Consumer Theory

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What is Consumer Theory?
of how people use their limited means to make purposeful choices.  Assumes that consumers understand their choices (possibilities) and the prices (opportunity costs) associated with each choice.  Assumes that consumers consider the alternatives and choose the one they like best. 
Study
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Consumer Theory - Why? 
Two

important reasons:

± to understand the foundations of market demand (bake the demand curve from scratch) ± to address several interesting consumer theory issues that are best understood using this model rather than the aggregate demand model

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Two Components of Consumer Demand 
Opportunities:

± What can the consumer afford? ± What are the consumption possibilities? ± Summarized by the budget constraint 
Preferences:

± What does the consumer like? ± How much does a consumer like a good? ± Summarized by the utility function
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5 .  The budget constraint measures the combinations of purchases that a person can afford to make with a given amount of monetary income.What is a Budget Constraint? A budget constraint shows the consumer¶s purchase opportunities as every combination of two goods that can be bought at given prices using a given amount of income.

± Rice costs $2/lb. ± Li has $40 of income.Li¶s Demand for Wheat and Rice of consumer theory  Li¶s demand for wheat and rice depends upon the prices for these goods. 6 .  Suppose we look first at her budget constraint:  Illustration ± Wheat costs $4/lb. and her preferences. her income.

Li¶s Budget Constraint  The mathematical expression for Li¶s budget constraint is: I = PW W + PR R R = I/PR .(PW / PR)W like to refer to the |slope| of the budget line as the ERS=Economic Rate of Substitution this case it is PW / PR I  In  For Li: PW=$4 PR=$2 I=$40 ERS=2 7 .

Li's Budget Constraint 20 15 Rice  10  5 0 0 5 10 Wheat 8 15 20 . as shown on the last slide. Each blue diamond is a point from the table. The slope is equal to -2.Graph of Li¶s Budget Constraint  The graph to the right shows a picture of Li¶s budget constraint.

Budget Line gymnastics  An increase in income only.  Note: Changes in the price of wheat relative to the price of rice will change the ERS.  An increase in the price of wheat only.  Income doubles as do the prices of wheat and rice.  A decrease in the price of rice only. 9 .

Preferences  Let R = ³at least as good as´ ± B0 R B1 means: B0 is at least as good as B1  Let IN = ³indifferent to´ B0 IN B1 ± B0 R B1 and B1 R B0 impli  Let P = ³strictly preferred to´ B0 P B1 ± B0 R B1 and not B1 R B0 impli 10 .

then B2 R B0 and B1 11 .Preferences  Basic assumptions about an individual¶s preferences (R) over bundles (B) ± mor i b tt r: If B0 has more in it than B1 then B0 R B1 ± transitivity: If B0 R B1 and B1 R B2 t n B0 R B2 ± av rage b ndles are at least as good as extreme b ndles: If B0 IN B1 and B2 is an ³average´ of B0 and B1.

 Utility 12 .Utility and Preferences is the way economists represent preferences.  If two bundles have the same utility. the one with the higher utility is the preferred bundle. we say that the consumer is indifferent.  Among two bundles.

13 .  We will assume only two goods when using indifference curve analysis.  The set of all indifference curves that describe an individual¶s preferences are referred to as an indifference curve map.Indifference Curves  Preferences that satisfy the conditions I have noted above can be represented by indifference curves.  An indifference curve connects all of the bundles that a consumer likes equally.

 Indifference curves will not be ³bowed out.  Better bundles are to the northeast.´ 14 .  Indifference curves can not cross one another.Indifference Curve Map Properties  An indifference curve should not slope up.

Higher indifference curves indicate more utility (IC2 is preferred to IC1). Lower indifference curves indicate less utility (IC1 is preferred to IC0).Li¶s Preferences in Indifference Curves     An indifference curve connects all the bundles that have the same utility. L s nd erence ur es 30 25 20 I2 I1 I0 ce 15 10 5 0 0 10 20 hea 15 . The indifference curve map is FULL of indifference curves.

Common to assume the MRS declines as we move down an indifference curve. The MRS=|slope| of the indifference curve at a bundle.The Marginal Rate of Substitution    The Marginal Rate of Substitution(MRS) tells us how much of one good Li would willingly trade for an incremental unit of the other good and remain indifferent. L s nd erence ur es 30 25 20 I2 I1 I0 ce 15 10 5 0 0 10 20 hea 16 .

.  Li¶s ± Get to the highest indifference curve possible ± Stay on the budget constraint (b/c more is better) 17 .How Much Wheat and Rice optimal amount of wheat and rice to consume is the amount that maximizes Li¶s utility subject to her budget constraint..  In the graph.

Li has spent all her income but is not on the highest indifference curve possible. R*) she is doing the best she can subject to her budget constraint. The pink bundle is not the best. Rice 20 R* IC2 IC1 IC0 W* 10 Wheat 18 .How to Find Li¶s Best Combination     The black bundle is best. Bundles n/e of IC0 are better and some are affordable. At (W*.

How to Find the Best Combination  Utility is maximized when: ± the indifference curve is just tangent to the budget line.  Utility is maximized when: ± you are on the budget line and ± the slope of the indifference curve equals the slope of the budget line  Utility is maximized when: ± Income=PRR + PWW ± MRS=ERS 19 .

The ³bang per buck´ story  Let MUW = Li¶s marginal utility of wheat ± it measures the change in utility as we change wheat consumption by an incremental unit while holding rice constant  Let MUR = Li¶s marginal utility of rice ± it measures the change in utility as we change rice consumption by an incremental unit while holding wheat constant  Common to assume that marginal utilities decline as we increase consumption .the law of diminishing marginal utility 20 .

The ³bang per buck´ story  The MRS = MUW / MUR  The ERS = PW / PR  At an optimal bundle: MRS=ERS  Rewritten we have: ± MUW / MUR = PW / PR ± MUW/PW = MUR/PR ± bang/buck in wheat = bang/buck in rice  Get same optimal bundle either way 21 .

B. The equation MRS=ERS is satisfied at each of the points. and $1 for wheat. Rice Li's Demand for Wheat 30 25 I2 I1 I0 4 2 1 20  20 15 10 5 0 0 5 10 15 C B A  Wheat 22 . $2. and C represents the best that Li can do at prices of $4.Handling a change in PW  Li wants to achieve the highest indifference curve that the budget constraints permit. The points A.

 These Li's emand for Wheat Quantity rice oint 6 4 10 2 16 1 23 . are the points of tangency from the previous slide.Li¶s Demand for Wheat  The table shows the amount of wheat that Li demands at each price.

B. The points A. L s Demand for Wheat 4 3 2 1 0 0 2 4 6 8 10 12 14 16 18 20 Quant ty C  24 . and C correspond to the tangencies of the budget constraint and the indifference curves.Graph of Li¶s Demand for Wheat  Pr e When we connect the points from the table in the previous slide we get Li¶s demand for wheat.

L s Best Cho ce of 30 25 20 Rice heat and Rice E B C 15 10 I2 I1 I0 2 A 5 F 0 0 5 10 heat 15 20 25 . The point C is preferred to B but cannot be purchased with Li¶s $40 income at the given prices. The point B is optimal. The point F is feasible but Li prefers less wheat and more rice (B. it is above the red budget line. The point E is feasible but Li prefers more wheat and less rice (B). again). There is no combination that Li prefers to B that she is able to buy.Li¶s Best Choice Reconsidered        Consider the choice at PW=$2/lb. The point A is feasible but inferior to all points on the red budget line between E and F.

and C represents the best that Li can do at prices of $4. Rice Li's Demand for Wheat 30 25 I2 I1 I0 4 2 1 20  20 15 10 5 0 0 5 10 15 C B A  Wheat 26 . The points A.Handling a change in PW  Li wants to achieve the highest indifference curve that the budget constraints permit. B. $2. The equation MRS=ERS is satisfied at each of the points. and $1 for wheat.

Li¶s Demand for Wheat  The table shows the amount of wheat that Li demands at each price. are the points of tangency from the previous slide.  These Li's emand for Wheat Quantity rice oint 6 4 10 2 16 1 27 .

B. Li's Demand for Wheat 4 3 B 2 1 0 0 2 4 6 8 10 12 14 16 18 20 Quantity C A  28 . and C correspond to the tangencies of the budget constraint and the indifference curves.Graph of Li¶s Demand for Wheat  Price When we connect the points from the table in the previous slide we get Li¶s demand for wheat. The points A.

From IC Map to Li¶s Demand for Wheat Li's e and f r Wheat 4 i A e a W heat 30 25 20 I2 I1 I0 4 2 1 20 3 ice ice B 2 1 15 10 5 0 0 5 10 C B A C 0 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 15 Wheat ua tit 29 .

cheaper goods are substituted for more expensive ones.Income and Substitution Effects    Economists decompose the effect of a change in price on the quantity demanded into an income and a substitution effect. Income effect: due to the increase in real income associated with a fall in prices (you can buy more with the same nominal income) or the loss of real income associated with a rise in prices (you cannot buy as much as you once did with the same nominal income). 30 . Substitution effect: due to the change in the relative price of the good.

the quantity demanded rises for two reasons. For normal goods. 31 . The income effect: real income is higher because the same money income buys more at the lower prices. ³X´ normal    When the price of a good falls. The substitution effect: consumers substitute the now cheaper good for ones whose price has not fallen. the income effect of a price fall is positive. This increase in demand is called the substitution effect of a price decline.Income and Substitution Effects: Price Decline. then. real income held constant.

the price decline is like giving Li an additional $20 of real income. The movement from point A to point D is the substitution effect: Li buys less rice and more wheat.Li¶s Income and Substitution Effects: Price Fall. (A) to $1/lb. The movement from point D to point C is the income effect. and would do so even if she had an income of only $20 (as the black budget line shows). Rice normal    Graph shows the income and substitution effects of the fall in the price of wheat from $4/lb. (C). Li's Income and S bstit tion Effects 30 25 20 Rice 15 10 5 0 0 5 10 Wheat 15 20 I2 I0 4 1 1 C A D 32 .

33 . staying on the same indifference curve (compare points A and D). that is.  Substitution effect is the difference between Li's consumption of wheat at the new and old prices holding her real income constant.Li¶s Substitution Effect  The substitution effect is the amount by which Li's wheat consumption increased holding real income constant.

of wheat to $1/lb. The income effect is the difference between what she would have bought on the old indifference curve at the lower wheat price (point D) and what she actually did buy with her nominal income ($40) at the lower price (point C). 34 . Li is able to buy both more wheat and more rice.Li¶s Income Effect    When the price falls from $4/lb. Li increases her consumption of wheat and rice because of the increase in her real income from the price decline. per wheat.

General effect of a price fall PX falls Income effect .you feel richer Substitution Effect X now looks relatively cheaper ³X´ normal ³X´ inferior uantity demanded increases uantity demanded decreases uantity demanded increases Total effect is the substitution effect AND the income effect working at the same time. 35 .

From Individual to Market Demand  Market demand is the sum of all individual demands in the economy.  In the following example there are two consumers of wheat: Li and Juanita. 36 .  The market demand. then. is the sum of the quantities demand by Li and Juanita.

Her preferences are different from Li¶s. Juanita's Demand for Wheat 30 25 20 Rice 15 10 5 0 0 5 10 Wheat 15 20 I2 I1 I0 4 2 1 B A C 37 . Her demand for wheat is derived in the figure at the left.Juanita¶s Demand for Wheat     Juanita¶s income is also $40. Juanita faces the same price for rice as Li: $2/lb.

B and C correspond to Juanita¶s best choices given her income and the three prices of wheat illustrated. Juanita' D 4 3 ri 2 1 0 0 2 4 6 8 and for at A B 10 12 14 16 18 20 uantit 38 .Graph of Juanita¶s Demand for Wheat  The points A.  This is her demand curve for wheat.

Li demands 6 lbs... Juanita demands 5 lbs. Juanita demands 18 lbs. Li demands 16 lbs. Mark t for 4 h at h at 3 Li' D ita' D 2 Mar tD and and Pri of 1 0 0 20 40 Quantity of h at 39 . and the market demand is 20 lbs.Market Demand     The market demand (green) is the sum of Li¶s (blue) and Juanita¶s (red) demand for wheat at each price. Li and Juanita demand 10 lbs. At PW=4. At PW=2. and the market demand is 34 lbs. and the market demand is 11 lbs. At PW=1.

Application: Effect of a Tax & Transfer Program   Suppose I have the preferences illustrated at the right. Question A: If Income = $16 If Price of food = $1 If Price of shelter = $1 Food = ? Shelter = ? Indifference curve = ? references 16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 Shelter I6 I5 I4 I3 I2 I1 9 10 11 12 13 14 15 16 Food 40 .

Answer A  Point A: If Income = $16 If Price of food = $1 If Price of shelter = $1 Shelter Initial oint 16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 A Food = Shelter = Indifference curve = I4 I6 I5 I4 I3 I2 I1 9 10 11 12 13 14 15 16 Food 41 .

Effect of a Tax and Transfer Program: Addition of Tax  Shelter Question B: If Income = $16 If Price of food = $1 If Price of shelter = $1 and Tax on shelter = 100% Tax-inclusive price of shelter = ? Food = ? Shelter = ? Indifference curve = ? Initial oint 16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 A I6 I5 I4 I3 I2 I1 9 10 11 12 13 14 15 16 Food 42 .

Answer B  Shelter Point B If Income = $16 If Price of food = $1 If Price of shelter = $1 and Tax on shelter = 100% Tax-inclusive price of shelter = 2 Food = Shelter = 3.5 Indifference curve = I2 Tax Only 16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 A I6 I5 I4 B I3 I2 I1 9 10 11 12 13 14 15 16 Food 43 .

Effect of a Tax and Transfer Program: Tax & Transfer  Question : If Income = $16 If Price of food = $1 If Price of shelter = $1 and Tax on shelter = 100% and Transfer payment = $8 Food = ? Shelter = ? Indifference curve = ? Tax Only 16 15 14 13 12 11 10 9 8 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 Shelter A I6 I5 I4 B I3 I2 I1 7 8 9 10 11 12 13 14 15 16 Food 44 .

Answer C  Point C If Income = $16 If Price of food = $1 If Price of shelter = $1 and Tax on shelter = 100% and Transfer payment = $8 Food = 10 Shelter = Indifference curve = I4 Tax and Transfer 16 15 14 13 12 11 10 9 7 6 5 4 3 2 1 0 0 1 2 3 4 5 6 7 Shelter A C I6 I5 I4 B I3 I2 I1 9 10 11 12 13 14 15 16 Food 45 .

while the transfer is $8 per person.Tax and Transfer Systems Give Pure Substitution Effects     Notice in the example that the consumer ends up on the same indifference curve after the tax and transfer program as in the initial choice (I4). tax receipts are $ per person (= units of shelter x $1 tax). 46 . In our example. Knowledge of the substitution effect of the price change induced by the shelter tax is sufficient to predict the effect of the complete tax and transfer system. This is as close to ³balanced´ as we can get and still be able to graph the consumer¶s choice legibly. In public finance (the study of tax and transfer systems) this result usually occurs when the tax and transfer system is combined with a balanced budget.

$$$$$  Suppose the following for the Parker family: ± ± ± ± u(F. $aog) where $aog=$all other goods I=$200 PF = $2/unit Paog = $1  Consider three alternative government policies ± no support ± $200 in food stamps ± $200 in cash 47 .Food Stamps vs.

Food Stamps vs. $$$$$ $aog  Notes: ± the budget line under the food stamp program is the thick black segment and the purple segment ± The budget line with cash is the red and purple segments ± the Parkers are indifferent between food stamps and cash 200 IC1 IC0 BL0 100 200 Food 48 .

$$$$$ $aog  Notes: ± the budget line under the food stamp program is the thick black segment and the purple segment ± The budget line with cash is the red and purple segments ± if this is the case then the Parkers prefer cash to food stamps IC$$ ICFS IC0 BL0 Food 49 .Food Stamps vs.

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