Consumer Choice CHAPTER © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Budget Constraint Budget constraint Budget line Different combinations of goods A consumer can afford with a limited budget At given prices Budget line Graphical representation of a budget constraint Maximum affordable quantity of one good, for given amounts of another good © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Budget Constraint Max Relative price Total entertainment budget = $100 per month Price of a movie = $10 Price of a concert = $20 Relative price Price of one good relative to the price of another © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 The Budget Constraint © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 The Budget Constraint With $100 per month, Max can afford 10 movies and no concerts, . . . Number of Concerts per Month Number of Movies per Month A 10 5 8 movies and 1 concert or any other combination on the budget line. B 8 1 C But not points above the line. 6 H 2 D 4 G Points below the line are also affordable. 3 E 2 4 F © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Budget Constraint If Then, Px/Py is Py: price of the good on the vertical axis Px: price of the good on the horizontal axis Then, Px/Py is The relative price of good X The opportunity cost of one more unit of good X The absolute value of the slope of the consumer’s budget line © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes in the Budget Line Changes in income An increase in income will shift the budget line upward (and rightward) A decrease in income will shift the budget line downward (and leftward) These shifts are parallel Changes in income do not affect the budget line’s slope © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Changes in the Budget Line Changes in price The budget line rotates The slope of the budget line changes One of the intercepts of the budget line changes © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Changes in the Budget Line Number of Concerts per Month Number of movies per month (a) Number of Concerts per Month Number of movies per month (b) Number of Concerts per Month Number of movies per month (c) 1. An increase in income shifts the budget line rightward, with no change in slope. 10 20 20 2. A decrease in the price of movies rotates the budget line upward . . . 3. While a decrease in the price of concerts rotates it rightward 5 10 5 10 5 10 10 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Preferences Rational preferences satisfy two conditions: Any two alternatives can be compared, and one is preferred or else the two are valued equally The comparisons are logically consistent or transitive More is better Always choose a point on the budget line, rather than a point below it © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Marginal Utility Approach Quantitative measure of pleasure/ satisfaction obtained from consuming goods and services Marginal utility Change in total utility From consuming an additional unit of a good or service © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Total and Marginal Utility © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Total and Marginal Utility Ice cream cones per week Utils 10 20 30 40 50 60 70 1 2 3 4 5 6 Total Utility 1. The change in total utility from one more ice cream cone . . . Ice cream cones per week Utils 10 20 30 1 2 3 4 5 6 2. Is called the marginal utility of an additional cone. 3. Marginal utility falls as more cones are consumed. Marginal Utility © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Marginal Utility Approach Law of diminishing marginal utility As consumption of a good or service increases, marginal utility decreases Marginal utility Can be zero Assumption Marginal utility for every good is positive ‘More is better’ © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Marginal Utility Approach Utility maximization Consumer will choose the point on the budget line Where marginal utility per dollar is the same for both goods: MUx/Px = MUy/Py There is no further gain from reallocating expenditures in either direction © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 Total and Marginal Utility of Concerts and Movies © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Consumer Decision Making © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Consumer Decision Making Number of Concerts per Month Number of Movies per Month 8 1 2 6 4 3 10 5 A B C D G E F The budget line shows the maximum number of movies Max could attend for each number of concerts he attends. He would never choose an interior point like G because there are affordable points—on the line—that make him better off. Max will choose the point on the budget line at which the marginal utilities per dollar spent on movies and concerts are equal. From the table, this occurs at point D. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Marginal Utility Approach A rise in income With no change in prices A new quantity demanded for each good Individual preferences (marginal utility) Normal good – quantity demanded increases Inferior good – quantity demanded decreases © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Effects of an Increase in Income © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Effects of an Increase in Income Number of Concerts per Month Number of Movies per Month 20 10 G H J K L 1. When Max's income rises to $200, his budget line shifts outward. 14 16 18 2. If his preferences are as given in the table, he'll choose point K. 12 A B C D E F 10 5 8 1 6 6 2 7 4 3 8 9 2 4 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

6 Normal and Inferior Goods Number of Concerts per Month Number of Movies per Month 8 1 2 6 4 3 7 9 14 16 18 12 5 10 20 If income rises and concerts are inferior, Max moves to a point like K″ (fewer concerts). K” K K’ A B C D E F If income rises and movies are inferior, Max moves to a point like K′ (fewer movies). © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Marginal Utility Approach Change in prices Decrease in the price of one good Other things constant Rotates the budget line rightward Individual demand curve Quantity of a good a consumer demands at each different price © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7 Deriving the Demand Curve © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

7 Deriving the Demand Curve Number of Concerts per month Number of Movies per Month 4 5 6 10 3 8 20 1. When the price of concerts is $20, point D is best for Max. 2. If the price falls to $10, Max's budget line rotates rightward, and he chooses point R. T R 3. And if the price drops to $5, he chooses point T. D Number of Concerts per month Price per Concert $5 $10 $20 3 5 8 D 4. The demand curve shows the quantity Max chooses at each price R T © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Income and Substitution Effects As the price of a good falls, the consumer substitutes that good in place of other goods whose prices have not changed Arises from a change in the relative price of a good It moves quantity demanded in the opposite direction to the price change © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Income and Substitution Effects Income effect As the price of a good decreases, the consumer’s purchasing power increases Causing a change in quantity demanded for the good Arises from a change in purchasing power over both goods © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Income and Substitution Effects Normal goods Substitution and income effects work together Quantity demanded - moves in the opposite direction of the price Always obey the law of demand © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Income and Substitution Effects Inferior goods Substitution and income effects work against each other Substitution effect virtually always dominates Virtually always obey the law of demand © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

8 Income and Substitution Effects © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Consumers in Markets Market demand curve Horizontally summing the individual demand curves of every consumer in the market Obeys the law of demand Downward sloping © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9 From Individual to Market Demand (a) Price Jerry Price George Price Number of Bottles per Week Price Jerry Number of Bottles per Week Price George Number of Bottles per Week Price Elaine $4 3 2 $4 3 2 $4 3 2 C C’ C” 4 6 1 1 1 8 12 9 12 10 20 The individual demand curves show how much bottled water will be demanded by Jerry, George, and Elaine at different prices. As the price falls, each demands more. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

9 From Individual to Market Demand (b) Number of Bottles per Week Price A $4 3 Market Demand Curve B 3 C 2 10 D 1 27 E 44 The market demand curve in panel (b) is obtained by adding up the total quantity demanded by all market participants at different prices. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Consumer Theory in Perspective Extensions of the model Incorporate choices among many goods Recognize saving and borrowing Incorporate uncertainty and imperfect information Behavioral economics © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Consumer Theory in Perspective Behavioral economics Subfield of economics Decision-making patterns that deviate from those predicted by traditional consumer theory Salience of a particular outcome The extent to which it “jumps out at them” © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Consumer Theory in Perspective Preference for defaults People tend to stick to the default choice Decision-making environment Environment in which a decision is made - can exert a strong and surprising influence Self-binding To a narrower set of choices - long-run good © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Consumer Theory in Perspective Behavioral economics and policy Financial incentive for firms to make “automatic contribution” by employees the default choice People with gambling problems - voluntarily put themselves on a list that bans them from any casino Industry-wide “vanilla” versions of mortgages, student loans, credit card agreements © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Consumer Theory in Perspective Behavioral economics and traditional theory Traditional economic theory: assumes that consumers have rational preferences Behavioral economics: analyzes decisions that violate rational preferences © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Model of consumer choice Improving Education Model of consumer choice Student’s time allocation problem Only two activities: studying economics and studying French Each of these activities costs time Students “buy” points on their exams with hours spent studying © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Student’s time allocation problem Improving Education Student’s time allocation problem Opportunity cost of scoring better in French Scoring lower in economics Slope of budget line = -PF/PE = -2 Each additional point in French: sacrifice 2 points in economics © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

New computer-assisted technique in French class Improving Education New computer-assisted technique in French class Learn more French with the same study time or to study less and learn the same amount A decrease in the price of French points Budget line rotates outward © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

10 Time Allocation French score Economics score 90 70 80 75 (a) (b) F E C D C Panel (a) shows combinations of French and economics test scores that can be obtained for a given amount of study time. The slope of −2 indicates that each additional point in French requires a sacrifice of 2 points in economics. The student chooses point C. Panel (b) shows that computer-assisted French instruction causes the budget line to rotate outward; French points are now less expensive. The student might move to point D, attaining a higher French score. Or she might choose F, using all of the time freed up in French to study economics. Or she might choose an intermediate point, such as E. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Indifference Curve Approach Assumptions Rational preferences: an individual can compare any two options and decide which is best Makes choices that are logically consistent An individual prefers more of every good to less Consumer - choose to be on budget line, rather than below it © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Marginal rate of substitution, MRSy,x An Indifference Curve An indifference curve All combinations of two goods that make the consumer equally well off Slopes downward Marginal rate of substitution, MRSy,x Of good y for good x along any segment of an indifference curve Is the maximum rate at which a consumer would willingly trade units of y for units of x © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Number of Concerts per Month A.1 An Indifference Curve Number of Concerts per Month Number of Movies per Month 6 3 4 11 20 1 2 5 If Max gets another concert . . . +1 G -9 He could give up 9 movies and be just as satisfied. +1 H -5 +1 J -2 +1 K -1 L © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

MRS at any point on the indifference curve An Indifference Curve MRS at any point on the indifference curve The (absolute value of) the slope of the curve at that point Maximum rate at which a consumer would willingly trade good y for a tiny bit more of good x © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Indifference Map Indifference map A set of indifference curves that describe one persons’ preferences Any point on a higher indifference curve is preferred to any point on a lower one © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Number of Concerts per Month A.2 An Indifference Map Number of Concerts per Month Number of Movies per Month 6 11 20 1 2 3 1.Max prefers any point on this indifference curve… G H J R S 2.to any point on this one. 3.And any point on this curve is preferred to any point on the other two. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Consumer Decision Making Optimal combination of goods The point on the budget line where an indifference curve is tangent to the budget line That combination on the budget line for which MRSy,x = Px/Py © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A.3 Consumer Decision Making with Indifference Curves Number of Movies per Month Number of Concerts per Month 6 10 1 2 3 4 5 8 A B 2. But point D (also affordable) is preferred because it is on a higher indifference curve. 1. Points B and E are affordable . . . D E © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What Happens When Things Change? A rise in income With no change in prices Leads to a new quantity demanded for each good Quantity demanded increases (normal good) Quantity demanded decreases (inferior good) Depends on the individual’s preferences Indifference map © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A.4 An Increase in Income Number of Concerts per Month Number of Movies per Month 8 4 3 6 5 10 20 1. When Max's income rises to $200, his budget line shifts outward. 2. With the preferences represented by these indifference curves, he'll choose point H. 3. In this case, both movies and concerts are normal goods for Max. H D © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A.4 An Increase in Income Number of Concerts per Month Number of Movies per Month 2 4 3 9 5 10 20 8 6 5. Concerts would be normal for Max, but movies would be inferior. 4. But if Max instead had these indifference curves, he would choose point H’ . . . D H’ © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What Happens When Things Change? Changes in price Budget line rotates Quantity demanded changes Downward sloping demand curve © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

A.5 Deriving the Demand Curve with Indifference Curves Number of Concerts per Month Number of Movies per Month 5 4 3 8 10 6 20 1. When the price of concerts is $20, MRSm,c = Pc /Pm at Point D. K 2. But when the price of concerts falls to $10, this condition is satisfied at point J. J D Number of Concerts per Month Price per concert $5 3 8 5 $20 $10 D 3. The demand curve shows the quantity of concerts Max chooses at each price for concerts. J K © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.