NHM 373: Consumer EconomicsMicroeconomics and BehaviorChapter Five: Consumer Equilibrium

Economic Puzzle Why doesnt Food Stamp increase food demand?

Utility Utility: a measure of the relative satisfaction or desiredness from consumption Marginal Utility (MU): The gain in utility a person gets from the last unit of a good or service consumed, other things being equal. We make two assumptions about utility Diminishing marginal Utility Positive Marginal Utility

Diminishing MU: Too much of one thing? As you increase consumption of a product, you get less and less marginal utility from consuming each additional unit of that product. Example: All-you-can-eat buffet

Diminishing MU

Positive MU: The More, The BetterZ is preferred to A because it has more of each good than A has. For the same reason, A is preferred to W. It follows that on the line joining W and Z there must be a bundle B that is equally attractive as A. In similar fashion, we can find a Bundle C that is equally attractive as B.

QuestionSuppose you are eating hamburgers. The first hamburger gives you 15 utils of satisfaction, the second hamburger 8 additional utils, and the third brings the total utilty to 29. What was the Marginal Utility of the third hamburger?A. 6

Indifference Curve In a world of two goods, consumer preference between the two alternatives can be visually mapped. Since several different bundles can be equally satisfying, a curve can be defined by connecting a set of bundles among which the consumer is indifferent.

For Examplean indifference curve is a set of bundles that the consumer considered equally attractive. Any bundle, such as L, that lies above an indifference curve is preferred to any bundle on the indifference cure. Any bundle on the indifference curve, in turn, is preferred to any bundle, such as K, that lies below the indifference curve.

A Set of Indifference Curves A consumers preference can be represented by a set (or a family) of indifference curves. Four properties of Indifference Curves1. Have a negative slope (willing to give up some to get more of other goods)2. Further from the origin (0,0) preferred (the more, the better)3. Convex toward 0 (decreasing marginal utility)4. Indifference curves cannot cross.

Satisfaction Can Be Mapped as ContoursThe entire set of a consumers indifference curves is called the consumers indifference map. Bundles on any indifference curve are less preferred than bundles on a higher indifference curve, and more preferred than bundles on a lower indifference curve.

Just like a contour map

Why Two Indifference Curves Cannot CrossIf indifference curves were to cross, they would have violate at least one of the assumed properties of preference orderings.

Slope of the Indifference Curve Marginal Rate of Substitution (MRS) Slope of the indifference curve at a given point Willingness to trade between food and shelter MRS at any point along an indifference curve is defined as the absolute value of the slope of the indifference curve at that point. It is the amount of food the consumer must be given to compensate for the loss of 1 unit of shelter.

Diminishing Marginal Rate of SubstitutionThe more food the consumer has, the more she is willing to give up to obtain an additional unit of shelter. The marginal rates if substitution at Bundles A,C, and D are 3, 1, and respectively.

People with Different TastesRelatively speaking, Tex us a potato lover; Mohan, is a rice lover. This difference shows up in the fact that at any given bundle Texs marginal rate of substitution of potatoes for rice is smaller than Mohans.

Consumer Equilibrium Best affordable Bundle The consumption bundle that maximizes satisfaction under income and price constraint Among all affordable bundles, you would want to choose the one that makes you most satisfied. In the graph, the equilibrium is where the budget line and the indifference curve are tangent to each other. Best: it is on the highest attainable indifference curve. Affordable: it is still on the budget line

Consumer Equilibrium: The Best Affordable BundleThe best the consumer can do is to choose the bundle on the budget constraint that lies on the highest attainable indifference curve. Here, that is bundle F, which lies at a tangency between the indifference curve and the budget constraint.

Now Consider Food Stamps Suppose a person with an income of $400/m receives $100/m worth of food stamps, or $100/m cash allowance Would the consumer be better off if he is given cash? (= Which would give him a higher level of satisfaction, cash or food stamps?) Would the program goal be better achieved with food stamp? Can food stamp make people spend more money on food than cash allowance can?

Food Stamps vs. Cash ProgramBy comparison with the budget constraint under a cash grant (AE), the budget constraint under food stamps (ADF) limits the amount that can be spent on nonfood goods. But for the consumer whose indifference map is shown, the equilibrium bundles are the same under both programs.

Initial income $400 Price of food: Px AE: Budget constraint under cash program ADF: Budget constraint under food stamp.

Comparison of the Two Programs For Y < $400, the budget constraint under food stamps is exactly the same as the budget constraint under the cash program. Both programs will move the consumer choice from J Lets the customer attain the same level of utility (I2) Increase both food and non-food consumption Not all $100 value is spent on food only, even with Food stampsThen, what is the difference? The difference: with the food stamp program, the consumer is not able to buy $500 of nongood goods. A kinked budget constraint Is it possible that some customers prefer cash to food stamps?For the consumer whose indifference map is shown, a cash grant would be preferred to food stamps, which force him to devote more to food than he would choose to spend on his own. The only case where food stamps are different from cash is when you normally consume less than the food stamps. If given cash, change from J L If given Food Stamps, change from J D In this last case, the food stamps program causes the recipient to increase food consumption more than the cash program sold. For the majority of food stamp participants, food stamp covers only (small) part of food expenditures. Therefore, the effect of of foods stamp would be the same as the effect of cash program.

Policy Choice Economic choice model suggests giving cash may be better than giving a gift The budget constraint shows that not being able to use stamps to buy other things is a meaningless restriction On efficiency grounds, cash assistance might be a simpler program achieving is equivalent (or better) effect. Then why did Congress not decide to just give cash?

Mathematical Representation of Consumer equilibrium Tangency condition revisited At equilibrium, the slope of the budget line equals the slope of indifference curve Opportunity Cost = MRS Opportunity Cost: slope of the budget line Marginal Rate of Substitution (MRS): slope of the indifference curve Px = MUX PY MUY

Utility Maximizing Rule at Consumer Equilibrium Given positive and declining marginal utility, the utility maximizing consumer buys goods X and Y at prices PX and PY such thatMUX =MUPXPxPy This is, a rational consumer focuses on the last unit of goods being purchased and make sure that the utility from the dollar spent on the last unit of each good to be the same.

QuestionJane decides to buy a $75 ticket to a particular professional hokey game rather than a $50 ticket for a particular Broadway play. We can conclude that Jane:

A consumer is choosing between books and movies. The price of a book is 10 and the price of the movie is 5. The marginal rate of substitution is 4, with books on the horizontal axis and movies on the vertical axis. The consumer is purchasing:

Suppose it costs Frank $3 to go to the club, and $6 to go to the game (Px = 3, Py = 6). How many nights in one week.

How does a price change affect consumer choice? Price changes affect customers in two ways: Income Effect A decline in the price of any product will make the household better off, all else equal. The change in consumption of the good due to this improvement in the households purchasing power is called income effect. Substitution Effect A decline in the price of a product, that product becomes relatively cheaper, becoming more attractive relative to potential substitutes. The change in consumption of the good due to changes in its relative attractiveness compared to alternatives is called substitution effect.

Substitution and Income effects

When price of shelter goes up, Budget line changes from B0 B1 Equilibrium moves from A D A C BY SUSTITUTION EFFECT C D by Income Effect

Income and Substitution Effects for a Normal Good

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