Consumer Choice Theory

8/8/2019 Consumer Choice Theory

1/24

1

Consumer TheoryConsumer Theory

You are constantly making economic decisions

At the highest level of generality, we are all verymuch alike

Come up against the same constraintsToo little income or wealth

Too little time to enjoy it all

The theory of individual decision making is

called consumer theory


2/24

2

Part I. The Budget ConstraintPart I. The Budget Constraint

Virtually all individuals must face two facts ofeconomic life

Have to pay prices for the goods andservices they buy

Have limited funds to spend A consumers budget constraint identifies which

combinations of goods and services the consumercan afford with a limited budget

Mathematical expression: Px * X + Py * Y =m Where m is budget, Px and Py are prices for

good X and good Y respectively


3/24

3

The Budget ConstraintThe Budget Constraint

Graphical representation of a budget constraint:budget line

The price of one good relative to the price ofanother

Interpretation on the vertical / horizontal intercepts

The slope of the budget line indicates the spendingtrade-off between one good and another

Amount of one good, that must be sacrificed inorder to buy more of another good

If PY is the price of the good on the vertical axis,then the slope of the budget line is PX / PY


4/24

4

Figure 1: The Budget LineFigure 1: The Budget Line

xP

m

Slope is - Px/Py

(a)

Good X

Good Y

yP

m


5/24


6/24

6

Figure 1(a): The Budget Constraint-- Example

Figure 1(a): The Budget Constraint-- Example

A

B

G

H

Number ofConcerts

per Month

Number ofMovies per

Month

15

12

9

6

3

1 2 3 4 5

With $150 per month, Maxcan afford 15 movies andno concerts, . . .

12 movies and 1 concert or any other

combination onthe budget line.

Points below the line arealso affordable.

But notpoints

abovethe line.

D

F

E

C


7/24

7

Changes in the Budget LineChanges in the Budget Line

Changes in income

Increase in income will shift the budget lineupward (and rightward)

A decrease in income will shift the budgetline downward (and leftward)

Shifts are parallel

Changes in income do not affect the budget

lines slope


8/24

8

Figure 2a: Income Changes in theBudget LineFigure 2a: Income Changes in theBudget Line

1. An increase in income shiftsthe budget line rightward,with no change in slope.

(a)

Number ofConcerts per

Month

5

15

15

Number of Moviesper Month

30

10


9/24

9

Changes in the Budget LineChanges in the Budget Line

Changes in price In each case, one of the budget

lines intercepts will change, aswell as its slope

When the price of a good

changes, the budget line rotatesBoth its slope and one of its

intercepts will change


10/24

10

Figure 2b: Price Changes in the BudgetLineFigure 2b: Price Changes in the BudgetLine

2. A decrease in the price of moviesrotates the budget line upward.Movieticketpricedrop form $10 to $5

(b)


Month

5

15

15


30


11/24

11

Figure 2c: Price Changes in the Budget LineFigure 2c: Price Changes in the Budget Line

3. while a decrease in the price of concertsrotates it rightward.Concertticketpricedrops from $30 to $10


Mo

nth

5

15

15


30

(c)


12/24

12

Part II. PreferencesPart II. Preferences

How can we possibly speak systematicallyabout peoples preferences?

People are different Despite differences in preferences, can find

some important common denominators

something true for a wide variety of people

They are focus in our theory ofconsumer choice


13/24

13

Assumptions on Preferences-- (1) Rationality

Assumptions on Preferences-- (1) Rationality

People have preferences We assume that you can look at two

alternatives and state either that you prefer

one to the other or entirely indifferentbetween the Preferences are logically consistent, or

transitive Rational preference: choices can be made and

they are logically consistent Rationality is a matter of how you make your

choices, and not what choices you make What matters is that you make logically

consistent choices


14/24

14

Assumptions on Preferences-- (2) More Is Better

Assumptions on Preferences-- (2) More Is Better

We generally feel that more is better

The model of consumer choice in thischapter is designed for preferences thatsatisfy the more is better condition It would have to be modified to take

account of exceptions

The consumer will always choose a point onthe budget line Rather than a point below it


15/24

15

Consumer Choice: Two TheoriesConsumer Choice: Two Theories

Theories of consumer decision making

Marginal utility

Indifference curveBoth assume that preferences are rationalBoth assume that consumer would be better

off with more of any good

Both theories come to same general

conclusions about consumer behavior However, to arrive at those conclusions

each theory takes a different road


16/24

16

The Marginal UtilityApproachThe Marginal UtilityApproach

Utility: a quantitative measure of pleasureor satisfaction obtained from consuminggoods and services

Assume that consumers as striving tomaximize their utility

any decision maker tries to make thebest out of any situation

Anything that makes the consumer betteroff is assumed to raise his utility

Anything that makes the consumerworse off will decrease his utility


17/24

17

Marginal UtilityMarginal Utility

Marginal utility (MU) of an additional unit

Change in utility derived from consuming

an additional unit of a good The law of diminishing marginal utility, as

defined by Alfred Marshall (1842-1924) statesthat

Marginal utility of a thing to anyonediminisheswith every increase in theamount of it he / she already has


18/24

18

Example: Total And Marginal Utility-- Ice Cream Consumption

Example: Total And Marginal Utility-- Ice Cream Consumption

Number ofcones

TotalUtility

MarginalUtility

0 0 -

1 30 30

2 50 20

3 60 10

4 65 5

5 68 3

6 68 0


19/24

19

Figure 3: Total And Marginal UtilityFigure 3: Total And Marginal Utility

Total Utility

Marginal Utility

Utils 3020

10

Ice Cream Cones per Week1 2 3 4 5 6

Utils60

50

40

70

30

20

10

Ice Cream Cones per Week1 2 3 4 5 6

1. The changeintotalutility from

one more ice cream cone . . .

2. is called the marginalutility

of an additional cone.3. Marginal utility

falls as more conesare consumed.


20/24

20

Marginal UtilityApproach-- Central Idea

Marginal UtilityApproach-- Central Idea

An individuals utility-maximizing choice

What is the best affordable combination ofthe two goods?

Considering both marginal utility values andthe budget constraint

Central idea:

Highest possible utility will be point at whichmarginal utility per dollar is the same forboth goods

Otherwise, individual has incentive to deviate,i.e., chooses alternative combination


21/24

21

Marginal UtilityApproach-- How does it work?

Marginal UtilityApproach-- How does it work?

For any two goods x and y, with prices Px and PY,whenever MUx / Px > MUY / PY, a consumer ismade better off shifting away from y and toward x

Vice versa Leads to an important conclusion

A utility-maximizing consumer will choose thepoint on the budget line where marginal utility

per dollar is the same for both goods (MUX / PX= MUY / PY)

At that point, there is no further gain fromreallocating expenditures in either direction


22/24

22

Marginal UtilityApproach-- Utility Maximization Condition

Marginal UtilityApproach-- Utility Maximization Condition

Utility will be maximized where

MUX / PX = MUY / PY for any pair of

goods x and y If this condition is not satisfied, consumer

will be better off consuming more of one andless of the other good in the pair


23/24

23

What Happens When Things Change:Changes In IncomeWhat Happens When Things Change:Changes In Income

A rise in incomewith no change in priceleadsto a new quantity demanded for each good

Whether a particular good is normal (quantitydemanded increases) or inferior (quantitydemanded decreases) depends on theindividuals preferences


24/24

24

The Individuals Demand CurveThe Individuals Demand Curve

Curve showing quantity of a good orservice demanded by a particular

individual at each different price

Documents

Consumer Choice Theory