Consumer Choice Theory: Introduction Lecture 3 Consumer Choice Theory: Introduction

Lecture Outline The Budget Constraint Preferences ( Level 200) The Budget Line Shifts in the budget line changes in money income changes in relative prices Preferences ( Level 200)

Consumer Choice People constantly making economic decisions How to spend money How to spend time To understand the economic choices that people make, we must know What are they trying to achieve (goals)? What are constraint/limitations they face?

Consumer Choice Individuals have desires and constraints that are specific to each person But in general...we are quite alike All want to maximize our overall satisfaction We are all faced by some type of constraint Too little income or too little time

The Budget Constraint Begin analysis with Constraints All individuals face two facts of economic life Have to pay for goods and services you buy Have limited funds to spend

The Budget Constraint These facts summarized by consumers budget constraint Budget constraint identifies which combinations of goods and services the consumer can afford with a limited budget, at given prices

The Budget Constraint Consider this scenario Yaa loves both stage plays and gospel music She has a total entertainment budget of Ghc100 to spend each month Each stage play costs Ghc10 and each live gospel concert costs Ghc20 If Yaa spends her entire budget on movies, she can watch 10 plays a month; or attend 5 gospel concerts if he spend his entire budget on music

The Budget Constraint However, Yaa could spend budget on combination of stage plays and gospel music.

The Budget Constraint Yaa’s Consumption Possibilities with Income of Ghc100 Music Concerts at Ghc20 Stage Plays at Ghc10 Qty Total expenditure (Ghc) Total expenditure (Ghc) A 10 100 B 1 20 8 80 C 2 40 6 60 D 3 4 E F 5

The Budget Constraint Budget line Graphical representation of a budget constraint

The Budget Constraint Every time Yaa buys an additional concert, she must give up ??? Stage plays per month What concept is this? Slope of the budget line Trade-off between one good and another Amount of one good that must be sacrificed in order to buy more of another good 10 A Plays per month 8 B 6 C 4 D E 2 F 1 2 3 4 5 Concerts Per month

The Budget Constraint Prices tell us how many Ghc she must give up to get another unit of good Relative price Price of one good relative to the other Calculated as ratio of prices Relative price of concert= Pc/Pp= Ghc20/Ghc10= 2 Note: ‘2’ is also opportunity cost of concert What is the relative price of a movie?

General Relationship If Py is the price of the good on the vertical axis and Px is the price of the good on the horizontal axis, then the slope of the budget line is Px/Py Slope BL= Opportunity Cost= Relative Price (X)

Changes in the Budget Line Earlier budget line assumed given prices (of music concerts and stage plays) and consumer income (Yaa’s income= Ghc100) If any of these ‘givens’ change, the budget line will change

Changes in the Budget Line: Changes in Income Assume Yaa’s monthly income increases from Ghc100 to Ghc200 She can afford to consume more movies, more concerts, or more of both Assuming prices constant Concert= Ghc20 and Plays= Ghc10 ...Yaa can attend 10 concerts or watch 20 stage plays, if devoting entire income to each What would new budget line look like?

The Budget Constraint: Change in Income Old Income= 100 New Income= 200 Rightwards shift of BL No change in slope Pp= Ghc10 Pc= Ghc20 What is the new relative price of concerts? 20 10 A Movies per month 8 B 6 C 4 D E 2 F 1 2 3 4 5 10 Concerts Per month

The Budget Constraint: Changes in Price Assume Pp falls from Ghc10 to Ghc5 Original budget of Ghc100 What is the effect on the budget line?

The Budget Constraint: Change in Price (movie) Old Pp= Ghc10 New Pp= Ghc5 Pc= Ghc20 Income= 100 BL rotates outwards Vertical intercept higher No change in horizontal intercept What is new BL slope/ OC/Relative Price of Concerts? Interpretation? 20 10 A Movies per month 8 B 6 C 4 D E 2 F 1 2 3 4 5 10 Concerts Per month

The Budget Constraint: Changes in Price Assume Pc falls from Ghc20 to Ghc10 Original budget of Ghc100 What is the effect on the budget line?

The Budget Constraint: Change in Price (concerts) Pp= Ghc10 Old Pc= Ghc20 New Pc= Ghc10 Income= 100 BL rotates outwards Vertical intercept unchanged Horizontal intercept changes What is new BL slope/ OC/Relative Price of Concerts? Interpretation? 10 A Movies per month 8 B 6 C 4 D E 2 F 1 2 3 4 5 10 Concerts Per month

Changes in the Budget Line Changes in income - shift the budget line Income increase - upward-rightward shift Income decrease - downward-leftward shift Do not affect the budget line’s slope Changes in price – rotate the budget line The slope changes One of the intercepts changes

Preferences Budget Constraint is only one side of story Indicates trade-offs consumers are able to make Preferences is other side of the story Indicates trade-offs consumers want to make

Preferences How can we speak systematically about people’s preferences? People are different; like different things... Teenagers and social media; not very common among older folk Some people like local dishes; others prefer continental...etc However, some common denominators are true for most people…

Preferences: Rationality Rationality is a critical assumption behind consumer theory First, assumes people HAVE preferences An individual can look at two goods and either state that he/she prefers one to the other, or indifferent between the two

Preferences: Rationality Rationality is a critical assumption behind consumer theory Second, assumes logical consistency If Ama prefers a Toyota to a Honda, and a Honda to a Jeep, then she must prefer a Toyota to a Jeep! When a consumer can make choices and is logically consistent, then we say s/he has rational preferences

Preferences: More is Better! Most people feel that more is better Caveat: More of a GOOD thing is better …and nothing else taken away The model of consumer choice designed for preferences that satisfy the ‘More is Better’ criteria Relationship between ‘More is Better’ condition and BL?

Preferences: More is Better Examine point G in diagram.... What do you think? 15 A Movies per month 12 B 9 C H G 6 D E 3 F 1 2 3 4 5 Concerts Per month

Consumer Decisions: Consumer Utility Knowing that consumer will not choose G narrows options for point that s/he WILL choose How can we find the ONE point on BL that consumer WILL choose?? Theories Marginal Utility Theory Indifference Curve Approach

Consumer’s Decisions: Consumer Utility Both assume preferences are rational Both assume More is Better Both come to same general conclusions about consumer behaviour However, each takes a different road to arrive at these conclusions

Take-Home Exercise Nana, a pharmacology student, has allocated Ghc120 per month to spend on paperback novels and used CDs. Novels cost Ghc8 each; CDs cost Ghc6 each. Draw his budget line. Draw and label a second budget line that shows what happens when the price of a CD rises to Ghc10 Draw and label a third budget line that shows what happens when the price of a CD rises to Ghc12 and Nana’s income rises to Ghc240