emba sem i managerial economics session7-theory of consumer choice (1)

8/10/2019 EMBA Sem I Managerial Economics Session7-Theory of Consumer Choice (1)

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Managerial EconomicsExecutive MBA Program

Session VII: Theory ofConsumer Choice

InstructorSandeep [email protected]


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ACTIVE LEARNING 1:Budget constraint

The consumers income: $1000Prices: $10 per pizza, $2 per pint of Pepsi

A. If the consumer spends all his income on pizza,how many pizzas does he buy?

B. If the consumer spends all his income on Pepsi,how many pints of Pepsi does he buy?

C. If the consumer spends $400 on pizza,how many pizzas and Pepsis does he buy?

D. Plot each of the bundles from parts A-C on adiagram that measures the quantity of pizza onthe horizontal axis and quantity of Pepsi on the

vertical axis, then connect the dots. 2


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ACTIVE LEARNING 1:Answers

3

0

100

200

300

400

500

0 20 40 60 80 100Pizzas

Pepsis

A

B

D. The budget constraintshows the variouscombinations of goods

the consumer can affordgiven his or her incomeand the prices of thetwo goods.

A. $1000/$10= 100pizzas

B. $1000/$2

= 500PepsisC. $400/$10

= 40pizzas

$600/$2

= 300Pepsis

C


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CHAPTER 21 THE

THEORY OF CONSUMERCHOICE

The Slope of the Budget Constraint

From Cto D,

rise = 100Pepsis

run = +20

pizzasSlope =5

Consumer must

give up 5 Pepsisto get anotherpizza. 0

100

200

300

400

500

0 20 40 60 80 100Pizzas

Pepsis

D

C


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CHAPTER 21 THE

THEORY OF CONSUMERCHOICE

The Slope of the Budget Constraint

The slope of the budget constraint

equals the rate at which the consumer

can trade Pepsi for pizza: the opportunitycost of pizza in terms of Pepsi

the relative price of pizza: price of onegood compared to the other

$$

price of pizza 10 5 Pepsis per pizzaprice of Pepsi 2


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ACTIVE LEARNING 2:Exercise

What happens tothe budgetconstraint if:

A.Income falls to$800

6

0

100

200

300

400

500

0 20 40 60 80 100Pizzas

Pepsis


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ACTIVE LEARNING 2A:Answers

7

0

100

200

300

400

500

0 20 40 60 80 100Pizzas

Pepsis

Consumercan buy

$800/$10

= 80pizzas

or $800/$2

= 400Pepsis

or any

combinationin between.

A fall in income

shifts the budgetconstraint inward.


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ACTIVE LEARNING 2:Exercise

What happens tothe budgetconstraint if:

B.The price ofPepsi rises to$4/pint.

8

0

100

200

300

400

500

0 20 40 60 80 100Pizzas

Pepsis


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ACTIVE LEARNING 2B:Answers

9

0

100

200

300

400

500

0 20 40 60 80 100Pizzas

Pepsis

Consumercan still buy

100pizzas.

But now,

can only buy

$1000/$4

= 250Pepsis.

Notice: slope issmaller, relative price

of pizza now only 2.5

Pepsis.

An increase in the price

of one good pivots thebudget constraint inward.


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PREFERENCES: WHAT THECONSUMER WANT

The consumers preferences allow him tochoose among different bundles of thesame goods he wants, for example Pepsiand Pizza, that best suits his tastes.

If the two bundles suit his tastes equallywell, the consumer is indifferentbetweentwo bundles.

A graphical representation of the bundles ofconsumption that make the consumerequally happy is called the indifferencecurve.


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The Consumers Preferences

Quantity

of Pizza

Quantity

of Pepsi

0

Indifference

curve, I1

C

B

A

An indifference curve is a curve that

shows consumption bundles that give

the consumer the same level of

satisfaction, such as in points A, B or C

If the consumption of pizza is reduced,

consumption of Pepsi must increase tokeep him equally happy.


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The Consumers Preferences-MRS

Quantity

of Pizza

Quantityof Pepsi

0

Indifference

curve, I1

5

MRS

C

B

A

MRS is the rate at which a consumer iswilling to trade one good for another.

It is the amount of one good that aconsumer requires as compensation to

give up one unit of the other good.

MRS tells how much Pepsi the consumer requires to be

compensated for a one unit increase in pizza consumption

The slope at any point on an indifference curve is the

Marginal Rate of Substi tu t ion MRS

100

200

30 50


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Higher and Lower Indifference Curves: Indifference Map

Quantity

of Pizza

Quantityof Pepsi

0

Indifference

curve, I1

I2

5

MRS

C

B

A

D

E

Higher indifferencecurves represent higher

level of satisfaction


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Four Properties of Indifference Curves

Higher indifference curves arepreferred to lower ones.

Indifference curves are downward

sloping. Indifference curves do not cross.

Indifference curves are bowed inward.


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Property 1: Higher indifference curvesare preferred to lower ones.

Consumers usually prefer more of

something to less of it. Higher indifference curves represent

larger quantities of goods than do lowerindifference curves.


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Quantity

of Pizza

Quantity

of Pepsi

0

Indifference

curve, I1

I2

C

B

A

D


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Property 2: Indifference curves aredownward sloping.

A consumer is willing to give up one good

only if he or she gets more of the othergood in order to remain equally happy.

If the quantity of one good is reduced, thequantity of the other good must increase.

For this reason, most indifference curvesslope downward.


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Quantity

of Pizza

Quantity

of Pepsi

0

Indifference

curve, I1


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Property 3: Indifference curves do notcross.

Points A and B should make the

consumer equally happy. Points B and C should make the

consumer equally happy.

This implies that A and C would make theconsumer equally happy.

But C has more of both goods comparedto A.


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The Impossibility of Intersecting Indifference Curves

Quantity

of Pizza

Quantity

of Pepsi

0

C

A

B


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Property 4: Indifference curves arebowed inward.

People are more willing to trade away

goods that they have in abundance andless willing to trade away goods of whichthey have little.

These differences in a consumers

marginal substitution rates cause his orher indifference curve to bow inward.


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Bowed Indifference Curves

Quantityof Pizza

Quantity

of Pepsi

0

Indifferencecurve

8

3

A

3

7

B

1

MRS= 6

1

MRS= 14

6

14

2


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OPTIMIZATION: HOW THECONSUMER CHOOSES?

Step 1:

Consumer chooses to buy on or belowhis budget constraint.

Step 2:

He get the combination of goods on thehighest possible indifference curve.


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The Consumers Optimum

Quantityof Pizza

Quantity

of Pepsi

0

Budget constraint

I1I2

I3

Optimum

AB

Consumer optimum occurs at the point

where the highestindifference curve

and the budget constraint are tangent(slope of budget constraint and

indifference curve is equal).

Note:Slop of IDcurve: MRS

Slop of BC: Relative price of

Pepsi and Pizza


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An Increase in Income-choice of indifference curve

Quantityof Pizza

Quantityof Pepsi

0

New budget constraint

I1

I2

Initialbudgetconstraint

Initialoptimum

Which

Indifference

curve would

the consumer

chose?


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Quantityof Pizza

Quantityof Pepsi

0


I1


Initialoptimum

I3

Which

Indifference

curve would

the consumer

chose?


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Quantityof Pizza

Quantityof Pepsi

0


I1


Initialoptimum

Which

Indifference

curve would

the consumer

chose?


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An Increase in Income-Normal goods case

Quantityof Pizza

Quantity

of Pepsi

0


I1

I3


Initialoptimum

New optimum


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Increase in Income- An Inferior Good case (Pepsi)

Quantityof Pizza

Quantity

of Pepsi

0

Initial

budgetconstraint


I1 I2

Initialoptimum

New optimum


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Cases

What happens when consumersincome level increase or decreases?

Normal good and inferior good cases

What happens when price of thegood(s) increases or decreases?(Price effect)

Assume that price of Pepsi decreasesfrom $2 to $1 per pint.


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Price Effect

Effect1

Pepsi isrelativelycheaper

Pizza isrelativelyexpensiv

e

Opportunity

cost ofbuyingPizza ishigher

Buy morePepsi andless Pizza

Interaction Effect

Substitution effect

Moves to anothercombination of Indifference

curve


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Price Effect

EffectI1

Pepsi isrelativelycheaper

Can buymore

goods with

extramoney

Jumps tohigher

indifferenc

e curve

NormalGood -

Buy more

goods

Interaction Effect

Income effect

Incomelevel

increase

d

Inferior Good- Buy less of

inferiorgoods


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Price Effect

Total Price Effect =Substitution effect + Income Effect

A Ch i P i P i f P i d f $2 t $1


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Quantityof Pizza

Quantityof Pepsi

0

I1

I2A

Initial optimum


Initialbudget

constraint

Substitution effect

B

C New optimum

A Change in Price- Price of Pepsi decreases from $2 to $1

Income effectTotal effect


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Utility Function

Two ways to represent consumer

preferences: Indifference Curve

Utility

Utility is an abstract measure of thesatisfaction that a consumer receives froma bundle of goods.

Indifference Curve and Utility are closely

related. Because the consumer prefers points on higher

indifference curves, bundles of goods on higherindifference curves provide higher utility.


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0

50

120

150

0 1 2 3 4 5

Cones per hour

TotalUtilityinUtils

Utility Function (Similar to Production Function)

1505

1404

1203

902

501

00

Total

Utility(Utility/Hr)

Cones/

Hour

1406

140

6


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Marginal Utility

The marginal utilityof consumption of any input

is the increase in utility arising from an additionalunit of consumption of that input, holding all otherinputs constant.

Marginal Utility =Tot. Uti l i ty

Consumpt ion

Utilit M i i ti


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Utility MaximizationThe Rational Spending Rule:

Spend ing should be al located across goods so that the

marginal ut i l ity per dol lar is th e same for each good.i.e,,Marginal ut i l i ty from X per $ = Marginal ut i l i ty from Y per$

The Rational Spending Rule: MUx / Px = MUy / Py


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Deriving a Demand Curve

QuantityofY

PriceofX

($)

Quantity of X

Quantity of X

100

2001251000

0

Px=$10

Px=$5

Px=$8

906550

906550

5

8

10

Demand for X


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Thank you

emba sem i managerial economics session7-theory of consumer choice (1)

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