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CH 4 Consumer Choice - Edited
CH 4 Consumer Choice - Edited
CONSUMER CHOICE
Chapter Outline
4-2
1. Preferences.
2. Utility.
3. Budget Constraint.
5. Behavioral Economics.
Premises of Consumer
4-3
Behavior
The model of consumer behavior is
based on the following premises:
Individual preferences determine the
on their choices.
Consumers maximize their well-being
Concentrate on goods
Five Properties of Consumer
Preferences
4-7
preferred
preferred by
by
c A c
25 25
Lisa?
Lisa?
f
20 20
Lisa prefers
bundle feover
over
B, Burr
B, Burr
e
15 15
e
a bundle e,d, since fe a
d
10 b
has more
10 of both b I1
goods: Pizza and
5 Burritos
B
15 25 30 15 25 30
,ZPizzas per semester ,ZPizzas per semester
If Lisa
Lisa prefers
is indifferent we can draw an
bundle e bundles
between to any e, a, indifferent curve over
4-10
bundle
and c …..
in area B those three points
Indifference Curves
4-11
(a) (c)
itos per semester
f f
20 20
e I2
15 15
e
B, Burr
B, Burr
a a
d d
10 b 10 I1
5
B I0
15 25 30 15 25 30
,ZPizzas per semester ,ZPizzas per semester
we can draw an
indifferent curve over
those three points
Fig 3.2 Impossible Indifference
4-15
Curves r per semester
Lisa is indifferent
between e and a, and
also between e and
b…
so by transitivity she
itos
B, Bur
should also be
indifferent between a
e
b
and b…
but this is impossible,
a I1
I0
since b must be
preferred to a given it
Indifference curves
has more of both
, ZPizzas per semester can not (cross:
goods. A given
More-is-better)
bundle cannot be on
Impossible Indifference
4-16
Curves
Lisa is indifferent
r per semester
between b and a
since both points
are in the same b
indifference
curve…
itos
B, Bur
But this
contradicts the a
“more is better”
assumption. Can I
you tell why?
Yes, b has more of
both and hence it
should be , ZPizzas per semester
preferred over a.
Impossible Indifference Curves
4-17
Problem
4-18
Consumer is
indifferent between b
and a since both
points are in the same
itos
indifference curve…
B, Bur
b
a
But this contradicts the
“more is better”
assumption since b has
I more of both and hence
it should be preferred
over a.
, ZPizzas per semester
Utility
4-20
Clothing Basket U = FC
C 25 =
15 2.5(10)
A 25 = 5(5)
B 25 =
C 10(2.5)
10
A U3 = 100
5
B U2 = 50
U1 = 25
Food
0 5 10 15
21
Utility Function: Example
4-22
24
Ordinal Preferences
4-25
points.
B, Bur
b
5 From bundle c
1
-2 to bundle d,
Lisa is willing to From b to c,
c
3 1 MRS = -2.
-1 d give up 1
2 This is the same as the
1 Burritos in
I slope of the
exchange for 1
0 3 4 5 6 more Pizza… indifference curve
between those two
, ZPizzas per semester
points.
The indifference curve is convex
(bowed inward) only if MRS is
4-29
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diminishing
r per semester
0 3 4 5 6
, ZPizzas per semester
29
(b) Marginal Rate of Substitution with
concave indifference curves
4-30
(b) Indif
erence
f Curve Concav
e to the O
rigin From bundle a to
r per semester
bundle b, Lisa is
willing to give up
7
a 2 Pizzas for 1
Burrito.
–2
itos
b Nevertheless, from
B, Bur
5
1 b to c she is
–3 willing to give up 3
Pizzas for 1 burrito.
c
2
1
This is very
I unlikely
0 3 4 5 6 Could you think
,ZPizzas per semester why?
(b) Marginal Rate of Substitution with
concave indifference curves
4-31
Utility and
U, Utils
350 Utility function,U (10, Z)
Marginal Utility
250 U = 20
230 U
As Lisa consumes Z = 1 MU Z
Z
more pizza, holding
her consumption of
burritos constant at
10, her total utility,
U, increases…
and her marginal 0 1 2 3 4 5 6 7 8 9 10
utility of pizza, MUZ, , ZPizzas per semester
decreases (though (b) Marginal Utility
utility of pizza
it remains positive). 130
Marginal utility is
the slope of the
, Marginal
utility function as
we hold the
quantity of the
Z
MU
other good
constant. 20
MUZ
4-33 0 1 2 3 4 5 6 7 8 9 10
, ZPizzas per semester
Marginal Utility
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34
Marginal Utility and
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Indifference Curves
35
Marginal Utility and
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Consumer Choice
It must be the case along an indifference
curve that
0 MUX(X) MUY(Y)
No change in total utility along an indifference curve.
Trade off of one good to the other leaves the consumer
just as well off.
36
Marginal Utility and
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Consumer Choice
Rearranging:
Y / X MU X / MU Y
Since
Y / X MRS of X for Y
We can say
MRS MUX/MUY
37
Willingness to Substitute
4-38
between goods
Suppose more generally we have an indifference curve:
Then once we select a value for q1, then the point q2 is determined by the equation of the indifference curve, so we can write q2 as a function of q1, i.e. q2(q1)
(Example: U=FC; For utility=25, indifference curve is FC=25, or C=25/F)
Where U1 is MU of
good 1
Marginal Rate of
4-39
Substitution
Graphical representation of the slope of an
IC
42
Curvature of Indifference
4-43
Curves.
Casual observation suggests that most
people’s indifference curves are convex.
Exceptions:
4 Pepsi as perfect
substitutes: can
you tell how his
3 indifference
curves would look
2 like?
Coke
0 1 2 3
Pie
, Slices per
week
EXERCISE
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46
Imperfect Substitutes
4-47
f
r per semester
The standard-
shaped, convex
indifference curve
in panel lies
between these
two extreme
itos
examples.
B, Bur
Convex
indifference
I curves show that a
consumer views
,ZPizzas per semester two goods as
imperfect
substitutes.
Application: Indifference Curves Between
Food and Clothing
4-48
Research has
shown that at low
(subsistence) levels
of income (I1),
there is little
willingness to
substitute between
food and clothing.
Consumer Preferences:
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An Application
An analysis of consumer preferences
would help to determine where to spend
more on changes in car design:
performance or styling
Styling
These
consumers
place a greater
value on
performance
than styling
Performance
50
Consumer Preferences:
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An Application
Styling
These consumers
place a greater
value on styling
than performance
Performance
51
Budget Constraint
4-52
Y PZ Z
B
PB
If pZ = $1, pB = $2, and Y = $50, then:
$50 ($1 Z )
B 25 0.5Z
$2
Budget Constraint
Amount of Burritos From previous slide we
consumed if all income have that if:pZ = $1, pB = $2,
is allocated for and Y = $50, then the budget
r per semester
25 = Y/pB
a $50 ($1 Z )
B 25 0.5Z
b $2
20
L1
itos
Amount of Pizza
B, Bur
d
0 10 30 50 = Y /pZ
, ZPizzas per semester
4-55
Budget Constraint (cont).
4-56
PB B PZ Z Y
PB B Y PZ Z
Y PZ Z
B
PB
Budget Constraints: Budget Line
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57
The Slope of the Budget Constraint
4-58
Y PZ
B Z
PB PB
Slope = B/Z = MRT
The slope of the budget line is also called the marginal
rate of transformation (MRT)
rate at which Lisa can trade burritos for pizza in the
marketplace
Table: Allocations of a $50 Budget
Between Burritos and Pizza
4-59
(a) Changes in the Budget Constraint: An
increase in the Price of Pizzas.
4-60
Y - PZ = $1
$2
B= Z
r per semester
line increases
Loss
This area represents
L (pZ = $2)
2
the bundles she can
no longer afford!!!
0 25 50
, ZPizzas per semester
Slope = -$2/$2 = -1
(b) Changes in the Budget Constraint:
Increase in Income (Y)
4-61
$100
$50 PZ
B= P - Z
B PB
B, Burritos per semester
If Lisa’s income
50 increases by $50 the
L3 (Y =$100) budget line shifts to
the right (with the
same slope!)
25
This area represents
Gain
the new consumption
L1 (Y = $50) bundles she can now
afford!!!
0 50 100
, ZPizzas per semester
Solved Problem
4-62
64
Consumer Choice
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65
Consumer Choice
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66
Consumer Choice
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67
(a) Consumer Maximization: Interior Solution
Would Lisa be able to
consume any bundle along Bundle e is called a
I3 (i.e. bundle f)? consumer’s optimum.
r per semester
25
Would Lisa be able to
c
consume any bundle along
f
20 I1?
Yes; she could afford
B bundles d, c, and a.
e
10
I3
d I2
A a
I1
0 10 30 50
, ZPizzas per semester
4-68
Consumer Choice
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69
Consumer Maximization: Interior
Solution
The budget constraint and the indifference curve
r per semester
MU 2 P2
B, Bur
25
Slope of I2
Slope of BL
e
I2
0 50
, ZPizzas per semester
4-70
Consumer Choice
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PX
MRS
PY
72
Consumer Choice
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73
Marginal Utility and
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Consumer Choice
Rearranging, gives the equation for
utility maximization:
MU X / PX MU Y / PY
Total utility is maximized when the
budget is allocated so that the marginal
utility per dollar of expenditure is the
same for each good
74
Consumer Choice
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75
Consumer Choice
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Clothing,Y
(units per
week) Point B does not
maximize satisfaction
40 because the
-MRS = 10/10 = 1
is greater than the
B
30 price ratio = 1/2
-10C
20
+10F U1
0 20 40 80 76Food, X(units per week)
Consumer Choice
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77
Practice
4-78
Sally consumes two goods, dinners (X) and DVDs (Y). Her
utility function is given by the expression U = 3XY. The current
market price for X is $10. Sally's current income is $500.
Suppose Sally exhausts her income by consuming 20 dinners
and 60 DVDs. What is the price of a DVD? Write the budget
constraint equation.
Draw (accurately) a set of two indifference curves for Sally in
her consumption of dinners and DVDs. Put dinners on the
horizontal axis.
What is the opportunity cost of dinners in terms of DVDs?
What is the opportunity cost of DVDs in terms of dinners?
Determine the dinner and DVD combination which maximizes
Sally's utility, given her budget constraint. Show her optimum
point on a graph.
Utility Maximation: Solution
4-79
80
Figure 3.6 (b) Consumer
Maximization: Corner Solution
4-81 (Quasi-linear utility)
r per semester
|MRS|≤Px/Py
itos
B, Bur
e
25
I3
I2
Budget line
I1
50
, ZPizzas per semester
A Corner Solution -
Example
Suppose Jane Doe’s parents set up a trust
fund for her college education
The money must be used only for education
Original budget line, PQ, with a market
basket, A, of education and other goods
Trust fund shifts out the budget line as long
as trust fund, PB, is spent on education
Although a welcome gift, an unrestricted gift
might be better
82
A Corner Solution - Example
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Other
Consumption
($) •Jane better off
on U2
•B is corner
solution
P
B •|MRS| ≠ PE/POG
U2
A
U1
Q Education ($)
83
A Corner Solution - Example
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Other
Consumption
($) •If gift is
unrestricted,
C Jane can be at
point C on U3
U3 •Better off than
P
with restricted
B U2 gift
A
U1
Q Education ($)
84
Food Stamps
4-85
C e
Y I3
d I2
I1
B
Budget line with
ood
f stamps
A Original
b
udget line
0 100 Y Y + 100
4-87
o
Fod per month
Problem 3.3
4-88
Jennifer’s parents give her $30 each month to spend on either blue
pens or black pens. Suppose that blue pens and black pens are perfect
substitutes for Jennifer, and that she is wiling to substitute the two
goods on a one-for-one basis. Determine Jennifer’s optimal
consumption bundle for each of the following cases. Draw a diagram
showing the budget constraint, the indifference curve, and the utility
maximizing bundles, clearly indicating each. Put blue pens on the
horizontal axis. (Draw a separate diagram for each part a, b, and c.)
a)Draw the indifference curves associated with U=4, U=6 and show
that the good X and good Y are perfect complements for the
consumer, i.e., indifference curve is L shaped.
25
Would Lisa be able to
c
consume any bundle along
f
20 I1?
Yes; she could afford
B bundles d, c, and a.
e
10
I3
d I2
A a
I1
0 10 30 50
, ZPizzas per semester
4-97
Minimizing Expenditure
4-98
The rule for minimizing expenditure while achieving a given level of utility is to
choose the lowest expenditure such that the budget line touches-is tangent to-the
relevant indifference curve
Minimizing Expenditure
4-100
ball.
How much does the ball cost?
Heuristics or rules of thumb
4-108
can mislead
Almost everyone reports an initial tendency to
answer “10 cents” because the sum
$1.10 separates naturally into $1 and 10 cents,
and 10 cents is about the right magnitude.
Frederick (2003) found that many intelligent
people yield to this immediate impulse: 50
percent (47/93) of agroup of Princeton students
and 56 percent (164/293) of students at the
University of Michigan gave the wrong answer.
Another one:
4-109