Theory of Consumer Choice

1. Theory of Consumer Choice

2. Main Assumption • Homo-Economus • The Economic Man • Assume people are rational and make rational decisions • That is, they “maximize” or “minimize” correctly

3. Consumer Problem • Maximize happiness (or utility) • Constrained by prices in the market and their budget • They have some function that describes their “happiness” or “utility” as an output where goods they consume are the input • Similar to a firm producing a good with various inputs

4. Budget Constraint • Limit to two goods for simplicity (easily generalize to many goods) • Budget constraint • Limits the consumption bundles a consumer can afford • There is a trade off between consuming one good (means less of another) • Slope of the budget constraint • Rate at which a consumer can give up one good and buy the other • Equals the price ratios of the two goods • How far out the budget line is reflects income level

5. Budget Constraint Quantity of Good A If spent all money on good A could buy 10 units Say Income = $100 Good B cost $20 Good A cost $10 10 Slope = rise/run = Q of A/Q of B = -10/5 = -2 Slope = -2 = Price B/Price A So it reflects the trade off b/w A and B Give up 2 of A for 1 of B If spent all money on good B could buy 5 units 5 Quantity of Good B

6. Preferences: What You Want • Tells us what people prefer, what they like • Can be represented in a curve called an Indifference Curve • Shows the consumption bundles that give the same level of satisfaction/happiness/utility • All points on the curve have the same utility • Further out curves are “happier” curves (more is assumed to be better) • Slope of the indifference curve • Rate at which consumers are willing to trade off b/w two goods and keep same level of utility • Called Marginal Rate of Substitution

7. Indifference Curves Quantity of Good A Points A,B,C all have same happiness/utility level associated with them b/c they are on the same Indifference Curve. D and E have same level also and both are equally better than A,B or C. A D E B IC2 MRS C IC1 Quantity of Good B

8. Properties of Indifference Curves • Higher ones are preferred to lower ones • More is better • The slope downward • To stay at the same utility you can’t get more of both, then you’d be happier • They never cross • If they represent happiness/utility levels, then crossing would imply they had the same happiness level • They bow inwardly • Because of decreasing marginal satisfaction, initial unit of B is really good, so give up a lot of A, later on not so much

9. IC’s Cannot Cross Quantity of Good A Since B is on both IC’s then B makes you just as happy as A and just as happy as C. Therefore C must make you just as happy as A, but this can’t be b/c C has more of both goods, and more is better. C A B Quantity of Good B

10. Curvature of IC’s Quantity of Good A When you have only a little of B, its very valuable and you’ll give a lot of A up for it in order to stay just as happy. MRS is high. Good A/Good B Example of diminishing utility leading to changing MRS, and so IC’s bow inward. Once you have a lot of B its not as valuable, so you will only give up a little A for it in order to stay just as happy. Low MRS. Good A/Good B Quantity of Good B

11. Extreme IC’s Perfect Substitutes Perfect Compliments Old Dollar Bill Left Shoe IC’s are right angled, more of one gives no more happiness without the other IC’s are straight lines: MRS is constant New Dollar Bill Right Shoe

12. Optimal Choice • Given a budget, prices, and a utility function, what is the best consumption bundle to choose? • Budget curve is fixed • Highest IC that has at least one point on the budget line • The point where IC and budget line are tangent, or just touch. • Slope of IC equals slope of budget line • MRS = price ratios

13. Optimal Consumer Choice Quantity of Good A Utility maximizing point Can’t afford this utility level Can do better than this level Quantity of Good B

14. Optimal Consumer Choice II: Why Tangency Quantity of Good A Could afford this point, but could do better. IC is steeper than budget curve. So you’re willing to give up more of A for B than the market demands. So B is worth more to you at this point (relatively) than to the market, so giving up A and taking more B makes you better off and you can still afford it. So moving here makes you better off. Quantity of Good B

15. Deriving Demand Curves • We can use indifference curves to derive our downward sloping demand curve • As one price changes (the good whose demand curve we wish to chart) the intercept of the budget curve changes • We find a new optimal point • Use these points to chart demand curve • Prices/Quantities demanded

16. Constructing Demand Curves from IC’s Good A As price of B falls budget curve intercept goes out because could by more if spent all money on B. Good B Price of B P1 P2 P3 Quantity B

17. Applications of IC’s • Could use to describe purchasing decisions (as we did here) • Could use to describe labor/leisure trade off as wages change (that is labor supply) • Could use to describe savings rates as interest rates change

18. Similarities in Production • Production decisions have a similar nature to our consumer choice here • Instead of indifference curves we call them Iso-quant curves • Show trade off b/w two inputs that still produce the same output • Instead of budget lines have iso-cost curves • Show bundles on factor inputs that cost the same • Leads to the same type of decision • How do I produce • Previously we only looked at how much to produce