1. MICROECONOMICS: Theory & Applications By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 10 th Edition, Copyright 2009 PowerPoint prepared by Della L. Sue, Marist College Chapter 3: The Theory of Consumer Choice

2. Copyright 2009John Wiley & Sons, Inc. 2 Learning Objectives Develop an approach for analyzing consumer preferences. Explain how a consumer’s income and the prices that must be paid for various goods limit consumption choices. Understand how the market basket chosen by a consumer reflects both the consumer’s preferences and the budget constraints imposed on the consumer by income and the prices that must be paid for various goods. (continued)

3. Copyright 2009John Wiley & Sons, Inc. 3 Learning Objectives (continued) Determine how changes in income affect consumption choices. Show how altruism can be explained by the theory of consumer choice. Relate the utility approach to the indifference curve method of analyzing consumer choice.

4. Copyright 2009John Wiley & Sons, Inc. 4 Consumer Preferences Economists make three assumptions about the typical consumer’s preferences: 1. Preferences are complete. 2. Preferences are transitive. 3. More of any good is preferred to less.

5. Copyright 2009John Wiley & Sons, Inc. 5 Definitions Indifferent – when a consumer finds two options to be equally satisfactory Economic “bads” – commodities of which less is preferred to more over all possible ranges of consumption Economics “goods” – commodities of which more is better than less

6. Copyright 2009John Wiley & Sons, Inc. 6 Consumer Preferences Graphed as Indifference Curves Indifference curve – plots all the market baskets that a consumer views as being equally satisfactory Figure 3.1

7. Copyright 2009John Wiley & Sons, Inc. 7 An Indifference Map [Figure 3.2]

8. Copyright 2009John Wiley & Sons, Inc. 8 Characteristics of Indifference Curves Characteristics: An indifference curve has a downward slope if both goods are desirable. An indifference curve that lies farther from the origin is preferred to one that is closer to the origin. Two indifference curves cannot intersect. An indifference map is a set of indifference curves. A set of indifference curves represents an ordinal ranking.

9. Copyright 2009John Wiley & Sons, Inc. 9 Why Intersecting Indifference Curves Are Inconsistent [Figure 3.3]

10. Copyright 2009John Wiley & Sons, Inc. 10 Curvature of Indifference Curves Indifference curves are convex to the origin. Why? Diminishing marginal rate of substitution (MRS): a consumer’s willingness to give up less and less of some other good to obtain still more of the first good Figure 3.4

11. Copyright 2009John Wiley & Sons, Inc. 11 Individuals Have Different Preferences [Figure 3.5]

12. Copyright 2009John Wiley & Sons, Inc. 12 Graphing Economic Bads and Economic Neuters [Figure 3.6]

13. Copyright 2009John Wiley & Sons, Inc. 13 Perfect Substitutes and Complements [Figure 3.7]

14. Copyright 2009John Wiley & Sons, Inc. 14 The Budget Constrain [Figure 3.8] Budget line: a line that shows the combinations of goods that can be purchased at the specified prices and assuming that all of the consumer’s income is expended. See Table 3.1 for data used in graph.

15. Copyright 2009John Wiley & Sons, Inc. 15 Table 3.1 Note: Income = $90; P M =$9/movie pass; P C =$18/compact disc

16. Copyright 2009John Wiley & Sons, Inc. 16 Geometry of the Budget Line The intercepts with the axes show the maximum amount of one good that can be purchased if none of the other is bought. The slope indicates how much of one good must be given up to buy one more of the other good: Slope = ΔY/ΔX = -P X /P Y

17. Copyright 2009John Wiley & Sons, Inc. 17 Effect of an Income Change on the Budget Line [Figure 3.9]

18. Copyright 2009John Wiley & Sons, Inc. 18 Effect of a Price Change on the Budget Line [Figure 3.10]

19. Copyright 2009John Wiley & Sons, Inc. 19 Shifts in Budget Lines A change in income with constant prices produces a parallel shift in the budget line. A change in the price of one good, with income and the other good’s price remaining unchanged, causes the budget line to rotate about one of the intercepts.

20. Copyright 2009John Wiley & Sons, Inc. 20 The Consumer’s Optimal Consumption Choice [Figure 3.11]

21. Copyright 2009John Wiley & Sons, Inc. 21 The Consumer’s Choice Marginal benefit The value the consumer derives from consuming one more unit of a good Measured by the MRS XY Marginal cost The cost of consuming one more unit of a good Measured by the price ratio Consumer’s optimal choice MRS XY = P X /P Y

22. Copyright 2009John Wiley & Sons, Inc. 22 A Corner Solution The consumer’s optimal choice is not characterized by an equality between the MRS and the price ratio. Only clothing is purchased because the value of the first unit of Dom Perignon is less than the cost. Figure 3.12

23. Copyright 2009John Wiley & Sons, Inc. 23 The Composite-Good Convention [Figure 3.13]

24. Copyright 2009John Wiley & Sons, Inc. 24 Changes in Income and Consumption Choices Income-consumption curve: the curve that joins all the optimal consumption points generated by varying income The curve slopes upward for normal goods. Figure 3.14

25. Copyright 2009John Wiley & Sons, Inc. 25 Income-consumption Curve for an Inferior Good The curve slopes downward for inferior goods. Figure 3.15

26. Copyright 2009John Wiley & Sons, Inc. 26 The Food Stamp Program [Figure 3.16]

27. Copyright 2009John Wiley & Sons, Inc. 27 The Allocation of Commencement Tickets [Figure 3.17]

28. Copyright 2009John Wiley & Sons, Inc. 28 Are People Selfish? [Figure 3.18]

29. Copyright 2009John Wiley & Sons, Inc. 29 Is Altruism a Normal Good? [Figure 3.19]

30. Copyright 2009John Wiley & Sons, Inc. 30 The Utility Approach to Consumer Choice Total utility - assuming that it is measurable, the total satisfaction a consumer receives from a given level of consumption Marginal utility - the amount by which total utility rises when consumption increases by one unit Diminishing marginal utility – the assumption that as more of a given good is consumed, the marginal utility associated with the consumption of additional units tends to decline, other things equal.

31. Copyright 2009John Wiley & Sons, Inc. 31 Total and Marginal Utility [Table 3.2]

32. Copyright 2009John Wiley & Sons, Inc. 32 The Consumer’s Optimal Choice The utility-maximizing market basket is one for which the consumer allocates income so that the marginal utility divided by the good’s price is equal for every good purchased: MU X /P X = MU Y /P Y The equality between the marginal utility per dollar’s worth of both goods is the same as the equality between the MRS and the price ratio.

33. Copyright 2009John Wiley & Sons, Inc. 33 Relationship to Indifference Curves [Figure 3.20] The slope of an indifference curve is related to the marginal utilities of the two goods. At Point R, ΔC/ΔF = MU F /MU C

34. Copyright 2009John Wiley & Sons, Inc. 34 The Mathematics Behind Consumer Choice Preferences of the Consumer: The slope of an indifference curve (MRS) equals (minus) the ratio of the marginal utilities. The Budget Constraint: The slope of the budget line equals the negative of the price ratio. The Consumer’s Choice: To maximize utility, the ratio of marginal utilities equals the ratio of prices MRS = slope of the budget line The consumer’s choice must lie on the budget line.

35. Copyright 2009John Wiley & Sons, Inc. 35 Copyright © 2009 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein.