3Managerial Economics, Lecture 7: Consumer Choice Review: PreferencesIndifference 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) = MUB/MUA.
4Managerial Economics, Lecture 7: Consumer Choice Review: Budget ConstraintsA 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) = PB/PA = rate at which Good A can be exchanged for Good B.
5Managerial Economics, Lecture 7: Consumer Choice Budget Line Meets Indifference CurvesHouseholds 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.
6Managerial Economics, Lecture 7: Consumer Choice Interior SolutionThe 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.
8Managerial Economics, Lecture 7: Consumer Choice Tangency PropertyThe 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
9Managerial Economics, Lecture 7: Consumer Choice Summary: Utility MaximizedTo 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 = MRTThe last dollar spent on one good gives as much extra utility as the last dollar spent on any other consumed good.
10Managerial Economics, Lecture 7: Consumer Choice Marginal ConditionsThis 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!
11Managerial Economics, Lecture 7: Consumer Choice Marginal Conditions and Public AdministrationThe 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!
12Managerial Economics, Lecture 7: Consumer Choice Optimal Bundle: Corner SolutionThe 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.
14Managerial Economics, Lecture 7: Consumer Choice Solved Problem: Food StampsAre poor people better off receiving food stamps or a comparable amount of cash?
15Managerial Economics, Lecture 7: Consumer Choice AnswerCash gives recipients more choice.Whether that greater choice matters depends on the recipients tastes or, roughly, on how much food they eat.
16Managerial Economics, Lecture 7: Consumer Choice Figure Food Stamps Versus CashAll other goodsper monthBudget line with cashY+100fCeYI3dI2I1BBudget line withfood stampsAOriginalbudget line100YY+100Food per month
17Managerial Economics, Lecture 7: Consumer Choice Food Stamps Versus Cash, ContinuedAll other goodsper monthBudget line with cashY+100fCeYI3dHousehold 1I2I1I 2*Household 2BI 1*ABudget line withOriginalfood stampsbudget line50100150160YY+100Food per month
18Managerial Economics, Lecture 7: Consumer Choice Cash vs. In-Kind Transfers: LessonsCash 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, thenthe cash transfer leads to higher utility, andthe in-kind transfer leads to more consumption of Good A.
19Managerial Economics, Lecture 7: Consumer Choice A Price Subsidy and an Equal-Cost Cash GrantFoodClothingF1F3F2Budget Line withCash GrantCost of Both Programs(in Units of Food)Tangency Pointwith Price SubsidyI3I2I1Budget Line with Price Subsidywith Cash Grant
20Managerial Economics, Lecture 7: Consumer Choice Cash vs. a Price Subsidy: LessonsA cash transfer and an equal-cost price subsidy have the same income effect, but the price subsidy also has a price effect.It follows thatthe cash transfer leads to higher utility, andthe price subsidy leads to more consumption of the subsidized good.