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Theory of Consumer Behavior Basics of micro theory: how individuals choose what to consume when faced with limited income? Components of consumer demand theory: –Preferences –Budget Constraints –Consumer Choices: Maximize utility subject to budget constraint.

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Consumer Preferences Preferences: tastes or likes/dislikes for different goods. MUST simplify: actual #goods infinite; we reduce to two! One market basket: one potential combination of the two goods. Then compare market baskets. Example: two goods: Food and Clothing.

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Assumptions Underlying Consumer Demand Theory 1. Preferences are complete: We can compare baskets and can rank; which indifferent between? 2. Preferences are transitive (from math): If prefer A to B, and prefer B to C, then know prefer A to C. 3. MIB (more is better; or non- satiation): unless stated otherwise, all goods are “good” so that we receive utility from consuming each additional one. 4. Diminishing MRS: more later.

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Shape of Indifference Curves 1. Negative slope: slopes downward to right to show tradeoffs shows how willing to substitute one good for another. 2. Nonlinear: so slope not constant. Marginal rate of substitution (MRS): amount of a good that the consumer will give up to get one more unit of another good. MRS = slope of indifference curve MRS = clothing / food MRS is positive number; measures value of food in foregone clothing.

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Diminishing MRS MRS falls as move down and to right on a single indifference curve). Same as saying that indifference curve goes from relatively steep to relatively flat. Implies that indifference curves are convex to the origin. Can infer from shape of indifference curve if two goods are more like complements or more like substitutes.

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Measuring Utility Ordinal utility functions: we use this; functions that yield a ranking (an order). Cardinal utility functions: utility functions which assign a numerical value: –U(F,C) = F + 2C; – if F=8 and C=3 then: 8 + 2*3 = 14. –Can interpret this by saying that this basket yields 14 units of utility. All other combinations of F and C that yield 14 units of utility will lie on the same indifference curve.

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Indifference Curves: Exercise Draw two typical indifference curves for each of the following cases. Describe the MRS in each case. –A. Name-brand aspirin and generic aspirin (consumer considers them equal in every way). –B. Right gloves and left gloves for consumer who only wants to wear both. –C. Right gloves and left gloves for a rock star who only wears the left gloves; considers the right gloves useless.

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Budget Line Will be used with indifference curves. Budget Line: shows all combinations of goods for which the total amount of money spent is equal to income. –Two goods: F, C –Spend ALL of Income on F and C –Equation for budget line: –P F F + P C C = Income

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Example of Budget Line Remember: P F F + P C C = I Weekly Income = I = $80 P F = $1; P C = $2 1*F + 2*C = 80 If spend all income on C: –Then F = 0. –Then C = 80/2. –Or: C = I/P C –This is an intercept.

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Slope of Budget Constraint Slope of b.c. = rise/run = C/ F Example: go from A to B: C/ F = -10/20 = -1/2. Slope: how much clothing must be given up to get an extra unit of food. Slope: the rate at which the two goods can be substituted, given a fixed total budget and prices. Remember: P F = 1; P C = 2: Slope = -P F /P C

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Show Slope Using Equation of a Line Recall: P F F + P C C = I Rewrite with C on left hand side since it is on vertical axis. C = I/P C – (P F /P C )*F Slope = C/ F = -P F /P C Like a derivative in math Vertical Intercept (max C if all income spent on C) = I/P C

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Position and Slope of Budget Line Position and slope depends on income and prices. Income: determines vertical and horizontal intercepts. If Income changes, both intercepts change. If Income changes, show as parallel shift of b.c. If one price changes, change the slope of the b.c. (a pivot of the curve; only one intercept changes).

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Exercise Given equation for budget line: P F F + P C C = I Assume: I = $200; P C = $10; P F = $5. 1. Find the intercepts and slope and draw the b.c. (and label); put C on vertical axis. 2. What if P F to $10? Re-do #1. 3. Starting from (1), what if I to $400? Re-do #1.

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Put Budget and Preferences Together Remember the behavioral assumption: consumers maximize utility subject to budget constraint. So optimal choice must satisfy two conditions: –1) must be located on budget line. –2) must yield maximum satisfaction possible.

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Optimal Consumption Basket * Indifference curve tangent to budget constraint. Slope of indifference curve equal to slope of b.c. MRS = -P F /P C. Rule: Choose C and F such that the rate at which I am willing to trade C for F exactly equals the rate at which the b.c. (or relative prices) says that C must be given up to get an extra unit of F.

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Marginal Decision- Making Common economics concept: –Should I buy one more of a good? –Should I work one more hour? Marginal Decision Rule: have a utility-maximizing point when: –Marginal benefit = marginal cost; –MRS = price ratio.

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Exercise Back to F and C example with C on vertical axis: 1. If MRS = 5 and –P F /P C = 3: –Is this a tangency? –If not, will consumer want to F or C? Why? 2. If MRS = 2 and –P F /P C = 3: –Is this a tangency? –If not, will consumer want to F or C? Why?

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Decision Making and Public Policy Funding from federal government given to states: TYPE of funding affects HOW money is spent. –1. Nonmatching grant: federal govt just gives the $$ without any restriction on how $$ is spent. –2. Matching grant: every grant dollar from the federal govt must be matched by state dollars spent exactly how the Feds say. Example: the Feds give $1 for every $3 the state spends.

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Federal Grants (continued) Nonmatching grant: like an increase in income shift to right of budget constraint. Matching grant: like a change in the price ratio change in slope of b.c. Key finding: Nonmatching grant leads to higher utility but less increase in spending in targeted area.

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Corner Solution Occurs when U-max choice occurs right on vertical or horizontal axis. With F and C example, means that individual will end up consuming only F or only C. Corner solution (if on horizontal axis): MRS P F /P C Key: Not always a U-max. –Implies that if individual could choose to give up more of the unchosen good, he would.

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College Trust Fund Like an increase in income that can ONLY be spent on college. (An extreme example of a matching grant.) Could end up with corner solution. Same Key Point: individual prefers money with no strings attached.

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Marginal Decision- Making Original rule: maximize utility subject to budget constraint. This refers to total utility. Marginal decision-making: how do I decide to consume one more of a specific good? Marginal utility: change in total utility (additional satisfaction) gained from consuming one more of a good. Diminishing MU: As F keeps by one: each extra F consumed adds less and less to total utility.

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More with MU As move along an indifference curve, F and C but total utility fixed. As F: the total utility gained from this F equals the MU F times the F; or: MU F * F. As C: the total utility gained from this C equals the MU C times the C; or: MU C * C.

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When Total Utility Equals Zero Remember: utility is constant along a given indifference curve. So the full TU from the F and C equals zero. 0 = (MU F * F) + (MU C * C) - MU C * C = MU F * F Rewrite this as: - C/ F = MU F /-MU C Recall: –- C/ F = MRS –MRS = slope of indifference curve. So: MRS = ratio of MUs

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Now Include Price Ratio Recall: MRS = P F /P C at U max –Ignore negatives for now. So: MU F /MU C = P F /P C Finally: MU F /P F = MU C /P C In words: Utility max is achieved when the MU per dollar of expenditure is the same for each good equal marginal principle. If MU F /P F MU C /P C, indiv will F (so MU F will ); same for C

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Revealed Preference Given information about market baskets chosen when faced with different budget constraints, we can infer something about shape of indifference curve even if were not told shape of indifference curve. Basic Idea: If a consumer chooses one market basket over another and if the chosen market basket is available at the same budget as the alternative, then the consumer must prefer the chosen market basket.

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