1. Consumer Choice Theory

2. Consumer Choice You are constantly making economic decisions
trivial;may have profound impact
Involves spending
Other economic choices (not so obvious)
involve allocation of time
To understand the choices that pple make, we must understand what they are trying to achieve and the limitations that they face
Specific goals and specific constraints
Generally, we are all very much alike; maximize satisfaction; come up against some limitations
Constraints
Too little income or wealth
Too little time to enjoy it all
Consumer theory: choices about spending-
The theory of individual decision making- how pple decide what to buy

3. The Budget Constraint Two facts of economic life
Pay for goods and services bought
Limited funds to spend
These two facts are summarized by the budget constraint
A consumer’s budget constraint identifies combinations of goods and services the consumer can afford with a limited budget

4. The Budget Constraint Budget line
Graphical representation of a budget constraint
Slope of the budget line
Trade-off between one good and another
Amount of one good that must be sacrificed in order to buy more of another good
Assume the price of movie tickets $10 and concert ticket is $30

5. The Budget Constraint Figure 1 The Budget Constraint
Number of Concerts per Month
Number of Movies per Month 15 12 9 6 3 1 2 4 5 A
With $150 per month, Kofi can afford 15 movies and no concerts, . . . B
12 movies and 1 concert or any other combination on the budget line. G
Points below the line are also affordable. C H
But not points above the line. D E F

6. The Budget Constraint

7. Changes in the Budget Line
To draw the budget line, we were given prices of movie and concert tickets as well as Kofi’s income
These ‘givens’ are always constant as we move along the budge line
If any of one these ‘givens’ change, the budge line will change as well.
Changes in income – bodily shift in the budget line
Income increase - upward-rightward shift
Income decrease - downward-leftward shift
Do not affect the budget line’s slope
Changes in price – rotate the budget line
The slope changes
One of the intercepts changes

8. Changes in the Budget Line
Figure 2 Changes in the Budget Line (a) assume Kofi’s income doubles
Number of Concerts per Month 5 15
Number of Movies per Month 30 10
1. An increase in income shifts the budget line rightward, with no change in slope.

9. Changes in the Budget Line
Figure 2 Changes in the Budget Line (b) price of movie falls from $10 to $5
Number of Concerts per Month 5 15
Number of Movies per Month 30
2. A decrease in the price of movies rotates the budget line upward.

10. Changes in the Budget Line
Figure 2 Changes in the Budget Line (c) price of concert falls from $30 to $10
Number of Concerts per Month 5 15
Number of Movies per Month 30
3. while a decrease in the price of concerts rotates it rightward.

11. Preferences
One common assumption behind consumer theory is that people have preferences
Rational preferences
Any two alternatives can be compared
one is preferred or the two are valued equally
The comparisons are logically consistent (transitive)
If you prefer jollof to red-red, and red-red to waakye,then it must be that you prefere jollof to waakye
rationality in choices is about how you make choices and not what choices you make.
You can be rational even if you like apples better than oranges or oranges better than apples
You can even like chloroquin better than chocolates so far as you are logically consistent with your choices
More is Better
Choose a point on the budget line rather than a point below it

12. Marginal Utility Theory
Economists assume that any decision maker- manager of a business, a consumer or a government is seeking to make the best of any situation
The marginal utility theory treats consumers as striving to maximize their utility
Utility
The quantitative measure of satisfaction or well-being.
Anything that makes the consumer better off/worse off is assumed to increase/decrease utility
Utility Analysis
The analysis of consumer decision making based on utility maximization
Util
A representative unit by which utility is measured

13. Marginal Utility Theory
The change in total utility due to a one- unit change in the quantity of a good or service consumed
Marginal utility =
Change in total utility
Change in number of units consumed
Chapter 21 - Consumer Choice

14. Graphical Analysis
We can appreciate total and marginal utility by using graphical analysis.

15. Total and Marginal Utility of Downloading and Listening to Digital Music Albums

16. Total and Marginal Utility of Downloading and Listening to Digital Music Albums
Chapter 21 - Consumer Choice

17. Total and Marginal Utility of Downloading and Listening to Digital Music Albums

18. Total and Marginal Utility of Downloading and Listening to Digital Music Albums
Total utility is
maximized...
…where marginal
utility equals zero.

19. Graphical Analysis Observations
Marginal utility falls as more is consumed.
Marginal utility equals zero when total utility is at its maximum.

20. Diminishing Marginal Utility
The principle that as more of any good or service is consumed, its extra benefit declines
Increases in total utility from consumption of a good or service become smaller and smaller as more is consumed during a given time period.

21. Newspaper Vending Machines versus Candy Vending Machines
How many people take more than one paper from the vending machine?
Why not dispense candy the same way?
The answer is found in the concept of diminishing marginal utility.

22. Combining the Budget constraint and Preferences
Marginal Utility
Tells us about a person’s preferences
Budget Constraint
Which combinations of goods s/he can afford
Combining both preferences and budget constraint can yield an individual’s utility-maximising choice

23. Illustration
Go back to Kofi and his consumption of concerts and movies
Same information about his budget constraint
Entertainment budget, prices of movies and concerts
Additional information about preferences

24. The Budget Constraint and Preferences
Kofi Consumption Possibilities with Income of Ghc150 per month
Point on Budget line
Concerts at Ghc30
Movies at Ghc10
No. of concerts / month
MU from last concert (MU)
MU per Ghc spent on last concert (MU/P)
No. of Movies / month
MU from last movie (MU)
MU per Ghc spent on last movie (MU/P) A - 15 50 5 B 1
1500 12
100 10 C 2
1200 40 9
150 D 3
600 20 6
200 E 4
450
350 35 F
360

25. Budget Constraint and Preferences
MU/P is marginal utility per Ghc spent by Kofi on concerts or movies
Gain in utility for each Ghc Kofi spends on each good
MU/P also decreases with increases in consumption
Why?

26. Budget Constraint and Preferences
Kweku’s aim is to find affordable combination of movies and concerts that gives him highest possible utility
This is where the marginal utility per Ghc is the same for both goods
i.e. (MU/P) movies = (MU/P) concerts
Why is this so?

27. The Budget Constraint and Preferences
Kweku Consumption Possibilities with Income of Ghc150 per month
Point on Budget line
Concerts at Ghc30
Movies at Ghc10
No. of concerts / month
MU from last concert (MU)
MU per Ghc spent on last concert (MU/P)
No. of Movies / month
MU from last movie (MU)
MU per Ghc spent on last movie (MU/P) A - 15 50 5 B 1
1500 12
100 10 C 2
1200 40 9
150 D 3
600 20 6
200 E 4
450
350 35 F
360

28. The Budget Constraint and Preferences
Kweku will continue to shift consumption until he is at point D. 15 A
(MU/P)c= 40; (MU/P)m= 15
Movies per month 12 B 9 C
(MU/P)c= 20; (MU/P)m= 20
(MU/P)c= 15; (MU/P)m= 35 6 D E 3 F 1 2 3 4 5
Concerts Per month

29. Budget Constraint and Preferences
Generalization
For any two goods x and y, with prices Px and Py,
Whenever MUx/Px > MUy/Py,
A consumer is made better off by shifting spending away from y and towards x
.....And vice-versa

30. Budget Constraint and Preferences
Further Generalization
A utility-maximising consumer will choose a point on the budget line where marginal utility per dollar is the same for both goods

31. Marginal Utility (MU) versus Marginal Utility per Price (MU/P)
Shouldn’t a consumer spend whenever marginal utility is greater?
Suppose individual likes private jets and wrist watches.
MU for private jet is 2000utils; MU for a watch is 1000utils.
Should funds be diverted to private jets or wrist watches?
What if private jet costs Ghc200 but wrist watches cost Ghc20?
Is your answer the same?

32. Marginal Utility (MU) versus Marginal Utility per Price (MU/P)
Shouldn’t a consumer spend whenever marginal utility is greater?
No! Why?
Private jet rides give twice as much additional satisfaction…
… but cost 10 times more than wrist watches
Give up 10 wrist watches for a single private jet ride
Additional utility from spending Ghc1 on watches is 50; only 10 from private jets
Spend on wrist watches
Private Jet
Wrist watch MU
2000
1000 P
200 20
MU/P 10 50

33. What happens when things change?
Changes in Income
Suppose Kofi’s income increases to Ghc300?
What do you think will happen to his budget line?

34. The Budget Constraint and Preferences
Kweku Consumption Possibilities with Income of Ghc300 per month
Concerts at Ghc30
Movies at Ghc10
No. of concerts / month
MU from last concert (MU)
MU per Ghc spent on last concert (MU/P)
No. of Movies / month
MU from last movie (MU)
MU per Ghc spent on last movie (MU/P) 3
600 20 21 2 4
450 15 18 30 5
360 12 50 6
300 10
100 7
180 9
150

35. The Budget Constraint and Preferences
Movies per month
At H, what type of a good is concerts? Movies?
At point J, what type of a good is concerts? Movies?
At K, what type of a good is concerts? Movies? K 27 H 12 D 6 J 3 3 6 9
Concerts Per month

36. The Budget Constraint and Preferences
Change in income
A rise in income with no change in prices leads to a new quantity demanded for each good.
Whether a particular good is normal (increase in quantity demanded) or inferior (quantity demanded decreases) depends on the individual’s preferences

37. The Budget Constraint and Preferences
Change in income
A rise in income with no change in prices leads to a new quantity demanded for each good.
Whether a particular good is normal (increase in quantity demanded) or inferior (quantity demanded decreases) depends on the individual’s preferences

38. The Budget Constraint and Preferences
Change in income
A rise in income with no change in prices leads to a new quantity demanded for each good.
Whether a particular good is normal (increase in quantity demanded) or inferior (quantity demanded decreases) depends on the individual’s preferences

39. What happens when Things Change?
Change in Price
What happens to Kofi’s consumption when the price of a concert decreases from Ghc30 to Ghc10
Assume income and price of movies remains constant

40. The Budget Constraint and Preferences
Kweku Consumption Possibilities with Income of Ghc150 per month
Concerts at Ghc10
Movies at Ghc10
No. of concerts / month
MU from last concert (MU)
MU per Ghc spent on last concert (MU/P)
No. of Movies / month
MU from last movie (MU)
MU per Ghc spent on last movie (MU/P) 3
600 60 12
100 10 4
450 45 11
120 5
360 36
135
13.5 6
300 30 9
150 15 7
180 18 8
190 19
200 20
67.5
6.75
210 21

41. Deriving the Demand Curve
What happens if price of concerts falls further to Ghc5?
Illustrate with diagram
Each time the price of concerts changes, so does quantity demanded of concerts

42. Deriving the demand Curve
Movies per month 10 8 6
Price per Concert 3 7 10 15 30
Concerts Per month 30 10 5 3 7 10
Concerts Per month

43. Next Class Indifference Theory
Diminishing marginal rate of substitution
consumer equilibrium
price consumption curve
income consumption curve
Derivation of the consumer’s demand curve