Consumer Choice Theory

Consumer Choice You are constantly making economic decisions trivial;may have profound impact Involves spending Other economic choices (not so obvious) involve allocation of time To understand the choices that pple make, we must understand what they are trying to achieve and the limitations that they face Specific goals and specific constraints Generally, we are all very much alike; maximize satisfaction; come up against some limitations Constraints Too little income or wealth Too little time to enjoy it all Consumer theory: choices about spending- The theory of individual decision making- how pple decide what to buy

The Budget Constraint Two facts of economic life Pay for goods and services bought Limited funds to spend These two facts are summarized by the budget constraint A consumer’s budget constraint identifies combinations of goods and services the consumer can afford with a limited budget

The Budget Constraint Budget line Graphical representation of a budget constraint Slope of the budget line Trade-off between one good and another Amount of one good that must be sacrificed in order to buy more of another good Assume the price of movie tickets $10 and concert ticket is $30

The Budget Constraint Figure 1 The Budget Constraint Number of Concerts per Month Number of Movies per Month 15 12 9 6 3 1 2 4 5 A With $150 per month, Kofi can afford 15 movies and no concerts, . . . B 12 movies and 1 concert or any other combination on the budget line. G Points below the line are also affordable. C H But not points above the line. D E F

The Budget Constraint  

Changes in the Budget Line To draw the budget line, we were given prices of movie and concert tickets as well as Kofi’s income These ‘givens’ are always constant as we move along the budge line If any of one these ‘givens’ change, the budge line will change as well. Changes in income – bodily shift in the budget line Income increase - upward-rightward shift Income decrease - downward-leftward shift Do not affect the budget line’s slope Changes in price – rotate the budget line The slope changes One of the intercepts changes

Changes in the Budget Line Figure 2 Changes in the Budget Line (a) assume Kofi’s income doubles Number of Concerts per Month 5 15 Number of Movies per Month 30 10 1. An increase in income shifts the budget line rightward, with no change in slope.

Changes in the Budget Line Figure 2 Changes in the Budget Line (b) price of movie falls from $10 to $5 Number of Concerts per Month 5 15 Number of Movies per Month 30 2. A decrease in the price of movies rotates the budget line upward.

Changes in the Budget Line Figure 2 Changes in the Budget Line (c) price of concert falls from $30 to $10 Number of Concerts per Month 5 15 Number of Movies per Month 30 3. while a decrease in the price of concerts rotates it rightward.

Preferences One common assumption behind consumer theory is that people have preferences Rational preferences Any two alternatives can be compared one is preferred or the two are valued equally The comparisons are logically consistent (transitive) If you prefer jollof to red-red, and red-red to waakye,then it must be that you prefere jollof to waakye rationality in choices is about how you make choices and not what choices you make. You can be rational even if you like apples better than oranges or oranges better than apples You can even like chloroquin better than chocolates so far as you are logically consistent with your choices More is Better Choose a point on the budget line rather than a point below it

Marginal Utility Theory Economists assume that any decision maker- manager of a business, a consumer or a government is seeking to make the best of any situation The marginal utility theory treats consumers as striving to maximize their utility Utility The quantitative measure of satisfaction or well-being. Anything that makes the consumer better off/worse off is assumed to increase/decrease utility Utility Analysis The analysis of consumer decision making based on utility maximization Util A representative unit by which utility is measured

Marginal Utility Theory The change in total utility due to a one- unit change in the quantity of a good or service consumed Marginal utility = Change in total utility Change in number of units consumed Chapter 21 - Consumer Choice

Graphical Analysis We can appreciate total and marginal utility by using graphical analysis.

Total and Marginal Utility of Downloading and Listening to Digital Music Albums

Total and Marginal Utility of Downloading and Listening to Digital Music Albums Chapter 21 - Consumer Choice

Total and Marginal Utility of Downloading and Listening to Digital Music Albums

Total and Marginal Utility of Downloading and Listening to Digital Music Albums Total utility is maximized... …where marginal utility equals zero.

Graphical Analysis Observations Marginal utility falls as more is consumed. Marginal utility equals zero when total utility is at its maximum.

Diminishing Marginal Utility The principle that as more of any good or service is consumed, its extra benefit declines Increases in total utility from consumption of a good or service become smaller and smaller as more is consumed during a given time period.

Newspaper Vending Machines versus Candy Vending Machines How many people take more than one paper from the vending machine? Why not dispense candy the same way? The answer is found in the concept of diminishing marginal utility.

Combining the Budget constraint and Preferences Marginal Utility Tells us about a person’s preferences Budget Constraint Which combinations of goods s/he can afford Combining both preferences and budget constraint can yield an individual’s utility-maximising choice

Illustration Go back to Kofi and his consumption of concerts and movies Same information about his budget constraint Entertainment budget, prices of movies and concerts Additional information about preferences

The Budget Constraint and Preferences Kofi Consumption Possibilities with Income of Ghc150 per month Point on Budget line Concerts at Ghc30 Movies at Ghc10 No. of concerts / month MU from last concert (MU) MU per Ghc spent on last concert (MU/P) No. of Movies / month MU from last movie (MU) MU per Ghc spent on last movie (MU/P) A - 15 50 5 B 1 1500 12 100 10 C 2 1200 40 9 150 D 3 600 20 6 200 E 4 450 350 35 F 360

Budget Constraint and Preferences MU/P is marginal utility per Ghc spent by Kofi on concerts or movies Gain in utility for each Ghc Kofi spends on each good MU/P also decreases with increases in consumption Why?

Budget Constraint and Preferences Kweku’s aim is to find affordable combination of movies and concerts that gives him highest possible utility This is where the marginal utility per Ghc is the same for both goods i.e. (MU/P) movies = (MU/P) concerts Why is this so?

The Budget Constraint and Preferences Kweku Consumption Possibilities with Income of Ghc150 per month Point on Budget line Concerts at Ghc30 Movies at Ghc10 No. of concerts / month MU from last concert (MU) MU per Ghc spent on last concert (MU/P) No. of Movies / month MU from last movie (MU) MU per Ghc spent on last movie (MU/P) A - 15 50 5 B 1 1500 12 100 10 C 2 1200 40 9 150 D 3 600 20 6 200 E 4 450 350 35 F 360

The Budget Constraint and Preferences Kweku will continue to shift consumption until he is at point D. 15 A (MU/P)c= 40; (MU/P)m= 15 Movies per month 12 B 9 C (MU/P)c= 20; (MU/P)m= 20 (MU/P)c= 15; (MU/P)m= 35 6 D E 3 F 1 2 3 4 5 Concerts Per month

Budget Constraint and Preferences Generalization For any two goods x and y, with prices Px and Py, Whenever MUx/Px > MUy/Py, A consumer is made better off by shifting spending away from y and towards x .....And vice-versa

Budget Constraint and Preferences Further Generalization A utility-maximising consumer will choose a point on the budget line where marginal utility per dollar is the same for both goods

Marginal Utility (MU) versus Marginal Utility per Price (MU/P) Shouldn’t a consumer spend whenever marginal utility is greater? Suppose individual likes private jets and wrist watches. MU for private jet is 2000utils; MU for a watch is 1000utils. Should funds be diverted to private jets or wrist watches? What if private jet costs Ghc200 but wrist watches cost Ghc20? Is your answer the same?

Marginal Utility (MU) versus Marginal Utility per Price (MU/P) Shouldn’t a consumer spend whenever marginal utility is greater? No! Why? Private jet rides give twice as much additional satisfaction… … but cost 10 times more than wrist watches Give up 10 wrist watches for a single private jet ride Additional utility from spending Ghc1 on watches is 50; only 10 from private jets Spend on wrist watches Private Jet Wrist watch MU 2000 1000 P 200 20 MU/P 10 50

What happens when things change? Changes in Income Suppose Kofi’s income increases to Ghc300? What do you think will happen to his budget line?

The Budget Constraint and Preferences Kweku Consumption Possibilities with Income of Ghc300 per month Concerts at Ghc30 Movies at Ghc10 No. of concerts / month MU from last concert (MU) MU per Ghc spent on last concert (MU/P) No. of Movies / month MU from last movie (MU) MU per Ghc spent on last movie (MU/P) 3 600 20 21 2 4 450 15 18 30 5 360 12 50 6 300 10 100 7 180 9 150

The Budget Constraint and Preferences Movies per month At H, what type of a good is concerts? Movies? At point J, what type of a good is concerts? Movies? At K, what type of a good is concerts? Movies? K 27 H 12 D 6 J 3 3 6 9 Concerts Per month

The Budget Constraint and Preferences Change in income A rise in income with no change in prices leads to a new quantity demanded for each good. Whether a particular good is normal (increase in quantity demanded) or inferior (quantity demanded decreases) depends on the individual’s preferences

The Budget Constraint and Preferences Change in income A rise in income with no change in prices leads to a new quantity demanded for each good. Whether a particular good is normal (increase in quantity demanded) or inferior (quantity demanded decreases) depends on the individual’s preferences

The Budget Constraint and Preferences Change in income A rise in income with no change in prices leads to a new quantity demanded for each good. Whether a particular good is normal (increase in quantity demanded) or inferior (quantity demanded decreases) depends on the individual’s preferences

What happens when Things Change? Change in Price What happens to Kofi’s consumption when the price of a concert decreases from Ghc30 to Ghc10 Assume income and price of movies remains constant

The Budget Constraint and Preferences Kweku Consumption Possibilities with Income of Ghc150 per month Concerts at Ghc10 Movies at Ghc10 No. of concerts / month MU from last concert (MU) MU per Ghc spent on last concert (MU/P) No. of Movies / month MU from last movie (MU) MU per Ghc spent on last movie (MU/P) 3 600 60 12 100 10 4 450 45 11 120 5 360 36 135 13.5 6 300 30 9 150 15 7 180 18 8 190 19 200 20 67.5 6.75 210 21

Deriving the Demand Curve What happens if price of concerts falls further to Ghc5? Illustrate with diagram Each time the price of concerts changes, so does quantity demanded of concerts

Deriving the demand Curve Movies per month 10 8 6 Price per Concert 3 7 10 15 30 Concerts Per month 30 10 5 3 7 10 Concerts Per month

Next Class Indifference Theory Diminishing marginal rate of substitution consumer equilibrium price consumption curve income consumption curve Derivation of the consumer’s demand curve