MicroEconomics theory and application 12th by browning an zupan chapter 03

 Describe how the market basket chosen by a consumer reflects both the consumer’s preferences and the budget constraints imposed on the consumer by income and the prices that must be pa

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MICROECONOMICS: Theory & Applications

By Edgar K Browning & Mark A Zupan

John Wiley & Sons, Inc.

Chapter 3: The Theory of Consumer Choice

Prepared by Dr Della Lee Sue, Marist College

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Learning Objectives

 Develop an approach for analyzing consumer preferences

 Explain how a consumer’s income and the prices that must

be paid for various goods limit consumption choices

 Describe how the market basket chosen by a consumer

reflects both the consumer’s preferences and the budget

constraints imposed on the consumer by income and the

prices that must be paid for various goods

 Determine how changes in income affect consumption

choices

(continued)

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Learning Objectives (continued)

 Explain how altruism can be explained by the theory of

consumer choice

 Relate the utility approach to the indifference curve method

of analyzing consumer choice

 Explain the mathematics behind consumer choice

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3.1 CONSUMER PREFERENCES

Develop an approach for analyzing consumer preferences.

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Consumer Preferences

Economists make three assumptions about the typical

consumer’s preferences:

 Preferences are complete

 Preferences are transitive

 More of any good is preferred to less

aka “nonsatiation”

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 Indifferent – when a consumer finds two options to be

equally satisfactory

 Market baskets – combinations of goods

 Economic “bads” – commodities of which less is preferred

to more over all possible ranges of consumption

 Economics “goods” – commodities of which more is better

than less

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Figure 3.1 – An Indifference Curve

 Indifference curve – a plot

of all the market baskets

the consumer views as

being equally satisfactory

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Figure 3.2 - An Indifference Map

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Characteristics of Indifference

Curves

 Characteristics:

 An indifference curve has a downward slope if both

goods are desirable

 An indifference curve that lies farther from the origin is preferred to one that is closer to the origin

 Two indifference curves cannot intersect

 An indifference map is a set of indifference curves.

 A set of indifference curves represents an ordinal ranking

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Figure 3.3 - Why Intersecting

Indifference Curves Are Inconsistent

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Marginal Rate of Substitution

 Depends upon the initial endowment

 Related to the slope of an indifference curve

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Figure 3.4 - Curvature of Indifference

Curves

 Indifference curves are

convex to the origin

less and less of some

other good to obtain

still more of the first

good

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Convexity of Indifference Curves

 both goods in the market basket are economic “goods”

 Declining MRS

 pertains to a movement along a given indifference curve

 NOT to a movement from one curve to another

 slope of each curve becomes flatter as move down the curve

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Individuals Have Different Preferences

 Indifference curves – indicate the relative desirability of different combinations of goods

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Figure 3.5 – Indifference Map of Two

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Categories of Goods

 “Good” – when more is preferred to less

 “Bad” – when less is preferred to more

 “Neuter” – when the consumer does not care about a

particular good

 Perfect Substitutes – when a consumer is willing to

substitute one good for another at some constant rate and remain equally well off

 Perfect Complements – when goods must be consumed

in a precise combination in order for the consumer to

remain equally well off

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Figure 3.6 – Indifference Maps for a “Bad”

and a “Neuter”

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Figure 3.7 - Perfect Substitutes and

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3.2 THE BUDGET CONSTRAINT

Explain how a consumer’s income and the prices that must be paid for various goods limit consumption choices.

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The Budget Constraint

 Budget constraint – the way in which a consumer’s income

and the prices that must be paid for various goods limit

choices

 Budget line - a line that shows the combinations of goods

that can be purchased at the specified prices and assuming that all of the consumer’s income is expended

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Figure 3.8 - The Budget Line

 Budget line: a line that

shows the combinations of

goods that can be

purchased with a given

income

 See Table 3.1 for data used

in graph [next slide]

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Table 3.1 – Data used in Figure 3.8

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Geometry of the Budget Line

 The intercepts with the axes show the maximum amount of

one good that can be purchased if none of the other is

bought

 The slope indicates how much of one good must be given

up to buy one more of the other good:

Slope = ΔY/ΔX = -PY/ΔX = -PΔY/ΔX = -PX = -PX/ΔX = -PPY

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Shifts in Budget Lines

 Two underlying factors:

Indicative of change in real or relative prices

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Figure 3.9 - Effect of an Income Change

on the Budget Line

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Figure 3.10 - Effect of a Price Change

on the Budget Line

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3.3 THE CONSUMER’S CHOICE

Describe how the market basket chosen by a consumer reflects both the consumer’s preferences and the budget constraints imposed on the

consumer by income and the prices that must be paid for various goods.

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The Consumer’s Choice

 The cost of consuming one more unit of a good

 Measured by the price ratio

 Consumer’s optimal choice

MRSXY = PX/ΔX = -PPY

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Figure 3.11 - The Consumer’s Optimal Consumption Choice

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A Corner Solution

 Corner solution – a situation in which a particular good is

not consumed at all by an individual consumer because the value of the first unit of the good is less than the cost

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Figure 3.12 - A Corner Solution

 The consumer’s optimal

choice is not characterized

by an equality between the

MRS and the price ratio

 Only clothing is purchased

because the value of the

first unit of Dom Perignon

is less than the cost

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The Composite-Good Convention

 Composite good

 a number of goods treated as a group

 Measured by total outlays ($)

 Price of a composite good is normalized to $1.00

Prices of goods in the group are constant

 Measured along vertical axis

 MRS (slope of an indifference curve)

 Shows how much the consumer is will to reduce outlays

on other goods to obtain one more of the good measured

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Figure 3.13 - The Composite-Good

Convention

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3.4 CHANGES IN INCOME AND

CONSUMPTION CHOICES

Determine how changes in income affect consumption choices.

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Changes in Income and Consumption

Choices

 Income-consumption curve: the curve that joins all the

optimal consumption points generated by varying income

 For normal goods,

 the income-consumption curve slopes upward

 the demand curve shifts rightward for increases in

income

 For inferior goods,

 the income-consumption curve slopes backward

 the demand curve shifts leftward for increases in income

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Figure 3.14 - Income Changes and Optimal Consumption Choice (Normal Good)

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Figure 3.15 – Income Changes and

Purchases of an Inferior Good

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Inferior Good: additional points

 A good may be inferior for some people and normal for others

 A good may be a normal good for an individual at some income levels but an inferior good at other income levels

 An inferior good should not be confused with an economic

“bad”

 Inferior goods tend to have certain common characteristics

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Figure 3.16 – Effects of the Food Stamp Program on Consumption

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Figure 3.17 - The Allocation of

Commencement Tickets

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3.5 ARE PEOPLE SELFISH?

Explain how altruism can be explained by the theory of consumer choice.

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Figure 3.18 - Transferring Income to

Another Person

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Figure 3.19 - Is Altruism a Normal

Good?

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3.6 THE UTILITY APPROACH TO

CONSUMER CHOICE

Relate the utility approach to the indifference curve method of analyzing consumer choice.

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The Utility Approach to Consumer

Choice

 Total utility - assuming that it is measurable, the total

satisfaction a consumer receives from a given level of

consumption

 Marginal utility - the amount by which total utility rises

when consumption increases by one unit

 Diminishing marginal utility – the assumption that as more

of a given good is consumed, the marginal utility associated with the consumption of additional units tends to decline, other things equal

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Table 3.2

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The Consumer’s Optimal Choice

 The utility-maximizing market basket is one for which

the consumer allocates income so that the marginal utility divided by the good’s price is equal for every good

purchased:

MUX/ΔX = -PPX = MUY/ΔX = -PPY

 The equality between the marginal utility per dollar’s worth

of both goods is the same as the equality between the MRS and the price ratio

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Relationship to Indifference Curves

 The slope of an

indifference curve is equal

to the ratio of the marginal

utilities of the two goods

 At Point R,

ΔY/ΔX = -PC/ΔX = -PΔY/ΔX = -PF = MUF/ΔX = -PMUC

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3.7 THE MATHEMATICS BEHIND

CONSUMER CHOICE*

Explain the mathematics behind consumer choice.

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The Mathematics Behind Consumer

Choice

 Preferences of the Consumer:

 The slope of an indifference curve (MRS) equals (minus) the ratio of the marginal utilities.

 The Budget Constraint:

 The slope of the budget line equals the negative of the price ratio.

 The Consumer’s Choice:

 To maximize utility, the ratio of marginal utilities equals the ratio of prices

 MRS = slope of the budget line

 The consumer’s choice must lie on the budget line.

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Preferences of the Consumer

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The Budget Constraint

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The Consumer’s Choice

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