section 2-consumer theory and demand

8/8/2019 Section 2-Consumer Theory and Demand

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ECO 301 Intermediate Microeconomics

Consumer Preferences and Demand

Section 2

Chapters 3-4

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Rational Consumer Choice

We assume the consumers make well-defined rational choices in the marketplace

Constrained by resources Clear preferences

The Opportunity or Budget Constraint

Consider 2 goods, Food and Shelter

Choice: Consume all Food (lb/wk) or all Shelter (sq yd/wk) or some combination of

each Assume you have $100/wk in resources

Price of Food $10/lb, Price of Shelter $5/sq yd

If you consume all food you consume 10 lb

If you consume all shelter you consume 20 sq yds

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What combinations are possible: The BudgetLine (B)

The red line shows the combinations of

food & shelter possible at $100

Point E - Unattainable

Point D Only $65 spent

Relative prices determine the slope ofthe line


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Budgets and Affordable Choices

The units consumed are based on a period of time and are consideredflows

Income is also a flow Assets would be considered stocks

what is available at a point in time

Given two goods, the budget constraint is determined by the amount of income (M) and

the monetary cost of food (F) and shelter (S)

PF and PS denote the prices of food and shelter The affordable setare the bundles on or below the budget constraint

The budget constraint must satisfy the following equation

M = PSS + PFF

To represent this so we can show the budget line we need to rearrange the

equation to

The amount of food consumed is determined by the total resources divided by the price

of food and the amount of shelter consumed and the relative price of shelter to food

Change M, PS or PF and the budget line will change (shift or change of slope) 3

M P S

P F P F

F = - S


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Price Change Currently the budget constraint is

Change the price of shelter from $5 to $ 10 and the new budget constraint is

The slope went from -1/2 to -1

The budget line went from B1 to B2 The maximum amount of F consumed does not change but the maximum amount

of S goes from 20 to 10

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100 5

10 10

F = - S

100 10

10 10

F = - S


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Income Change

Suppose income is cut from $100 to $50. The new budget constraint is

The slope remained unchanged at -1/2 The budget line went from B1 to B2, a parallel shift down in the budget line

The maximum amount of F and S are reduced by half

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50 5

10 10F = - S


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Generally, budgets involve more than two choices. This becomes more difficult to graph

because it involves a multidimensional plane

The most we can graph is three dimensions

The solution is the Composite Good

Compare Food (F) to all other goods represented by (X) PX becomes a weighted average price of the composite goods

A change in the price of one of the composite goods changes the average price and

the effects are the same as with a two-good analysis

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Budgets and Affordable ChoicesKinked Budget Constraints

There are times when the budget constraint will be nonlinear

One case is the kinked budget line

Volume discounts

Surcharges after a certain amount of usage (firstXis free and y/unit will cost extra)

Example 3.1 electricity usage

Up to 1000 kilowatt-hours (kWh), the price is $0.10/kWh, after that it is $0.05/kWh

For the first 1000 kWh the opportunity cost is 100 units of Y

For every incremental 1000 kWh consumed the amount of Y given up is 50

For those who use a lot of electricity, they would be more likely to use incrementally

more than those who use less electricity

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Consumer Preferences

One of the fundamental principles in Microeconomics is Consumer Preferences

Given our budget constraints that define our possible choices, our preferences

determine the actual choices made

While we each have unique preferences, in general we tend to have common

preferences, so we can analyze preferences overall

In studying the representative consumer, we can make statements about the bunndlesthey will choose

One key assumption is that consumers have logical Preference Ordering

Bundle A is preferred to bundle B (A > B)

Bundle 2A is preferred to bundle A (2A > A)

There are 4 properties of preference ordering

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Preference Ordering

1. Completeness: The consumer is able to rank all combinations of goods and services

2. More-is-Better: More of a good is preferred to less. However, diminishing marginal

utility means that at some point saturation is reached and no more is preferred

3. Transitivity: Assume 3 bundles A, B, C. If A > B, and B > C, then A > C. The assumption

is that if we have 10 bundles, A to J, and A > C and C> J, then A > J. However, this does

not always occur because not all outcomes relate so logically.

4. Convexity: Mixtures of goods are preferred to extremes. One may be indifferent

between bundle A (4,0) and bundle B (0,4), but will prefer Bundle C (2,2) to either A or

B

This is due to Diminishing Marginal Utility

Given these properties, we can examine bundles and determine the bundles that are

preferred and the bundles that we are indifferent toward

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Indifference Curves

Suppose you have three bundles, A, B and C, and you are indifferent as to which bundle

you choose.

Looking at bundle A, Bundle W is worse, giving less satisfaction (less Food and Shelter).

Bundle Z is better than A (More Food and Shelter)

A consumer is indifferent if the amount of Food she gives up is equal in utility to the

amount of Shelter she gains

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Indifference Curves

We can plot combinations of Food and Shelter where the level of utility is equal and we are

indifferent. This gives us the Indifference Curve

Any bundle along the Indifference Curve I0 is preferred to bundle K and bundle L is

preferred to any bundle along the indifference curve Fig. 3-9

We can create an Indifference Map (Fig 3-10) that shows the indifference curves at verious

levels of satisfaction

Any point on I2 is preferred to any point on I1

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Fig 3-9Fig 3-10


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Trade-Offs between Two Goods

Indifference curves give us the amount of a good we are willing to exchange for another

good to maintain the same level of satisfaction

That is measured by the Marginal Rate of Substitution (MRS)

The MRS is the ratio of the change in F for the change in S

-F/ S

The delta represents a small change in units

The ratio is always negative or at most zero

The MRS changes as we move along the indifference curve due to the convexity property

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Comparing Two Consumers

Two consumers, Tex and Mohan

Because their preferences are different, they have different indifference curves

Tex and Mohan like potatoes, but Mohan likes rice more than Tex

Their MRS will be different. Tex will not be willing to give up as much in potatoes for

rice as Mohan would

When we aggregate preferences for many consumers, the indifference curve will reflect an

weighted average of individual indifference curves and MRS

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The Best Feasible Bundle

The budget line shows us the possible combinations of Food and Shelter we can afford

Indifference curves show is the combinations of Food and Shelter we prefer at a given level

of satisfaction

Put them together and we get the combination of Food and Shelter that we can both afford

and maximize our level of satisfaction (utility) Point F is our optimal point

Points A and E are affordable, but less satisfying

Point D is both less satisfying and less efficient

Point G is unattainable

At point F, the MRS equals the relative prices of Food and Shelter (MRS = PS/PF) 14


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Application of the Rational Choice Model

Is it better to give poor people cash or food stamps?

Give either $100/mo in food stamps or $100/mo in cash

Consumer has $400 initial budget

Which alternative gives us a higher indifference curve?

In Figure 3-18, even though the consumer is constrained, his choices would be the same inthis case

In Figure 3-19, if his indifference curve is such that he would be at point L with cash, but

point D with food stamps. Point D would be on a lower indifference curve, so cash would

be better

However, alcoholics would prefer cash since they cannot buy liquor with food stamps15

Fig 3-18

Fig 3-19


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The Utility FunctionIndifference Curves represent a level of utility. Higher indifference curves reflect a higher

level of utility

Economists use the Utility Function to analyze utility

U(F, S) F=Food and S=Shelter

In reality, utility cannot be directly measured, but it provides a means to understand

exchange Assume U(F, S) = FS

We can graph the various indifference curves

Assuming 1 Util, indifference curve 1 can be represented by S=1/F

More generally it would be S = U0/F

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The Utility FunctionIn order to maintain the same level of utility, the marginal utility (MU) we give up of one

good should equal the marginal utility we gain from the exchange

MUFF = MUFS

Or

MUFMUS = F/S

At the optimal level of utility, given the budget constraint it is also true that

MUFMUS = PF/PS = MRS

While we can create examples using cardinal utility, such as above, because it is not reallypossible to measure utility, so we rely on Ordinal Utility

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A discussion about Incentives

So far we have discussed rational choice from the perspective of satisfaction or utility.

Rational choice also depends on incentives

Paris Hilton pleaded guilty of cocaine possession. Why?

The prosecution charged her with misdemeanor in return for a guilty plea and she

would not go to jail

If she had been charged with a felony, would she have pleaded guilty?

She was given an incentive to plead guilty

We could say that the incentive was a reduced cost or a reduced negative utility for Paris

Hilton

However, would it dissuade Paris Hilton from possessing cocaine in the future?

Many times the benefits are not clear-cut. In Freakonomics, the authors give an example

of a day-care center that fined parent $3 if they were late picking up their children. The

result was that the number of late parents increased

A social incentive (guilt) was replaced with a cost incentive ($3) which parents saw as

cheaper than the guilt they felt

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Indifference Curves and Demand

As prices change, the budget line changes and becomes tangent to a new indifference

curve

New combinations of Food and Shelter are consumed

The above graph shows the effect of a change in the price of Shelter

The points of tangency are connected by the Price-Consumption Curve (PPC)

The amounts of Shelter at each price can be plotted, giving us our demand curve

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Income and Consumption

When incomes change, the constraint shifts

The amounts of consumption of both good will change accordingly

The new combinations of goods consumed as incomes shift is shown by the Income-

Consumption Curve (ICC)

In this case, the increase in come leads to increases in the consumption of both Food

and Shelter

We can plot the amounts of Shelter consumed at each level of income using the

Engel Curve

Dont forget that we assume no changes in the prices of either goods 20


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Normal and Inferior goods

If income rises and quantity demanded for a good also rises the Engel Curve will be upward

sloping This is considered a Normal Good(quantity demanded rises as incomes rise)

If incomes rise but quantity demanded for a good declines, then the Engel Curve will be

downward sloping

This is considered an Inferior Good(quantity demanded declines as incomes rise)

We discussed this earlier, but the Engel Curve is the best tool for demonstrating the type of

good

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Income and Substitution Effects of a Price Change

When the price of a good changes, there are two effects

If relative consumption shifts from one good to another, we call it the Substitution

Effect(the component of the total effect of a price change that results from the

associated change in the relative attractiveness of other goods

If the price of Shelter increases, consumers will consume more Food relative to

Shelter If overall consumption changes because the consumer has more or less purchasing

power, we call it the Income Effect(the component of the total effect of a price

change that results from the associated change in real purchasing power

If the price of Shelter increases you have to give up more food for the same amount

of Shelter and total potential Shelter consumption is less (less purchasing power

These effects are combined to give us the total effect of a price change 22


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Income and Substitution Effects of a Price Change

Consider an increase in Shelter from $6/sq. yd. to $24/sq. yd.

On the original indifference curve, the optimal choice would go from point A to C

representing the substitution effect (This is determined by where the new budget linewould be if the price of Shelter was offset by the price of Y shown by a parallel line to

the new budget line. Consumption of s would go from 10 to 6 and consumption of Y

would go from 60 to 96

The income effect represents the combinations of S and Y at the new budget line

(Final consumption of S would be 2 and final consumption of Y would be 72 (point D))

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section 2-consumer theory and demand

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