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Consumer Choice

Consumer Choice. Consumer Behavior. Law of Demand Reviewed. Common Sense High Price discourages customers from buying Low Price encourages customers to buy Consumer Behavior is reflected in the Demand Curve. The Income Effect. The change in the price of a product will have effects on….

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Consumer Choice

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  1. Consumer Choice Consumer Behavior

  2. Law of Demand Reviewed • Common Sense • High Price discourages customers from buying • Low Price encourages customers to buy • Consumer Behavior is reflected in the Demand Curve

  3. The Income Effect • The change in the price of a product will have effects on…. • Consumer’s real income • The quantity demanded of that product • When the price of a good declines, people will have more money to spend • My son’s allowance: $20 per week • He drinks 8 Monsters a week at $2.50 • If price of monsters were to decrease to $2.00 • He would have $4.00 Extra! • He can either purchase more Monsters or other goods

  4. Substitution Effect • This is the impact that a change in product’s price has on its relative expensiveness and on the quantity demanded • When price of a product falls, that product is now cheaper relative to other products • If Monster falls from $2.50 to $2.00, it becomes a better buy • Lower price induces my son to substitute Monsters for other caffeinated drinks • He will buy More of it

  5. Law of Diminishing Marginal Utility • Mankiw’s Priniciple #3: Rational People Think at the Margin • Margin—an incremental adjustment • What is the benefit of the next item consumed? • What is the cost of the next item consumed? • Utility • Want satisfying power • Marginal Utility is the extra satisfaction that a person derives from an additional consumption of one more item

  6. Example: Diminishing Marginal Utiity

  7. Vending Machines Soda Machines Newspaper Box

  8. Indifference Curve Analysis • Consumer behavior and equilibrium is based on: • Budget Lines • Indifference Curves

  9. Budget Line • Technical Constraint • Schedule or curve that shows various combinations of two products a consumer can purchase with specific income

  10. Budget Line: Combinations of Monster and Snickers Bars (Income of $20)

  11. Budget Line Monsters Snickers

  12. Budget Line • Two (2) things can cause the budget line to shift • Income Changes • Increase in income will shift the curve to the left • Price Changes • Decreases in the price of both items will shift the curve to the left • Change in price relative to the other will cause change in slope

  13. Indifference Curves • Subjective • An indifference curve shows all the combinations of two products (A and B) that will yield the same total satisfaction or total utility to a consumer

  14. Indifference Schedule

  15. Indifference Curve Schedule Snickers j Monsters

  16. Indifference Curve Characteristics • Convex to origin • Slope at each point measures Marginal Rate of Substitution • Rate at which consumer will substitute one good for the other in order to remain equally satisfied. • As the amount of Monsters increases, its marginal utility decreases • As the amount of Snickers decreases, its marginal utility increases

  17. A Group of Indifference Curves

  18. Indifference Map • Curves farther from origin indicate higher levels of total utility • Curves closer to origin represent less total utility

  19. Indifference Curves and Budget Constraints • The best combination is the point where the indifference curve and the budget line are tangent.

  20. Indifference Curves and Budget Constraints

  21. Deriving a Demand Curve from the Indifference Curve • Demand is the quantity of a good that a person will buy at various prices.

  22. Deriving a Demand Curve from the Indifference Curve • By varying the price of one of the goods while holding the price of other constant, the points of tangency will change. • This gives alternative price/quantity combinations.

  23. Deriving a Demand Curve from the Indifference Curve

  24. Concluding Remarks • Does everyone think this way? • As Mankiw points out: No • Consumer behavior is a model

  25. Revenues and Profits A brief overview

  26. Revenue • Total Income from sales

  27. Revenue S P D Q REVENUE = PRICE X QUANTITY

  28. Costs • Fixed Costs • Incurred no matter what the output is • RENT • VEHICLES • EQUIPMENT • Variable Costs • Costs which vary per with output • LABOR • UTILITIES • FUEL CONSUMPTION

  29. TOTAL COSTS • TOTAL COST = FIXED + VARIABLE

  30. ACCOUNTING PROFIT • Very Simple • PROFIT = Revenue – Total Cost

  31. Economic Profit • Takes into account Explicit Costs (like an accountant) • Also takes into account Implicit Costs • Opportunity Cost

  32. Economic Profit vs Accounting Profit Economist Accountant Implicit Costs Economic Profit Accounting Profit Explicit Costs Explicit Costs

  33. Opportunity Cost • A firm’s implicit costs are the opportunity costs of using its self-owned, self employed resources. • To the firm, opportunity costs are the money payments that self employed resources could have earned in their best alternative use

  34. Economic Profit Example • You are earning $22,000 per year as a salesperson at the Gap • You decide to open up your own store! • You have saved up $20,000 in CDs that were paying 5% per year • Use that $20K as a down-payment/initial investment on your new store • New store’s lease is $5K per year • You hire clerk to help out and give her $18K annually

  35. End of Your 1st Year! Looks Good…..right????

  36. Your Economic Profit????

  37. Economic Profit • Economic Profit is not a cost, because it is a return in excess of the normal profit that is required to retain the entrepreneur • Even if the Economic Profit is zero, the entrepreneur is still covering all explicit and implicit costs, including a normal profit. • In our example, as long as accounting profit is $33,000 or more, you will continue to operate

  38. Questions??

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