Consumer Theory-1 Lecture 12 Dr. Jennifer P. Wissink ©2017 John M. Abowd and Jennifer P. Wissink, all rights reserved. March 13, 2017

i>clicker question How will Maryclaire’s budget line change if just the PB decreases? It will get steeper. It will shift in parallel to itself. It will get flatter. It will shift out parallel to itself. It will not change since the prices did not change.

i>clicker question How will Maryclaire’s budget line change if her income stays the same and both the price of beans and the price of carrots double? It will get steeper. It will shift in parallel to itself. It will get flatter. It will shift out parallel to itself. It will not change since the prices did not change.

More Budget Line Gymnastics $mlo The case of quantity discounts for rubber bands BLold Rubber Bands

Now Onto The Consumer’s Preferences How can we model what you like?

Preferences: Definitions A bundle of goods, G, specifies exact quantities of all the possible goods and services a consumer cares about. ASSUME: Our consumer has preferences over all the possible bundles that could be assembled. How can we define these preferences? With an “at least as good as” operator. Let R = “at least as good as” G0 R G1 means bundle G0 is “at least as good as” bundle G1 . Let I = “indifferent to” G0 I G1 means bundle G0 is “indifferent to” bundle G1 . Let S = “strictly preferred to” G0 P G1 means bundle G0 is “strictly preferred to” bundle G1 .

Assumptions on the Consumer’s (Maryclaire’s) “at least as good as” operator A1: More is at least as good as less (monotonicity) If Y has more of at least one good than X (and no less of any other good), then Y R X If Y has more of ALL goods, then let’s agree that we will say Y is actually better than X, so then Y P X A2: Rationality (transitivity) If X R Y and Y R Z, then X R Z A3: Average bundles are at least as good as extreme bundles (convexity) If X I Y and Z is an “average” of X and Y, then Z R X and Z R Y C B C B

From Preferences to Indifference Curve Maps A particular indifference curve connects bundles that a consumer likes equally. So along a particular indifference curve, W I X I Y I Z and so on... An indifference curve map is ALL the indifference curves. Indifference curve maps for nicely behaved preferences have 5 properties. (P1) Every bundle lives on some indifference curve. (P2) Indifference Curves never slope “up”. (P3) Better bundles are on indifference curves to the “north-east”. (P4) Indifference Curves never cross each other. (P5) Indifference Curves never “bow-out”, they’re either linear or “bowed-in”. C C C B B B

Maryclaire’s Preferences Represented via Indifference Curves These 3 indifference curves describe a part of Maryclaire’s preferences. Points on IC2 are preferred to points on IC1. Points on IC1 are preferred to points on IC0.

Maryclaire’s Marginal Rates of Substitution At any given bundle, the Marginal Rate of Substitution (MRS) tells us how much of one good Maryclaire would willingly trade for an extra unit of the other good and remain indifferent. Her MRS equals the absolute value of the slope of the indifference curve at a bundle of beans and carrots. Her MRS declines (or stays constant) as we move down an indifference curve – it never gets larger.

i>clicker question Mikko lives in Oulu Finland. He cares nothing about road quality in Cortland. However he does care about road quality in Oulu. Which indifference curve map below would most likely be Mikko’s? A B C IC2 IC1 IC2 IC2 IC1 IC1 IC1 IC2 D E IC2 IC1

i>clicker question Chester consumes nothing but ounces of Pepsi and ounces of Coke. However he can not distinguish the difference between them. He considers them to be perfect substitutes. Which indifference curve map below would most likely be Chester’s? A B C IC2 IC2 IC1 IC2 IC1 IC1 D E IC2 IC2 IC1 IC1

i>clicker question Scrooge cares for nothing but pennies and dimes. Which indifference curve map below would most likely be Scrooge’s? A B C D E

i>clicker question James Bond like his martinis with equal parts Clearheart gin and Prairie Organic vodka. Shaken not stirred. He considers gin and vodka to be perfect complements. Which indifference curve map below would most likely be James Bond’s? A B C D E

i>clicker question Cathy and Susan consume only X and Y. Suppose Susan’s indifference curve is the BLUE one and Cathy’s indifference curve is the RED one. Which one of the following is the best choice? Susan likes X relatively more than Cathy likes X. Susan likes Y relatively more that Cathy likes Y. Susan has more income than Cathy. Susan has less income than Cathy. Susan and Cathy are irrational consumers since their indifference curves cross.

From Preferences to Utility Utility is the way economists describe and measure preferences. Between two bundles, the one with the higher utility is the preferred bundle. If two bundles generate the same satisfaction then they have the same utility and we say that the consumer is indifferent between the two. UtilityMaryclaire = u(B, C) This is a 3-dimensional function! The indifference curve map versus the utility function!

The Consumer Theory Problem: Decisions, Decisions, Decisions! So… for Maryclaire and Beans and Carrots, what bundle is best? Ok, what bundle will she buy? Let’s bring together what she is willing to do with what she is able to do! The optimal amount of beans and carrots to consume is the amount that maximizes her utility subject to her budget set. Maryclaire’s (the consumer’s) formal problem: Choose a bundle of (Beans, Carrots) to maximize UtilityMaryclaire = u(B, C) subject to $PBB + $PCC ≤ $I

How to Find Maryclaire’s Best Bundle When I=$40, PC=$2 & PB=$4

How to Find Maryclaire’s Best Bundle When I=$40, PC=$2 & PB=$4