principles of economics session 3. topics to be discussed consumer preferences budget constraints ...
TRANSCRIPT
Topics To Be Discussed
Consumer Preferences
Budget Constraints
Consumer Choice
Marginal Utility
Substitution and Income Effect
Steps of Studying Consumer Behavior
Study consumer preferences How and why do people prefer one good to another?
Study budget constraint How are consumers constrained by their limited
incomes?
Combine consumer preferences and budget constraints to determine consumer choices What combination of goods will consumers buy to
maximize their satisfaction?
Market Basket
A market basket is a collection of one or more commodities.
One market basket may be preferred over another market basket containing a different combination of goods.
Three Basic Assumptions
Preferences are complete.
Preferences are transitive.
Consumers always prefer more of any good to less.
Consumer PreferencesMarket Basket
Units of Food
Units of Clothing
A 20 30
B 10 50
D 40 20
E 30 40
G 10 20
H 10 40
Indifference Curves
Indifference curves represent all combinations
of market baskets that provide the same level of satisfaction to a person.
Combination B,A, & D yields the same satisfaction
E is preferred to U1
U1 is preferred to H & G
Indifference Curve
Consumer Preferences
Food(units per week)
10
20
30
40
10 20 30 40
Clothing(units per week)
50
G
D
A
EH
B
The consumer prefersA to all combinationsin the blue box, whileall those in the pink
box are preferred to A.
Consumer Preferences
Food(units per week)
10
20
30
40
10 20 30 40
Clothing(units per week)
50
G
A
EH
B
D
Indifference Map
An indifference map is a set of indifference curves that describes a person’s preferences for all combinations of two commodities.
U2
U3
Indifference Map
Food(units per week)
Clothing(units per week)
U1
AB
D
Market basket A is preferred to B.
Market basket B is preferred to D.
U1U2
Indifference Curves Can’t Cross
Food(units per week)
Clothing(units per week)
A
D
B
The consumer should be indifferent between A, B and D. However, B contains more of both goods than D.
-6
1
A
B
D
EG-1
1
-4
-21
1
The amount of clothing given up for a unit of food decreases from 6 to 1
Substitution
Food(units per week)
Clothing(units
per week)
2 3 4 51
2
4
6
8
10
12
14
16
Marginal Rate of Substitution
The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good.
It is measured by the slope of the indifference curve.
Diminishing MRS
Food(units per week)
Clothing(units
per week)
2 3 4 51
2
4
6
8
10
12
14
16 A
B
D
EG
-6
1
1
11
-4
-2
-1
MRS = 6
MRS = 2
FCMRS
Perfect Substitutes and Perfect Complements
Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant.
Two goods are perfect complements when the indifference curves for the goods are shaped as right angles.
Application of Consumer Preferences
Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling.
An analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars.
Consumer Preferences
Consumers are willing to give up
considerablestyling for additional
performance
Styling
Performance
MRS >1
Consumer PreferencesConsumers are
willing to give upconsiderable
performance for additional styling
Styling
Performance
MRS <1
Utility
Utility refers to numerical score representing the satisfaction that a consumer gets from a given market basket.
Utility FunctionU=f(X1 , X2 , X3 , … Xn)
Assume the utility function for food (F) and clothing (C)U=f(F, C) = F + 2C
Market Baskets F Units C Units UtilsA 8 3 8 + 2(3) = 14
B 6 4 6 + 2(4) = 14
C 4 4 4 + 2(4) = 12
The consumer is indifferent to A & B
The consumer prefers A & B to C
Utility Functions & Indifference Curves
Food(units per week)
10 155
5
10
15
0
Clothing(units
per week)
U1 = 25
U2 = 50 (Preferred to U1)
U3 = 100 (Preferred to U2)A
B
C
Assume: U = FC C 25 = 2.5×10 A 25 = 5 ×5 B 25 = 10 ×2.5
Ordinal vs. Cardinal Utility
Ordinal Utility Function: places market baskets in the order of most preferred to least preferred, but it does not indicate how much one market basket is preferred to another.
Cardinal Utility Function: utility function describing the extent to which one market basket is preferred to another.
Budget Constraints
Budget constraints limit an individual’s ability to consume in light of the prices they must pay for various goods and services.
Budget Line
The budget line indicates all combinations of two commodities for which total money spent equals total income.
Budget Line
Let F = amount of food purchased C = amount of clothing purchased Pf = Price of food Pc = price of clothing M = money income
Then
CPFPM cf
Budget Line
Market Basket
Food (F)Pf=$1
Clothing (C)Pc=$2
Total SpendingPfF+PcC=M
A 0 40 $80
B 20 30 $80
D 40 20 $80
E 60 10 $80
G 80 0 $80
Budget Line F + 2C = $80(M/PC) = 40
Budget Line
Food(units per week)40 60 80 = (M/PF)20
10
20
30
0
A
B
D
E
G
Clothing(units
per week)
Pc = $2 Pf = $1 M = $80
2
1/
/
//
cf
f
c
PP
PM
PMFCSlope
Budget Line
As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other.
The slope of the line measures the relative cost of food and clothing.
Budget Line
The slope is the negative of the ratio of the prices of the two goods.
The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent.
Budget Line
The vertical intercept (M/PC), illustrates the maximum amount of C that can be purchased with income M.
The horizontal intercept (M/PF), illustrates the maximum amount of F that can be purchased with income M.
Effect of Income Change
Food(units per week)
Clothing(units
per week)
80 120 16040
20
40
60
80
0
(M = $80)
L1
A increase in income shifts the
budget line outward
(M = $160)L2
L3
A decrease in income shifts the
budget line inward
(M=$40)
Effect of Price Change
Food(units per week)
Clothing(units
per week)
80 120 16040
40
(PF = 1)
L1
An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward.
L3
(PF = 2)(PF = 1/2)
L2
A decrease in the price of food to $.50 changes the slope of the
budget line and rotates it outward.
Consumer Choice
Consumers choose a combination of goods that will maximize the satisfaction they can achieve,
given the limited budget available to them.
Conditions to Maximize Utility
The choice must be located on the budget line.
The choice must give the consumer the most preferred combination of goods and services.
The MRS of an indifference curve is:
Consumer Choice
The slope of the budget line is:
Therefore, satisfaction is maximized where:
F
CMRS
c
f
P
PSlope
c
f
P
PMRS
Satisfaction Maximization
Satisfaction is maximizedwhen marginal rate of
substitution (of F and C) is equal to the ratio of the
prices (of F and C).
Consumer Choice
Food (units per week)
Clothing(units per
week)
40 8020
20
30
40
0
U1
B
Point B does not maximize satisfaction because the
MRS (-10/10) = 1 is greater than the price ratio (1/2).
-10C
+10F
Budget Line
Pc = $2 Pf = $1 M = $80
Consumer Choice
U3
D
Market basket D cannot be attainedgiven the current
budget constraint.
Food (units per week)
Clothing(units per
week)
40 8020
20
30
40
0
Budget Line
Pc = $2 Pf = $1 M = $80
U2
Consumer Choice
At market basket A the budget line and the indifference curve are tangent and no higher level of satisfaction can be attained.
AAt A: MRS =Pf /Pc = .5
Food (units per week)
Clothing(units per
week)
40 8020
20
30
40
0
Budget Line
Pc = $2 Pf = $1 M = $80
Consumer Choice
U3
D
Food (units per week)
Clothing(units per
week)
40 8020
20
30
40
0
Budget Line
Pc = $2 Pf = $1 M = $80
U2
A
B
U1
D is not available. A offers less satisfaction than B.
B is the optimum choice.
Marginal utility measures the additional satisfaction
obtained from consuming one additional unit of a good.
Marginal Utility andConsumer Choice
The marginal utility derived from increasing from 0 to 1 units of food might be 9
Increasing from 1 to 2 might be 7
Increasing from 2 to 3 might be 5
Diminishing Marginal Utility
The principle of diminishing marginal utility states that as more
and more of a good is consumed, consuming additional amounts will yield smaller and smaller additions
to utility.
Principle of Diminishing MU
If consumption moves along an indifference curve, the additional utility derived from an increase in the consumption one good, food (F), must balance the loss of utility from the decrease in the consumption in the other good, clothing (C).
Marginal Utility andIndifference Curve
Marginal Utility andConsumer Choice
c
F
MU
MU
F
C
) ( ) (C MU F MUc F
C
F
P
P
F
CMRS
C
F
c
F
P
P
MU
MU
The equal marginal principle states that total utility is
maximized when the budget is allocated so that the marginal
utility per dollar of expenditure is the same for each good.
Equal Marginal Principle
Equal Marginal Principle
Units per game
MU of hot dogs (MUH )
MUH /PH
MU of Cokes (MUc )
MUc /Pc
1 20 8 60 30
2 15 6 40 20
3 12.5 5 20 10
4 10 4 16 8
5 7.5 3 8 4
6 5 2 4 2
Constraint=$20 Hot dog price=$2.5 Coke price=$2
Equal Marginal Principle
Increase in units sold
Number of ads MBTV MBRadio
1 400 360
2 300 270
3 280 240
4 260 225
5 240 150
6 200 120
Budget=$2,000 TV ad price=$400 Radio ad price=$300
Equal Marginal Principle
Increase in units sold
Number of ads MBTV MBRadio
1 400/400=1.00 360/300=1.20
2 300/400=0.75 270/300=0.90
3 280/400=0.70 240/300=0.80
4 260/400=0.65 225/300=0.75
5 240/400=0.60 150/300=0.50
6 200/400=0.50 120/300=0.40
Budget=$2,000 TV ad price=$400 Radio ad price=$300
Effect of a Price Change
Food (units per month)
Clothing(units per
month)
Three separateindifference curves
are tangent toeach budget line.
M = $20PC= $2PF =$2, $1, $0.5
3
7 A
U1
10
10
5U3
D
4020
U2
B
8
6
Effect of a Price Change
Food (units per month)
Clothing(units per
month)
3
7 A
U1
10
10
5U3
D
40
The price-consumption curve traces out the utility maximizing
market basket for the various prices for food.
Price-consumption curve
20
U2
B
8
6
Demand Curve
Food (units per month)
Clothing(units per
month)
20
6
U2
B
83
7 A
U1
10
10
5U3
D
40
Food (units per month)
Priceof Food
20
$0.50
3
$2.00
8
$1.00 Demand curve
Effects of Income Changes
Food (units per month)
Clothing(units per
month)
Pf = $1Pc = $2M = $10, $20, $30
D7
16
U3
30
15
3
4
A U1
5
10
B
U2
20
10 Income-consumptioncurve
Effects of Income Changes
Food (units per month)
Priceof
food
An increase in income,from $10 to $20 to $30,with the prices fixed,shifts the consumer’s
demand curve to the right.
$1.00
4
D1
E
10
D2
G
16
D3
H
Effects of Income Changes
An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve.
Simultaneously, the increase in income shifts the demand curve to the right.
Normal Good vs. Inferior GoodNormal Good
The income-consumption curve has a positive slope.
The quantity demanded increases with income.
The income elasticity of demand is positive.
Normal Good vs. Inferior GoodInferior Good
The income-consumption curve has a negative slope.
The quantity demanded decreases with income.
The income elasticity of demand is negative.
An Inferior Good
Hamburger (units per month)
Steak(units per
month)
15
30
U3
C
Income-Consumption Curve
…but hamburger becomes an inferior good when the income
consumption curve bends backward between B and C.
U2
105 20
5
10
AU1
B
Both hamburger and steak behave as a normal good, between A and B...
Income and Substitution Effects
Substitution EffectConsumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is now relatively more expensive.
Income EffectConsumers experience an increase in real purchasing power when the price of one good falls.
Income and Substitution Effects
Food (units per month)O
Clothing(units per
month)
Income Effect
5
22.5 30
U2
B
20
204
16 A
U1
18
SubstitutionEffect
D
Normal Good M=$60, Pf = $3, Pc = $3
Decreased Pf = $2
17
25.5Total Effect
Total Effect = 18.5
Income Effect = 4.5
Substitution Effect = 14
Income and Substitution Effects
Food (units per month)O
Clothing(units per
month)
Income Effect
13
10.5 30
U2
B
20
204
16 A
U1
SubstitutionEffect
D
Inferior GoodM=$60, Pf = $3, Pc = $3
Decreased Pf = $2
17
25.5
Total Effect
Total Effect = 6.5
Income Effect = - 7.5
Substitution Effect = 14
18
5
Substitution Effect > Income Effect.
Food (units per month)O
Clothing(units per
month)
E
D
Total Effect
Income Effect
The income effect may theoretically be large enough
to cause the demand curve for a good to slope upward. This is of little practical interest
Income and Substitution Effects
Giffen Good
F2T
B
U2
R
F1S
A
U1
SubstitutionEffect
Market Demand
1 6 10 16 32
2 4 8 13 25
3 2 6 10 18
4 0 4 7 11
5 0 2 4 6
Price Individual A Individual B Individual C Market($) (units) (units) (units) (units)
Market Demand Curve
Quantity
1
2
3
4
Price
0
5
5 10 15 20 25 30
DB DC
Market Demand
DA
The market demandcurve is obtained by
summing the consumer’s demand curves
Consumer Surplus
Willingness to pay is the maximum price that a buyer is willing and able to pay for a good.
It measures how much the buyer values the good or service.
Consumer Surplus
Consumer surplus is the amount a buyer is willing to pay for a
good minus the amount the buyer actually pays for it.
Four Possible Buyers’ Willingness to Pay
Buyer Willingness to Pay
John $100
Paul 80
George 70
Ringo 50
Consumer Surplus
The market demand curve depicts the various quantities that buyers
would be willing and able to purchase at different prices.
Four Possible Buyers’ Willingness to Pay
Price Buyer Quantity Demanded
More than $100 None 0
$80 to $100 John 1
$70 to $80 John, Paul 2
$50 to $70 John, Paul, George 3
$50 or less John, Paul, George, Ringo
4
Measuring Consumer Surplus with the Demand Curve
Price ofAlbum
50
7080
0
$100
1 2 3 4
Quantity ofAlbums
John’s willingness to pay
Paul’s willingness to pay
George’s willingness to pay
Ringo’s willingness to pay
Demand
Measuring Consumer Surplus with the Demand Curve
Price ofAlbum
50
7080
0
$100
1 2 3 4Quantity of
Albums
Demand
John’s consumer surplus ($20)
Price = $80
Measuring Consumer Surplus with the Demand Curve...
Price ofAlbum
50
7080
0
$100
1 2 3 4Quantity of
Albums
Demand
John’s consumer surplus ($30)
Total consumer surplus ($40)
Price = $70
Paul’s consumer surplus ($10)
Measuring Consumer Surplus with the Demand
Curve
The area below the demand curve and above the price measures the consumer surplus in the market.
Q2
P2
How the Price Affects Consumer Surplus
Quantity
Price
0
Demand
Initialconsumersurplus
Additional consumer surplus to initial consumers
Consumer surplus to new consumers
Q1
P1
D EF
BC
A
Paradox of Value
Nothing is more useful than water; but it will scare purchase anything. A
diamond, on the contrary, has scarce any value in use; but a very great
quantity of other goods may frequently be had in exchange for it
- The Wealth of Nations, Adam Smith
Consumer Surplus and Economic Well-Being
Consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it.
Consumer Surplus and Importation
Price
0 Quantity
Domesticsupply
Domestic demand
World Price
Price after trade
Domesticquantitysupplied
Domesticquantitydemanded
Price before trade
Imports
Consumer Surplus and Importation
Price
0 Quantity
Domesticsupply
World Price
Domestic demand
Price after trade
Price before trade
A
Consumer surplusbefore trade
Consumer Surplus and Importation
Price
0 Quantity
Domesticsupply
World Price
Domestic demand
Price after trade
Price before trade
A
Consumer surplusafter trade
B D
Imports
What’s the Difference?Durable investments in complementary asse
ts Hardware Software Wetware
Supplier wants to lock-in customerCustomer wants to avoid lock-inBasic principle: Look ahead and reason bac
k
Small Switching Costs Matter
Phone number portabilityEmail addressesHotmail (advertising, portability)ACM, CalTechLook at lockin costs on a per customer
basis
Classification of Lock-InContractual commitments: damagesDurable purchases and replacement: decline
s with timeBrand-specific training: rises with time Information and data: rises with timeSpecialized suppliers: may riseSearch costs: learn about alternativesLoyalty programs: rebuild cumulative usage
Contractual Commitments
“Requirements contract”:
Purchase supplies from one supplier
Beware of “evergreen contracts”