Consumer Choice

1
Consumer Choice

• Hall and Lieberman, 3rd edition, Thomson
  South-Western, Chapter 5

2
Overview

• You will learn from this chapter
• Budget constraint, interpretation of its slope
  and components
• Marginal utility and the law of diminishing
  marginal utility
• Assumptions economists make about preferences
• Utility maximization and the solution derivation
  logic

3
Consumer Theory

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

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Part I. The Budget Constraint

• Virtually all individuals must face two facts of
  economic life
• Have to pay prices for the goods and services
  they buy
• Have limited funds to spend
• A consumers budget constraint identifies which
  combinations of goods and services the consumer
  can afford with a limited budget
• Mathematical expression
• Px X Py Y m
• Where m is budget, Px and Py are prices for good
  X and good Y respectively

5
The Budget Constraint

• Graphical representation of a budget constraint
  budget line
• The price of one good relative to the price of
  another
• Interpretation on the vertical / horizontal
  intercepts
• 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

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Figure 1 The Budget Line
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Figure 1(a) The Budget Constraint --
Example

• Maxs entertainment budget
• m 150
• Max is making choice to go to a local rock
  concert (Good X) or see a movie (Good Y)
• A movie ticket (Px) 10
• A concert ticket (Py) 30

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Figure 1(a) The Budget Constraint --
Example
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Changes in the Budget Line

• Changes in income
• Increase in income will shift the budget line
  upward (and rightward)
• A decrease in income will shift the budget line
  downward (and leftward)
• Shifts are parallel
• Changes in income do not affect the budget lines
  slope

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Figure 2a Income Changes in the Budget Line
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Changes in the Budget Line

• Changes in price
• In each case, one of the budget lines 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

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Figure 2b Price Changes in the Budget Line
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Figure 2c Price Changes in the Budget Line
14
Part II. Preferences

• How can we possibly speak systematically about
  peoples preferences?
• People are different
• Despite differences in preferences, can find some
  important common denominators
• something true for a wide variety of people
• They are focus in our theory of consumer choice

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Assumptions on Preferences -- (1) Rationality

• People have preferences
• We assume that you can look at two alternatives
  and state either that you prefer one to the other
  or entirely indifferent between the
• Preferences are logically consistent, or
  transitive
• Rational preference choices can be made and they
  are logically consistent
• 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

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Assumptions on Preferences -- (2) 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

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Consumer Choice 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

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Part III. Consumer Decisions The Marginal
Utility Approach

• Utility a quantitative measure of pleasure or
  satisfaction obtained from consuming goods and
  services
• Assume that consumers as striving to maximize
  their utility
• any decision maker tries to make the best out of
  any situation
• Anything that makes the consumer better off is
  assumed to raise his utility
• Anything that makes the consumer worse off will
  decrease his utility

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Marginal Utility

• Marginal utility (MU) 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 / she
  already has

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Example Total And Marginal Utility -- Ice
Cream Consumption
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Figure 3 Total And Marginal Utility
Total Utility
Marginal Utility
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Marginal Utility Approach -- Central Idea

• An individuals utility-maximizing choice
• What is the best affordable combination of the
  two goods?
• Considering both marginal utility values and the
  budget constraint
• Central idea
• Highest possible utility will be point at which
  marginal utility per dollar is the same for both
  goods
• Otherwise, individual has incentive to deviate,
  i.e., chooses alternative combination

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Figure 4 Consumer Decision Making
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Marginal Utility Approach -- How does it work?

• For any two goods x and y, with prices Px and PY,
  whenever MUx / Px gt MUY / PY, a consumer is made
  better off shifting away from y and toward x
• Vice versa
• Leads to an important conclusion
• 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

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Marginal Utility Approach -- Utility
Maximization Condition

• Utility will be maximized where
• 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

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What Happens When Things Change Changes In
Income

• A rise in incomewith no change in priceleads 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 individuals
  preferences
• As represented by the marginal utilities for each
  good, at each point along the budget line

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Figure 5 Effects of an Increase in Income
H''
H'
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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

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The Individuals Demand Curve

• Curve showing quantity of a good or service
  demanded by a particular individual at each
  different price

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Figure 6 Deriving the Demand Curve
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