of Mangos
A. $1200/$4
= 300 fish
B. $1200/$1
= 1200
mangos
C. 100 fish
cost $400,
$800 left
buys 800
mangos
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B
D. Hurley’s budget
constraint shows
the bundles he can
afford.
C
A
Quantity
of Fish
The Slope of the Budget Constraint
From C to D,
Quantity
of Mangos
“rise” =
–200 mangos
“run” =
+50 fish
Slope = – 4
C
D
Hurley must
give up
4 mangos
to get one fish.
THE THEORY OF CONSUMER CHOICE
Quantity
of Fish
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The Slope of the Budget Constraint
The slope of the budget constraint equals
 the rate at which Hurley
can trade mangos for fish
 the opportunity cost of fish in terms of mangos
 the relative price of fish:
price of fish
$4

 4 mangos per fish
price of mangos
$1
THE THEORY OF CONSUMER CHOICE
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ACTIVE LEARNING
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Budget constraint, continued.
Show what happens to Hurley’s budget constraint if:
A. His income falls to $800.
B. The price of mangos rises to
PM = $2 per mango
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ACTIVE LEARNING
Answers, part A
Now,
Hurley
can buy
Quantity
of Mangos
2
A fall in income
shifts the budget
constraint down.
$800/$4
= 200 fish
or
$800/$1
= 800 mangos
or any
combination in
between.
Quantity
of Fish
ACTIVE LEARNING
Answers, part B
Hurley
can still buy
300 fish.
Quantity
of Mangos
2
An increase in the
price of one good
pivots the budget
constraint inward.
But now he
can only buy
$1200/$2 =
600 mangos.
Notice:
slope is smaller,
relative price of
fish is now only
2 mangos.
Quantity
of Fish
Preferences: What the Consumer Wants
Indifference curve:
shows consumption
bundles that give the
consumer the same
level of satisfaction
Quantity
of Mangos
A, B, and all other
bundles on I1 make
Hurley equally happy –
he is indifferent
between them.
One of Hurley’s
indifference curves
B
A
I1
Quantity
of Fish
THE THEORY OF CONSUMER CHOICE
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Four Properties of Indifference Curves
1. Indifference curves
are downwardsloping.
Quantity
of Mangos
If the quantity of
fish is reduced,
the quantity of
mangos must be
increased to keep
Hurley equally
happy.
THE THEORY OF CONSUMER CHOICE
One of Hurley’s
indifference curves
B
A
I1
Quantity
of Fish
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Four Properties of Indifference Curves
2. Higher indifference
curves are preferred
to lower ones.
A few of Hurley’s
indifference curves
Quantity
of Mangos
Hurley prefers every
bundle on I2 (like C)
to every bundle on I1
(like A).
He prefers every
bundle on I1 (like A)
to every bundle on I0
(like D).
THE THEORY OF CONSUMER CHOICE
C
D
I2
A
I1
I0
Quantity
of Fish
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Four Properties of Indifference Curves
3. Indifference curves
cannot cross.
Hurley’s
indifference curves
Quantity
of Mangos
Suppose they did.
Hurley should prefer
B to C, since B has
more of both goods.
Yet, Hurley is indifferent
between B and C:
He likes C as much as A
(both are on I4).
He likes A as much as B
(both are on I1).
THE THEORY OF CONSUMER CHOICE
B
C
A
I1 I4
Quantity
of Fish
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Four Properties of Indifference Curves
4. Indifference curves
are bowed inward.
Quantity
of Mangos
Hurley is willing to give
up more mangos for a
fish if he has few fish
(A) than if he has
many (B).
A
6
1
2
B
1
I1
Quantity
of Fish
THE THEORY OF CONSUMER CHOICE
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The Marginal Rate of Substitution
Quantity
Marginal rate of
of Mangos
substitution (MRS):
the rate at which a consumer
is willing to trade one good for
another.
Hurley’s MRS is the
amount of mangos he
would substitute for
another fish.
MRS falls as you move
down along an
indifference curve.
THE THEORY OF CONSUMER CHOICE
MRS = slope of
indifference curve
A
MRS = 6
1
MRS = 2
B
1
I1
Quantity
of Fish
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One Extreme Case: Perfect Substitutes
Perfect substitutes: two goods with
straight-line indifference curves,
constant MRS
Example: nickels & dimes
Consumer is always willing to trade
two nickels for one dime.
THE THEORY OF CONSUMER CHOICE
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Another Extreme Case: Perfect Complements
Perfect complements: two goods with
right-angle indifference curves
Example: Left shoes, right shoes
{7 left shoes, 5 right shoes}
is just as good as
{5 left shoes, 5 right shoes}
THE THEORY OF CONSUMER CHOICE
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Less Extreme Cases:
Close Substitutes and Close Complements
Quantity
of Pepsi
Indifference
curves for close
substitutes are
not very bowed
Quantity
of Coke
Quantity
of hot
dog buns
Indifference
curves for
close
complements
are very
bowed
Quantity
of hot dogs
Optimization: What the Consumer Chooses
A is the optimum:
the point on the
budget constraint
that touches the
highest possible
indifference curve.
Quantity
of Mangos
The optimum
is the bundle
Hurley most
prefers out of
all the bundles
he can afford.
1200
Hurley prefers B to A,
but he cannot afford B.
Hurley can afford C
and D,
but A is on a higher
indifference curve.
THE THEORY OF CONSUMER CHOICE
B
A
600
C
D
150
300
Quantity
of Fish
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Optimization: What the Consumer Chooses
At the optimum,
slope of the
indifference curve
equals
slope of the budget
constraint:
Quantity
of Mangos
1200
MRS = PF/PM
marginal
value of fish
(in terms of
mangos)
Consumer
optimization is
another example
of “thinking at the
margin.”
price of fish
(in terms of
mangos)
THE THEORY OF CONSUMER CHOICE
600
A
150
300
Quantity
of Fish
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The Effects of an Increase in Income
Quantity
of Mangos
An increase in
income shifts the
budget constraint
outward.
If both goods are
“normal,” Hurley
buys more of each.
B
A
Quantity
of Fish
THE THEORY OF CONSUMER CHOICE
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Income and Substitution Effects
The Income Effect
Price changes affect households in two ways. First, if we assume
that households confine their choices to products that improve
their well-being, then a decline in the price of any product, ceteris
paribus, will make the household unequivocally better off.
In other words, if a household continues to buy the same amount
of every good and service after the price decrease, it will have
income left over. That extra income may be spent on the product
whose price has declined, hereafter called good X, or on other
products.
The change in consumption of X due to this improvement in wellbeing is called the income effect of a price change.
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Income and Substitution Effects
The Substitution Effect
When the price of a product falls, that product also becomes
relatively cheaper. That is, it becomes more attractive relative to
potential substitutes. A fall in the price of product X might cause a
household to shift its purchasing pattern away from substitutes
toward X. This shift is called the substitution effect of a price
change.
Everything works in the opposite direction when a price rises,
ceteris paribus. When the price of a product rises, that item
becomes more expensive relative to potential substitutes and the
household is likely to substitute other goods for it.
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Income and Substitution Effects
FIGURE 6.4 Diminishing Marginal
Utility and Downward-Sloping Demand
For normal goods, the income and substitution effects work in the same direction. Higher
prices lead to a lower quantity demanded, and lower prices lead to a higher quantity
demanded.
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The Effects of a Price Change
Initially,
Quantity
of Mangos
PF = $4
PM = $1
PF falls to $2
budget constraint
rotates outward,
Hurley buys
more fish and
fewer mangos.
1200
initial
optimum
new
optimum
600
500
150
300
600
350
THE THEORY OF CONSUMER CHOICE
Quantity
of Fish
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The Income and Substitution Effects
A fall in the price of fish has two effects on
Hurley’s optimal consumption of both goods.
 Income effect
A fall in PF boosts the purchasing power of Hurley’s
income, allows him to buy more mangos and more
fish.
 Substitution effect
A fall in PF makes mangos more expensive relative
to fish, causes Hurley to buy fewer mangos & more
fish.
Notice: The net effect on mangos is ambiguous.
THE THEORY OF CONSUMER CHOICE
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The Income and Substitution Effects
Initial
optimum at A.
Quantity
of Mangos
In this example,
the net effect
on mangos is
negative.
PF falls.
Substitution effect:
from A to B,
buy more fish and
fewer mangos.
Income effect:
from B to C,
buy more of both
goods.
THE THEORY OF CONSUMER CHOICE
A
C
B
Quantity
of Fish
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Application 1: Giffen Goods
 Do all goods obey the Law of Demand?
 Suppose the goods are potatoes and meat,
and potatoes are an inferior good.
 If price of potatoes rises,
 substitution effect: buy less potatoes
 income effect: buy more potatoes
 If income effect > substitution effect,
then potatoes are a Giffen good, a good for which
an increase in price raises the quantity demanded.
THE THEORY OF CONSUMER CHOICE
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Application 1:
Giffen Goods
THE THEORY OF CONSUMER CHOICE
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The Basis of Choice: Utility
utility The satisfaction, or reward, a product yields
relative to its alternatives. The basis of choice.
Diminishing Marginal Utility
marginal utility (MU) The additional satisfaction
gained by the consumption or use of one more unit
of something.
total utility The total amount of satisfaction obtained
from consumption of a good or service.
law of diminishing marginal utility The more of any
one good consumed in a given period, the less
satisfaction (utility) generated by consuming each
additional (marginal) unit of the same good.
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The Basis of Choice: Utility
FIGURE 6.3 Graphs of Frank’s Total
and Marginal Utility
Marginal utility is the additional utility
gained by consuming one additional
unit of a commodity—in this case,
trips to the club. When marginal utility
is zero, total utility stops rising.
TABLE 6.2 Total Utility and Marginal
Utility of Trips to the
Club Per Week
Trips
to Club
Total
Utility
Marginal
Utility
1
12
12
2
22
10
3
28
6
4
32
4
5
34
2
6
34
0
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The Basis of Choice: Utility
Allocating Income To Maximize Utility
TABLE 6.3 Allocation of Fixed Expenditure per Week Between Two Alternatives
(5) Marginal
Utility per Dollar
(MU/P)
4.0
(1) Trips to Club
per Week
1
(2) Total Utility
12
(3) Marginal
Utility (MU)
12
2
22
10
3.00
3.3
3
28
6
3.00
2.0
4
32
4
3.00
1.3
5
6
34
34
2
0
3.00
3.00
0.7
0
(1) Basketball
Games per Week
(2) Total Utility
(3) Marginal
Utility (MU)
(4) Price (P)
$3.00
(4) Price (P)
(5) Marginal Utility
per Dollar
(MU/P)
1
2
21
33
21
12
$6.00
6.00
3.5
2.0
3
4
42
48
9
6
6.00
6.00
1.5
1.0
5
51
3
6.00
.5
6
51
0
6.00
0
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The Basis of Choice: Utility
The Utility-Maximizing Rule
In general, utility-maximizing consumers spread out their
expenditures until the following condition holds:
utility-maximizing rule:
MU X
MU Y

for all goods
PX
PY
utility-maximizing rule Equating the ratio of the marginal
utility of a good to its price for all goods.
diamond/water paradox A paradox stating that (1) the things
with the greatest value in use frequently have little or no
value in exchange and (2) the things with the greatest value
in exchange frequently have little or no value in use.
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The Basis of Choice: Utility
Diminishing Marginal Utility and Downward-Sloping Demand
FIGURE 6.4 Diminishing Marginal
Utility and Downward-Sloping Demand
At a price of $40, the utility gained
from even the first Thai meal is not
worth the price.
However, a lower price of $25 lures
Ann and Tom into the Thai restaurant
5 times a month. (The utility from the
sixth meal is not worth $25.)
If the price is $15, Ann and Tom will
eat Thai meals 10 times a month—
until the marginal utility of a Thai meal
drops below the utility they could gain
from spending $15 on other goods.
At 25 meals a month, they cannot
tolerate the thought of another Thai
meal even if it is free.
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