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PPA 723: Managerial Economics Lecture 7: Consumer Choice.

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Presentation on theme: "PPA 723: Managerial Economics Lecture 7: Consumer Choice."— Presentation transcript:

1 PPA 723: Managerial Economics Lecture 7: Consumer Choice

2 Managerial Economics, Lecture 7: Consumer Choice Outline  Consumer Utility Maximization  Application to Food Stamps

3 Managerial Economics, Lecture 7: Consumer Choice Review: Preferences  Indifference curve map summarizes preferences.  Higher indifference curves indicate higher utility.  Marginal utility = extra utility from one more unit of a good holding constant consumption of all other goods.  Slope of an indifference curve = marginal rate of substitution (MRS) = MU B /MU A.

4 Managerial Economics, Lecture 7: Consumer Choice Review: Budget Constraints  A consumer's opportunity set increases with income and decreases with prices.  A budget constraint shows bundles that a consumer can buy by spending all of his or her income at given prices.   The slope of budget line = marginal rate of transformation (MRT) = P B /P A = rate at which Good A can be exchanged for Good B.

5 Managerial Economics, Lecture 7: Consumer Choice Budget Line Meets Indifference Curves  Households maximize utility subject to their budget constraint.  There are two possibilities for the optimal bundle:  an interior solution: buy some units of all goods.  a corner solution: buy only one good.

6 Managerial Economics, Lecture 7: Consumer Choice Interior Solution  The consumer buys some of all goods.  The optimum bundle is where highest indifference curve just touches the budget line—but does not cross it!  This is a tangency point.

7 Managerial Economics, Lecture 7: Consumer Choice Figure 4.8a Consumer Maximization B, Burritos per semester (a) Interior Solution Budget line Z, Pizzas per semester I 1 I 2 I 3 d fc e a g A B Optimal Bundle

8 Managerial Economics, Lecture 7: Consumer Choice Tangency Property  The tangency of the indifference curve and the budget line implies that:  The last dollar spent on pizza gives as much extra utility as that spent on burritos

9 Managerial Economics, Lecture 7: Consumer Choice Summary: Utility Maximized  To maximize their well-being subject to their budget, consumers pick the point where the highest possible indifference curve hits budget constraint.  This indifference curve is tangent to budget constraint, which implies that MRS = MRT  The last dollar spent on one good gives as much extra utility as the last dollar spent on any other consumed good.

10 Managerial Economics, Lecture 7: Consumer Choice Marginal Conditions  This rule provides the introduction to a very different way of thinking:  The best choice requires getting things right at the margin.  Consumers maximize their utility when they cannot gain by fiddling with their choices at the margin.  No gain from further fiddling is equivalent to finding the overall utility maximum!

11 Managerial Economics, Lecture 7: Consumer Choice Marginal Conditions and Public Administration  The use of marginal conditions is a critical management tool.  As a manager, your best choices will involve getting the same marginal return per dollar from all activities or purchases.  To maximize any objective, make sure you can’t fiddle any more at the margin.  No gain from further fiddling is equivalent to finding your overall maximum!

12 Managerial Economics, Lecture 7: Consumer Choice Optimal Bundle: Corner Solution  The optimal bundle is still at the point where highest indifference curve touches budget line.  But this point is at a “corner” where only one good is consumed.  The indifference curve and budget line are not tangent at the optimal bundle.

13 Managerial Economics, Lecture 7: Consumer Choice Figure 4.8b Consumer Maximization B, Burritos per semester (b) Corner Solution Budget line Z, Pizzas per semester I 1 I 2 I 3 e Optimal Bundle

14 Managerial Economics, Lecture 7: Consumer Choice Solved Problem: Food Stamps Are poor people better off receiving food stamps or a comparable amount of cash?

15 Managerial Economics, Lecture 7: Consumer Choice Answer  Cash gives recipients more choice.  Whether that greater choice matters depends on the recipients tastes or, roughly, on how much food they eat.

16 Managerial Economics, Lecture 7: Consumer Choice Figure 4.10 Food Stamps Versus Cash All other goods per month YY +100 Y + 0 Food per month Budget line with food stamps Budget line with cash Original budget line A B f d e Y C I 1 I 2 I 3

17 Managerial Economics, Lecture 7: Consumer Choice Food Stamps Versus Cash, Continued All other goods per month YY +100 Y + 0 Food per month Budget line with food stamps Budget line with cash Original budget line A B f d e Y C I 1 I 2 I 3 I 1* I 2* Household 1 Household

18 Managerial Economics, Lecture 7: Consumer Choice Cash vs. In-Kind Transfers: Lessons  Cash and in-kind transfers of Good A are equivalent unless the in-kind transfer is large relative to the recipient’s initial consumption of Good A.  If the in-kind transfer is large relative to initial consumption, then  the cash transfer leads to higher utility, and  the in-kind transfer leads to more consumption of Good A.

19 Managerial Economics, Lecture 7: Consumer Choice Food Clothing F1F1 F3F3 F2F2 Budget Line with Cash Grant Cost of Both Programs (in Units of Food) Tangency Point with Price Subsidy I3I3 I2I2 I1I1 Budget Line with Price Subsidy Tangency Point with Cash Grant A Price Subsidy and an Equal-Cost Cash Grant

20 Managerial Economics, Lecture 7: Consumer Choice Cash vs. a Price Subsidy: Lessons  A cash transfer and an equal-cost price subsidy have the same income effect, but the price subsidy also has a price effect.  It follows that  the cash transfer leads to higher utility, and  the price subsidy leads to more consumption of the subsidized good.


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