principles of economics session 3. topics to be discussed consumer preferences budget constraints ...

Principles of Economics

Session 3

Topics To Be Discussed

Consumer Preferences

Budget Constraints

Consumer Choice

Marginal Utility

Substitution and Income Effect

Topics to be Discussed

Market Demand

Consumer Surplus

Recognizing Lock-In

Steps of Studying Consumer Behavior

Study consumer preferences How and why do people prefer one good to another?

Study budget constraint How are consumers constrained by their limited

incomes?

Combine consumer preferences and budget constraints to determine consumer choices What combination of goods will consumers buy to

maximize their satisfaction?

Market Basket

A market basket is a collection of one or more commodities.

One market basket may be preferred over another market basket containing a different combination of goods.

Three Basic Assumptions

Preferences are complete.

Preferences are transitive.

Consumers always prefer more of any good to less.

Consumer PreferencesMarket Basket

Units of Food

Units of Clothing

A 20 30

B 10 50

D 40 20

E 30 40

G 10 20

H 10 40

Indifference Curves

Indifference curves represent all combinations

of market baskets that provide the same level of satisfaction to a person.

Combination B,A, & D yields the same satisfaction

E is preferred to U1

U1 is preferred to H & G

Indifference Curve


Food(units per week)

10

20

30

40

10 20 30 40

Clothing(units per week)

50

G

D

A

EH

B

The consumer prefersA to all combinationsin the blue box, whileall those in the pink

box are preferred to A.



10

20

30

40

10 20 30 40


50

G

A

EH

B

D

Indifference Map

An indifference map is a set of indifference curves that describes a person’s preferences for all combinations of two commodities.

U2

U3

Indifference Map



U1

AB

D

Market basket A is preferred to B.

Market basket B is preferred to D.

U1U2

Indifference Curves Can’t Cross



A

D

B

The consumer should be indifferent between A, B and D. However, B contains more of both goods than D.

-6

1

A

B

D

EG-1

1

-4

-21

1

The amount of clothing given up for a unit of food decreases from 6 to 1

Substitution


Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16

Marginal Rate of Substitution

The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good.

It is measured by the slope of the indifference curve.

Diminishing MRS


Clothing(units

per week)

2 3 4 51

2

4

6

8

10

12

14

16 A

B

D

EG

-6

1

1

11

-4

-2

-1

MRS = 6

MRS = 2

FCMRS

Perfect Substitutes and Perfect Complements

Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant.

Two goods are perfect complements when the indifference curves for the goods are shaped as right angles.

Perfect Substitutes

Orange Juice(glasses)

Apple Juice

(glasses)

2 3 41

1

2

3

4

0

Perfect Complements

Right Shoes

LeftShoes

2 3 41

1

2

3

4

0

Application of Consumer Preferences

Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling.

An analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars.


Consumers are willing to give up

considerablestyling for additional

performance

Styling

Performance

MRS ＞1

Consumer PreferencesConsumers are

willing to give upconsiderable

performance for additional styling

Styling

Performance

MRS ＜1

Utility

Utility refers to numerical score representing the satisfaction that a consumer gets from a given market basket.

Utility FunctionU=f(X1 , X2 , X3 , … Xn)

Assume the utility function for food (F) and clothing (C)U=f(F, C) = F + 2C

Market Baskets F Units C Units UtilsA 8 3 8 + 2(3) = 14

B 6 4 6 + 2(4) = 14

C 4 4 4 + 2(4) = 12

The consumer is indifferent to A & B

The consumer prefers A & B to C

Utility Functions & Indifference Curves


10 155

5

10

15

0

Clothing(units

per week)

U1 = 25

U2 = 50 (Preferred to U1)

U3 = 100 (Preferred to U2)A

B

C

Assume: U = FC C 25 = 2.5×10 A 25 = 5 ×5 B 25 = 10 ×2.5

Ordinal vs. Cardinal Utility

Ordinal Utility Function: places market baskets in the order of most preferred to least preferred, but it does not indicate how much one market basket is preferred to another.

Cardinal Utility Function: utility function describing the extent to which one market basket is preferred to another.

Budget Constraints

Budget constraints limit an individual’s ability to consume in light of the prices they must pay for various goods and services.

Budget Line

The budget line indicates all combinations of two commodities for which total money spent equals total income.

Budget Line

Let F = amount of food purchased C = amount of clothing purchased Pf = Price of food Pc = price of clothing M = money income

Then

CPFPM cf

Budget Line

Market Basket

Food (F)Pf=$1

Clothing (C)Pc=$2

Total SpendingPfF+PcC=M

A 0 40 $80

B 20 30 $80

D 40 20 $80

E 60 10 $80

G 80 0 $80

Budget Line F + 2C = $80(M/PC) = 40

Budget Line

Food(units per week)40 60 80 = (M/PF)20

10

20

30

0

A

B

D

E

G

Clothing(units

per week)

Pc = $2 Pf = $1 M = $80

2

1/

/

//

cf

f

c

PP

PM

PMFCSlope

Budget Line

As consumption moves along a budget line from the intercept, the consumer spends less on one item and more on the other.

The slope of the line measures the relative cost of food and clothing.

Budget Line

The slope is the negative of the ratio of the prices of the two goods.

The slope indicates the rate at which the two goods can be substituted without changing the amount of money spent.

Budget Line

The vertical intercept (M/PC), illustrates the maximum amount of C that can be purchased with income M.

The horizontal intercept (M/PF), illustrates the maximum amount of F that can be purchased with income M.

Effect of Income Change


Clothing(units

per week)

80 120 16040

20

40

60

80

0

(M = $80)

L1

A increase in income shifts the

budget line outward

(M = $160)L2

L3

A decrease in income shifts the

budget line inward

(M=$40)

Effect of Price Change


Clothing(units

per week)

80 120 16040

40

(PF = 1)

L1

An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward.

L3

(PF = 2)(PF = 1/2)

L2

A decrease in the price of food to $.50 changes the slope of the

budget line and rotates it outward.

Consumer Choice

Consumers choose a combination of goods that will maximize the satisfaction they can achieve,

given the limited budget available to them.

Conditions to Maximize Utility

The choice must be located on the budget line.

The choice must give the consumer the most preferred combination of goods and services.

The MRS of an indifference curve is:

Consumer Choice

The slope of the budget line is:

Therefore, satisfaction is maximized where:

F

CMRS

c

f

P

PSlope

c

f

P

PMRS

Satisfaction Maximization

Satisfaction is maximizedwhen marginal rate of

substitution (of F and C) is equal to the ratio of the

prices (of F and C).

Consumer Choice

Food (units per week)

Clothing(units per

week)

40 8020

20

30

40

0

U1

B

Point B does not maximize satisfaction because the

MRS (-10/10) = 1 is greater than the price ratio (1/2).

-10C

+10F

Budget Line

Pc = $2 Pf = $1 M = $80

Consumer Choice

U3

D

Market basket D cannot be attainedgiven the current

budget constraint.


Clothing(units per

week)

40 8020

20

30

40

0

Budget Line

Pc = $2 Pf = $1 M = $80

U2

Consumer Choice

At market basket A the budget line and the indifference curve are tangent and no higher level of satisfaction can be attained.

AAt A: MRS =Pf /Pc = .5


Clothing(units per

week)

40 8020

20

30

40

0

Budget Line

Pc = $2 Pf = $1 M = $80

Consumer Choice

U3

D


Clothing(units per

week)

40 8020

20

30

40

0

Budget Line

Pc = $2 Pf = $1 M = $80

U2

A

B

U1

D is not available. A offers less satisfaction than B.

B is the optimum choice.

Marginal utility measures the additional satisfaction

obtained from consuming one additional unit of a good.

Marginal Utility andConsumer Choice

The marginal utility derived from increasing from 0 to 1 units of food might be 9

Increasing from 1 to 2 might be 7

Increasing from 2 to 3 might be 5

Diminishing Marginal Utility

The principle of diminishing marginal utility states that as more

and more of a good is consumed, consuming additional amounts will yield smaller and smaller additions

to utility.

Principle of Diminishing MU

If consumption moves along an indifference curve, the additional utility derived from an increase in the consumption one good, food (F), must balance the loss of utility from the decrease in the consumption in the other good, clothing (C).

Marginal Utility andIndifference Curve

Marginal Utility andConsumer Choice

c

F

MU

MU

F

C

) ( ) (C MU F MUc F

C

F

P

P

F

CMRS

C

F

c

F

P

P

MU

MU

Equation for Utility Maximization

C

c

F

F

P

MU

P

MU

The equal marginal principle states that total utility is

maximized when the budget is allocated so that the marginal

utility per dollar of expenditure is the same for each good.

Equal Marginal Principle


Units per game

MU of hot dogs (MUH )

MUH /PH

MU of Cokes (MUc )

MUc /Pc

1 20 8 60 30

2 15 6 40 20

3 12.5 5 20 10

4 10 4 16 8

5 7.5 3 8 4

6 5 2 4 2

Constraint=$20 Hot dog price=$2.5 Coke price=$2


N

N

P

MU

P

MU

P

MU

P

MU ...

3

3

2

2

1

1


Increase in units sold

Number of ads MBTV MBRadio

1 400 360

2 300 270

3 280 240

4 260 225

5 240 150

6 200 120

Budget=$2,000 TV ad price=$400 Radio ad price=$300


Increase in units sold

Number of ads MBTV MBRadio

1 400/400=1.00 360/300=1.20

2 300/400=0.75 270/300=0.90

3 280/400=0.70 240/300=0.80

4 260/400=0.65 225/300=0.75

5 240/400=0.60 150/300=0.50

6 200/400=0.50 120/300=0.40

Budget=$2,000 TV ad price=$400 Radio ad price=$300

Effect of a Price Change

Food (units per month)

Clothing(units per

month)

Three separateindifference curves

are tangent toeach budget line.

M = $20PC= $2PF =$2, $1, $0.5

3

7 A

U1

10

10

5U3

D

4020

U2

B

8

6

Effect of a Price Change


Clothing(units per

month)

3

7 A

U1

10

10

5U3

D

40

The price-consumption curve traces out the utility maximizing

market basket for the various prices for food.

Price-consumption curve

20

U2

B

8

6

Demand Curve


Clothing(units per

month)

20

6

U2

B

83

7 A

U1

10

10

5U3

D

40


Priceof Food

20

$0.50

3

$2.00

8

$1.00 Demand curve

Effects of Income Changes


Clothing(units per

month)

Pf = $1Pc = $2M = $10, $20, $30

D7

16

U3

30

15

3

4

A U1

5

10

B

U2

20

10 Income-consumptioncurve



Priceof

food

An increase in income,from $10 to $20 to $30,with the prices fixed,shifts the consumer’s

demand curve to the right.

$1.00

4

D1

E

10

D2

G

16

D3

H


An increase in income shifts the budget line to the right, increasing consumption along the income-consumption curve.

Simultaneously, the increase in income shifts the demand curve to the right.

Normal Good vs. Inferior GoodNormal Good

The income-consumption curve has a positive slope.

The quantity demanded increases with income.

The income elasticity of demand is positive.

Normal Good vs. Inferior GoodInferior Good

The income-consumption curve has a negative slope.

The quantity demanded decreases with income.

The income elasticity of demand is negative.

An Inferior Good

Hamburger (units per month)

Steak(units per

month)

15

30

U3

C

Income-Consumption Curve

…but hamburger becomes an inferior good when the income

consumption curve bends backward between B and C.

U2

105 20

5

10

AU1

B

Both hamburger and steak behave as a normal good, between A and B...

Income and Substitution Effects

Substitution EffectConsumers will tend to buy more of the good that has become relatively cheaper, and less of the good that is now relatively more expensive.

Income EffectConsumers experience an increase in real purchasing power when the price of one good falls.


Food (units per month)O

Clothing(units per

month)

Income Effect

5

22.5 30

U2

B

20

204

16 A

U1

18

SubstitutionEffect

D

Normal Good M=$60, Pf = $3, Pc = $3

Decreased Pf = $2

17

25.5Total Effect

Total Effect = 18.5

Income Effect = 4.5

Substitution Effect = 14



Clothing(units per

month)

Income Effect

13

10.5 30

U2

B

20

204

16 A

U1

SubstitutionEffect

D

Inferior GoodM=$60, Pf = $3, Pc = $3

Decreased Pf = $2

17

25.5

Total Effect

Total Effect = 6.5

Income Effect = - 7.5

Substitution Effect = 14

18

5

Substitution Effect ＞ Income Effect.


Clothing(units per

month)

E

D

Total Effect

Income Effect

The income effect may theoretically be large enough

to cause the demand curve for a good to slope upward. This is of little practical interest


Giffen Good

F2T

B

U2

R

F1S

A

U1

SubstitutionEffect

Market Demand

1 6 10 16 32

2 4 8 13 25

3 2 6 10 18

4 0 4 7 11

5 0 2 4 6

Price Individual A Individual B Individual C Market($) (units) (units) (units) (units)

Market Demand Curve

Quantity

1

2

3

4

Price

0

5

5 10 15 20 25 30

DB DC

Market Demand

DA

The market demandcurve is obtained by

summing the consumer’s demand curves

Consumer Surplus

Willingness to pay is the maximum price that a buyer is willing and able to pay for a good.

It measures how much the buyer values the good or service.

Consumer Surplus

Consumer surplus is the amount a buyer is willing to pay for a

good minus the amount the buyer actually pays for it.

Four Possible Buyers’ Willingness to Pay

Buyer Willingness to Pay

John $100

Paul 80

George 70

Ringo 50

Consumer Surplus

The market demand curve depicts the various quantities that buyers

would be willing and able to purchase at different prices.

Four Possible Buyers’ Willingness to Pay

Price Buyer Quantity Demanded

More than $100 None 0

$80 to $100 John 1

$70 to $80 John, Paul 2

$50 to $70 John, Paul, George 3

$50 or less John, Paul, George, Ringo

4

Measuring Consumer Surplus with the Demand Curve

Price ofAlbum

50

7080

0

$100

1 2 3 4

Quantity ofAlbums

John’s willingness to pay

Paul’s willingness to pay

George’s willingness to pay

Ringo’s willingness to pay

Demand

Measuring Consumer Surplus with the Demand Curve

Price ofAlbum

50

7080

0

$100

1 2 3 4Quantity of

Albums

Demand

John’s consumer surplus ($20)

Price = $80

Measuring Consumer Surplus with the Demand Curve...

Price ofAlbum

50

7080

0

$100

1 2 3 4Quantity of

Albums

Demand

John’s consumer surplus ($30)

Total consumer surplus ($40)

Price = $70

Paul’s consumer surplus ($10)

Measuring Consumer Surplus with the Demand

Curve

The area below the demand curve and above the price measures the consumer surplus in the market.

Q2

P2

How the Price Affects Consumer Surplus

Quantity

Price

0

Demand

Initialconsumersurplus

Additional consumer surplus to initial consumers

Consumer surplus to new consumers

Q1

P1

D EF

BC

A

Paradox of Value

Nothing is more useful than water; but it will scare purchase anything. A

diamond, on the contrary, has scarce any value in use; but a very great

quantity of other goods may frequently be had in exchange for it

－ The Wealth of Nations, Adam Smith

Consumer SurplusP

Price and Usefulnessof Diamond

Quantity

Price

0

Demand

Q

Consumer Surplus

Price and Usefulnessof Water

Quantity

Price

0

Demand

QP

Consumer Surplus and Economic Well-Being

Consumer surplus, the amount that buyers are willing to pay for a good minus the amount they actually pay for it, measures the benefit that buyers receive from a good as the buyers themselves perceive it.

Consumer Surplus and Importation

Price

0 Quantity

Domesticsupply

Domestic demand

World Price

Price after trade

Domesticquantitysupplied

Domesticquantitydemanded

Price before trade

Imports


Price

0 Quantity

Domesticsupply

World Price

Domestic demand

Price after trade

Price before trade

A

Consumer surplusbefore trade


Price

0 Quantity

Domesticsupply

World Price

Domestic demand

Price after trade

Price before trade

A

Consumer surplusafter trade

B D

Imports

Recognizing Lock-In

Recognizing Lock-In

Cost of switching

Compare

Ford v. GM

Mac v. PC

What’s the Difference?Durable investments in complementary asse

ts Hardware Software Wetware

Supplier wants to lock-in customerCustomer wants to avoid lock-inBasic principle: Look ahead and reason bac

k

Small Switching Costs Matter

Phone number portabilityEmail addressesHotmail (advertising, portability)ACM, CalTechLook at lockin costs on a per customer

basis

Classification of Lock-InContractual commitments: damagesDurable purchases and replacement: decline

s with timeBrand-specific training: rises with time Information and data: rises with timeSpecialized suppliers: may riseSearch costs: learn about alternativesLoyalty programs: rebuild cumulative usage

Contractual Commitments

“Requirements contract”:

Purchase supplies from one supplier

Beware of “evergreen contracts”

Follow the Lock-in cycle

Brand Selection

SamplingLock-In

Entrenchment

Assignment

Review Chapter 5Answer questions on P94Preview Chapter 6

Thanks

principles of economics session 3. topics to be discussed consumer preferences budget constraints ...

Documents

weekthe consumer

market basket b

market basketa market

set of indifference

indifference mapfoodunits

perfect complementstwo

persons preferences

different combination