C H A P T E R 6 Prepared by: Fernando and Yvonn Quijano © 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. Consumer Choice

© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 6: Consumer Choice C H A P T E R 6: Consumer Choice 2 of 14 How do you choose?

© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 6: Consumer Choice C H A P T E R 6: Consumer Choice 3 of 14 Consumer Choice Consumer choice theory is based on the notion that consumers do the best they can, given the limitations dictated by their incomes and consumer prices.

© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 6: Consumer Choice C H A P T E R 6: Consumer Choice 4 of 14 Consumer Constraints: The Budget Line Budget line: The line connecting all the combinations of two goods that exhaust a consumer’s budget. Budget set: A set of points that includes all the combinations of goods that a consumer can afford, given the consumer’s income and the prices of the goods. Price ratio: The ratio of the price of one good to the price of a second good; the market trade- off.

© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 6: Consumer Choice C H A P T E R 6: Consumer Choice 5 of 14 Consumer Preferences: Indifference Curves Indifference curve: A curve showing the different combinations of two goods that generate the same level of utility or satisfaction. Utility: The satisfaction experienced from consuming a product.

© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 6: Consumer Choice C H A P T E R 6: Consumer Choice 6 of 14 Consumer Preferences: Indifference Curves Marginal rate of substitution (MRS): The rate at which a consumer is willing to trade or substitute one good for another. The slope of the indifference curve is the marginal rate of substitution between two goods. Superior combinations generate higher utility (point h). Inferior combinations generate lower utility (point r). Equivalent combinations generate the same utility (points on the curve).

© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 6: Consumer Choice C H A P T E R 6: Consumer Choice 7 of 14 Consumer Preferences: Indifference Curves An indifference map shows a set of indifference curves, each with a different level of utility. Utility increases as we move northeasterly to higher indifference curves (from C 1 to C 2 to C 4 and so on).

© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 6: Consumer Choice C H A P T E R 6: Consumer Choice 8 of 14 Maximizing Utility The consumer maximizes utility at tangency of an indifference curve and a budget line (point e). Point z does not exhaust the entire budget. Point b does not lie on the highest indifference curve that can be reached. Point w is desirable but not affordable. Point e generates maximum utility.

© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 6: Consumer Choice C H A P T E R 6: Consumer Choice 9 of 14 The Utility-Maximizing Rule: MRS = Price Ratio Utility-maximizing rule: Pick the affordable combination that makes the marginal rate of substitution equal to the price ratio.

© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 6: Consumer Choice C H A P T E R 6: Consumer Choice 10 of 14 Drawing the Demand Curve At a price of $3 per movie, utility is maximized with 4 movies and 18 books. At a price of $2 per movie, utility is maximized with 7 movies and 16 books.At a price of $2 per movie, utility is maximized with 7 movies and 16 books. The individual demand for movies shows the quantity of movies demanded at each price level.The individual demand for movies shows the quantity of movies demanded at each price level.

© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 6: Consumer Choice C H A P T E R 6: Consumer Choice 11 of 14 Applications of the Consumer Choice Model Music Piracy and Online Music Stores When music is sold as bundles on CDs, the consumer has budget points rather than an entire budget line. Each CD carries 15 songs and has a price of $15, so the consumer buys songs in multiples of 15.

© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 6: Consumer Choice C H A P T E R 6: Consumer Choice 12 of 14 Applications of the Consumer Choice Model Music Piracy and Online Music Stores If songs are sold individually, the consumer has a full budget line and can legally reach his or her ideal combination of 6 songs and 48 arcade games (point i).

© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 6: Consumer Choice C H A P T E R 6: Consumer Choice 13 of 14 Applications of the Consumer Choice Model Inflation, the Real-Nominal Principle, and Consumer Choice Inflation does not affect the consumer’s decision because it does not affect the budget set. This is an application of the real-nominal principle. The REAL-NOMINAL Principle What matters to people is the real value of money or income—its purchasing power— not the “face” value of money or income.

© 2006 Prentice Hall Business Publishing Economics: principles and tools Arthur O’Sullivan, Steven M. Sheffrin—4 th ed. C H A P T E R 6: Consumer Choice C H A P T E R 6: Consumer Choice 14 of 14 Applications of the Consumer Choice Model The Equimarginal Rule If the marginal benefit per dollar spent on one thing exceeds the marginal benefit per dollar spent on a second, do more of the first and less of the second. To get the best possible combination of the two things, pick the mix that equalizes the marginal benefit per dollar spent.