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Section 2 Chapters 3-‐4
Rational Consumer Choice
We assume the consumers make well-‐defined rational choices in the marketplace • Constrained by resources • Clear preferences The Opportunity or Budget Constraint • Consider 2 goods, Food and Shelter • Choice: Consume all Food (lb/wk) or all Shelter (sq yd/wk) or some combination of each • Assume you have $100/wk in resources • Price of Food $10/lb, Price of Shelter $5/sq yd • If you consume all food you consume 10 lb • If you consume all shelter you consume 20 sq yds •What combinations are possible: The Budget Line (B) • The red line shows the combinations of food & shelter possible at $100 • Point E -‐ Unattainable • Point D – Only $65 spent • Relative prices determine the slope of the line
PS or PF and the budget line will change (shift or change of slope) 3 . the budget constraint is determined by the amount of income (M) and the monetary cost of food (F) and shelter (S) • PF and PS denote the prices of food and shelter • The affordable set are the bundles on or below the budget constraint • The budget constraint must satisfy the following equation M = PSS + PFF • To represent this so we can show the budget line we need to rearrange the equation to F = M PF -‐ PS PF S The amount of food consumed is determined by the total resources divided by the price of food and the amount of shelter consumed and the relative price of shelter to food Change M.Budgets and Affordable Choices The units consumed are based on a period of time and are considered flows • Income is also a flow • Assets would be considered stocks • what is available at a point in time Given two goods.
Budgets and Affordable Choices Price Change • Currently the budget constraint is F = 100 10 -‐ 5 10 S • Change the price of shelter from $5 to $ 10 and the new budget constraint is F = 100 10 -‐ 10 10 S • The slope went from -‐1/2 to -‐1 • The budget line went from B1 to B2 • The maximum amount of F consumed does not change but the maximum amount of S goes from 20 to 10 4 .
Budgets and Affordable Choices Income Change • Suppose income is cut from $100 to $50. The new budget constraint is F = 50 -‐ 10 5 S 10 • The slope remained unchanged at -‐1/2 • The budget line went from B1 to B2. a parallel shift down in the budget line • The maximum amount of F and S are reduced by half 5 .
This becomes more difficult to graph because it involves a multidimensional plane • The most we can graph is three dimensions The solution is the Composite Good • Compare Food (F) to all other goods represented by (X) • PX becomes a ‘weighted average’ price of the composite goods • A change in the price of one of the composite goods changes the average price and the effects are the same as with a two-‐good analysis 6 .Budgets and Affordable Choices Generally. budgets involve more than two choices.
1 – electricity usage • Up to 1000 kilowatt-‐hours (kWh). after that it is $0.Budgets and Affordable Choices Kinked Budget Constraints There are times when the budget constraint will be nonlinear One case is the kinked budget line • Volume discounts • Surcharges after a certain amount of usage (first X is free and y/unit will cost extra) Example 3.05/kWh • For the first 1000 kWh the opportunity cost is 100 units of Y • For every incremental 1000 kWh consumed the amount of Y given up is 50 • For those who use a lot of electricity.10/kWh. they would be more likely to use incrementally more than those who use less electricity 7 . the price is $0.
our preferences determine the actual choices made • While we each have unique preferences.Consumer Preferences One of the fundamental principles in Microeconomics is Consumer Preferences • Given our budget constraints that define our possible choices. we can make statements about the bunndles they will choose One key assumption is that consumers have logical Preference Ordering • Bundle A is preferred to bundle B (A > B) • Bundle 2A is preferred to bundle A (2A > A) There are 4 properties of preference ordering 8 . so we can analyze preferences overall In studying the representative consumer. in general we tend to have common preferences.
However. 4.2) to either A or B • This is due to Diminishing Marginal Utility Given these properties. A to J. and B > C. then A > C. One may be indifferent between bundle A (4.Preference Ordering 1.4). More-‐is-‐Better: More of a good is preferred to less. we can examine bundles and determine the bundles that are preferred and the bundles that we are indifferent toward 9 . If A > B. However. The assumption is that if we have 10 bundles. this does not always occur because not all outcomes relate so logically. B. then A > J. Completeness: The consumer is able to rank all combinations of goods and services 2. C. but will prefer Bundle C (2. Transitivity: Assume 3 bundles A.0) and bundle B (0. and A > C and C> J. Convexity: Mixtures of goods are preferred to extremes. diminishing marginal utility means that at some point saturation is reached and no more is preferred 3.
Indifference Curves Suppose you have three bundles. and you are indifferent as to which bundle you choose. Bundle Z is better than A (More Food and Shelter) A consumer is indifferent if the amount of Food she gives up is equal in utility to the amount of Shelter she gains 10 . Looking at bundle A. Bundle W is worse. giving less satisfaction (less Food and Shelter). B and C. A.
Indifference Curves Fig 3-‐9 Fig 3-‐10 We can plot combinations of Food and Shelter where the level of utility is equal and we are indifferent. This gives us the Indifference Curve • Any bundle along the Indifference Curve I0 is preferred to bundle K and bundle L is preferred to any bundle along the indifference curve Fig. 3-‐9 We can create an Indifference Map (Fig 3-‐10) that shows the indifference curves at verious levels of satisfaction • Any point on I2 is preferred to any point on I1 11 .
Trade-‐Offs between Two Goods Indifference curves give us the amount of a good we are willing to exchange for another good to maintain the same level of satisfaction That is measured by the Marginal Rate of Substitution (MRS) • The MRS is the ratio of the change in F for the change in S • -‐ F/ S • The delta represents a small change in units • The ratio is always negative or at most zero The MRS changes as we move along the indifference curve due to the convexity property 12 .
Comparing Two Consumers Two consumers. the indifference curve will reflect an weighted average of individual indifference curves and MRS 13 . Tex will not be willing to give up as much in potatoes for rice as Mohan would When we aggregate preferences for many consumers. they have different indifference curves • Tex and Mohan like potatoes. but Mohan likes rice more than Tex • Their MRS will be different. Tex and Mohan • Because their preferences are different.
The Best Feasible Bundle The budget line shows us the possible combinations of Food and Shelter we can afford Indifference curves show is the combinations of Food and Shelter we prefer at a given level of satisfaction Put them together and we get the combination of Food and Shelter that we can both afford and maximize our level of satisfaction (utility) • Point F is our optimal point • Points A and E are affordable. but less satisfying • Point D is both less satisfying and less efficient • Point G is unattainable At point F. the MRS equals the relative prices of Food and Shelter (MRS = PS/PF) 14 .
Point D would be on a lower indifference curve. but point D with food stamps. so cash would be better • However. alcoholics would prefer cash since they cannot buy liquor with food stamps 15 . his choices would be the same in this case In Figure 3-‐19. even though the consumer is constrained. if his indifference curve is such that he would be at point L with cash.Application of the Rational Choice Model Fig 3-‐18 Fig 3-‐19 Is it better to give poor people cash or food stamps? • Give either $100/mo in food stamps or $100/mo in cash • Consumer has $400 initial budget • Which alternative gives us a higher indifference curve? In Figure 3-‐18.
utility cannot be directly measured. Higher indifference curves reflect a higher level of utility Economists use the Utility Function to analyze utility U(F. S) F=Food and S=Shelter In reality.The Utility Function Indifference Curves represent a level of utility. but it provides a means to understand exchange • Assume U(F. S) = FS • We can graph the various indifference curves • Assuming 1 Util. indifference curve 1 can be represented by S=1/F • More generally it would be S = U0/F 16 .
because it is not really possible to measure utility. so we rely on Ordinal Utility 17 . such as above.The Utility Function In order to maintain the same level of utility. given the budget constraint it is also true that MUF MUS = PF/PS = MRS While we can create examples using cardinal utility. the marginal utility (MU) we give up of one good should equal the marginal utility we gain from the exchange MUF F = MUF S Or MUF MUS = F/ S At the optimal level of utility.
A discussion about Incentives So far we have discussed rational choice from the perspective of satisfaction or utility. Rational choice also depends on incentives • Paris Hilton pleaded guilty of cocaine possession. would she have pleaded guilty? • She was given an incentive to plead guilty We could say that the incentive was a reduced cost or a reduced negative utility for Paris Hilton • However. the authors give an example of a day-‐care center that fined parent $3 if they were late picking up their children. Why? • The prosecution charged her with misdemeanor in return for a guilty plea and she would not go to jail • If she had been charged with a felony. In Freakonomics. The result was that the number of late parents increased • A social incentive (guilt) was replaced with a cost incentive ($3) which parents saw as cheaper than the guilt they felt 18 . would it dissuade Paris Hilton from possessing cocaine in the future? Many times the benefits are not clear-‐cut.
the budget line changes and becomes tangent to a new indifference curve • New combinations of Food and Shelter are consumed • The above graph shows the effect of a change in the price of Shelter • The points of tangency are connected by the Price-‐Consumption Curve (PPC) • The amounts of Shelter at each price can be plotted. giving us our demand curve 19 .Indifference Curves and Demand As prices change.
Income and Consumption When incomes change. the increase in come leads to increases in the consumption of both Food and Shelter • We can plot the amounts of Shelter consumed at each level of income using the Engel Curve • Don’t forget that we assume no changes in the prices of either goods 20 . the constraint shifts • The amounts of consumption of both good will change accordingly • The new combinations of goods consumed as incomes shift is shown by the Income-‐ Consumption Curve (ICC) • In this case.
then the Engel Curve will be downward sloping • This is considered an Inferior Good (quantity demanded declines as incomes rise) We discussed this earlier.Normal and Inferior goods If income rises and quantity demanded for a good also rises the Engel Curve will be upward sloping • This is considered a Normal Good (quantity demanded rises as incomes rise) If incomes rise but quantity demanded for a good declines. but the Engel Curve is the best tool for demonstrating the type of good 21 .
there are two effects • If relative consumption shifts from one good to another. we call it the Income Effect (the component of the total effect of a price change that results from the associated change in real purchasing power • If the price of Shelter increases you have to give up more food for the same amount of Shelter and total potential Shelter consumption is less (less purchasing power • These effects are combined to give us the total effect of a price change 22 .Income and Substitution Effects of a Price Change When the price of a good changes. we call it the Substitution Effect (the component of the total effect of a price change that results from the associated change in the relative attractiveness of other goods • If the price of Shelter increases. consumers will consume more Food relative to Shelter • If overall consumption changes because the consumer has more or less purchasing power.
the optimal choice would go from point A to C representing the substitution effect (This is determined by where the new budget line would be if the price of Shelter was offset by the price of Y shown by a parallel line to the new budget line. to $24/sq. yd. • On the original indifference curve. yd. Consumption of s would go from 10 to 6 and consumption of Y would go from 60 to 96 • The income effect represents the combinations of S and Y at the new budget line (Final consumption of S would be 2 and final consumption of Y would be 72 (point D)) 23 .Income and Substitution Effects of a Price Change Consider an increase in Shelter from $6/sq.