theory consumer choice
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About the theory of consumer choice in microeconomics.TRANSCRIPT
2121The Theory of Consumer Choice
Utility, Total Utility and Marginal Utility • In economics, the satisfaction or pleasure consumers
derive from the consumption of goods is called “utility”.
• Total utility is the total utility a consumer derives from the consumption of all units of a good over a given consumption period.
• Marginal utility is the utility a consumer derives from the last unit of a good she or he consumes during a given consumption period.
• Total utility = Sum of marginal utilities
• The Law of Diminishing Marginal Utility
Over a given consumption period, as more and more of a good is consumed by a consumer, beyond a certain point, the marginal utility of additional units begins to fall.
Total Utility
0
50
100
150
200
1 2 3 4 5 6 7 8 9 10 11
Marginal Utility
-20
-10
0
10
20
30
40
50
1 2 3 4 5 6 7 8 9 10 11
Q ($) TU ($) MU0 01 40 402 85 453 120 354 140 205 150 106 157 77 160 38 160 09 155 -510 145 -10
145
How much ice cream does Jill buy in a month?
Total and Marginal Utility for Ice Cream
BUDGET CONSTRAINT: What a consumer can afford
• The budget constraint depicts the limit on the consumption “bundles” that a consumer can afford.• People consume less than they desire because their
spending is constrained by their income.
• Budget constraint shows various combinations of goods the consumer can afford given his or her income and the prices of the two goods.
• If a consumer wants to spend $ 1,000 on Pepsi and pizza, where price of Pepsi is $ 2 and Pizza is $10, then probable combinations would be:
Probable combinations of Pepsi and Pizza under Budget Constraint
Figure 1 The Consumer’s Budget Constraint
Quantityof Pepsi
0
Consumer’sbudget constraint
500B
250
50
C
100
A
Cannot be EE
Quantity of Pizza
• Illustration of Figure 1 (Consumer’s Budget Constraint)
• For example, if the consumer buys no pizzas, he can afford 500 pints of Pepsi (point B). If he buys no Pepsi, he can afford 100 pizzas (point A).
• Alternately, the consumer can buy 50 pizzas and 250 pints of Pepsi (point C).
• But the consumer cannot go out of the inner boundary of budget line (point E).
• Any point on the budget line indicates the consumer’s combination or tradeoff between two goods
• The slope of the budget line equals the relative price of the two goods, that is, the ratio of price of one good compared to the price of the other.
• It measures the rate at which a consumer trade a good for other
PREFERENCES: What a consumer wants
• A consumer’s preference among consumption bundles may be illustrated with indifference curves.
• An indifference curve is a curve that shows consumption bundles that give the consumer the same level of satisfaction
Figure 2 The Consumer’s Preferences
Quantityof Pepsi
0
Indifferencecurve, I1
I2
C
B
A
D
Quantity of Pizza
Representing Preferences with Indifference Curves
• The Consumer’s Preferences
• The consumer is indifferent, or equally happy, with the combinations shown at points A, B, and C because they are all on the same curve.
• The Marginal Rate of Substitution
• The slope at any point on an indifference curve is the marginal rate of substitution.
• It is the rate at which a consumer is willing to trade one good for another.
• It is the amount of one good that a consumer requires as compensation to give up one unit of the other good.
Figure 2 The Consumer’s Preferences
Quantityof Pepsi
0
Indifferencecurve, I1
I21
MRS
C
B
A
D
Quantity of Pizza
MRS = MU (Piz) / MU (Pep) = Change in Pepsi/Change in Pizza
Four Properties of Indifference Curves
• Property 1: Higher indifference curves are preferred to lower ones.• Consumers usually prefer more of something to get.
• Higher indifference curves represent larger quantities of goods than do lower indifference curves.
• Property 2: Indifference curves are downward sloping.• A consumer is willing to give up one good only if he or she gets
more of the other good in order to remain equally happy.
• If the quantity of one good is reduced, the quantity of the other good must increase.
• For this reason, most indifference curves slope downward.
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Figure 2 The Consumer’s Preferences
Quantityof Pepsi
0
Indifferencecurve, I1
I2
C
B
A
D
Quantity of Pizza
• Property 3: Indifference curves do not cross.• Points A and B should make the consumer equally happy.
• Points B and C should make the consumer equally happy.
• This implies that A and C would make the consumer equally happy.
• But C has more of both goods compared to A.
• Property 4: Indifference curves are bowed inward.• People are more willing to trade away goods that they have in
abundance and less willing to trade away goods of which they have little.
• These differences in a consumer’s marginal substitution rates cause his or her indifference curve to bow inward.
Four Properties of Indifference Curves
Figure 3 The Impossibility of Intersecting Indifference Curves
Quantityof Pepsi
0
C
A
B
Quantity of Pizza
Figure 4 Bowed Indifference Curves
Quantityof Pepsi
0
Indifferencecurve
8
3
A
3
7
B
1
MRS = 6
1MRS = 14
6
14
2Quantity of Pizza
OPTIMIZATION: What the consumer chooses
• Consumers want to get the combination of goods on the highest possible indifference curve.
• However, the consumer must also end up on or below his budget constraint.
The Consumer’s Optimal Choices
• Combining the indifference curve and the budget constraint determines the consumer’s optimal choice.
Figure 6 The Consumer’s Optimum
Quantityof Pepsi
0
Budget constraint
I1
I2
I3
Optimum
AB
MRS = MUPiz /MUPep= PPiz /PPep
Quantity of Pizza
The Consumer’s Optimal Choice
• Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent.
• The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the relative price.
• For Two-Good Rule
MUPep $PPep
--------- = ----------
MUPiz $PPiz
How Changes in Income Affect the Consumer’s Choices
• An increase in income shifts the budget constraint outward.• The consumer is able to choose a better combination of
goods on a higher indifference curve.
• Normal versus Inferior Goods• If a consumer buys more of a good when his or her income
rises, the good is called a normal good (+)
• If a consumer buys less of a good when his or her income rises, the good is called an inferior good (-).
Figure 7 An Increase in Income
Quantityof Pizza
Quantityof Pepsi
0
New budget constraint
I1
I2
2. . . . raising pizza consumption . . .
3. . . . andPepsiconsumption.
Initialbudgetconstraint
1. An increase in income shifts thebudget constraint outward . . .
Initialoptimum
New optimum
Figure 8 An Inferior Good
Quantityof Pepsi
0
Initialbudgetconstraint
New budget constraint
I1I2
1. When an increase in income shifts thebudget constraint outward . . .3. . . . but
Pepsiconsumptionfalls, makingPepsi aninferior good.
2. . . . pizza consumption rises, making pizza a normal good . . .
Initialoptimum
New optimum
Quantity of Pizza
How Changes in Prices Affect Consumer’s Choices
• A fall in the price of any good rotates the budget constraint outward and changes the slope of the budget constraint.
• Substitute the cheaper goods if price of one goods increase relative to another
Figure 9 A Change in Price
Quantityof Pepsi
0
1,000 D
500 B
100
A
I1
I2
Initial optimum
New budget constraint
Initialbudgetconstraint
1. A fall in the price of Pepsi rotates the budget constraint outward . . .
3. . . . andraising Pepsiconsumption.
2. . . . reducing pizza consumption . . .
New optimum
Quantity of Pizza
Summary
• A consumer’s budget constraint shows the possible combinations of different goods he can buy given his income and the prices of the goods.
• The slope of the budget constraint equals the relative price of the goods.
• The consumer’s indifference curves represent his preferences.
• Points on higher indifference curves are preferred to points on lower indifference curves.
• The slope of an indifference curve at any point is the consumer’s marginal rate of substitution.
• A consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve.
Summary• When the price of a good falls, the impact on the
consumer’s choices can be broken down into an income effect and a substitution effect.
The two effects of a price change:
• Income effect:Normal good (+)
Inferior goods (-)
• Substitution effect Happens as Price of Pepsi decreases, Pizza became
comparatively expensive
Consumer buy less Pizza and substituting it with Pepsi until
the optimizing condition is restored (-)