section 2-consumer theory and demand
TRANSCRIPT
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ECO 301 Intermediate Microeconomics
Consumer Preferences and Demand
Section 2
Chapters 3-4
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Rational Consumer Choice
We assume the consumers make well-defined rational choices in the marketplace
Constrained by resources Clear preferences
The Opportunity or Budget Constraint
Consider 2 goods, Food and Shelter
Choice: Consume all Food (lb/wk) or all Shelter (sq yd/wk) or some combination of
each Assume you have $100/wk in resources
Price of Food $10/lb, Price of Shelter $5/sq yd
If you consume all food you consume 10 lb
If you consume all shelter you consume 20 sq yds
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What combinations are possible: The BudgetLine (B)
The red line shows the combinations of
food & shelter possible at $100
Point E - Unattainable
Point D Only $65 spent
Relative prices determine the slope ofthe line
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Budgets and Affordable Choices
The units consumed are based on a period of time and are consideredflows
Income is also a flow Assets would be considered stocks
what is available at a point in time
Given two goods, the budget constraint is determined by the amount of income (M) and
the monetary cost of food (F) and shelter (S)
PF and PS denote the prices of food and shelter The affordable setare the bundles on or below the budget constraint
The budget constraint must satisfy the following equation
M = PSS + PFF
To represent this so we can show the budget line we need to rearrange the
equation to
The amount of food consumed is determined by the total resources divided by the price
of food and the amount of shelter consumed and the relative price of shelter to food
Change M, PS or PF and the budget line will change (shift or change of slope) 3
M P S
P F P F
F = - S
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Budgets and Affordable Choices
Price Change Currently the budget constraint is
Change the price of shelter from $5 to $ 10 and the new budget constraint is
The slope went from -1/2 to -1
The budget line went from B1 to B2 The maximum amount of F consumed does not change but the maximum amount
of S goes from 20 to 10
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100 5
10 10
F = - S
100 10
10 10
F = - S
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Budgets and Affordable Choices
Income Change
Suppose income is cut from $100 to $50. The new budget constraint is
The slope remained unchanged at -1/2 The budget line went from B1 to B2, a parallel shift down in the budget line
The maximum amount of F and S are reduced by half
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50 5
10 10F = - S
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Budgets and Affordable Choices
Generally, budgets involve more than two choices. This becomes more difficult to graph
because it involves a multidimensional plane
The most we can graph is three dimensions
The solution is the Composite Good
Compare Food (F) to all other goods represented by (X) PX becomes a weighted average price of the composite goods
A change in the price of one of the composite goods changes the average price and
the effects are the same as with a two-good analysis
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Budgets and Affordable ChoicesKinked Budget Constraints
There are times when the budget constraint will be nonlinear
One case is the kinked budget line
Volume discounts
Surcharges after a certain amount of usage (firstXis free and y/unit will cost extra)
Example 3.1 electricity usage
Up to 1000 kilowatt-hours (kWh), the price is $0.10/kWh, after that it is $0.05/kWh
For the first 1000 kWh the opportunity cost is 100 units of Y
For every incremental 1000 kWh consumed the amount of Y given up is 50
For those who use a lot of electricity, they would be more likely to use incrementally
more than those who use less electricity
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Consumer Preferences
One of the fundamental principles in Microeconomics is Consumer Preferences
Given our budget constraints that define our possible choices, our preferences
determine the actual choices made
While we each have unique preferences, in general we tend to have common
preferences, so we can analyze preferences overall
In studying the representative consumer, we can make statements about the bunndlesthey will choose
One key assumption is that consumers have logical Preference Ordering
Bundle A is preferred to bundle B (A > B)
Bundle 2A is preferred to bundle A (2A > A)
There are 4 properties of preference ordering
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Preference Ordering
1. Completeness: The consumer is able to rank all combinations of goods and services
2. More-is-Better: More of a good is preferred to less. However, diminishing marginal
utility means that at some point saturation is reached and no more is preferred
3. Transitivity: Assume 3 bundles A, B, C. If A > B, and B > C, then A > C. The assumption
is that if we have 10 bundles, A to J, and A > C and C> J, then A > J. However, this does
not always occur because not all outcomes relate so logically.
4. Convexity: Mixtures of goods are preferred to extremes. One may be indifferent
between bundle A (4,0) and bundle B (0,4), but will prefer Bundle C (2,2) to either A or
B
This is due to Diminishing Marginal Utility
Given these properties, we can examine bundles and determine the bundles that are
preferred and the bundles that we are indifferent toward
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Indifference Curves
Suppose you have three bundles, A, B and C, and you are indifferent as to which bundle
you choose.
Looking at bundle A, Bundle W is worse, giving less satisfaction (less Food and Shelter).
Bundle Z is better than A (More Food and Shelter)
A consumer is indifferent if the amount of Food she gives up is equal in utility to the
amount of Shelter she gains
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Indifference Curves
We can plot combinations of Food and Shelter where the level of utility is equal and we are
indifferent. This gives us the Indifference Curve
Any bundle along the Indifference Curve I0 is preferred to bundle K and bundle L is
preferred to any bundle along the indifference curve Fig. 3-9
We can create an Indifference Map (Fig 3-10) that shows the indifference curves at verious
levels of satisfaction
Any point on I2 is preferred to any point on I1
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Fig 3-9Fig 3-10
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Trade-Offs between Two Goods
Indifference curves give us the amount of a good we are willing to exchange for another
good to maintain the same level of satisfaction
That is measured by the Marginal Rate of Substitution (MRS)
The MRS is the ratio of the change in F for the change in S
-F/ S
The delta represents a small change in units
The ratio is always negative or at most zero
The MRS changes as we move along the indifference curve due to the convexity property
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Comparing Two Consumers
Two consumers, Tex and Mohan
Because their preferences are different, they have different indifference curves
Tex and Mohan like potatoes, but Mohan likes rice more than Tex
Their MRS will be different. Tex will not be willing to give up as much in potatoes for
rice as Mohan would
When we aggregate preferences for many consumers, the indifference curve will reflect an
weighted average of individual indifference curves and MRS
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The Best Feasible Bundle
The budget line shows us the possible combinations of Food and Shelter we can afford
Indifference curves show is the combinations of Food and Shelter we prefer at a given level
of satisfaction
Put them together and we get the combination of Food and Shelter that we can both afford
and maximize our level of satisfaction (utility) Point F is our optimal point
Points A and E are affordable, but less satisfying
Point D is both less satisfying and less efficient
Point G is unattainable
At point F, the MRS equals the relative prices of Food and Shelter (MRS = PS/PF) 14
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Application of the Rational Choice Model
Is it better to give poor people cash or food stamps?
Give either $100/mo in food stamps or $100/mo in cash
Consumer has $400 initial budget
Which alternative gives us a higher indifference curve?
In Figure 3-18, even though the consumer is constrained, his choices would be the same inthis case
In Figure 3-19, if his indifference curve is such that he would be at point L with cash, but
point D with food stamps. Point D would be on a lower indifference curve, so cash would
be better
However, alcoholics would prefer cash since they cannot buy liquor with food stamps15
Fig 3-18
Fig 3-19
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The Utility FunctionIndifference Curves represent a level of utility. Higher indifference curves reflect a higher
level of utility
Economists use the Utility Function to analyze utility
U(F, S) F=Food and S=Shelter
In reality, utility cannot be directly measured, but it provides a means to understand
exchange Assume U(F, S) = FS
We can graph the various indifference curves
Assuming 1 Util, indifference curve 1 can be represented by S=1/F
More generally it would be S = U0/F
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The Utility FunctionIn order to maintain the same level of utility, the marginal utility (MU) we give up of one
good should equal the marginal utility we gain from the exchange
MUFF = MUFS
Or
MUFMUS = F/S
At the optimal level of utility, given the budget constraint it is also true that
MUFMUS = PF/PS = MRS
While we can create examples using cardinal utility, such as above, because it is not reallypossible to measure utility, so we rely on Ordinal Utility
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A discussion about Incentives
So far we have discussed rational choice from the perspective of satisfaction or utility.
Rational choice also depends on incentives
Paris Hilton pleaded guilty of cocaine possession. Why?
The prosecution charged her with misdemeanor in return for a guilty plea and she
would not go to jail
If she had been charged with a felony, would she have pleaded guilty?
She was given an incentive to plead guilty
We could say that the incentive was a reduced cost or a reduced negative utility for Paris
Hilton
However, would it dissuade Paris Hilton from possessing cocaine in the future?
Many times the benefits are not clear-cut. In Freakonomics, the authors give an example
of a day-care center that fined parent $3 if they were late picking up their children. The
result was that the number of late parents increased
A social incentive (guilt) was replaced with a cost incentive ($3) which parents saw as
cheaper than the guilt they felt
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Indifference Curves and Demand
As prices change, the budget line changes and becomes tangent to a new indifference
curve
New combinations of Food and Shelter are consumed
The above graph shows the effect of a change in the price of Shelter
The points of tangency are connected by the Price-Consumption Curve (PPC)
The amounts of Shelter at each price can be plotted, giving us our demand curve
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Income and Consumption
When incomes change, the constraint shifts
The amounts of consumption of both good will change accordingly
The new combinations of goods consumed as incomes shift is shown by the Income-
Consumption Curve (ICC)
In this case, the increase in come leads to increases in the consumption of both Food
and Shelter
We can plot the amounts of Shelter consumed at each level of income using the
Engel Curve
Dont forget that we assume no changes in the prices of either goods 20
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Normal and Inferior goods
If income rises and quantity demanded for a good also rises the Engel Curve will be upward
sloping This is considered a Normal Good(quantity demanded rises as incomes rise)
If incomes rise but quantity demanded for a good declines, then the Engel Curve will be
downward sloping
This is considered an Inferior Good(quantity demanded declines as incomes rise)
We discussed this earlier, but the Engel Curve is the best tool for demonstrating the type of
good
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Income and Substitution Effects of a Price Change
When the price of a good changes, there are two effects
If relative consumption shifts from one good to another, we call it the Substitution
Effect(the component of the total effect of a price change that results from the
associated change in the relative attractiveness of other goods
If the price of Shelter increases, consumers will consume more Food relative to
Shelter If overall consumption changes because the consumer has more or less purchasing
power, we call it the Income Effect(the component of the total effect of a price
change that results from the associated change in real purchasing power
If the price of Shelter increases you have to give up more food for the same amount
of Shelter and total potential Shelter consumption is less (less purchasing power
These effects are combined to give us the total effect of a price change 22
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Income and Substitution Effects of a Price Change
Consider an increase in Shelter from $6/sq. yd. to $24/sq. yd.
On the original indifference curve, the optimal choice would go from point A to C
representing the substitution effect (This is determined by where the new budget linewould be if the price of Shelter was offset by the price of Y shown by a parallel line to
the new budget line. Consumption of s would go from 10 to 6 and consumption of Y
would go from 60 to 96
The income effect represents the combinations of S and Y at the new budget line
(Final consumption of S would be 2 and final consumption of Y would be 72 (point D))
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