1. RATIONAL CONSUMER CHOICE

2. Drawing on Chapter 3
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3. Rational Choice Model given 1. Possibilities 2. Preferences
opportunity set of quantities, bought with income M at prices P
2. Preferences
preference ordering (indifference curves) or utility function
and 3. Rationality,
seeking the best affordable bundle of quantities
we 4. Predict choices
of quantities

4. 2. Preferences Preference Orderings Definition Assumed Properties
Personal ranking of all possible combinations (bundles) of goods
E.g., A is preferred to B, or vice versa, or the person is indifferent between them
Assumed Properties
Complete
More is better
Transitive
Convex (more variety or balance is better)

5. Figure 3-8: Generating Equally Preferred Bundles

6. Indifference Curves Definition Implied Properties
A set of equally preferred bundles of goods
I.e., the person is indifferent between them
Implied Properties
Every bundle is on one
Negative slope
Cannot cross
Diminishing |slope|

7. Marginal Rate of Substitution (MRS)
The maximum rate at which a person is willing to give up one good to get another
The |slope| of the indifference curve
when substituting the good on the horizontal axis for the good on the vertical axis
where the curve is smooth (differentiable).
Its smoothness can be another assumption
Often written as negative, the slope of the indifference curve

8. Diminishing Marginal Rate of Substitution

9. Figure 3-12: The Marginal Rate of Substitution

10. Representing Different Preferences
Indifference curves with
Differences in slope (MRS) at a given bundle mean different relative preferences for the two goods
Different curvatures (rates at which MRS diminishes) mean different degrees of preference for variety

11. Extreme Preferences

12. 3. Rationality Rational Choice
Choose more of a good if the benefit exceeds the cost and it is affordable
Benefit: the most you are willing to give up (MRS)
Cost: the relative price of the good
The best affordable bundle
Usually the only contact of indifference curve and budget constraint
If both choices are positive and if indifference curves are smooth, I and B are tangent (have the same slope): MRS = relative price

13. Figure 3-15: The Best Affordable Bundle
4. Predict
Figure 3-15: The Best Affordable Bundle

14. Figure 3-16: A Corner Solution

15. Choice among Perfect Substitutes
Suppose
Water budget M=$4.80/week
Prices P1A= $0.80/btl. and PD=$.60/btl.
What is the best affordable bundle?
What if P2A= $0.48/btl. and PD=$.60/btl.?

16. Choice among Perfect Complements
Suppose
Food budget M=$3/meal
Prices PB= $0.75/brat and PN=$.75/bun
What is the best affordable choice?
What if the
Food budget doubled?
Prices were $1.00/brat and $.50/bun?

17. Figure 3-18: Food Stamp Program vs. Cash Grant Program

18. Figure 3-19: Where Food Stamps and Cash Grants Yield Different Outcomes