CHAPTER 3:

CONSUMER CHOICE

BY: PHD. TRẦN AN QUÂN

MAIN CONTENT
1) Contingent consumption
2) Utility function and probabilities
3) Expected utility
4) Risk Aversion/ loving/ neutral/ spreading
5) Market equilibrium
6) Inverse demand and supply curves
7) Taxes and Pareto efficiency
 CONTINGENT CONSUMPTION
• The consumer is concerned with the probability distribution of getting different
consumption bundles of goods. A probability distribution consists of a list of different
outcomes as consumption bundles and the probability associated with each outcome.
• For example, suppose that an individual initially has $35,000 worth of assets, but
there is a possibility that he may lose $10,000. For example, his car may be stolen, or
a storm may damage his house. Suppose that the probability of this event happening is
p = 0.01. Then the probability distribution the person is facing is a 1 percent
probability of having $25,000 of assets, and a 99 percent probability of having
$35,000.
 CONTINGENT CONSUMPTION
• The different outcomes of some random event as being different states of nature.
In the insurance, there were two states of nature: the loss occurs or it doesn’t.
• There could be many different states of nature. We can then think of a contingent
consumption plan as being a specification of what will be consumed in each
different state of nature-each different outcome of the random process.
• Contingent means depending on something not yet certain, so a contingent
consumption plan means a plan that depends on the outcome of some event.
 CONTINGENT CONSUMPTION

Insurance: The budget line associated with the purchase of insurance. The
insurance premium γ allows us to give up some consumption in the good
outcome (Cg) in order to have more consumption in the bad outcome
(Cb).
 UTILITY FUNCTION AND
PROBABILITIES
• The consumer has reasonable preferences about consumption in different
circumstances, then we will be able to use a utility function to describe these
preferences.
• In general, how a person values consumption in one state as compared to another
will depend on the probability that the state in question will actually occur.
 UTILITY FUNCTION AND PROBABILITIES

• Let c1 and c2 represent consumption in states 1 and 2, and let π1 and π2 be the
probabilities that state 1 or state 2 actually occurs. If the two states are mutually
exclusive, so that only one of them can happen, then π 2 = 1 − π1.
• Utility function for consumption in states 1 and 2 as u(c 1, c2, π1, π2)
• This gives a utility function of the form u(c1, c2, π1, π2) = π1c1 + π2c2.
We put weight to each consumption by probability that it will occur
• The Cobb-Douglas type of utility function:
 EXPECTED UTILITY
• One type of utility function:

• That utility can be written as a weighted sum of some function of

consumption in each state, v(c1) and v(c2), where the weights are given by the
probabilities π1 and π2
• π1v(c1) + π2v(c2) represents the average utility, or the expected utility, of the
pattern of consumption (c1, c2).
• We also call it as expected utility function
 EXPECTED UTILITY
• The expected utility function can be subjected to some kinds of monotonic
transformation and still have the expected utility property.
• A function v(u) is a positive affine transformation if it can be written in the
form: v(u) = au + b where a > 0. A positive affine transformation simply
means multiplying by a positive number and adding a constant.
 RISK AVERSION
• Suppose that a consumer currently has $10 of wealth and is contemplating a
gamble that gives him a 50 percent probability of winning $5 and a 50
percent probability of losing $5. His wealth will therefore be random: he has
a 50 percent probability of ending up with $5 and a 50 percent probability of
ending up with $15.
• The expected value of his wealth is $10, and the expected utility is:
 RISK AVERSION

• We have also depicted the utility of the expected value of wealth, which is
labeled u($10). Note that in this diagram the expected utility of wealth is less
than the utility of the expected wealth.
 RISK AVERSION

Risk aversion: For a risk-averse consumer the utility of the expected value of
wealth, u(10), is greater than the expected utility of wealth, 0.5u(5) + 0.5u(15)
 RISK LOVING

Risk loving: For a risk-loving consumer the expected utility of wealth, 0.5u(5)
+ 0.5u(15), is greater than the utility of the expected value of wealth, u(10).
 CONSUMER CHOICES TOWARDS RISKS

• The consumer is risk averter since he prefers to have the expected value of
his wealth rather than random distribution of wealth. The preferences of the
consumer were such that he prefers a random distribution of wealth to its
expected value, in which case we say that the consumer is a risk lover.
• The consumer is risk neutral: the expected utility of wealth is the utility of its
expected value. The intermediate case is that of a linear utility function.
 CONSUMER CHOICES TOWARDS RISKS

• The risk-averse consumer has a concave utility function—its slope gets

flatter as wealth is increased. The risk-loving consumer has a convex utility
function—its slope gets steeper as wealth increases. Thus the curvature of the
utility function measures the consumer’s attitude toward risk.
 RISK SPREADING
• Suppose that each consumer decides to diversify the risk that he faces. by selling some of their
risk to other individuals he can mitigate the total losses from the risks. Suppose that the 1000
consumers decide to insure one another. If anybody incurs the $10,000 loss, each of the 1000
consumers will contribute $10 to that person.
• By this way, the poor person whose house burns down is compensated for his loss, and the
other consumers have the peace of mind that they will be compensated if that poor soul
happens to be themselves
• This is an example of risk spreading: each consumer spreads his risk over all of the other
consumers and thereby reduces the amount of risk he bears
 RISK SPREADING
• The stock market plays a role similar to that of the insurance market in that it
allows for risk spreading.
• The stock market also allows them to convert their risky position of having
all their wealth tied up in one enterprise to a situation where they have a
lump sum that they can invest in a variety of assets. The original owners of
the firm have an incentive to issue shares in their company so that they can
spread the risk of that single company over a large number of shareholders.
 MARKET EQUILIBRIUM

• We have a number of consumers of a good. Given their individual demand

curves we can add them up to get a market demand curve. Similarly, if we
have a number of independent suppliers of this good, we can add up their
individual supply curves to get the market supply curve.
 MARKET EQUILIBRIUM

• The individual demanders and suppliers are assumed to take prices as given -
outside of their control and simply determine their best response given those
market prices.
• A market where each economic agent takes the market price as outside of his
control is called a competitive market
 MARKET EQUILIBRIUM

• The equilibrium price of a good is that price where the supply of the good equals
the demand. Geometrically, this is the price where the demand and the supply
curves cross.
• The demand and supply curves represent the optimal choices of the agents
involved, and the fact that they are equal at some price p∗ (equilibrium price)
indicates that the behaviors of the demanders and suppliers are compatible. At
any price other than the price where demand equals supply these two conditions
will not be met.
 MARKET EQUILIBRIUM

• Suppose some price p < p∗ where demand is greater than supply. Then some
suppliers will realize to sell their goods at more than the going price p to the
disappointed demanders. As more and more suppliers realize this, the market
price will be pushed up to the point where demand and supply are equal.
• If p > p∗, so that demand is less than supply, then some suppliers will not be
able to sell the amount that they expected to sell. The only way in which they
will be able to sell more output will be to offer it at a lower price.
2 SPECIAL CASES OF MARKET EQUILIBRIUM

Special cases of equilibrium: Case A shows a vertical supply curve where the equilibrium
price is determined solely by the demand curve. Case B depicts a horizontal supply curve
where the equilibrium price is determined solely by the supply curve.
 INVERSE DEMAND AND SUPPLY CURVE
• Individual demand curves are normally viewed as giving the optimal
quantities demanded as a function of the price charged. We view them as
inverse demand functions that measure the price that someone is willing to
pay in order to acquire some given amount of a good.
• Likewise, we view supply curves as measuring the quantity supplied as a
function of the price. But we also view inverse supply function as measuring
the price that must prevail in order to generate a given amount of supply
 INVERSE DEMAND AND SUPPLY CURVE

• If we let PS(q) be the inverse supply function and PD(q) be the inverse
demand function, equilibrium is determined by the condition PS(q∗) =
PD(q∗)
 TAXES
• When a tax is present in a market, there are two prices of interest: the price
the demander pays and the price the supplier gets. These two prices- the
demand price and the supply price- differ by the amount of the tax.
• There are several different kinds of taxes that one might impose. Two
examples we will consider here are quantity taxes and value taxes
 TAXES

• A quantity tax is a tax levied per unit of quantity bought or sold

In general, if t is the amount of the quantity tax per unit sold: PD = PS + t
• A value tax is a tax expressed in percentage units
In general, if the tax rate is given by τ : PD = (1 + τ )PS
 PARETO EFFICIENCY

• An economic situation is Pareto efficient if there is no way to make any person better
off without hurting anybody else. —but efficiency is not the only goal of economic
policy. For example, efficiency has almost nothing to say about income distribution or
economic justice.
• However, efficiency is an important goal, and it is worth asking how well a
competitive market does in achieving Pareto efficiency. A competitive market
determines how much is produced based on how much people are willing to pay to
purchase the good as compared to how much people must be paid to supply the good
 PARETO EFFICIENCY

Pareto efficiency: The competitive market determines a Pareto efficient amount of output
because at q∗ the price that someone is willing to pay to buy an extra unit of the good is
equal to the price that someone must be paid to sell an extra unit of the good
 PARETO EFFICIENCY

• At any amount of output less than the competitive amount q∗, there is
someone who is willing to supply an extra unit of the good at a price that is
less than the price that someone is willing to pay for an extra unit of the
good.
• If the good were produced and exchanged between these two people at any
price between the demand price and the supply price, they would both be
made better off. Thus any amount less than the equilibrium amount cannot be
Pareto efficient
 PARETO EFFICIENCY

• Similarly, at any output larger than q∗, the amount someone would be
willing to pay for an extra unit of the good is less than the price that it would
take to get it supplied. Only at the market equilibrium q∗ would we have a
Pareto efficient amount of output supplied- an amount such that the
willingness to pay for an extra unit is just equal to the willingness to be paid
to supply an extra unit