Consumer ChoicePremises of Consumer BehaviorThe model of consumer behavior is based on the following premises:Individual preferences determine the amount of pleasure people derive from the goods and services they consume.Consumers face constraints or limits on their choices. Consumers maximize their well-being or pleasure from consumption, subect to the constraints they face.!ive Properties of Consumer PreferencesCompleteness - when facing a choice between any two bundles of goods, a consumer can ran" them so that one and only one of the following relationships is true: The consumer prefers the first bundle to the second, prefers the second to the first, or is indifferent between them.!ive Properties of Consumer PreferencesTransitivity a consumer#s preferences over bundles is consistent in the sense that, if the consumer weakly prefers Bundle z to Bundle y $li"es z at least as much as y% and wea"ly prefers Bundle y to Bundle x, the consumer also wea"ly prefers Bundle z to Bundle x.!ive Properties of Consumer PreferencesMore Is Better -all else being the same, more of a commodity is better than less of it $always wanting more is "nown as nonsatiation%. Good - a commodity for which more is preferred to less, at least at some levels of consumptionBad - something for which less is preferred to more, such as pollutionConcentrate on goodsPreference &apsTo summari'e information about a consumer#s preferences is to create a graphical representation- a map-of them()ample: (ach semester, *isa, who lives for fast food, decides how many pi''as and burritos to eat.The various bundles of pi''as and burritos she might consume are shown in panel a of !igure +.,!igure +., Bundles of Pi''as and Burritos *isa &ight ConsumeB, Burritos per semester(a)30 25 15Z, Pizzas per semester252015105dabecfABB, Burritos per semester(b)30 25 15Z, Pizzas per semester25201510abI1ecWhich of these two bundles would be preferred by Lisa?Lisa prefers bundle e over bundle d, since e has more of both goods: Pizza and BurritosLisa prefers bundle e to any bundle in area BWhich of these two bundles would be preferred by Lisa?Lisa prefers bundle f over bundle e, since f has more of both goods: Pizza and BurritosLisa prefers any bundle in area A over eIf Lisa is indifferent between bundles e, a, and c !!we can draw an indifferent curve over those three pointsIndifference CurvesIndifference curve - the set of all bundles of goods that a consumer views as being e-ually desirable.It is downward sloping. To consume more pi''as, *isa is willing to give up some units of burritos and still get the same utility. In other words, if pi''a consumption is decreased, *isa needs to obtain more burritos to "eep the same level of utility.Indifference &apIndifference map - a complete set of indifference curves that summari'e a consumer#s tastes or preferencesProperties of Indifference &aps,. Bundles on indifference curves farther from the origin are preferred to those on indifference curves closer to the origin. $more is better%.. There is an indifference curve through every possible bundle.+. Indifference curves cannot cross./. Indifference curves slope downward.0. Indifference curves can not be thic".!igure +., Bundles of Pi''as and Burritos *isa &ight ConsumeB, Burritos per semester(a)30 25 15Z, Pizzas per semester252015105dabecfABB, Burritos per semester(c)30 25 15Z, Pizzas per semester25201510daI1ecfwe can draw an indifferent curve over those three pointsI2I0!ig +.. Impossible Indifference Curves*isa is indifferent between e and a, and also between e and b1so by transitivity she should also be indifferent between a and b1but this is impossible, since b must be preferred to a given it has more of both goods. $ &ore-is-better%B, Burritos per semesterZ, Pizzas per semesterI1I0abeIndifference curves can not cross: A given bundle cannot be on two indifference curvesImpossible Indifference Curves*isa is indifferent between b and a since both points are in the same indifference curve1But this contradicts the 2more is better3 assumption.Can you tell why?4es, b has more of both and hence it should be preferred over a.B, Burritos per semesterZ, Pizzas per semesterIabImpossible Indifference CurvesCan indifference curves e thic!?5nswer:Draw an indifference curve that is at least two bundles thick, and show that a preference property is violatedImpossible Indifference CurvesConsumer is indifferent between b and a since both points are in the same indifference curve1But this contradicts the 2more is better3 assumption since b has more of both and hence it should be preferred over a.B, Burritos per semesterabZ, Pizzas per semesterIImpossible Indifference Curves6tility"tility - a set of numerical values that reflect the relative rankings of various bundles of goods.5 numerical score representing the satisfaction that a consumer gets from a given mar"et bas"etIf buying + copies of Microeconomics ma"es you happier than buying one shirt, then we say that the boo"s give you more utility than the shirtutility function - the relationship between utility values and every possible bundle of goods. $!", !#%It increases in both -, and -. $more is preferred to less%6tility - ()ample!ood,7 ,0 00,7,07Clothing

" $ .0

# $ 07

% $ ,77&'C Bas"et 68!CC .0 8 ..0$,7%5 .0 8 0$0%B .0 8 ,7$..0%6tility !unction: ()ample9uppose that the utility *isa gets from pi''as $:, -,% and burritos $B, -. % isThis utility function gives us the relationship between *isa#s utility and one of her IC#s. 5n indifference curve would be those combinations of -, and -. that give the same level of utility. (ach IC reflects a different level of utility $indifference map;%#uestion$ Can we determine whether *isa would be happier if she had Bundle x with < burritos and ,= pi''as or Bundle y with ,+ of each; %nswer$ The utility she gets from x is ,.utils. The utility she gets from y is ,+utils. Therefore, she prefers y to x.2 1q q u = B Z = u6tility5lthough we numerically ran" bas"ets and indifference curves, numbers are >?*4 for ran"ingThe magnitude of utility difference does not tell us anything i.e. by how much one is preferred to another5 utility of / is not necessarily twice as good as a utility of .>rdinal PreferencesThere are two types of ran"ings>rdinal ran"ing: &n ordinal measure is one that tells us the relative ranking of two things but does not tell us how much more one rank is than anotherCardinal ran"ing: & cardinal measure is one by which absolute comparisons between ranks may be madeIf we "now only consumers# relative ran"ings of bundles, our measure of pleasure is ordinal rather than cardinal@illingness to 9ubstitute between goods: &A9Indifference curves are typically downward sloping and conve) $bowed inward%.Being conve) would mean that as more of one good is consumed, a consumer would prefer to give up fewer units of a second good to get additional units of the first one $property of diminishing &A9%In other words, consumers generally prefer a balanced mar"et bas"et@illingness to 9ubstitute between goods: &A9Mar&inal 'ate of (ustitution- ma)imum amount of one good that a consumer will sacrifice $trade% to obtain one more unit of another good 9lope of the indifference curveIndifference curve is downward sloping, hence a negative &A9 $a% &A9 along an Indifference curveThe &A9 from bundle a to bundle b is -+.This is the same as the slope of the indifference curve between those two points.!rom b to c, &A9 8 -..This is the same as the slope of the indifference curve between those two points."rom bundle c to bundle d, Lisa is willing to give up # Burritos in e$change for # more Pizza"rom bundle a to bundle b, Lisa is willing to give up % Burritos in e$change for # more PizzaB, Burritos per semesterIndiference Curve Convex to the Origin5381-11120-233 4 5 6Z, Pizzas per semesterabcdIFor most cases, it does! At point a, the consumer has many units of burritos and few units of pizza and therefore, it is reasonable to assume that s/he may value pizza relatively more than burritos s/he would !ive up a lot of burritos "# units$ to obtain 1 additional unit of pizza and still be able to %eep the same level of utility&'owever, at point c, s/he has few burritos and a lot of pizza&(he)s only willin! to !ive up a small amount of burritos for an additional unit of pizza, ma%in! the slope very flat& *herefore, it is reasonable to assume that +,( diminishes as we move down the indifference curve&The indifference curve is conve) $bowed inward% only if &A9 is diminishing4-25B, Burritos per semester5381-11120-233 4 5 6Z, Pizzas per semesterabcdIDoes diminishing MRS make sense?&arginal Aate of 9ubstitutionGraphical representation of the slope of an IC&A9 at e 8 slope of indifference curve at e 6tility and&arginal 6tility5s *isa consumes more pi''a, holding her consumption of burritos constant at ,7, her total utility, , increases1and her marginal utility of pi''a, M(, decreases $though it remains positive%.&arginal utility is the slope of the utility function as we hold the -uantity of the other good constant.ZUMUZ=MUZ, Marginal utility of pizzaMUZ10 9 8 7 6 5 4 3 2 1Z, Pizzas per semester0130(b) Marginal Utility20U, UtilsU = 20Utility function,U (10,Z)Z = 110 9 8 7 6 5 4 3 2 1Z, Pizzas per semester0350250(a) Utility230&arginal 6tilityThe principle of diminishing marginal utility states that as more of a good is consumed, the additional utility the consumer gains will be smaller and smaller?ote that total utility will continue to increase since consumer ma"es choices that ma"e them happier!igure +./a Perfect 9ubstitutesBill views Co"e and Pepsi as perfect substitutes: can you tell how his indifference curves would loo! li!e?9traight, parallel lines with an &A9 $slope% of B,. Bill is willing to e)change one can of Co"e for one can of Pepsi.Coke, Cans perweek1 2 3 4Pepsi, Cans perweek10234I1I2I3I4!igure +./b Perfect ComplementsIce cream, Scoops perweek1 2 3Pie, Slices perweek1230I1I2I3adecbIf the consumer has only one piece of pie, she gets as much pleasure from it and one scoop of ice cream, a, as from it and two scoops, d, or as from it and three scoops, e!Budget Constraintud&et line $or budget constraint% - the bundles of goods that can be bought if the entire budget is spent on those goods at given prices.opportunity set - all the bundles a consumer can buy, including all the bundles inside the budget constraint and on the budget constraintBudget ConstraintIf *isa spends all her budget, ), on pi''a and burritos, thenpBB + pZZ = Ywhere pBB is the amount she spends on burritos and pZZ is the amount she spends on pi''as. This e-uation is her budget constraint. It shows that her e)penditures on burritos and pi''a use up her entire budget.Budget Constraint $cont%.!rom previous slide we have:If pZ 8 C,, pB 8 C., and Y 8 C07, then:BZPZ P YB=ZZB 2- & . 2-2 /$ 1 "/ -. / = =!igure +.0 Budget ConstraintZZB 2- & . 2-2 /$ 1 "/ -. / = ="rom previous slide we have that if: pZ & '#, pB & '(, and Y & ')*, then the budget constraint, L#, is:B, Burritos per semesterOpportunity set50=Y /pZL125=Y/pB201010 0 30Z, Pizzas per semesterabcd+mount of Burritos consumed if all income is allocated for Burritos!+mount of Pizza consumed if all income is allocated for Pizza!Budget Constraint $cont%.Dow many burritos can *isa buy;To answer solve budget constraint for B $-uantity of burritos%:BZZ BZ BPZ P YBZ P Y B PY Z P B P= == +Budget Constraints: Budget *ine*etting ) and y be the goods on the )- and y-a)is respectively:The vertical intercept, IEPy, illustrates the ma)imum amount of good y that can be purchased with income IThe hori'ontal intercept, IEP), illustrates the ma)imum amount of ) that can be purchased with income IThe slope of the line measures the relative cost of food and clothingF it#s the relative price of the good on the )-a)is.The slope is the negative of the ratio of the prices of the two goodsF it#s GP)EPyThe 9lope of the Budget Constraint@e have seen that the budget constraint for *isa is given by the following e-uation:The slope of the budget line is also called the mar&inal rate of transformation )MRT*rate at which *isa can trade burritos for pi''a in the mar"etplaceZPPPYBBZB =,lope & B/Z & -./Table: 5llocations of a C07 Budget Between Burritos and Pi''a$a% Changes in the Budget Constraint: 5n increase in the Price of Pi''as.B, Burritos per semesterLoss50L1 (pZ = $1)L2 (pZ = $2)2525 0Z, Pizzas per semesterB = YPB- PZ = $1PBZ If the price of Pizza doubles, 0increases from '# to '(1 the slope of the budget line increases/his area represents the bundles she can no longer afford222$2,lope & 3'#4'( & 3*!)Slope = -$2/$2 = -1$b% Changes in the Budget Constraint: Increase in Income $Y%GainL3 (Y = $100)L1 (Y = $50)0B = $50PB- PZ PBZ If Lisa5s income increases by ')* the budget line shifts to the right 0with the same slope21$100/his area represents the new consumption bundles she can now afford222100 50Z, Pizzas per semesterB, Burritos per semester50259olved Problem5 government rations water, setting a -uota on how much a consumer can purchase. If a consumer can afford to buy ,. thousand gallons a month but the government restricts purchases to no more than ,7 thousand gallons a month, how does the consumer#s opportunity set change;9olved ProblemConsumer ChoiceHiven preferences and budget constraints, how do consumers choose what to buy;Consumers choose a combination of goods that will ma)imi'e their satisfaction, given the limited budget available to them.This is referred to as the 2utility ma)imi'ation3 or 2consumer choice3 problemConsumer ChoiceThe ma)imi'ing mar"et bas"et must satisfy two conditions:,. It must be located on the budget lineThey spend all their income because more is better.. It must give the consumer the most preferred combination of goods and servicesConsumer ChoiceHraphically, we can see different indifference curves of a consumer choosing between clothing and foodAemember that 6+ I 6. I 6, for our indifference curvesConsumer wants to choose highest utility within their budget!igure +.= $a% Consumer&a)imi'ation: Interior 9olution@ould *isa be able to consume any bundle along I+ $i.e. bundle f%;?oJ*isa does not have enough income to afford any bundle along I+B, Burritos per semester10202550 30 10 0Z, Pizzas per semesterI1I2I3df ceaABWould Lisa be able to consume any bundle along I#?6es7 she could afford bundles d, c, and a!Bundle e is called a consumers optimum.If Lisa is consuming this bundle, she has no incentive to change her behavior by substituting one good for another! Consumer ChoiceConsumer will choose highest indifference curve on budget lineIn previous graph, point e is where the indifference curve is ust tangent to the budget line9lope of the budget line e-uals the slope of the indifference curve at this pointConsumer&a)imi'ationMRTPPMUMUMRS = = =2121/he budget constraint and the indifference curve have the same slope at the point e where they touch!/herefore, at point e:Slope of I2B, Burritos per semester2550 0Z, Pizzas per semesterI2eSlope of BLConsumer ChoiceAecall, the slope of an indifference curve is:goodXY goodMRS=yPPSope! ="urther, the slope of the budget line is:Consumer ChoiceTherefore, it can be said at consumer#s optimal consumption point,YPPMRSX =Consumer ChoiceIt can be said that satisfaction is ma)imi'ed when marginal rate of substitution *of + and ), is e!ual to the ratio of the prices *of + and ),?ote this is >?*4 true at the optimal consumption point(KC(PTI>?9: Perfect substitutes and perfect complements and $possibly% -uasilinear utility functions.&arginal 6tility and Consumer ChoiceAearranging, gives the e-uation for utility ma)imi'ation:Total utility is ma)imi'ed when the budget is allocated so that the marginal utility per dollar of e)penditure is the same for each goodY Y X XP MU P MU / / =Consumer Choice>ptimal consumption point is where marginal benefits e-ual marginal costs&B 8 &A9 8 benefit associated with consumption of , more unit of K&C 8 cost of additional unit of K, unit K 8 L unit 4PKEP4Consumer ChoiceIf M&A9M N PKEP4 then individuals can reallocate bas"et to increase utilityIf M&A9M I PKEP4@ill increase good K and decrease good 4 until&A9 8 PKEP4If M&A9M O PKEP4@ill increase 4 and decrease K until M&A9M 8 PKEP4