RATIONAL CONSUMER CHOICE

Drawing on Chapter 3 Graphics copyright © 2010 The McGraw-Hill Companies, Inc. All rights reserved.

Rational Choice Model given 1. Possibilities 2. Preferences opportunity set of quantities, bought with income M at prices P 2. Preferences preference ordering (indifference curves) or utility function and 3. Rationality, seeking the best affordable bundle of quantities we 4. Predict choices of quantities

2. Preferences Preference Orderings Definition Assumed Properties Personal ranking of all possible combinations (bundles) of goods E.g., A is preferred to B, or vice versa, or the person is indifferent between them Assumed Properties Complete More is better Transitive Convex (more variety or balance is better)

Figure 3-8: Generating Equally Preferred Bundles

Indifference Curves Definition Implied Properties A set of equally preferred bundles of goods I.e., the person is indifferent between them Implied Properties Every bundle is on one Negative slope Cannot cross Diminishing |slope|

Marginal Rate of Substitution (MRS) The maximum rate at which a person is willing to give up one good to get another The |slope| of the indifference curve when substituting the good on the horizontal axis for the good on the vertical axis where the curve is smooth (differentiable). Its smoothness can be another assumption Often written as negative, the slope of the indifference curve

Diminishing Marginal Rate of Substitution

Figure 3-12: The Marginal Rate of Substitution

Representing Different Preferences Indifference curves with Differences in slope (MRS) at a given bundle mean different relative preferences for the two goods Different curvatures (rates at which MRS diminishes) mean different degrees of preference for variety

Extreme Preferences

3. Rationality Rational Choice Choose more of a good if the benefit exceeds the cost and it is affordable Benefit: the most you are willing to give up (MRS) Cost: the relative price of the good The best affordable bundle Usually the only contact of indifference curve and budget constraint If both choices are positive and if indifference curves are smooth, I and B are tangent (have the same slope): MRS = relative price

Figure 3-15: The Best Affordable Bundle 4. Predict Figure 3-15: The Best Affordable Bundle

Figure 3-16: A Corner Solution

Choice among Perfect Substitutes Suppose Water budget M=$4.80/week Prices P1A= $0.80/btl. and PD=$.60/btl. What is the best affordable bundle? What if P2A= $0.48/btl. and PD=$.60/btl.?

Choice among Perfect Complements Suppose Food budget M=$3/meal Prices PB= $0.75/brat and PN=$.75/bun What is the best affordable choice? What if the Food budget doubled? Prices were $1.00/brat and $.50/bun?

Figure 3-18: Food Stamp Program vs. Cash Grant Program

Figure 3-19: Where Food Stamps and Cash Grants Yield Different Outcomes