MN12217 Business Economics Lecture 4 - 2024 PDF

MN12217 Business Economics for Accountants Lecture 4 Consumer theory – a first look at the economics of choice Dr Tim Wakeley [email protected] Consumer theory – a first look at the economics of choice last week we took a first look at demand and supply. This week...

MN12217 Business Economics for Accountants Lecture 4 Consumer theory – a first look at the economics of choice Dr Tim Wakeley [email protected] Consumer theory – a first look at the economics of choice last week we took a first look at demand and supply. This week (& next) we’ll explore demand in greater depth. the tools… the indiffere budget nce constrain curves t the technique… constrained optimisation  Key assumption… consumers are rational economic agents who aim to maximise their own utility Image source: Katie McBroom (unsplash.com)  The consumer’s problem… how to choose from the enormous variety of goods and services on offer, so as to maximise utility subject to what they can afford i.e. their budget  What possibilities are affordable? A simple 2-good example… a schoolboy likes chocolate (good Y) and crisps (good X) the price of chocolate bars (PY) is £1.00 the price of crisps (P ) is X £2.00 the schoolboy has pocket money of £20.00 per week  the schoolboy can afford the following combinations of crisps and chocolate… Crisps (X) Chocolate (Y) 10 0 9 2 8 4 7 6 6 8 5 10 4 12 3 14 2 16 1 18  we plot these data to obtain the budget constraint line Chocolate a = feasible (a (Y) member of the 20 affordable set) b = not feasible c, d = members of the 15 c affordable set & all income spent b 10 d a 5 Crisps(X) 0 5 10 15 20 what is the opportunity cost of a what is the impact of a reduction in the price of crisps (e.g. to £1.00 per bag)? Chocolate (Y) 20 15 10 5 Crisps(X) 0 5 10 15 20 what is the impact of a fall in income (e.g. pocket money is reduced to £10.00 per week)? Chocolate (Y) 20 15 10 5 Crisps(X) 0 5 10 15 20  How do we know what possibilities are desirable? Every individual has a certain set of likes and dislikes so, in theory, they can give an opinion about the amount of utility they will get from consuming differentwhat In choice theory, combinations we look of forgoods are all the combinations of the two goods that lead to the same level of satisfaction An individual should be indifferent between which of these bundles is actually consumed, since they give the same level of utility These bundles can be plotted as an indifference curve  let us imagine that our schoolboy has listed some of the bundles of crisps & chocolate that he thinks would make him equally happy… Quantity Quantity Level of of of crisps satisfactio chocolate n 18 3 5 ‘utils’ 10 5 5 ‘utils’ 8 7 5 ‘utils’ 7 9 5 ‘utils’ We can identify the marginal rate of substitution (MRS): this is the rate at which our schoolboy will give up chocolate for crisps and, at the same time, remain indifferent.  When our schoolboy moves from a to b, he is willing to give up 8 bars of Y chocolate in exchange for 2 bags of (choc crisps in order to keep the same level ) of utility. When our schoolboy moves from b to c, a 18 an he is willing to give up 2 bars of indifferen chocolate in exchange for 2 bags of crisps in order to keep the same level ce curve of utility. b When our schoolboy moves from c to d, 10 c he is willing to give up 1 bar of 8 d chocolate in exchange for 2 bags of 7 5 ‘utils’ crisps in order to keep the same level of utility. Marginal rate of substitution (M 0 35 7 9 20 X (crisps) a to b: MRS = 8/2 b to= 4 c: MRS =DIMINISHING 2/2 c to= 1 d: MRS = 1/2 = ½ 12  Mathematical note… Y (choc The magnitude of ) the slope of the indifference curve is the MRS Δ Y Δ X Δ IC1 Y Δ X 0 X (crisps)  the diminishing MRS reflects the so-called ‘law of diminishing marginal utility’ this is the idea that each additional bag of crisps that our schoolboy consumes contributes less to his total utility than the previous bag (hence he values it less in terms of how much chocolate he is prepared the law oftodiminishing give up). marginal utility is what gives rise to the convex shaped indifference curves COMPENSATORY CHOICE “I’ll be happy to consume less of one good as long as I am able to consume more of the other” What happens if we offer our schoolboy more of both goods? Quantity Quantity Level of of of crisps satisfactio chocolate n 20 5 6 ‘utils’ 12 7 6 ‘utils’ 10 9 6 ‘utils’ 9 11 6 ‘utils’  An indifference map… Y (choc) Higher indifference 20 curves represent higher levels of total 15 utility because more is preferred to less Indifference 10 6 ‘utils’ curves can 5 ‘utils’ never cross! 5 See the ‘transitivity’ axiom (coming up) X (crisps) 0 15 20 5 10 The utility maximising consumer… Y The schoolboy wants to be (choc) on the highest 20 indifference curve he can reach, given his budget 15 constraint (‘constrained optimisation’) 10 z This is the point of 6 ‘utils’ tangency ‘z’ 5 ‘utils’ 5 4 ‘utils’ X (crisps) 0 5 10 15 20  The Axioms* of Rational Choice Theory consumers can rank bundles of goods in order of preference a consumer’s preferences are complete over all bundles of goods (not just between pair-wise combinations) consumers are consistent in their ranking, so if a > b it can never be the case that b > a (‘>’ is shorthand for ‘is preferred to’) preferences are transitive which simply means that if a > b and b > c then it must be true that a > c (implies that indifference curves cannot cross each other for a given individual) *a universally conceded principle; a self-evident truth  From utility analysis to an individual’s demand curve for a particular good an individual consumer’s demand curve plots the relationship between the price of a good and the quantity demanded of that good example: Charlie has an income of £100 per week Charlie likes to consume goods X and Y ood Y costs £20 per unit – we will hold this constant we will vary the price of good X: P1 = £50; P2 = £25; P3 = £10 how much of good X will Charlie purchase at each price level? Y P1 = £50 P2 = £25 5 P3 = £10 IC3 IC2 IC1 0 2 4 10 X £ 50 Charlie’s demand curve for 25 X 10 0 1 2 4 X  Indifference curve analysis Changes in price can be broken down into two components THE SUBSTITUTION THE INCOME EFFECT EFFECT measures the amount by measures the impact on which a consumer the amount of a good substitutes one good for consumed as a result of another, whilst the consequent change in maintaining the same real income levelthe it reflects of propensity utility of consumers to substitute between goods in response to a relative price change  Indifference curve analysis A A Substitution Quantity of A Income ’ Effect Potatoes B ’ Effect B A IC2 A’ IC1 0 Q1 Q2 Quantity of Bread  so what? The substitution effect always works in the same direction (i.e. when the price of a good - bread - falls it moves quantity demanded to the right) BUT… The income effect may not reinforce the substitution effect INFERIOR GOODS a good is defined as inferior if its consumption falls as income is increased (and vice versa)  the strongly inferior good… A A Substitution Quantity of A ’ Income Effect Potatoes B ’ Effect This implies an B upward sloping IC2 demand curve! Q A A’ IC1 Sir Robert Giffen (1837 – 1910) 0 Q2 Q1 Quantity of Bread The END