Chapter 3 - The theory of consumer choice. In this chapter students will be able to: Develop an approach for analyzing consumer preferences, explain how a consumer’s income and the prices that must be paid for various goods limit consumption choices, determine how changes in income affect consumption choices.
Prepared by Dr. Della Lee Sue, Marist College MICROECONOMICS: Theory & Applications Chapter 3: The Theory of Consumer Choice By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc 12th Edition, Copyright 2015 Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Learning Objectives Develop an approach for analyzing consumer preferences Explain how a consumer’s income and the prices that must be paid for various goods limit consumption choices Describe how the market basket chosen by a consumer reflects both the consumer’s preferences and the budget constraints imposed on the consumer by income and the prices that must be paid for various goods Determine how changes in income affect consumption choices (continued) Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Learning Objectives (continued) Explain how altruism can be explained by the theory of consumer choice Relate the utility approach to the indifference curve method of analyzing consumer choice Explain the mathematics behind consumer choice Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Develop an approach for analyzing consumer preferences 3.1 CONSUMER PREFERENCES Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Consumer Preferences Economists make three assumptions about the typical consumer’s preferences: Preferences are complete Preferences are transitive More of any good is preferred to less aka “nonsatiation” Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Definitions Indifferent – when a consumer finds two options to be equally satisfactory Market baskets – combinations of goods Economic “bads” – commodities of which less is preferred to more over all possible ranges of consumption Economics “goods” – commodities of which more is better than less Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Figure 3.1 – An Indifference Curve Indifference curve – a plot of all the market baskets the consumer views as being equally satisfactory Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Figure 3.2 An Indifference Map Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Characteristics of Indifference Curves Characteristics: An indifference curve has a downward slope if both goods are desirable An indifference curve that lies farther from the origin is preferred to one that is closer to the origin Two indifference curves cannot intersect An indifference map is a set of indifference curves A set of indifference curves represents an ordinal ranking Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Figure 3.3 Why Intersecting Indifference Curves Are Inconsistent Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 10 Figure 3.16 – Effects of the Food Stamp Program on Consumption Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 39 Figure 3.17 The Allocation of Commencement Tickets Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 40 Explain how altruism can be explained by the theory of consumer choice 3.5 ARE PEOPLE SELFISH? Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 41 Figure 3.18 Transferring Income to Another Person Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 42 Figure 3.19 Is Altruism a Normal Good? Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 43 Relate the utility approach to the indifference curve method of analyzing consumer choice 3.6 THE UTILITY APPROACH TO CONSUMER CHOICE Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 44 The Utility Approach to Consumer Choice Total utility assuming that it is measurable, the total satisfaction a consumer receives from a given level of consumption Marginal utility the amount by which total utility rises when consumption increases by one unit Diminishing marginal utility – the assumption that as more of a given good is consumed, the marginal utility associated with the consumption of additional units tends to decline, other things equal Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 45 Table 3.2 Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 46 The Consumer’s Optimal Choice The utilitymaximizing market basket is one for which the consumer allocates income so that the marginal utility divided by the good’s price is equal for every good purchased: MUX/PX = MUY/PY The equality between the marginal utility per dollar’s worth of both goods is the same as the equality between the MRS and the price ratio Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 47 Relationship to Indifference Curves The slope of an indifference curve is equal to the ratio of the marginal utilities of the two goods At Point R, ΔC/ΔF = MUF/MUC Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 48 Explain the mathematics behind consumer choice 3.7 THE MATHEMATICS BEHIND CONSUMER CHOICE* Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 49 The Mathematics Behind Consumer Choice Preferences of the Consumer: The slope of an indifference curve (MRS) equals (minus) the ratio of the marginal utilities The Budget Constraint: The slope of the budget line equals the negative of the price ratio The Consumer’s Choice: To maximize utility, the ratio of marginal utilities equals the ratio of prices MRS = slope of the budget line The consumer’s choice must lie on the budget line Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 50 Preferences of the Consumer Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 51 The Budget Constraint Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 52 The Consumer’s Choice Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 53 ... Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 16 Figure 3. 6 – Indifference Maps for a “Bad” and a “Neuter” Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 17 Figure 3. 7 Perfect Substitutes and Complements ... Describe how the market basket chosen by a consumer reflects both the consumer’s preferences and the budget constraints imposed on the consumer by income and the prices that must be paid for various goods 3. 3 THE CONSUMER’S CHOICE Copyright © 2015 John Wiley & Sons, Inc. All rights reserved... Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 30 Figure 3. 12 A Corner Solution The consumer’s optimal choice is not characterized by an equality between the MRS and the price ratio Only clothing is purchased