Module 4: Theory of Consumer Behavior PDF

Module 4: Theory of Consumer...

Module 4: Theory of Consumer Behavior Image retrieved from: https://www.123rf.com/photo_145540784_crowd-of-people-choosing-and- buying-to-stockpile-products-at-supermarket-store-after-thai-government.html Outline 01 Consumer Choice 02 Indifference Curve 03 Optimal Choice 2 Share your thoughts! How does it feel when you want to buy something but could not afford it? What do you usually do in this situation? Household Choice in Output Markets Every household must make three basic decisions: 1. How much of each product, or output, to demand? 2. How much labor to supply ? 3. How much to spend today and how much to save for the future? “PEOPLE FACE TRADE OFFS” 4 The Determinants of Household Demand The price of the product The income available to the household The household’s amount of accumulated wealth The prices of other products available to the household The household’s tastes and preferences The household’s expectations about future income, wealth, and prices 5  OPTION A- C affordable bundles CHOICE SET OR OPPORTUNITY SET FOR MARY Option Rent Food Transportation Total (USD) (USD) (USD) (USD) A 400 250 350 1,000 B 600 200 200 1,000 OPTION D not affordable bundles C 700 150 150 1,000 D 1,000 100 100 1,200 Source: https://static.stacker.com/s3fs-public/styles/slide_desktop/s3/2019-03/106.jpg Google Images 6 Preferences, Tastes, Trade-Offs, and Opportunity Cost Households are free to choose what they will and will not buy. Their ultimate choices are governed by their individual preferences and tastes As long as a household faces a limited budget— and all households ultimately do—the real cost of any good or service is the value of the other goods and services that could have been purchased with the same amount of money. The real cost of a good or service is its opportunity cost, and opportunity cost is determined by relative prices. 7  Budget Constraints and Opportunity Set Bottles of Servings Spending Spending Total Coke Chicken for Coke for Spending Drumstick (Php) Chicken (Php) Drumstick (Php) Coke 0 50 0 1000 1000 100 20 40 200 800 1000 60 20 600 400 1000 100 0 1000 0 1000 50 Chicken Drumstick 8  Both prices and incomes affect the size of a household’s opportunity set. If a price or a set of prices falls but income stays the same, the opportunity set gets bigger and the household is better off. On the other hand, when money income increases and prices go up even more, we say that the household’s “real income” has fallen. 9 Theory of Consumer Choice The theory of consumer choice examines the trade-offs that people face as consumers. The property of a good that enables it to satisfy human wants is called utility. As individuals consume more of a good per time period, their total utility (TU) or satisfaction increases, but their marginal utility diminishes. Marginal utility (MU) is the extra utility received from consuming one additional unit of the good per unit of time while holding constant the quantity consumed of all other commodities. Util the arbitrary unit of measure of utility. Law of diminishing marginal utility Each additional unit of a good eventually gives less and less extra utility. Cardinal and Ordinal Utility Cardinal utility means that an individual can attach specific values or numbers of utils from consuming each quantity of a good or basket of goods. Ordinal utility only ranks the utility received from consuming various amounts of a good or baskets of goods. In short, ordinal utility only ranks various consumption bundles, whereas cardinal utility provides an actual index or measure of satisfaction. “DOES MONEY BUY HAPPINESS?” Example: Trips to club per week Qx TUx MUx 0 0 … 1 12 12 2 22 10 3 28 6 4 32 4 5 34 2 6 34 0 12 Utility-Maximizing Rule Equating the ratio of the marginal utility of a good to its price for all goods MUx = Muy Px Py where MUx is the marginal utility derived from the last unit of X consumed, MUy is the marginal utility derived from the last unit of Y consumed, Px is the price per unit of X, and Py is the price per unit of Y. 13 Utility-Maximizing Rule MUx > Muy MUx = Muy Px Py Px Py 𝑴𝑼𝑿 𝑷𝑿 falls until such time that The consumer could 𝑴𝑼𝒀 they become equal with Increase utility by spending 𝑷𝒀 more dollar on X and less on Y. 14 The Equation of the Budget Constraint PxX + PyY = I Where CHANGE IN INCOME Px= price of X, X = the quantity of X consumed, PY = the price of Y, Y = the quantity of Y consumed, CHANGE IN PRICES and I = household income 15  Budget Constraints Change When Prices Rise or Fall CHANGE IN THE PRICE OF GOOD X When the price of a good decreases, the budget constraint swivels to the right, increasing the opportunities available and Good Y expanding choice. Good X CHANGE IN THE PRICE OF GOOD Y Good Y Good X 16  Budget Constraints Change When Income Rise or Fall RISE IN INCOME Good Y When there is a rise in income, the budget constraint shifts outward. Good X REDUCED INCOME Good Y When there is a rise in income, the budget constraint shifts inward. Good X 17 INDIFFERENCE CURVE What the consumer wants? A more formal process of choosing 18  ASSUMPTIONS 1. We assume that this analysis is restricted to goods that yield positive marginal utility, or, more simply, that “more is better”. One way to justify this assumption is to say that when more of something makes you worse off, you can simply throw it away at no cost. 2. The marginal rate of substitution is defined as MUx/MUy, or the ratio at which a household is willing to substitute X for Y. We assume a diminishing marginal rate of substitution. 19  ASSUMPTIONS 3. Weassume that consumers have the ability to choose among the combinations of goods and services available. For example: Between goods A and B: a. She prefers A>B b. She prefers B>A c. She prefers A=B. 4. We assume that consumer choices are consistent with a simple assumption of rationality. 20  INDIFFERENCE CURVE a curve that shows consumption bundles that give the consumer the same level of satisfaction Marginal rate of substitution the rate at which a consumer is willing to trade one good for another The rate at which a consumer is willing to trade one good for the other depends on the amounts of the goods she is already consuming. A consumer’s set of indifference curves gives a complete ranking of the consumer’s preferences MRS = Px /Py (1) MUx /MUy = Px /Py (2) MUx/Px = MUy /Py (3) 22 FOUR PROPERTIES OF INDIFFERENCE CURVES 23  1. Higher indifference curves are preferred over lower ones. Hurley prefers every bundle on I2 (like C) to every bundle on I1 (like A). He prefers every bundles on I1 to every bundle on Io. People usually prefer to consume more rather than less. This preference for greater quantities is reflected in the indifference curves  2. Indifference curves are downward sloping If the quantity of fish is reduced, the quantity of mangos must be increased to keep Hurley equally happy. The slope of an indifference curve reflects the rate at which the consumer is willing to substitute one good for the other.  3. Indifference curves cannot cross. A situation like this can never happen. According to these indifference curves, the consumer would be equally satisfied at points A, B, and C, even though point C has more of both goods than point A.  4. Indifference curves are bowed inward. urley is willing to give more mangos for a fish if he as few fish (A) than if he has many (B). One Extreme Case: Perfect Substitutes Perfect substitutes: two goods with straight-line indifference curves, constant MRS Example: nickels & dimes Consumer is always willing to trade two nickels for one dime. One Extreme Case: Perfect Complements Perfect complements: two goods with right-angle indifference curves Example: Left shoes, right shoes {7 left shoes, 5 right shoes} Is just as good as {5 left shoes, 5 right shoes}  The slope of the budget constraint Hurley’s income: $12,000 Prices: PF = $40 per fish, PM = $10 per mango A. If Hurley spends all his income on fish, how many fish does he buy? B. If Hurley spends all his income on mangos, how many mangos does he buy? C. If Hurley buys 100 fish, how many mangos can he buy? D. Plot each of the bundles from parts A – C on a graph that measures fish on the horizontal axis and mangos on the vertical, connect the dots.  The slope of the budget Hurley’s income: $12,000 constraint Prices: PF = $40 per fish, PM = $10 per mango A. If Hurley spends all his income on fish, how many fish does he buy? B. If Hurley spends all his income on A. $12000/$40 = mangos, how many mangos does he 300 fish buy? B. $12000/$10 = C. If Hurley buys 100 fish, how many 1200 mangos mangos can he buy? C. 100 fish cost D. Plot each of the bundles from parts $4000, $8000 A – C on a graph that measures fish left buys 800 on the horizontal axis and mangos mangos on the vertical, connect the dots.  The slope of the budget constraint From C to D, Price of fish/price of mangos “rise” = –200 mangos =$40/$10 “run” = +50 fish =4 mangos per fish Slope = – 4 Hurley must give up 4 mangos to get one fish Optimization: What Consumer Chooses A is the optimum: the point on the budget constraint that touches the highest possible indifference curve. Hurley prefers B to A, but he cannot afford B. Hurley can afford C and D, but A is on a higher indifference curve. 33 Optimization: What Consumer Chooses Quantity of Mangoes At the optimum, slope of the indifference curve equals slope of the budget constraint: MRS = PF /PM 34 How Changes in Income Affect the Consumer’s Choice normal good a good for which an increase in income raises the quantity demanded 35 How Changes in Income Affect the Consumer’s Choice inferior good a good for which an increase in income reduces the quantity demanded 36  How Changes in Price Affect the Consumer’s Choice The fall of the price expands the consumers’ rotates set of buying opportunities, it rotates the budget constraint outwards 37  How Changes in Price Affect the Consumer’s Choice We can categorize the effect of price change in consumer choice through income and substitution effects. INCOME EFFECT The change in consumption that results when a price change moves the consumer to a higher or lower indifference curve. SUBSTITUTION EFFECT The change in consumption that results when a price change moves the consumer along a given indifference curve to a point with a new marginal rate of substitution. 38  Income and Substitution Effects A fall in the price of fish has two effects on Hurley’s optimal consumption of both goods. Income effect ✓ A fall in PF boosts the purchasing power of Hurley’s income, allows him to buy more mangos and more fish. Substitution effect ✓ A fall in PF makes mangos more expensive relative to fish, causes Hurley to buy fewer mangos & more fish DERIVING THE DEMAND CURVE 41 Application 1: Do all goods obey the Law of Demand? Suppose the goods are potatoes and meat, and potatoes are an inferior good. If price of potatoes rises, substitution effect: buy less potatoes income effect: buy more potatoes If income effect > substitution effect, then potatoes are a Giffen good, a good for which an increase in price raises the quantity demanded. Price of Point at which good Potatoes takes up the entire budget P2 P1 Demand for Potatoes Q1 Q2 Quantity of Potatoes 43  Application 2: How do wages affect the labor supply? Budget constraint ✓ Shows a person’s tradeoff between consumption and leisure. ✓ Depends on how much time she has to divide between leisure and working. ✓ The relative price of an hour of leisure is the amount of consumption she could buy with an hour’s wages. Indifference curve ✓ Shows “bundles” of consumption and leisure that give her the same level of satisfaction. Application 2 An increase in the wage has two effects on the optimal quantity of labor supplied. ✓ Substitution effect (SE): A higher wage makes leisure more expensive relative to consumption. The person chooses less leisure, i.e., increases quantity of labor supplied. Application 2 An increase in the wage has two effects on the optimal quantity of labor supplied. ✓ Income effect (IE): With a higher wage, she can afford more of both “goods.” She chooses more leisure, i.e., reduces quantity of labor supplied.  Application 3: How do interest rates affect household savings? Saul lives for two period, between young and old. ✓ Period 1: young, works, earns $100,000 consumption = $100,000 minus amount saved ✓ Period 2: old, retired consumption = saving from Period 1 plus interest earned on saving = $110,000 The interest rate determines the relative price of consumption when young in terms of consumption when old. Application 3 Now consider what happens when the interest rate increases from 10 to 20 percent. ✓ Period 1: young, works, earns $100,000 consumption = $100,000 minus amount saved ✓ Period 2: old, retired consumption = saving from Period 1 plus interest earned on saving The interest rate determines the relative price of consumption when young in terms of consumption when old. Application 3 A person lives for two periods. ✓ Period 1: young, works, earns $100,000 consumption = $100,000 minus amount saved ✓ Period 2: old, retired consumption = saving from Period 1 plus interest earned on saving The interest rate determines the relative price of consumption when young in terms of consumption when old. Conclusion A consumer’s budget constraint shows the possible combinations of different goods she can buy given her income and the prices of the goods. The slope of the budget constraint equals the relative price of the goods. An indifference curve shows the various bundles of goods that make the consumer equally happy. The consumer optimizes by choosing the point on her budget constraint that lies on the highest indifference curve. The income effect is the change in consumption that arises because a lower price makes the consumer better off. The substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper. Reference Mankiw, N. Gregory (2018). Principles of Economics, Eighth edition Mankiw, N. Gregory. Principles of Economics. by Ron Cronovich 21 Modified by Joseph Tao-yi Wang Premium PPT (Salvatorre) Chapter 3 Theory of Consumer Behavior and Demand Case, Fair and Oster. Principles of Economics. Tenth Edition