OCR EC4101 Consumer Theory PDF

EC4101 Topic 7: Theory of consumer choice  THE QUESTION: HOW DO WE CHOOSE? How do rational consumers choose what to spend their money on? Learning objectives How consumers choose to spend their income on goods and services Why consumers make choices by maximising utility, a me...

EC4101 Topic 7: Theory of consumer choice  THE QUESTION: HOW DO WE CHOOSE? How do rational consumers choose what to spend their money on? Learning objectives How consumers choose to spend their income on goods and services Why consumers make choices by maximising utility, a measure of satisfaction from consumption Why the principle of diminishing marginal utility applies to the consumption of most goods and services How to use marginal analysis to find the optimal consumption bundle Before we start… some assumptions that will help 1. All goods have utility Utility: value or satisfaction from consumption. Marginal utility (MU): the change in utility from consuming one additional unit of a good 2. There is no saving. Consumers spend all income (ignore future consumption for now) 3. Marginal utility diminishes over time Diminishing marginal utility: Each additional unit of a good adds less to utility than the previous unit  Diminishing marginal utility Even buns have diminishing marginal utility…  Ciara’s total utility and marginal utility Total (a)Ciara’s utility function utility (utils) 70 Quantity Total utility Marginal utility 60 Utility of buns (utils) per bun (utils) 50 function 40 0 0 15 30 1 15 20 13 2 28 10 11 3 39 0 1 2 3 4 5 6 7 8 9 9 Quantity of buns 4 48 Marginal 7 (b)Ciara’s marginal utility curve 5 55 utility per 5 bun (utils) 6 60 3 16 7 63 1 14 8 64 12 –1 10 9 63 8 Marginal 6 utility 4 2 curve 0 Quantity of buns –2 1 2 3 4 5 6 7 8 9 Preference: what the consumer wants A consumer’s preference among consumption bundles may be illustrated with indifference curves An indifference curve is a curve that shows consumption bundles that give the consumer the same level of satisfaction The consumer’s preferences The consumer is indifferent, or equally happy, with the Quantity combinations shown at points A, B, of cola and C because they are all on the C same IC The consumer would prefer D over A, B or C as it is on a higher IC B D I2 Indifference A curve, I1 0 Quantity of Pizza Four properties of indifference curves 1. Higher indifference curves are preferred to lower ones 2. Indifference curves are downward sloping 3. Indifference curves do not intersect 4. Indifference curves are bowed inward (convex to origin) Properties of indifference curves Property 1: higher indifference curves are preferred to lower ones Consumers usually prefer more of something to less of it Higher indifference curves represent larger quantities of goods than do lower indifference curves Property 2: Indifference curves are downward sloping A consumer is willing to give up one good only if he or she gets more of the other good in order to remain equally happy If the quantity of one good is reduced, the quantity of the other good must increase Properties of indifference curves Property 3: indifference curves do not intersect Quantity Points A and B should make the of cola consumer equally happy Points B and C should make the consumer equally happy C This implies that A and C would make the consumer equally happy. A But C has more of both goods compared to A B 0 Quantity of pizza Properties of indifference curves Property 4: Indifference curves are bowed inward (i.e. they are convex to the origin) People are more willing to trade away goods that they have in abundance and less willing to trade away goods of which they have little These differences in a consumer’s marginal substitution rates cause his or her indifference curve to bow inward Slope of indifference curve The slope at any point on an indifference curve is the marginal rate of substitution (MRS). It is: The rate at which a consumer is willing to trade one good for another The amount of one good that a consumer requires as compensation to give up one unit of the other good The marginal rate of substitution equals the marginal utility of one good divided by the marginal utility of the other good  Bowed indifference curve Quantity of cola 14 MRS = 6 A 8 1 4 B MRS = 1 3 1 Indifference curve 0 2 3 6 7 Quantity of Pizza Two Extreme Examples of Indifference Curves 1. Perfect substitutes Two goods with straight-line indifference curves are perfect substitutes The marginal rate of substitution is a fixed number 2. Perfect complements Two goods with right-angle indifference curves are perfect complements Indifference curve for perfect substitutes Pepsi 3 2 1 I1 I2 I3 0 1 2 3 Coke Indifference curve for perfect complements Left Shoes I2 7 5 I1 0 5 7 Right Shoes How much you like it v. how much it costs Knowing how much utility a person derives from consuming a particular good and how willing they are to substitute one good for another is one thing… But the cost of the good (price) is also important in understanding how consumers make their choices Budget constraint The budget constraint depicts the limit on the consumption “bundles” that a consumer can afford People consume less than they desire because their spending is constrained, or limited, by their income The budget constraint shows the various combinations of goods the consumer can afford given his or her income and the prices of the two goods… Budget constraint Quantity of cola B 500 Any point on the budget constraint line indicates the consumer’s combination or trade-off between two goods. Consumer’s budget constraint For example, if the consumer buys no pizzas, he can afford 500 litres of cola (point A B). If he buys no cola, he can afford 100 0 100 Quantity pizzas (point A). of Pizza Budget constraint The slope of the budget constraint line equals the relative price of the two goods, that is, the price of one good compared to the price of the other It measures the rate at which the consumer can trade one good for the other Budget constraint A change in income shifts the budget constraint A rise in income causes it to shift to the right (and vice versa) Because the relative price of the two goods has not changed in both examples, the slope of the budget constraint remains the same Budget constraint A change in price of one good changes the budget constraint, i.e. the budget constraint will pivot on the axis of the good that does not change in price For example, if price of cola increases from €2 to €5, consumer with income of €1,000 can now only afford maximum of 200 colas and budget constraint pivots down If price of cola falls from €2 to €1.60, consumer with an income of €1,000 can now afford maximum of 625 colas and budget constraint pivots up Optimisation: what the consumer chooses Consumers want to get the combination of goods on the highest possible indifference curve However, the consumer must also end up on or below his budget constraint Combining the indifference curve and the budget constraint determines the consumer’s optimal choice Consumer optimum occurs at the point where the highest indifference curve and the budget constraint are tangent The consumer’s optimal choice The consumer chooses consumption of the two goods so that the marginal rate of substitution equals the ratio of the relative prices At the consumer’s optimum, the consumer’s valuation of the two goods equals the market’s valuation  The consumer’s optimal choice Point B is the optimum point where consumer is Quantity on highest IC possible given their income and of cola therefore maximising utility Point A is feasible but on a lower IC and therefore B not desirable. Point C is not possible unless A income increases or the price of one or both C goods decreases I3 I2 I1 Budget constraint 0 Quantity of Pizza  Impact of an increase in income… Quantity of cola New budget constraint An increase in income shifts the budget constraint outward 1. An increase in income shifts the budget constraint outward... The consumer is able to choose New optimum a better combination of goods 3.... and on a higher IC cola consumption. Initial optimum I2 Initial budget I1 constraint 0 Quantity of Pizza 2.... raising pizza consumption...  Impact of a price change Quantity of cola A fall in the price of any good rotates the budget constraint outward and changes the D New budget constraint 1,000 slope of the budget constraint New optimum B 1. A fall in the price of Pepsi rotates 500 the budget constraint outward... 3.... and raising cola Initial optimum consumption. Initial I2 budget I1 constraint A 0 100 Quantity of Pizza 2.... reducing pizza consumption... Marginal utility per € Alternative way of looking at how consumers choose is looking at how much extra utility (MU) you will get from spending your next Euro on pizzas or on colas The goal is to maximise the marginal utility per Euro spent Comparing marginal utility to price General rule: compare the MU and the price for all goods, and then adjust your spending toward the goods that give you more MU per € spent Example: If MUcola = 1 MUpizza = 2 Pcola= €0.25 Ppizza= €1.00 What can you do to increase total utility? MUcola MUpizza > , so… Pcola Ppizza Buy more cola: it makes you happier, Euro for Euro, than pizza. Optimal consumption bundle The optimal consumption bundle is always where MUA MUB MUZ = =⋯= Pa PB PZ (subject to budget constraints) for all goods Above optimum is the exact same as the point of tangency between the budget constraint and the highest indifference curve possible Check your understanding… Ciara has an income of €50, which she can spend on two goods: crisps or wine. Both are normal goods for her. Each bottle of wine costs €10 and each packet of crisps costs €2. For each of the following situations, decide whether this is Ciara’s optimal consumption bundle. If not, what should she do to achieve her optimum bundle? Ciara is considering buying 4 bottles of wine and 5 packets of crisps. At that bundle, her marginal rate of substitution of wine for crisps is 1; that is, she would be willing to forgo only one packet of crisps to acquire one bottle of wine. Ciara is considering buying 2 bottles of wine and 15 packets of crisps. Her marginal utility of the second bottle of wine is 25, and her marginal utility of the fifteenth packet of crisps is 5. Ciara is considering buying 1 bottle of wine and 10 packets of crisps. At that bundle, her marginal rate of substitution of wine for crisps is 5; that is, she would be just willing to exchange 5 packets of crisps for one bottle of wine. Summary 1. A consumer’s budget constraint shows the possible combinations of different goods he can buy given his income and the prices of the goods 2. The slope of the budget constraint equals the relative price of the goods 3. The consumer’s indifference curves represent his preferences 4. Points on higher indifference curves are preferred to points on lower indifference curves Summary 5. The slope of an indifference curve at any point is the consumer’s marginal rate of substitution 6. The consumer optimises by choosing the point on his budget constraint that lies on the highest indifference curve