PPA 723: Managerial Economics Lecture 7: Consumer Choice

Managerial Economics, Lecture 7: Consumer Choice Outline Consumer Utility Maximization Application to Food Stamps

Managerial Economics, Lecture 7: Consumer Choice Review: Preferences Indifference curve map summarizes preferences. Higher indifference curves indicate higher utility. Marginal utility = extra utility from one more unit of a good holding constant consumption of all other goods. Slope of an indifference curve = marginal rate of substitution (MRS) = MUB/MUA.

Managerial Economics, Lecture 7: Consumer Choice Review: Budget Constraints A consumer's opportunity set increases with income and decreases with prices. A budget constraint shows bundles that a consumer can buy by spending all of his or her income at given prices. The slope of budget line = marginal rate of transformation (MRT) = PB/PA = rate at which Good A can be exchanged for Good B.

Managerial Economics, Lecture 7: Consumer Choice Budget Line Meets Indifference Curves Households maximize utility subject to their budget constraint. There are two possibilities for the optimal bundle: an interior solution: buy some units of all goods. a corner solution: buy only one good.

Managerial Economics, Lecture 7: Consumer Choice Interior Solution The consumer buys some of all goods. The optimum bundle is where highest indifference curve just touches the budget line—but does not cross it! This is a tangency point.

Managerial Economics, Lecture 7: Consumer Choice Figure 4.8a Consumer Maximization B , Burritos Budget line per semester (a) Interior Solution g Optimal Bundle 25 c f 20 B e 10 I 3 d a I 2 A I 1 10 30 50 Z , Pizzas per semester

Managerial Economics, Lecture 7: Consumer Choice Tangency Property The tangency of the indifference curve and the budget line implies that: The last dollar spent on pizza gives as much extra utility as that spent on burritos

Managerial Economics, Lecture 7: Consumer Choice Summary: Utility Maximized To maximize their well-being subject to their budget, consumers pick the point where the highest possible indifference curve hits budget constraint. This indifference curve is tangent to budget constraint, which implies that MRS = MRT The last dollar spent on one good gives as much extra utility as the last dollar spent on any other consumed good.

Managerial Economics, Lecture 7: Consumer Choice Marginal Conditions This rule provides the introduction to a very different way of thinking: The best choice requires getting things right at the margin. Consumers maximize their utility when they cannot gain by fiddling with their choices at the margin. No gain from further fiddling is equivalent to finding the overall utility maximum!

Managerial Economics, Lecture 7: Consumer Choice Marginal Conditions and Public Administration The use of marginal conditions is a critical management tool. As a manager, your best choices will involve getting the same marginal return per dollar from all activities or purchases. To maximize any objective, make sure you can’t fiddle any more at the margin. No gain from further fiddling is equivalent to finding your overall maximum!

Managerial Economics, Lecture 7: Consumer Choice Optimal Bundle: Corner Solution The optimal bundle is still at the point where highest indifference curve touches budget line. But this point is at a “corner” where only one good is consumed. The indifference curve and budget line are not tangent at the optimal bundle.

Managerial Economics, Lecture 7: Consumer Choice Figure 4.8b Consumer Maximization (b) Corner Solution B , Burritos per semester Optimal Bundle e 25 I 3 I 2 Budget line I 1 50 Z , Pizzas per semester

Managerial Economics, Lecture 7: Consumer Choice Solved Problem: Food Stamps Are poor people better off receiving food stamps or a comparable amount of cash?

Managerial Economics, Lecture 7: Consumer Choice Answer Cash gives recipients more choice. Whether that greater choice matters depends on the recipients tastes or, roughly, on how much food they eat.

Managerial Economics, Lecture 7: Consumer Choice Figure 4.10 Food Stamps Versus Cash All other goods per month Budget line with cash Y + 100 f C e Y I 3 d I 2 I 1 B Budget line with food stamps A Original budget line 100 Y Y + 100 Food per month

Managerial Economics, Lecture 7: Consumer Choice Food Stamps Versus Cash, Continued All other goods per month Budget line with cash Y + 100 f C e Y I 3 d Household 1 I 2 I 1 I 2* Household 2 B I 1* A Budget line with Original food stamps budget line 50 100 150 160 Y Y + 100 Food per month

Managerial Economics, Lecture 7: Consumer Choice Cash vs. In-Kind Transfers: Lessons Cash and in-kind transfers of Good A are equivalent unless the in-kind transfer is large relative to the recipient’s initial consumption of Good A. If the in-kind transfer is large relative to initial consumption, then the cash transfer leads to higher utility, and the in-kind transfer leads to more consumption of Good A.

Managerial Economics, Lecture 7: Consumer Choice A Price Subsidy and an Equal-Cost Cash Grant Food Clothing F1 F3 F2 Budget Line with Cash Grant Cost of Both Programs (in Units of Food) Tangency Point with Price Subsidy I3 I2 I1 Budget Line with Price Subsidy with Cash Grant

Managerial Economics, Lecture 7: Consumer Choice Cash vs. a Price Subsidy: Lessons A cash transfer and an equal-cost price subsidy have the same income effect, but the price subsidy also has a price effect. It follows that the cash transfer leads to higher utility, and the price subsidy leads to more consumption of the subsidized good.