Chapter 5 - Consumer Choice

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					                    Consumer Choice
• You are constantly making economic decisions
• At the highest level of generality, we are all very
  much alike
     – Come up against the same constraints
          • A given income or wealth
          • A given time to enjoy it all
• The theory of individual decision making is
  called ―consumer theory‖



Hall & Leiberman;                                       1
Economics: Principles
              The Budget Constraint
• A consumer’s budget constraint identifies which
  combinations of goods and services the
  consumer can afford with a given budget
• Budget line is the graphical representation of a
  budget constraint
     – The price of one good relative to the price of another
     – The slope of the budget line indicates the spending
       trade-off between one good and another
          • Amount of one good, that must be sacrificed in order to buy
            more of another good
          • If PY is the price of the good on the vertical axis, then the
            slope of the budget line is –PX / PY

Hall & Leiberman;                                                           2
Economics: Principles
               Figure 1: The Budget
                     Constraint
Number of               With $150 per month, Max
Movies per
    Month               can afford 15 movies and
                        no concerts, . . .
          15     A
                                      12 movies and 1 concert or any other
                            B         combination on the budget line.
          12
                                                   Points below the line are
           9                          C
                                                 H also affordable.

           6                                     D
                                 G                               But not points
                                                             E   above the line.
           3
                                                                    F
                        1         2          3           4          5 Number of
                                                                       Concerts
                                                                      per Month
Hall & Leiberman;                                                                  3
Economics: Principles
          Changes in the Budget Line
• Changes in income
     – Increase in income will shift the budget line ____(and
       ____ward)
     – A decrease in income will shift the budget line
       ____ward (and _____ward)
     – Shifts are parallel
          • Changes in income do not affect the budget line’s slope
• Changes in price
     – In each case, one of the budget line’s intercepts will
       change, as well as its slope
          • When the price of a good changes, the budget line rotates
                – Both its slope and one of its intercepts will change


Hall & Leiberman;                                                        4
Economics: Principles
 Figure 2a: Changes in the Budget
               Line
                                  (a)
  Number of Movies
        per Month
                                 1. An increase in income shifts
                        30          the budget line rightward, with
                                    no change in slope.




                        15




                             5            10           15     Number of
                                                            Concerts per
Hall & Leiberman;                                                Month     5
Economics: Principles
 Figure 2b: Changes in the Budget
               Line
                                  (b)
  Number of Movies
        per Month
                                 2. A decrease in the price of
                        30          movies rotates the budget line
                                    upward.




                        15




                             5                         15     Number of
                                                            Concerts per
Hall & Leiberman;                                                Month     6
Economics: Principles
 Figure 2c: Changes in the Budget
               Line
                                  (c)
  Number of Movies
        per Month
                                 3. while a decrease in the price of
                        30          concerts rotates it rightward.




                        15




                             5                         15     Number of
                                                            Concerts per
Hall & Leiberman;                                                Month     7
Economics: Principles
                        Preferences
• How can we possibly speak systematically
  about people’s preferences?
     – People are different
• Despite differences in preferences, can
  find some important common
  denominators
     – In our theory of consumer choice, we will
       focus on these common denominators

Hall & Leiberman;                                  8
Economics: Principles
                           Rationality
• One common denominator
     – People have preferences
     – We assume that you can look at two alternatives and state either
       that you prefer one to the other or
          • That you are entirely indifferent between the two—you value them
            equally
• Another common denominator
     – Preferences are logically consistent, or transitive
          • When a consumer can make choices, and is logically consistent, we
            say that she has rational preferences
• Rationality is a matter of how you make your choices,
  and not what choices you make
     – What matters is that you make logically consistent choices

Hall & Leiberman;                                                              9
Economics: Principles
                         Two Theories
• Theories of consumer decision making
     – Marginal utility
     – Indifference curve
          • Both assume that preferences are rational
          • Both assume that consumer would be better off with more of
            any good
          • Both theories come to same general conclusions about
            consumer behavior
                – However, to arrive at those conclusions each theory takes a
                  different road
• Our goal is to describe and predict how
  consumers are likely to behave in markets
     – Rather than describe what actually goes on in their
       minds
Hall & Leiberman;                                                               10
Economics: Principles
                        More Is Better
• We generally feel that more is better
• The model of consumer choice in this
  chapter is designed for preferences that
  satisfy the ―more is better‖ condition
     – It would have to be modified to take account
       of exceptions
• The consumer will always choose a point
  on the budget line
     – Rather than a point below it

Hall & Leiberman;                                     11
Economics: Principles
                        Two Theories
• Theories of consumer decision making
     – Marginal utility
     – Indifference curve
          • Both assume that preferences are rational
          • Both assume that consumer would be better off with more of
            any good
          • Both theories come to same conclusions about consumer
            behavior
• Our goal is to describe and predict how
  consumers are likely to behave in markets
     – Rather than describe what actually goes on in their
       minds
Hall & Leiberman;                                                    12
Economics: Principles
Consumer Decisions: The Marginal
       Utility Approach
• What is utility?
• Assumption: any decision maker tries to
  make the best out of any situation
     – Marginal utility theory treats consumers as
       striving to maximize their utility
• Anything that makes the consumer better
  off is assumed to raise his utility
     – Anything that makes the consumer worse off
       will decrease his utility

Hall & Leiberman;                                    13
Economics: Principles
          Utility and Marginal Utility
• Marginal utility of an additional unit
     – Change in utility derived from consuming an
       additional unit of a good
• The law of diminishing marginal utility, as
  defined by Alfred Marshall (1842-1924)
  states that
     – Marginal utility of a thing to anyone diminishes
       with every increase in the amount of it he
       already has
Hall & Leiberman;                                    14
Economics: Principles
      Total Utility and Marginal Utility
No of cones             Total utility   Marginal Utility
            0                 0 utils
            1                30 utils       30 utils

            2                50 utils       20 utils

            3                60 utils       10 utils

            4                65 utils        5 utils

            5                68 utils        3 utils

            6
Hall & Leiberman;            69 utils        1 utils       15
Economics: Principles
 Figure 3: Total And Marginal Utility
Utils 70
      60                                              Total Utility
      50
      40                                  1. The change in total utility from
      30                                     one more ice cream cone . . .
      20
      10

                 1       2      3       4    5    6
                                     Ice Cream Cones per Week
                 2. is called the marginal utility       3. Marginal utility falls
Utils               of an additional cone.                  as more cones are
        30
        20                                                  consumed.
        10
                                                     Marginal Utility
                  1      2      3       4    5    6
                                     Ice Cream Cones per Week
Hall & Leiberman;                                                                    16
Economics: Principles
 Combining the Budget Constraint and
Preferences (Marginal Utility Approach)
• Putting the Budget Constraint and
  Preferences together
     – Can develop a useful rule to guide us to an
       individual’s utility-maximizing choice

• Look at marginal utility per unit price
• Utility is maximized at a point at which
  marginal utility per dollar is the same for
  both goods
Hall & Leiberman;                                    17
Economics: Principles
           Consumer decision making
         Income = $150, Pc = $ 30 each, Pm = $10 each

 No of         MU from      MUc/Pc   No of    MU from   MUm/Pm
Concerts        last C               Movies    last M
    0                   -     -       15        50        5
    1            1500        50       12       100       10
    2            1200        40        9       150       15
    3             600        20        6       200       20
    4             450        15        3       350       35
    5
Hall & Leiberman; 360
Economics: Principles
                             12        0         -        -   18
       Figure 4: Consumer Decision
                  Making
 Number of              MUconcerts             MUmovies
 Movies per                         40,                 15
     Month              Pconcerts              Pmovies
           15      A
                                    MUconcerts       MUmovies
                                                20,           20
           12
                            B       Pconcerts        Pmovies
                                                   MUconcerts       MUmovies
            9                       C                          15,           35
                                                   Pconcerts        Pmovies
                                               D
            6
                                G
                                                          E
            3
                                                               F

                        1       2          3          4        5      Number of
                                                                    Concerts per
                                                                         Month
Hall & Leiberman;                                                              19
Economics: Principles
                 Marginal Utility Approach

• For any two goods x and y, with prices Px and
  PY, whenever MUx / Px > MUY / PY, a consumer
  is made better off shifting away from y and
  toward x
• Implies …
     – A utility-maximizing consumer will choose the point on
       the budget line where marginal utility per dollar is the
       same for both goods (MUX / PX = MUY / PY)
     – At that point, there is no further gain from reallocating
       expenditures in either direction

Hall & Leiberman;                                             20
Economics: Principles
                 Marginal Utility Approach
• No matter how many goods there are to
  choose from, when the consumer is doing
  as well as possible
     – It must be true that MUX / PX = MUY / PY for
       any pair of goods x and y
     – If this condition is not satisfied, consumer will
       be better off consuming more of one and less
       of the other good in the pair



Hall & Leiberman;                                      21
Economics: Principles
        What Happens When Things
        Change: Changes In Income
• A rise in income—with no change in
  price—leads to a new quantity demanded
  for each good
     – Whether a particular good is normal (quantity
       demanded increases) or inferior (quantity
       demanded decreases) depends on the
       individual’s preferences
          • As represented by the marginal utilities for each
            good, at each point along the budget line

Hall & Leiberman;                                               22
Economics: Principles
                 An increase in income
   Income = $300, Pc = $ 30 each, Pm = $10 each

 No of          MU from   MUc/Pc   No of    MU from   MUm/Pm
Concerts         last C            Movies    last M

     3             600     20       21        20        2

     4             450     15       18        30        3

     5             360     12       15        50        5

     6             300     10       12       100       10

     7             180      6        9       150       15
Hall & Leiberman;                                           23
Economics: Principles
 Figure 5: Effects of an Increase in
              Income
       Number of 30                              2. If his preferences are as given
       Movies per 27             H''                in the table, he'll choose point H
           Month
  1. When Max's
     income rises
     to $300, his
     budget line             A
     shifts             15
                                 B
     outward.           12                           H            3.But different marginal
                                     C                              utility numbers could
                         9
                                         D                          lead him to H' or H''
                         6
                                             E
                         3                                   H'
                                                 F

                             1 2 3 4 5 6 7 8 9 10                     Number of Concerts
                                                                              per Month

Hall & Leiberman;                                                                            24
Economics: Principles
                        Changes In Price
• A drop in the price of concerts rotates the
  budget line rightward, pivoting around its
  vertical intercept
• The consumer will select the combination
  of movies and concerts on his budget line
  that makes him as well off as possible
     – Will be combination at which marginal utility
       per dollar spent on both goods is the same

Hall & Leiberman;                                      25
Economics: Principles
       Figure 6: Deriving the Demand
                   Curve
                              1. When the price of concerts is     2. If the price falls to
Number of 15                     $30, point D is best for Max.        $10, Max's budget
Movies per                                                            line rotates
    Month 10                                       K                  rightward, and he
           8                                                          choose point J.
           6                  D       J


                  0       3       5       7       10   15                            30
                                                              3. And if the price drops to
 Price per $30                D                                  $5, he chooses point K.
  Concert
                                                       4. The demand curve shows
                                                          the quantity Max chooses
             10                               J           at each price.
              5                                    K

                          3               7       10             Number of Concerts
                                                                         per Month
  Hall & Leiberman;                                                                       26
  Economics: Principles
 The Individual’s Demand Curve
• Curve showing quantity of a good or
  service demanded at each different price

• In theory, an individual’s demand curve
  could slope ____




Hall & Leiberman;                            27
Economics: Principles
 Income and Substitution Effects
• Two effects of price change along a demand curve
     – Effects sometimes work together, and sometimes oppose each
       other


• Substitution effect
     – As the price of a good falls, the consumer substitutes that good
       in place of other goods whose prices have not changed


• Substitution effect of a price change arises from a
  change in the relative price of a good
     – And it always moves quantity demanded in the opposite
       direction to the price change

Hall & Leiberman;                                                         28
Economics: Principles
                    The Income Effect
• A price cut means consumer is left with
  some extra money after buying what he
  was buying before
• It is as if he has an increase in income
• So he can buy more of both goods
• Will he actually buy more of both goods?

• … Remember Chapter 4?

Hall & Leiberman;                            29
Economics: Principles
                    The Income Effect
• Income effect
     – As price of a good decreases, the consumer’s
       purchasing power increases, causing _ _____ in
       quantity demanded for the good
• Income effect of a price change arises from a
  change in purchasing power over both goods
     – A drop (rise) in price increases (decreases)
       purchasing power
• Income effect can work to either increase or
  decrease the quantity of a good demanded,
  depending on whether the good is normal or
  inferior
Hall & Leiberman;                                       30
Economics: Principles
Combining Substitution and Income
             Effect
• A change in the price of a good changes
     – Relative price of the good (the substitution
       effect) and

     – Overall purchasing power of the consumer
       (the income effect)




Hall & Leiberman;                                     31
Economics: Principles
                        Normal Goods
• Substitution and income effects work
  together
     – Causing quantity demanded to move in
       opposite direction of price
          • Normal goods must always obey law of demand




Hall & Leiberman;                                         32
Economics: Principles
                        Inferior Goods
• Substitution and income effects of a price
  change work against each other
     – Substitution effect moves quantity demanded in the
       opposite direction of the price
     – While income effect moves it in same direction of
       price
     – But since substitution effect virtually always
       dominates
          • Consumption of inferior goods will virtually always obey law
            of demand


Hall & Leiberman;                                                          33
Economics: Principles
    Figure 7: Income and Substitution
                 Effects
    Price Decrease:                                         Ultimate
                                                             Effect
P              Substitution Effect                      (Almost Always)
                                     QD

                                                         QD
                  Purchasing         QD   if normal
                    Power            QD   if inferior


    Price Increase:

P              Substitution Effect
                                     QD

                                                         QD
                  Purchasing         QD   if normal
                    Power
                                     QD   if inferior

Hall & Leiberman;                                                   34
Economics: Principles
              Consumers in Markets
• Since market demand curve tells us
  quantity of a good demanded by all
  consumers in a market
     – Can derive it by summing individual
       demand curves of every consumer in
       that market



Hall & Leiberman;                            35
Economics: Principles
                        Market demand
Price            Quantity demanded (bottles per week) by

Per bottle Jerry             George   Elaine    Market

    $4                  0       0        0          0

    $3                  0       3        0          3

    $2                  4       6        0         10

    $1                  8       9        10        27

    $0
Hall & Leiberman;       12     12        20        44      36
Economics: Principles
            Figure 8(a): From Individual To
                    Market Demand
            Jerry                     George                                  Elaine
Price                         Price                         Price

  $4                            $4                            $4

  3                              3                             3

  2
               c          +      2
                                              C'        +      2        C''                  =
  1                              1                             1


        0     4     12                0   6        12               0            10    20
                                Number of Bottles per Week
  Hall & Leiberman;                                                                     37
  Economics: Principles
       Figure 8(b): From Individual To
               Market Demand

Price
         A
  $4

                 B           Market Demand
   3                         Curve

                         C
   2

                                       D
   1

                                                             E

             3          10           27                      44
                                     Number of Bottles per Week
Hall & Leiberman;                                             38
Economics: Principles
  Consumer Theory in Perspective:
      Extensions of the Model
• Problems
     – Our simple model ignores uncertainty
     – Imperfect information
     – People can spend more than their incomes in any
       given year by borrowing funds or spending out of
       savings
• You might think consumer theory always regards
  people as relentlessly selfish
     – In fact, when people trade in impersonal markets, this
       is mostly true
          • People try to allocate their spending among different goods
            to achieve the greatest possible satisfaction
Hall & Leiberman;                                                         39
Economics: Principles
           Challenges to the Model
• The model of consumer choice is quite
  versatile
     – Capable of adapting to more aspects of
       economic behavior than one might think
     – But certain types of behavior do not fit model
       at all
          • Violating our description of rational preferences




Hall & Leiberman;                                               40
Economics: Principles
              Behavioral Economics
• Tries to incorporate approaches of psychology and sociology to
  answer economic questions
• Behavioral economists incorporate notions about people’s actual
  thinking process in making decisions
     – Such behavior by large groups of people can alter a market’s
       equilibrium
• We do observe many cases where behavior is not rational
     – However, we observe far more cases where it is
• While the questions raised by behaviorists are fascinating
     – Standard economic models work much better for most macroeconomic
       studies
• Behavioral economics is more commonly viewed as an addition to
  the existing body of economic theory, rather than a new independent
  field of study

Hall & Leiberman;                                                     41
Economics: Principles
                        Kahneman




Hall & Leiberman;                  42
Economics: Principles
                 Improving Education
• Consumer theory can be extended to consider
  almost any decision between two alternatives
  including activities where cost is time rather than
  dollars
• Billions of dollars have been spent over the past
  few decades trying to improve the quality of
  education
• Economists find these studies highly suspect
     – Experimenters treat students as passive responders
       to stimuli
Hall & Leiberman;                                           43
Economics: Principles
                 Improving Education
• Let’s apply our model of consumer choice
  to a student’s time allocation problem
     – We’ll assume there are only two activities
          • Studying economics
          • Studying French
• Each of these activities costs time and
  there is only so much time available
     – Students ―buy‖ points on their exams with
       hours spent studying
Hall & Leiberman;                                   44
Economics: Principles
           Figure 9: Time Allocation
                          (a)                                     (b)

Economics                                 Economics
    Score                                     Score
         90                                      90
                                                          F
                                                              E
         80                                      80                D
                   C                                  C




         70         75   80                      70   75      80        90
                           French Score                         French Score
 Hall & Leiberman;                                                       45
 Economics: Principles
                 Improving Education
• Let’s introduce a new computer-assisted
  technique in the French class
     – It enables students to learn more French with
       the same study time or to study less and learn
       the same amount
          • It now takes fewer hours to earn a point in French
• Opportunity cost of an additional point in
  French is one point in economics rather
  than two
Hall & Leiberman;                                                46
Economics: Principles
                 Improving Education
• How can a new technique in the French
  course improve performance in economics
  but not at all in French
     – Substitution effect will tend to improve French
       score
     – If performance in French is a ―normal good‖
          • Increase in ―purchasing power‖ will work to
            increase the French score
     – But if it is an ―inferior good‖
          • Could work to decrease the French score

Hall & Leiberman;                                         47
Economics: Principles
                 Improving Education
• Expect a student to choose a point somewhere
  between, with performance improving in both
  courses
• Leads to a general conclusion
     – When we recognize that students make choices, we
       expect only some of the impact of a better technique
       to show up in the course in which it is used
• Leads to the conclusion that we remain justified
  in treating this research with some skepticism

Hall & Leiberman;                                             48
Economics: Principles

				
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