1. PPA 723: Managerial Economics
Lecture 7:
Consumer Choice

2. Managerial Economics, Lecture 7: Consumer Choice
Outline
Consumer Utility Maximization
Application to Food Stamps

3. Managerial Economics, Lecture 7: Consumer Choice
Review: Preferences
Indifference curve map summarizes preferences.
Higher indifference curves indicate higher utility.
Marginal utility = extra utility from one more unit of a good holding constant consumption of all other goods.
Slope of an indifference curve = marginal rate of substitution (MRS) = MUB/MUA.

4. Managerial Economics, Lecture 7: Consumer Choice
Review: Budget Constraints
A consumer's opportunity set increases with income and decreases with prices.
A budget constraint shows bundles that a consumer can buy by spending all of his or her income at given prices.
The slope of budget line = marginal rate of transformation (MRT) = PB/PA = rate at which Good A can be exchanged for Good B.

5. Managerial Economics, Lecture 7: Consumer Choice
Budget Line Meets Indifference Curves
Households maximize utility subject to their budget constraint.
There are two possibilities for the optimal bundle:
an interior solution: buy some units of all goods.
a corner solution: buy only one good.

6. Managerial Economics, Lecture 7: Consumer Choice
Interior Solution
The consumer buys some of all goods.
The optimum bundle is where highest indifference curve just touches the budget line—but does not cross it!
This is a tangency point.

7. Managerial Economics, Lecture 7: Consumer Choice
Figure 4.8a Consumer Maximization B
, Burritos
Budget line
per semester
(a) Interior Solution g
Optimal Bundle 25 c f 20 B e 10 I 3 d a I 2 A I 1 10 30 50 Z
, Pizzas per semester

8. Managerial Economics, Lecture 7: Consumer Choice
Tangency Property
The tangency of the indifference curve and the budget line implies that:
The last dollar spent on pizza gives as much extra utility as that spent on burritos

9. Managerial Economics, Lecture 7: Consumer Choice
Summary: Utility Maximized
To maximize their well-being subject to their budget, consumers pick the point where the highest possible indifference curve hits budget constraint.
This indifference curve is tangent to budget constraint, which implies that MRS = MRT
The last dollar spent on one good gives as much extra utility as the last dollar spent on any other consumed good.

10. Managerial Economics, Lecture 7: Consumer Choice
Marginal Conditions
This rule provides the introduction to a very different way of thinking:
The best choice requires getting things right at the margin.
Consumers maximize their utility when they cannot gain by fiddling with their choices at the margin.
No gain from further fiddling is equivalent to finding the overall utility maximum!

11. Managerial Economics, Lecture 7: Consumer Choice
Marginal Conditions and Public Administration
The use of marginal conditions is a critical management tool.
As a manager, your best choices will involve getting the same marginal return per dollar from all activities or purchases.
To maximize any objective, make sure you can’t fiddle any more at the margin.
No gain from further fiddling is equivalent to finding your overall maximum!

12. Managerial Economics, Lecture 7: Consumer Choice
Optimal Bundle: Corner Solution
The optimal bundle is still at the point where highest indifference curve touches budget line.
But this point is at a “corner” where only one good is consumed.
The indifference curve and budget line are not tangent at the optimal bundle.

13. Managerial Economics, Lecture 7: Consumer Choice
Figure 4.8b Consumer Maximization
(b) Corner Solution B
, Burritos
per semester
Optimal Bundle e 25 I 3 I 2
Budget line I 1 50 Z
, Pizzas per semester

14. Managerial Economics, Lecture 7: Consumer Choice
Solved Problem: Food Stamps
Are poor people better off receiving food stamps or a comparable amount of cash?

15. Managerial Economics, Lecture 7: Consumer Choice
Answer
Cash gives recipients more choice.
Whether that greater choice matters depends on the recipients tastes or, roughly, on how much food they eat.

16. Managerial Economics, Lecture 7: Consumer Choice
Figure Food Stamps Versus Cash
All other goods
per month
Budget line with cash Y +
100 f C e Y I 3 d I 2 I 1 B
Budget line with
food stamps A
Original
budget line
100 Y Y +
100
Food per month

17. Managerial Economics, Lecture 7: Consumer Choice
Food Stamps Versus Cash, Continued
All other goods
per month
Budget line with cash Y +
100 f C e Y I 3 d
Household 1 I 2 I 1
I 2*
Household 2 B
I 1* A
Budget line with
Original
food stamps
budget line 50
100
150
160 Y Y +
100
Food per month

18. Managerial Economics, Lecture 7: Consumer Choice
Cash vs. In-Kind Transfers: Lessons
Cash and in-kind transfers of Good A are equivalent unless the in-kind transfer is large relative to the recipient’s initial consumption of Good A.
If the in-kind transfer is large relative to initial consumption, then
the cash transfer leads to higher utility, and
the in-kind transfer leads to more consumption of Good A.

19. Managerial Economics, Lecture 7: Consumer Choice
A Price Subsidy and an Equal-Cost Cash Grant
Food
Clothing F1 F3 F2
Budget Line with
Cash Grant
Cost of Both Programs
(in Units of Food)
Tangency Point
with Price Subsidy I3 I2 I1
Budget Line with Price Subsidy
with Cash Grant

20. Managerial Economics, Lecture 7: Consumer Choice
Cash vs. a Price Subsidy: Lessons
A cash transfer and an equal-cost price subsidy have the same income effect, but the price subsidy also has a price effect.
It follows that
the cash transfer leads to higher utility, and
the price subsidy leads to more consumption of the subsidized good.