eco consumer+prefrences+and+choice

7/31/2019 Eco Consumer+Prefrences+and+Choice

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Consumer preferences and choices



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Lecture plan

Objectives

Consumer Choice

Cardinal Utility Analysis

Marginal Utility and Demand Curve

Ordinal Utility Analysis

Diminishing Marginal Rate of Substitution

Consumer’s Equilibrium

Revealed Preference Theory

Consumer Surplus



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Objectives

To introduce the crux of consumer behaviour,choices and preferences.

To explain the nuances of utility analysis, marginal

utility, total utility and law of diminishing marginal

utility.

To explain the difference between cardinal and

ordinal utility analyses of consumer behaviour.

To discuss how consumer equilibrium is attainedsubject to budget constraint.

To illustrate the concept of consumer surplus and

its application in decision making.



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Consumer Choice

Given the prices of different commodities,consumers decide on the quantities of thesecommodities according to their paying capacity, andtastes and preferences.

Consumers’ choices, tastes and preferences restson the following assumptions:

Completeness: A consumer would be able to state ownpreference or indifference between two distinct baskets ofgoods.

Transitivity: An individual consumer’s preferences arealways consistent.

Non-satiation: A consumer is never satiated permanently.More is always wanted; if “some” is good, “more” of thegood is better.



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Consumer Choice

Commodities are desired because of their utility

Utility is the attribute of a commodity to satisfy or satiate

a consumer’s wants

Utility is the satisfaction a consumer derives from

consumption of a commodity

Mathematically: utility is the function of the

quantities of different commodities consumed:

U= f(m1, n1, r1)



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Features

Utility is subjective Utility is relative

Utility is not essentially useful

Utility is independent of morality




Marshall and Jevons opined that Utility is a cardinalconcept and is measurable (in utils) like any otherphysical commodity

Total Utility (TU)

Sum total of utility levels out of each unit of a commodityconsumed within a given period of time

Marginal Utility (MU)

Change in total utility due to a unit change in the commodityconsumed within a given period of time.

MU=TUn -TUn-1 or MU=dQ

dTU



Assumptions

Utility can be measured in the cardinal numbers. Marginal utility of money remains constant.

Utility of one commodity is independent of the other.

Every unit of the commodity being used is of same

quality and size.

There is a continuous consumption of the commodity.

Commodity is consumed in some standard units.

Consumer is a rational person.




Law of Diminishing Marginal Utility

The law of diminishing marginal utility states that, other thingsbeing equal, the marginal utility of a good diminishes as more of it

is consumed in a given time period.

The following diagrams show Total Utility (TU) and Marginal

Utility (MU) curves

Quantity of X

TU of X

O

TU

Quantity of X

MU of X

O

MU



Cont….

The Law of Diminishing Marginal Utility

Marginal utility refers to the change in satisfaction which results when a little more

or little less of that good is consumed. For example, when a thirsty person takes five

bottles of cold drink continuously, the consumption of first bottle gives him utility,

second bottle gives him lesser utility than first but his total utility increases. Third

bottle gives him still less utility but increases total utility. The utility from fourth bottlemay be zero as he is no more thirsty. But the fifth bottle may cause uneasiness and

thus give negative utility, i.e., the total utility may now actually go down.Bottle consumed Total Utility (Units) Marginal Utility (Units)

0 0 –

1 14 14

2 23 9

3 27 4

4 27 0

5 24 –3

6 18 –6



Causes of its application

Commodities are imperfect substitute Alternative uses

Satiability of particular wants



Exceptions

Curious & Rare things Misers

Good books & Poems

Drunkards etc.




Law of Equimarginal Utility

Marginal utilities of all commodities should be equal

The consumer has to distribute his/her income on

different commodities so that utility derived from lastunit of each commodity is equal for all other

commodities in the consumption basket.

Mathematically: I

N

N

M

M MU

P

MU

P

MU ...



Edgeworth, Fisher and others negate the physicalmeasurement of utility.

A consumer is able to rank different combinations of the

commodities in order of preference or indifference.

Utility is not additive but comparative.

Indifference Curve Analysis (J.R. Hicks and R.G.D. Allen )

Indifference curve: Locus of points which show the different

combinations of two commodities among which the

consumer is indifferent, i.e. derives same utility.

Since all these points render equal utility to the consumer, an

indifference curve is also known as an isoutility (“iso” meaning

equal) curve.

Indifference map: group of indifference curves

Ordinal Utility Analysis



Cont….

INDIFFERENCE CURVE ANALYSIS

Assumptions

The following assumptions about the consumer psychology are implicit in this

analysis:

Transitivity : If a consumer is indifferent to two combinations of two goods,

then he is unaware of the third combination also.

Diminishing marginal rate of substitution : The scarcer a good the greater is

its substitution value.

Rationality : The consumer aims to maximise his total satisfaction and has got

complete market information.

Ordinal Utility : Utility in this approach is not measurable. A consumer can only

specify his preference for a particular combination of two goods, he cannot

specify how much.



Cont….

The Indifference Curve

If a consumer is asked whether he prefers combination 1 of two goods X and Y

(assuming that the market price of X and Y are fixed) or combination 2, he may give

one of the following answers:

he prefers combination 1 to 2

he prefers combination 2 to 1

he is indifferent about combinations 1 and 2.

Combination Units of X Units of Y

1 3 21

2 4 15

3 5 11

4 6 8

5 7 6

Indifference Combination of X and Y goods



Cont….

The Indifference Curve



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Properties of Indifference Curves

Indifference curves aredownward sloping.

This is because of the assumptionof non-satiation

Higher indifference curverepresents higher utility

Indifference curves can neverintersect

Indifference curves are convexto the origin.

This is because two goods cannotbe perfect substitutes of eachother

X

Y

D

A

B

O

C

Good X

G o o d Y

IC2

IC1



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MRS is the proportion of one good (M) that the consumer

would be willing to give up for more of another (N)

MRS is the ratio between rates of change in M and N, downthe indifference curve :

…..(1)

To increase consumption of M, the consumer has to reduce consumption of N and hence the negative sign. MRSMN goeson diminishing as we move down the indifference curve.

Gain in utility due to consumption of more units of one

commodity must be equal to the loss in utility due toconsumption of less units of the other commodity

…..(2)

…..(3)

Diminishing Marginal Rate of Substitution

M

N MRS

MN

MN

N

M MRS MU

MU

M N

MU

MU

N

M



Cont….

The Budget Line

The budget line is also known as the

price line, the consumption possibility

line or the price opportunity line. It

represents different combinations of two

goods X and Y which the consumer can

buy by spending all his income.

Example

A consumer having Rs 1200 as income can

buy 600 units of Y at Rs 2 per unit or 300

units of X at Rs 4 per unit as shown in Figure

12. The straight line joining the two points A

and B is called the budget line.

At any point on AB, the consumer spends all

his income but point C is unattainable. At

point D or any other point in DOAB he does

not spend all his income.



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Conditions for consumer’s equilibrium:

Consumer spends all income in buying the two commodities; hence

point of equilibrium will always lie on the budget line.

Point of equilibrium will always be on the highest possible

indifference curve the consumer can reach with the given budget line.

Consumer is able to maximize utility at a point where the budget line is

tangent to an indifference curve

This is the highest possible curve attainable by the consumer,

subject to budget constraint.

Budget line may shift either upwards or downwards due to any change in income of

the consumer while price of the commodities remaining same

Swivel at one point when price of one of the commodities changes,

while income and price of other commodity remain same.



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Quantity of M

Quantity of N

O QM

QN

A

B

E

IC4

IC3

IC1

IC2

C

D

Feasible set is the area

OAB, and area beyondbudget line AB is

infeasible area; therefore

IC4 is beyond reach of the

consumer.

Equilibrium is attained atpoint E where the AB is

tangent to curve IC3

(highest attainable

indifference curve).

Point C and B areattainable but on lower

indifference curve.

Equilibrium quantities of

commodities M and N are

QM and QN.



Price of Related Goods

Almost all the goods that a consumer purchases in a market are "related goods"

either by way of complementarity or substitutability. X and Y are compliments if the

rise in demand of X increases the demand for Y, e.g., pen and ink, bread and butter,

etc. X and Y are substitutes, if the rise in demand for x reduces the demand for Y,e.g., tea and coffee.

Breaking up the Price Effect into Income and Substitution Effect: Hicksian

Approach

The price effect can be broken up into two parts: income effect and substitution

effect. Income effect occurs due to increase (decrease) in real income resulting from

a decrease (increase) in the price of a commodity. Substitution effect occurs due to

the consumer's inherent tendency to substitute cheaper goods for relatively

expensive ones.



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Consumer Surplus

The difference between the price consumers are

willing to pay and what they actually pay is called

consumer surplus.

Individual consumer surplus measures the gain that

a consumer makes by purchasing a product at a

price lower than what he/she had expected to pay.

In a market the total consumer surplus measures thegain to the society due to the existence of a market

transaction.



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Consumer Surplus

Equilibrium market price and

quantity are at (P*, Q*)

If there is a customer who is

willing to pay as high as P1 but

actually pays only P*, the

difference between the twoprices (P1 – P*) represents the

surplus of the first consumer.

If a second consumer is willing

to pay P2 and actually pays P*

gains a surplus of (P2 – P*).

Total consumer surplus in the

economy is given by the

triangular area P*DE

S

S

P2

Price

D

D

O

B

A P1

P*

Q1 Q2 Q* Quantity

E

Consumer

Surplus



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Summary

Utility is the measure of satisfaction a consumer derives fromconsumption of a commodity; it is an attribute of a commodity to

satisfy a consumer’s needs. According to cardinal school, utility is

measurable like any other physical commodity.

As per law of diminishing marginal utility, as you one consumes

more and more units of a commodity, total utility would goes on

increasing, but at a diminishing rate.

As per law of equimarginal utility, a consumer will maximize utilitywhen the marginal utility of the last unit of money spent on each

commodity is equal to the marginal utility of the last unit of money

spent on any other commodity.



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Summary

According to ordinal school, utility cannot be

measured in physical units; it is possible to rank utility

derived from various commodities.

Indifference curves are downward sloping and convexto the origin; a higher indifference curve would

represent higher utility and two indifference curves do

not intersect each other.

Marginal Rate of Substitution (MRS) shows the amount

of a good that a consumer would be willing to give up

for an additional unit of another commodity.



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Summary

Budget constraint to the consumer includes income of the

consumer and prices of the commodities in the consumptionbasket. A change in any of these constraints would lead to a shiftin the budget line. Such a shift can be of three types: upwards,

downwards and swivelling.

The consumer will be at equilibrium at a point where the budgetline is tangent to the highest attainable indifference curve.

According to the theory of revealed preferences, demand for a

commodity by a consumer can be ascertained by observing thebuying pattern of the consumer.

Consumer surplus is equal to the difference between the price aconsumer is willing to pay and the price he/she actually pays for

a commodity.

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