MICROECONOMICS: Theory & Applications Chapter 3: The Theory of Consumer Choice By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 11th Edition, Copyright 2012 PowerPoint prepared by Della L. Sue, Marist College

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. Understand 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. (continued) Copyright 2012 John Wiley & Sons, Inc.

Learning Objectives (continued) Determine how changes in income affect consumption choices. Show how altruism can be explained by the theory of consumer choice. Relate the utility approach to the indifference curve method of analyzing consumer choice. Copyright 2012 John Wiley & Sons, Inc.

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. Copyright 2012 John Wiley & Sons, Inc.

Definitions Indifferent – when a consumer finds two options to be equally satisfactory 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 Copyright 2012 John Wiley & Sons, Inc.

Figure 3.1 - Consumer Preferences Graphed as Indifference Curves Indifference curve – plots all the market baskets that a consumer views as being equally satisfactory Copyright 2012 John Wiley & Sons, Inc.

Figure 3.2 - An Indifference Map Copyright 2012 John Wiley & Sons, Inc.

Characteristics of Indifference Curves 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. Copyright 2012 John Wiley & Sons, Inc.

Figure 3.3 - Why Intersecting Indifference Curves Are Inconsistent Copyright 2012 John Wiley & Sons, Inc.

Figure 3.4 - Curvature of Indifference Curves Indifference curves are convex to the origin. Why? diminishing marginal rate of substitution (MRS): a consumer’s willingness to give up less and less of some other good to obtain still more of the first good Copyright 2012 John Wiley & Sons, Inc.

Figure 3.5 - Individuals Have Different Preferences Copyright 2012 John Wiley & Sons, Inc.

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 Copyright 2012 John Wiley & Sons, Inc.

Figure 3.6 - Graphing Economic Bads and Economic Neuters Copyright 2012 John Wiley & Sons, Inc.

Figure 3.7 - Perfect Substitutes and Complements Copyright 2012 John Wiley & Sons, Inc.

Figure 3. 8 - The Budget Constraint 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. See Table 3.1 for data used in graph. [next slide] Copyright 2012 John Wiley & Sons, Inc.

Table 3.1 – Data used in Figure 3.8 Copyright 2012 John Wiley & Sons, Inc.

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 = -PX/PY Copyright 2012 John Wiley & Sons, Inc.

Shifts in Budget Lines Two underlying factors: Income Changes A change in income with constant prices produces a parallel shift in the budget line. Price Changes A change in the price of one good, with income and the other good’s price remaining unchanged, causes the budget line to rotate about one of the intercepts. Indicative of change in real or relative prices Copyright 2012 John Wiley & Sons, Inc.

Figure 3.9 - Effect of an Income Change on the Budget Line Copyright 2012 John Wiley & Sons, Inc.

Figure 3.10 - Effect of a Price Change on the Budget Line Copyright 2012 John Wiley & Sons, Inc.

The Consumer’s Choice Marginal benefit Marginal cost The value the consumer derives from consuming one more unit of a good Measured by the MRSXY Marginal cost The cost of consuming one more unit of a good Measured by the price ratio Consumer’s optimal choice MRSXY = PX/PY Copyright 2012 John Wiley & Sons, Inc.

Figure 3.11 - The Consumer’s Optimal Consumption Choice Copyright 2012 John Wiley & Sons, Inc.

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. Copyright 2012 John Wiley & Sons, Inc.

Figure 3.13 - The Composite-Good Convention Copyright 2012 John Wiley & Sons, Inc.

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. Copyright 2012 John Wiley & Sons, Inc.

Figure 3.14 - Income Changes and Optimal Consumption Choice (Normal Good) Copyright 2012 John Wiley & Sons, Inc.

Figure 3.15 – Income Changes and Purchases of an Inferior Good Copyright 2012 John Wiley & Sons, Inc.

Figure 3.16 – Effects of the Food Stamp Program on Consumption Copyright 2012 John Wiley & Sons, Inc.

Figure 3.17 - The Allocation of Commencement Tickets Copyright 2012 John Wiley & Sons, Inc.

Figure 3. 18 - Are People Selfish Figure 3.18 - Are People Selfish? [Transferring Income to Another Person] Copyright 2012 John Wiley & Sons, Inc.

Figure 3.19 - Is Altruism a Normal Good? Copyright 2012 John Wiley & Sons, Inc.

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. Copyright 2012 John Wiley & Sons, Inc.

Table 3.2 Copyright 2012 John Wiley & Sons, Inc.

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/PX = MUY/PY 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. Copyright 2012 John Wiley & Sons, Inc.

Relationship to Indifference Curves The slope of an indifference curve is related to the marginal utilities of the two goods. At Point R, ΔC/ΔF = MUF/MUC Figure 3.20 Copyright 2012 John Wiley & Sons, Inc.

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. Copyright 2012 John Wiley & Sons, Inc.

Preferences of the Consumer Copyright 2012 John Wiley & Sons, Inc.

The Budget Constraint Copyright 2012 John Wiley & Sons, Inc.

The Consumer’s Choice Copyright 2012 John Wiley & Sons, Inc.

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