MICROECONOMICS: Theory & Applications Chapter 3 The Theory of Consumer Choice By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 9th Edition, copyright 2006 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) John Wiley & Sons, Inc. Copyright 2006

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. John Wiley & Sons, Inc. Copyright 2006

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. John Wiley & Sons, Inc. Copyright 2006

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 John Wiley & Sons, Inc. Copyright 2006

Consumer Preferences Graphed as Indifference Curves Indifference curve – plots all the market baskets that a consumer views as being equally satisfactory Figure 3.1 John Wiley & Sons, Inc. Copyright 2006

Characteristics of Indifference Curves An indifference curve has a downward slope if the good is 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. John Wiley & Sons, Inc. Copyright 2006

Curvature of Indifference Curves Indifference curves are convex to the origin. Why? Diminishing marginal rate of substitution: a consumer’s willingness to give up less and less of some other good to obtain still more of the first good Figure 3.4 John Wiley & Sons, Inc. Copyright 2006

Individuals Have Different Preferences [Figure 3.5] John Wiley & Sons, Inc. Copyright 2006

Graphing Economic Bads and Economic Neuters [Figure 3.6] John Wiley & Sons, Inc. Copyright 2006

Perfect Substitutes and Complements [Figure 3.7] John Wiley & Sons, Inc. Copyright 2006

The Budget Constraint [Figure 3.8] John Wiley & Sons, Inc. Copyright 2006

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 John Wiley & Sons, Inc. Copyright 2006

Shifts in Budget Lines A change in income with constant prices produces a parallel shift in the budget line. 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. John Wiley & Sons, Inc. Copyright 2006

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 John Wiley & Sons, Inc. Copyright 2006

A Corner Solution The consumer’s optimal choice is not characterized by an equality between the MRS and the price ratio. Figure 3.12 John Wiley & Sons, Inc. Copyright 2006

The Composite-Good Convention [Figure 3.13] John Wiley & Sons, Inc. Copyright 2006

Changes in Income and Consumption Choices Income-consumption curve: the curve that joins all the optimal consumption points generated by varying income The curve slopes upward for normal goods. Figure 3.14 John Wiley & Sons, Inc. Copyright 2006

Income-consumption Curve for an Inferior Good The curve slopes downward for normal goods. Figure 3.15 John Wiley & Sons, Inc. Copyright 2006

The Food Stamp Program [Figure 3.16] John Wiley & Sons, Inc. Copyright 2006

Are People Selfish? [Figure 3.18] John Wiley & Sons, Inc. Copyright 2006

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. John Wiley & Sons, Inc. Copyright 2006

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. John Wiley & Sons, Inc. Copyright 2006

Copyright 2006 John Wiley & Sons, Inc. All rights reserved Copyright 2006 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein. John Wiley & Sons, Inc. Copyright 2006