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Consumer Choice
Perloff Chapter 4
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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
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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
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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
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B, Burritosper semester
302515
Z, Pizzas per semester
25
20
15
10
0
da
bI
e
c
f
Indifference Curve
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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
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B, Burritosper semester
Z, Pizzas per semester
I 1
I0a
be
Property 3
• Indifference curves cannot cross
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B, Burritosper semester
Z, Pizzas per semester
I
a
b
Property 4
• Indifference curve slope downwards
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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
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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
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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
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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
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Food at homeper year
Clothing per year
I 4
I 3
I 2
I 1
Indifference Curves between Food and Clothing, What is happening?
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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.
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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.
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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
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Diminishing marginal utility, MarginalMUZ
utility of pizza
MUZ
10987654321
Z, Pizzas per semester
0
130
20
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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)
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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
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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
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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
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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