consumer theory ic

7/31/2019 Consumer Theory IC

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Consumer Theory


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What is Consumer Theory?

Study of how people use their limited means tomake purposeful choices.

Assumes that consumers understand their choices (possibilities) and the prices(opportunity costs) associated with eachchoice.

Assumes that consumers consider thealternatives and choose the one they like best.


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Consumer Theory - Why?

Two important reasons: to understand the foundations of market

demand (bake the demand curve fromscratch)

to address several interesting consumer theory issues that are best understood

using this model rather than the aggregatedemand model


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Two Components of Consumer Demand

Opportunities: What can the consumer afford?

What are the consumption possibilities? Summarized by the budget constraint

Preferences:

What does the consumer like? How much does a consumer like a good? Summarized by the utility function


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What is a Budget Constraint?

A budget constraint shows theconsumers purchase opportunities asevery combination of two goods that canbe bought at given prices using a givenamount of income.The budget constraint measures thecombinations of purchases that a personcan afford to make with a given amountof monetary income.


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Lis Demand for Wheat and Rice

Illustration of consumer theoryLis demand for wheat and rice depends

upon the prices for these goods, her income, and her preferences.Suppose we look first at her budget

constraint: Wheat costs $4/lb. Rice costs $2/lb. Li has $40 of income.


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Lis Budget Constraint

The mathematical expression for Lisbudget constraint is:

I = P W

W + P R

R R = I/P R - (P W / P R )W

I like to refer to the |slope| of the budget lineas the ERS= Economic Rate of Substitution

In this case it is P W / P R For Li: P W =$4 P R =$2 I=$40 ERS=2


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Graph of Lis BudgetConstraint

The graph to the rightshows a picture of Lisbudget constraint.

Li's Budget Constraint

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Wheat

R i c e

Each blue diamond is apoint from the table.

The slope is equal to -2,

as shown on the lastslide.


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RATIONAL BEHAVIOR:Three main assumptions are;

Consumer can make a decision (completeness) Either a preferred to b , or b preferred to a , or indifferent between the two:

Consumer is consistent (transitivity) If a preferred to b , and b preferred to c , then a preferred to c:

Consumer prefers more to less ( monotonicity ) If a has more of all goods than b , then a is preferred to b :

or or ~a b b a a b

if and , thena b b c a c

if and , thena b a b X X Y Y a b


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REM: Lis Preferences inIndifference Curves An indifference curve connectsall the bundles that have thesame utility.Higher indifference curves

indicate more utility (IC 2 ispreferred to IC 1).Lower indifference curvesindicate less utility (IC 1 ispreferred to IC 0).

The indifference curve map isFULL of indifference curves.

Li's Indifference Curves

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Wheat

R i c e I2I1

I0


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The Marginal Rate of Substitution

The Marginal Rate of Substitution(MRS) tells ushow much of one good Liwould willingly trade for anincremental unit of the other good and remain indifferent.The MRS=|slope| of theindifference curve at abundle.Common to assume the MRSdeclines as we move downan indifference curve.

Li's Indifference Curves

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Wheat

R i c e I2I1

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How Much Wheat and RiceLis optimal amount of wheat and rice toconsume is the amount that maximizes Lisutility subject to her budget constraint.

In the graph... Get to the highest indifference curve possible

Stay on the budget constraint (b/c more isbetter)


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How to Find Lis BestCombination

Wheat

Rice

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IC0 IC1

IC2

W*

R*

The black bundle is best.The pink bundle is not thebest. Li has spent all her income but is not on thehighest indifference curve

possible.Bundles n/e of IC 0 arebetter and some areaffordable.

At (W*, R*) she is doing thebest she can subject to her budget constraint.


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How to Find the BestCombination

Utility is maximized when: the indifference curve is just tangent to the budget

line.

Utility is maximized when: you are on the budget line and the slope of the indifference curve equals the

slope of the budget line

Utility is maximized when: Income=P RR + P WW MRS=ERS


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The bang per buck story Let MUW = Lis marginal utility of wheat it measures the change in utility as we change wheat

consumption by an incremental unit while holding riceconstant

Let MUR = Lis marginal utility of rice it measures the change in utility as we change rice

consumption by an incremental unit while holding

wheat constantCommon to assume that marginal utilities declineas we increase consumption - the law of diminishing marginal utility


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The bang per buck story The MRS = MU W / MURThe ERS = P W / P R

At an optimal bundle: MRS=ERSRewritten we have: MUW / MUR = P W / P R MU

W/P

W= MU

R/P

R bang/buck in wheat = bang/buck in rice

Get same optimal bundle either way


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Handling a change in P W Li wants to achieve thehighest indifference curvethat the budget constraintspermit.

The points A, B, and Crepresents the best that Lican do at prices of $4, $2,and $1 for wheat.

The equation MRS=ERS issatisfied at each of thepoints.

Li's Demand for Wheat

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Wheat

R i c e

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A


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Lis Demand for Wheat

The table shows theamount of wheatthat Li demands ateach price.

These are the pointsof tangency from theprevious slide.

Quantity Price Point6 4 A

10 2 B16 1 C



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Graph of Lis Demand for Wheat

When we connect thepoints from the table inthe previous slide weget Lis demand for wheat.

The points A, B, and Ccorrespond to thetangencies of thebudget constraint andthe indifference curves.


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Quantity

P r i c e

A

B

C


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Lis Best ChoiceReconsideredConsider the choice at P W=$2/lb.The point B is optimal.The point A is feasible but inferior toall points on the red budget linebetween E and F.

The point C is preferred to B butcannot be purchased with Lis $40income at the given prices; it isabove the red budget line.The point E is feasible but Li prefersmore wheat and less rice (B).The point F is feasible but Li prefersless wheat and more rice (B, again).There is no combination that Liprefers to B that she is able to buy.

Li's Best Choice of Wheat and Rice

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R i c e I2I1

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A

E

F

BC


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Handling a change in P W Li wants to achieve thehighest indifference curvethat the budget constraintspermit.

The points A, B, and Crepresents the best that Lican do at prices of $4, $2,and $1 for wheat.

The equation MRS=ERS issatisfied at each of thepoints.


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Wheat

R i c e

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A


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Lis Demand for Wheat

The table shows theamount of wheatthat Li demands ateach price.

These are the pointsof tangency from theprevious slide.

Quantity Price Point6 4 A

10 2 B16 1 C


h f d f


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Graph of Lis Demand for Wheat

When we connect thepoints from the table inthe previous slide weget Lis demand for wheat.

The points A, B, and Ccorrespond to thetangencies of thebudget constraint andthe indifference curves.


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Quantity

P r i c e

A

B

C

d


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Wheat

R i c e

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A


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Quantity

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From IC Map to Lis Demandfor Wheat

d S b i i


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Income and SubstitutionEffects

Economists decompose the effect of a change in priceon the quantity demanded into an income and asubstitution effect.Income effect : due to the increase in real incomeassociated with a fall in prices (you can buy more withthe same nominal income) or the loss of real incomeassociated with a rise in prices (you cannot buy as muchas you once did with the same nominal income).Substitution effect : due to the change in the relativeprice of the good, cheaper goods are substituted for more expensive ones.


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Income and Substitution Effects:Price Decline, X normal

When the price of a good falls, the quantitydemanded rises for two reasons.The income effect : real income is higher because thesame money income buys more at the lower prices.For normal goods, then, the income effect of a pricefall is positive.The substitution effect : consumers substitute the nowcheaper good for ones whose price has not fallen,real income held constant. This increase in demandis called the substitution effect of a price decline.


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Lis Income and SubstitutionEffects: Price Fall, Rice normal

Graph shows the income andsubstitution effects of the fall inthe price of wheat from $4/lb. (A)to $1/lb. (C).The movement from point A to

point D is the substitution effect:Li buys less rice and more wheat,and would do so even if she hadan income of only $20 (as theblack budget line shows).The movement from point D topoint C is the income effect, theprice decline is like giving Li anadditional $20 of real income.

Li's Income and Substitution Effects

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R i c e

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AD


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Lis Substitution Effect The substitution effect is the amount bywhich Li's wheat consumption increasedholding real income constant.Substitution effect is the differencebetween Li's consumption of wheat at thenew and old prices holding her realincome constant, that is, staying on thesame indifference curve (compare points

A and D).


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Lis Income Effect When the price falls from $4/lb. of wheat to $1/lb. per wheat, Li is able to buy both more wheat and morerice.The income effect is the difference between whatshe would have bought on the old indifference curveat the lower wheat price (point D) and what sheactually did buy with her nominal income ($40) at thelower price (point C).Li increases her consumption of wheat and ricebecause of the increase in her real income from theprice decline.


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General effect of a price fall

Income effect - you feel richer

X normal

Substitution EffectX now looks relatively cheaper

P X falls

Quantity demanded increases Quantity demanded increasesQuantity demanded decreases

Total effect is the substitution effect AND the income effect working at the same time.

X inferior

F I di id l t M k t


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From Individual to MarketDemand

Market demand is the sum of allindividual demands in the economy.

In the following example there are twoconsumers of wheat: Li and Juanita.The market demand, then, is the sum of the quantities demand by Li andJuanita.


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Juanitas Demand for Wheat Juanitas income is also$40.Juanita faces the sameprice for rice as Li: $2/lb.Her preferences aredifferent from Lis. Her demand for wheat isderived in the figure atthe left.

Juanita's Demand for Wheat

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Graph of Juanitas Demandfor WheatThe points A, B andC correspond toJuanitas best

choices given her income and thethree prices of wheat illustrated.This is her demandcurve for wheat.

Juanita's Demand for Wheat

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P r i c e

A

B

C


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Market DemandThe market demand (green)is the sum of Lis (blue) andJuanitas (red) demand for wheat at each price.

At P W=4, Li demands 6 lbs.,Juanita demands 5 lbs. andthe market demand is 11lbs.

At P W=2, Li and Juanitademand 10 lbs. and themarket demand is 20 lbs.

At P W=1, Li demands 16lbs., Juanita demands 18lbs. and the market demandis 34 lbs.

Market for Wheat

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P r i c e o

f W h e a t

Li's Demand

Juanita's Demand

Market Demand


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Application: Effect of a Tax &Transfer Program

Suppose I have thepreferences illustratedat the right.Question A:

If Income = $16If Price of food = $1If Price of shelter = $1

Food = ?Shelter = ?Indifference curve = ?

Preferences

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Food

S h e l

t e r

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Answer APoint A:If Income = $16If Price of food = $1If Price of shelter = $1

Food = 7 Shelter = 9Indifference curve = I4

Initial Point

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Food

S h e l

t e r

I1I2

I3

I4

I5

I6 A

Effect of a Ta and Transfer


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Effect of a Tax and Transfer Program: Addition of Tax

Question B :If Income = $16If Price of food = $1If Price of shelter = $1

and Tax on shelter =100%

Tax-inclusive price of shelter = ?Food = ?Shelter = ?Indifference curve = ?

Initial Point

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Food

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I6 A


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Answer BPoint B If Income = $16If Price of food = $1If Price of shelter = $1

and Tax on shelter =100%

Tax-inclusive price of shelter = 2 Food = 9Shelter = 3.5 Indifference curve = I2

Tax Only

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Food

S h e l

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I6 A

B

Effect of a Tax and Transfer


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Effect of a Tax and Transfer Program: Tax & Transfer

Question C: If Income = $16If Price of food = $1If Price of shelter = $1and Tax on shelter =100% andTransfer payment = $8

Food = ?Shelter = ?Indifference curve = ?

Tax Only

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S h e l

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B


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Answer CPoint C If Income = $16If Price of food = $1If Price of shelter = $1and Tax on shelter =100% andTransfer payment = $8

Food = 10 Shelter = 7Indifference curve = I4

Tax and Transfer

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Food

S h e l

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B

C

consumer theory ic

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