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Two problems:
(1) As a manager, you want to Market high-priced premium ice-cream –with more
cream, egg – that is more flavoured than most brands (but wishes are not horses then
beggars could ride!);
Resolve an important problem before extensively marketing – how high the price
should change? Pricing decision considerably affects profitability . Yes, consumers
would pay more for good ice-cream but that is not enough to know, - how much more
is the moot question?
Therefore you need to conduct a careful analysis of consumer preferences to
determine demand for ice-cream and its dependence on both price and quality.
(2) The government to take decision on Food coupon to procure food or income
subsidy for low-income groups? Analysis of consumer behaviour needed – government
has to decide how spending on food ,as opposed to other goods, is affected by changing
income levels or prices..
Slope = – 4 D
Umar must
give up
4 mangos
to get one fish.
Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 6
The Slope of the Budget Constraint
The slope of the budget constraint equals
the rate at which Umar
can trade mangos for fish
the opportunity cost of fish in terms of mangos
the relative price of fish:
8
ACTIVE LEARNING 2
Answers, part A
Quantity A
A fall
fall in
in income
income
Now, of Mangos shifts
shifts the
the budget
budget
Umar constraint
constraint down.
down.
can buy
$800/$4
= 200 fish
or
$800/$1
= 800 mangos
or any
combination in
between. Quantity
of Fish
ACTIVE LEARNING 2
Answers, part B
Quantity An
An increase
increase in
in the
the
Umar of Mangos price
price of
of one
one good
good
can still buy pivots
pivots the
the budget
budget
300 fish. constraint
constraint inward.
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
If the quantity of
B
fish is reduced,
the quantity of A
mangos must be
I1
increased to keep
Umar equally happy.
Quantity
of Fish
Quantity
4. Indifference curves of Mangos
are bowed inward.
A
Umar is willing to give
up more mangos for a 6
fish if he has few fish
1
(A) than if he has
B
many (B). 2
1 I1
Quantity
of Fish
Quantity Indifference
Indifference Quantity Indifference
Indifference
curves of hot curves
curves for
of Pepsi curves for
for close
close dog buns
for
substitutes
substitutes are
are close
close
not
not very
very bowed
bowed complements
complements
are
are very
very
bowed
bowed
Quantity Quantity
of Coke of hot dogs
Optimization: What the Consumer Chooses
A is the optimum: Quantity
of Mangos
The
The optimum
optimum
the point on the
is
is the
the bundle
bundle
budget constraint
Umar
Umar most
most
that touches the
1200 prefers
prefers outout of
of
highest possible
all
all the
the bundles
bundles
indifference curve.
he
he cancan afford.
afford.
Umar prefers B to A, B
but he cannot afford B. 600
A
Umar can afford C C
and D, D
but A is on a higher
indifference curve. 150 300 Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 20
Optimization: What the Consumer Chooses
Quantity
At the optimum, of Mangos Consumer
Consumer
slope of the optimization
optimization isis
indifference curve another
another example
example
equals 1200 of
of “thinking
“thinking at
at the
the
slope of the budget margin.”
margin.”
constraint:
MRS = PF/PM A
600
marginal
price of fish
value of fish
(in terms of
mangos)
(in terms of 150 300 Quantity
mangos) of Fish
THE THEORY OF CONSUMER CHOICE 21
The Effects of an Increase in Income
Quantity
of Mangos
An increase in
income shifts the
budget constraint
outward.
B
If both goods are A
“normal,” Umar
buys more of each.
Quantity
of Fish
THE THEORY OF CONSUMER CHOICE 22
Inferior vs. normal goods
An increase in income increases the quantity
demanded of normal goods and reduces the
quantity demanded of inferior goods.
Suppose fish is a normal good
but mangos are an inferior good.
Use a diagram to show the effects of
an increase in income on Hurley’s optimal
bundle of fish and mangos.
23
Quantity
of Mangos
If mangos are
inferior, the new
optimum will
contain fewer
mangos.
A
B
Quantity
of Fish
24
The Effects of a Price Change
Quantity
Initially,
of Mangos
PF = $4
1200
PM = $1 initial
optimum
PF falls to $2 new
optimum
budget constraint 600
500
rotates outward,
Umar buys
more fish and
fewer mangos.
150 300 600 Quantity
350 of Fish
28
ACTIVE LEARNING 4
Answers
But
ButInthe
Inthe substitution
both graphs,
graphs, the
substitution
both effect
effect
the is
is bigger
relative
relative pricefor
price
bigger substitutes
changes
for substitutes
changes
bythan
by the
than complements.
the same amount.
complements.
same amount.
Quantity
of Pepsi Quantity of
hot dog buns
A
B B
Quantity Quantity
of Coke of hot dogs
Deriving Umar’s Demand Curve for Fish
A: When
B: $4, Hurley
WhenPPF F==$2, Hurley demands
demands 350
150 fish.
fish.
Quantity Price of
of Mangos Fish
A
$4
A
B
B
$2
DFish
At
At the
the optimum,
optimum,
the
the MRS
MRS between
between
current
current and
and future
future
consumption
consumption equals
equals
the
the interest
interest rate.
rate.
41
The interest rate rises.
Substitution effect
Current consumption becomes more expensive
relative to future consumption.
Current consumption falls, saving rises,
future consumption rises.
Income effect
Can afford more consumption in both the
present and the future. Saving falls.
42
Application 3: Interest Rates and Saving
In
In this
this case,
case,
SE
SE >> IEIE and
and
saving
saving rises
rises
46
CHAPTER SUMMARY
48
CHAPTER SUMMARY
50