1. Consumer Choice Theory: Introduction
Lecture 3
Consumer Choice Theory:
Introduction

2. 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)

3. 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?

4. 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

5. 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

6. 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

7. 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

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

9. 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

10. The Budget Constraint Budget line
Graphical representation of a budget constraint

11. 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

12. 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?

13. 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)

14. 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

15. 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?

16. 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

17. 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?

18. 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

19. 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?

20. 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

21. 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

22. 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

23. 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…

24. 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

25. 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

26. 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?

27. 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

28. 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

29. 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

30. 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