Consumer Choice

Preferences - underlie consumption choices. Assumptions: 1. Completeness (ranking) 2. Transitivity (consistency) 3. More-is-better (non-satiation)

Indifference curve (IC) shows all combinations (bundles) of goods which give the consumer equal levels of utility or satisfaction i.e. all the bundles among which she is indifferent. 4 properties of IC maps: (Why?) 1. ICs further from 0 reflect higher levels of utility. 2. There is an IC thru every possible bundle. 3. ICs cannot cross. 4. ICs slope downwards. (& ICs cannot be thick.)

Slope of IC = marginal rate of substitution (MRS): rate at which the consumer will trade one good for the other (while at the same level of satisfaction), MRS = B/Z = -3.

Most ICs convex to the origin (bowed in): consumer is willing to give up successively smaller amounts of one good to get more of the other (diminishing MRS). 2 extreme cases:

Perfect substitutes: Pepsi & Coke to Bill panel (a). ICs are straight parallel lines. Perfect complements: Consumer only wants in fixed proportions panel (b) ice-cream & apple pie (1 slice, 1 scoop). ICs are right angles.

*according to these estimates food & clothing are perfect compliments when the consumer has little or either good & perfect substitute when the consumer has large quantities of both goods. I4 looks flatter as it moves away from the origin perfect substitute I1 looks like a right angle IC perfect compliment Utility - pleasure / satisfaction Utility function: relates U to consumption bundles (a theoretical idea). Utility measurement is ordinal (not cardinal). IC further from 0 = greater U.

Total U & marginal U: Note DMU: MUZ = U Z B Z - MUZ MUB

Utility & MRS: MRS

As Lisa consumes more pizza, holding her consumption of burritos constant at 10, her total utility, U, increases o and her marginal utility of pizza, MUZ, decreases (though it remains positive). Marginal utility is the slope of the utility function as we hold the quantity of the other good constant.

Budget Constraints

Budget constraint shows combinations that use up all available income. Opportunity set bundles inside & along budget line. Slope ( pZ/pB): rate at which one good can be traded for the other in the market = marginal rate of transformation (MRT). Affected by price and income changes.

Price & Income Changes

Price change: budget line will pivot / swivel (a) pizza price ; pizza intercept & slope change Income change: budget line shifts parallel (b) income ; slope unchanged.

Constrained Choice

Utility maximization: combine ICs (prefs) & budget (affordability) Interior solution (most likely / realistic) (a): to max U given budget, find point on budget line that touches highest IC optimal bundle is e. Slopes of IC = slope of budget constraint at that point: MRT= -pZ pB = MRS = MUZ MUB

(rate at which consumer will trade off one good for the other = rate at which the two are traded in the market) MUZ pZ = MUB pB

In equilibrium / at optimal bundle / to max U, consume goods such that the last $ spent on each brings as much U. Corner solution: (b) Spensers ICs: highest IC he can reach given budget is I2 , bundle e.