Consumer Choice

Perloff Chapter 4

Introduction

• Demand curve– As price of a good increases we buy less of it.

• Consumers are making a choice

• What governs the ways in which these choice are made

• Preferences are central

Assumptions

• Completeness– Given any two bundles consumer can always rank them

or say he/she is indifferent.

• Transitivity– If bundle 1 is preferred to bundle 2 and bundle 2 is

preferred to bundle 3 this implies that 1 is preferred to 3.

• More is better– Bundles containing more of all goods are preferred

B, Burritosper semester

302515

Z, Pizzas per semester

25

20

15

10

0

da

b

e

c

f

A

B

Source: Perloff

Using transitivity to construct an preference map

B, Burritosper semester

302515

Z, Pizzas per semester

25

20

15

10

0

da

bI

e

c

f

Indifference Curve

B, Burritosper semester

302515

Z, Pizzas per semester

25

20

15

10

0

d

I0

I 1

I 2

e

c

f

Properties 1 and 2

• Indifference curves further away from the origin are preferred.

• There is an indifference curve through every bundle

B, Burritosper semester

Z, Pizzas per semester

I 1

I0a

be

Property 3

• Indifference curves cannot cross

B, Burritosper semester

Z, Pizzas per semester

I

a

b

Property 4

• Indifference curve slope downwards

B, Burritosper semester

5

3

8

1–1

1

12

0

–2

– 3

3 4 5 6

Z, Pizzas per semester

a

b

c

d

I

Property 5

• Indifference curves are convex to the origin

B, Burritosper semester

5

3

8

2

0 3 4 5 6

Z, Pizzas per semester

a

d

I

Marginal Rate of Substitution

• How many burritos will be exchanged for 1 Pizza

-6

3

23

6

x

yMRS

Coke, Cansper week

1 2 3 4

Pepsi, Cans per week

1

0

2

3

4

I1 I2 I3 I4

Perfect Substitutes

A

B

C

Ice cream,Scoops per week

1 2 3

Pie, Slices per week

1

2

3

0

I1

I2

I3

a

d

e c

b

Perfect Complements

Food at homeper year

Clothing per year

I 4

I 3

I 2

I 1

Indifference Curves between Food and Clothing, What is happening?

Utility

• Indicates the position of a bundle of goods in the consumers preference ordering.

• Higher ranking implies higher utility.

• Preferences are fundamental.

• Utility is a simply a useful way of summarising preferences.

Utility Function

BZU

B Z U

2 2 2

2 8 4

12 3 6

18 2 6

32 2 8

Mathematical relationship between the quantities of the goods and the level of utility.

Marginal UtilityThe change in utility when the consumption of a good changes by one unit

U, Utils

U = 20

Utility function, U (10, Z )

Z = 1

10987654321

Z, Pizzas per semester

0

350

250230

Z

UMU

Diminishing marginal utility, MarginalMUZ

utility of pizza

MUZ

10987654321

Z, Pizzas per semester

0

130

20

Budget ConstraintA person spends £50, burritos cost £2 and pizzas cost £1, they buy 10 pizzas, how many burritos can they buy?

Cost of Pizzas:10101 ZPZ

Money left for burritos:

401050 ZPY Z

Number of Burritos:

202

40

B

Z

P

ZPY

In general:

ZP

P

P

YB

B

Z

B

Intercept Slope (MRT)

B, Burritosper semester

Opportunity set

50 = Y/pZ

L1 (pZ = £1, Y = £50)

25 = Y/pB

20

10

100 30

Z, Pizzas per semester

a

b

c

d

ZB2

1

2

50

Opportunity Set

B, Burritosper semester

Loss

50

L1 (pZ = £1)

L2 (pZ = £2)

25

250

Z, Pizzas per semester

2

2

2

1

B

Z

P

P

Increase in Price

B, Burritosper semester

Gain

100

L3 (Y = £100)

L1 (Y = £50)

50

25

500

Z, Pizzas per semester

2

100

2

50

BP

Y

Income Increases

The optimal choiceB, Burritos

per semesterBudget line

10

20

25

5030100Z, Pizzas per semester

I1I2I3

d

fc

e

a

g

A

B

B

Z

B

Z

P

P

MU

MUMRS