Recall: Consumer behavior Why are we interested? –New good in the market. What price should be charged? How much more for a premium brand? –Subsidy program: in cash or in kind? Which will make consumers better off? Which will help achieve social objectives?

Understand consumer behavior in 3 steps 1.Budget constraints – what can people afford? 2.Preferences – how to describe how people might prefer one good (or consumption bundle) to another? (Concept of utility function) 3.Choice: given preferences and limited budgets, what combinations of goods will consumers buy to maximize their satisfaction?

Assumptions on preferences impose a degree of rationality Complete – consumers can compare and rank all consumption bundles (regardless of cost), e.g. one is preferred to another or indifferent between the two Reflexive – consumption bundle is at least as good as itself Transitive – ensures that consumer preferences are rational (consistent)

Indifference curves Indifference curve represents all combinations of consumption bundles that provide the same level of satisfaction to a person. A person is indifferent among the bundles represented by the locus of points on the curve. Indifference map: a set of ICs to describe person’s preference for all combinations of good 1 and 2 Weakly preferred set: bundles weakly preferred to X Indifference curves cannot cross (or what will happen?)

We know A is preferred to E. And D is preferred to A. But comparison with others needs more information

Say, IC connects A, B and C. Means consumer feels neither better nor worse off giving up 10 units of books to get 20 units of CDs (from A to B) …

Well-behaved preferences More of any good is preferred to less (ignoring “bads”) – monotonicity –Implication : IC slopes downward from left to right. Averages preferred to extremes – convexity –Consumers generally prefer a balanced consumption bundle –Implication: set of bundles weakly preferred to X is a convex set

Marginal rate of substitution People face trade-offs when choosing between goods. IC help to show these trade-offs. MRS: maximum amount of good 2 that a person is willing to give up to obtain one additional unit of good 1 (- CD/ B) The MRS at any point is equal in absolute value to the slope of the IC at that point. –Slope of the IC becomes less negative (increases) as we move down the IC. That is, MRS diminishes. (As consumption of good 1 increases, consumers desire for still more should diminish. So should be willing to give up less and less of good 2 to obtain it)

Budget constraint Budget line indicates all combinations of good 1 and good 2 for which total money spent is equal to income. Slope of the budget line is the negative of the ratio of the prices of the two goods. Magnitude tells us the rate at which the two goods can be substituted for each other without changing the total amount of money spent. Purchasing power of consumer (ability to buy goods) is determined not only by income but also by prices. Purchasing power can double either because income doubles OR because prices of all goods falls by half. A inflation in which all prices and income levels rise proportionately will not affect the consumers budget line or purchasing power.

Consumer Choice We assume consumers maximize the satisfaction they can achieve, given their budget constraint. –Bundle must be located on the budget line –Bundle must give the consumer the most preferred combination of goods and services (We assume that all income is spent now) Can determine graphically how individual consumers choose how much of each good to buy.

books CDs B A C

Therefore The bundle that maximizes satisfaction must lie on the highest IC that touches the budget line. At A, slope of budget line = slope of the IC. Result: given budget constraint, satisfaction is maximized at point where MRS = P b /P cd

examples NG-LGU dynamics: Non-matching vs. matching grants College trust funds Note: Corner solution – MRS not equal to price ratio. Impossible to consume negative amounts of good 2.

Assuming consumers can rank alternatives, IC allow us to describe consumer preferences graphically. Consumer preferences can also be described using the concepts of utility and marginal utility

Utility Utility is the level of satisfaction that a person gets from consuming a good or undertaking an activity. In economic analysis, utility is most often used to summarize the preference ranking of consumption bundles. Utility function is obtained by attaching a number to each consumption bundle, so that if bundle A is preferred to bundle B, the number will be higher for A than for B. Utility function provides the same information about preferences that an indifference map does. Both order consumer choices in terms of level of satisfaction.

Ordinal properties Levels of utility associated with bundles A, B and C might be 4, 2, and 1. Or may be 3, 2, 1. Because most choices can be explained simply by the ordinal ranking of utility levels, both sets of indicators provide the same information. In other words, what is important is the relative rankings that are given. Actual numbers attached to the IC are for convenience only.

Marginal utility When analyzing costs and benefits of public projects, valuable to use some of the cardinal properties of utility functions. Marginal utility measures the additional satisfaction obtained from consuming an additional amount of a good. Diminishing marginal utility: as more and more of a good is consumed the process of consumption will (at some point) yield smaller and smaller additions to utility. (example – TV).

Relating ‘marginal utility’ to consumer utility max problem: A small movement down and along an IC: additional consumption of books, B, will generate marginal utility MU b for each unit. This results in total increase in utility of MU b. At the same time, the loss of consumption of CD,,will lower utility by MU cd Since all points on an indifference curve generate the same level of utility, the total gain in utility associated with increase in B must balance the loss due to lower consumption of CD.

Formally Utility maximization is achieved when the budget is allocated so that the MU per peso of expenditure is the same for each good.