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CONSUMER PREFERENCES:Budget Constraints, Consumer Choice

<< Consumer Behavior:Consumer Preferences, Indifference curves
Note it is repeated:Consumer Preferences, Revealed Preferences >>
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Microeconomics ­ECO402
VU
LESSON 7
CONSUMER PREFERENCES
Utility
­  Numerical score representing the satisfaction that a consumer gets from a
given market basket.
­  If buying 3 copies of Microeconomics makes you happier than buying one shirt,
then we say that the books give you more utility than the shirt.
Utility Functions
­  Assume: The utility function for food (F) and clothing (C)
U(F,C) = F + 2C
Market Baskets:
F units
C units
U (F, C) = F + 2C
A
8
3
8 + 2(3) = 14
B
6
4
6 + 2(4) = 14
C
4
4
4 + 2(4) = 12
The consumer is indifferent to A & B
­
The consumer prefers A & B to C
­
Utility Functions & Indifference Curves
Clothing
(units
per week)
Assume: U = FC
Market Basket
U = FC
15
C
25 = 2.5(10)
A
25 = 5(5)
B
25 = 10(2.5)
C
10
U3 = 100 (Preferred to
A
5
B
U2 = 50 (Preferred to
U1 = 25
Food
0
5
10
15
(units per week)
Ordinal Versus Cardinal Utility
­  Ordinal Utility Function: places market baskets in the order of most preferred
to least preferred, but it does not indicate how much one market basket is
preferred to another.
­  Cardinal Utility Function: utility function describing the extent to which one
market basket is preferred to another.
Ordinal Versus Cardinal Rankings
­  The actual unit of measurement for utility is not important.
­  Therefore, an ordinal ranking is sufficient to explain how most individual
decisions are made.
Budget Constraints
Preferences do not explain all of consumer behavior.
Budget constraints also limit an individual's ability to consume in light of the prices they
must pay for various goods and services.
The Budget Line
The budget line indicates all combinations of two commodities for which total
money spent equals total income.
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Microeconomics ­ECO402
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The Budget Line
Let F equal the amount of food purchased, and C is the amount of clothing.
Price of food = Pf and price of
clothing = Pc
Then Pf F is the amount of money spent on food, and Pc C is the amount of
money spent on clothing.
The budget line then can be written:
PFF + PCC = I
Market Basket
Food (F)
Clothing (C)
Total Spending
Pf = ($1)
Pc = ($2)
PfF + PcC = I
A
0
40
$80
B
20
30
$80
D
40
20
$80
E
60
10
$80
G
80
0
$80
Clothing
Pc = $2
Pf = $1
I = $80
(units
per week)
Budget Line F + 2C = $80
A
(I/PC) = 40
B
30
1
Slope = ΔC/ΔF = -
= - PF/PC
1
2
D
20
2
E
10
G
Food
80 = (I/PF) (units per week)
0
20
40
60
The Budget Line
­  As consumption moves along a budget line from the intercept, the consumer
spends less on one item and more on the other.
­  The slope of the line measures the relative cost of food and clothing.
­  The slope is the negative of the ratio of the prices of the two goods.
­  The slope indicates the rate at which the two goods can be substituted without
changing the amount of money spent.
­  The vertical intercept (I/PC), illustrates the maximum amount of C that can be
purchased with income I.
­  The horizontal intercept (I/PF), illustrates the maximum amount of F that can be
purchased with income I.
The Effects of Changes in Income and Prices
­  Income Changes
An increase in income causes the budget line to shift outward, parallel
to the original line (holding prices constant).
A decrease in income causes the budget line to shift inward, parallel to
the original line (holding prices constant).
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Microeconomics ­ECO402
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Clothing
A increase in
(units
income shifts
per week)
the budget line
80
outward
60
A decrease in
income shifts
the budget line
40
inward
L3
20
L2
L1
(I =
(I =
(I =
$40
Food
40
80
120
160
0
(units per week)
Price Changes
­
·  If the price of one good increases, the budget line shifts inward, pivoting
from the other good's intercept.
·  If the price of one good decreases, the budget line shifts outward,
pivoting from the other good's intercept.
Clothing
An increase in the
(units
price of food to
per week)
$2.00 changes
the slope of the
budget line and
A decrease in the
rotates it inward.
40
price of food to
$.50 changes
the slope of the
budget line and
rotates it outward.
L2
L3
L1
(PF = 1)
(PF = 1/2)
(PF = 2)
Food
40
80
120
160
(units per week)
The Effects of Changes in Income and Prices
­  Price Changes
·  If the two goods increase in price, but the ratio of the two prices is
unchanged, the slope will not change.
·  However, the budget line will shift inward to a point parallel to the
original budget line.
·  If the two goods decrease in price, but the ratio of the two prices is
unchanged, the slope will not change.
·  However, the budget line will shift outward to a point parallel to the
original budget line.
Consumer Choice
Consumers choose a combination of goods that will maximize the satisfaction they can
achieve, given the limited budget available to them.
The maximizing market basket must satisfy two conditions:
1) It must be located on the budget line.
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Microeconomics ­ECO402
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2) Must give the consumer the most preferred combination of goods and
services.
Recall, the slope of an indifference curve is:
ΔC
MRS = -
ΔF
Further, the slope of the budget line is:
PF
Slope = -
PC
Therefore, it can be said that satisfaction is maximized where:
PF
M RS =
PC
It can be said that satisfaction is maximized when marginal rate of substitution (of F
and C) is equal to the ratio of the prices (of F and C).
Clothing
Pc = $2
Pf = $1
I = $80
(units per
Point B does not
week)
maximize satisfaction
40
because the
MRS (-(-10/10) = 1
is greater than the
B
price ratio (1/2).
30
-10C
Budget
20
U1
+10
0
20
40
80
Food (units per week)
Clothing
(units per
Pc = $2
Pf = $1
I = $80
week)
40
Market basket D
D
cannot be attained
30
given the current
budget constraint.
20
U3
Budget
0
20
40
80
Food (units per week)
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Microeconomics ­ECO402
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Clothing
(units per
Pc = $2
Pf = $1
I = $80
week)
At market basket A
the budget line and the
40
indifference curve are
tangent and no higher
level of satisfaction
can be attained.
30
A
At A:
20
MRS =Pf/Pc = .5
U2
Budget
0
20
40
80
Food (units per week)
Designing New Automobiles (II)
­  Consider two groups of consumers, each wishing to spend $10,000 on the
styling and performance of cars.
­  Each group has different preferences.
­  By finding the point of tangency between a group's indifference curve and the
­  budget constraint auto companies can design a production and marketing plan.
Styling
These consumers
$10,000
are willing to trade
off a considerable
amount of styling
for some additional
performance
$3,000
$7,000
$10,000 Performance
Styling
These consumers
$10,000
are willing to trade
off a considerable
amount of
$7,000
performance for
some additional
styling
$10,000 Performance
$3,000
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Microeconomics ­ECO402
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Decision making & Public Policy
­  Choosing between a non-matching and matching grant to fund police
expenditures
Private
Non-matching Grant
Expenditures ($)
Before Grant
·  Budget line: PQ
P
·A: Preference maximizing
market basket
·Expenditure
A
R
·OR: Private
·OS: Police
U1
Police
O
S
Q
Expenditures ($)
Private
Expenditures ($)
Non-matching Grant
T
After Grant
·  Budget line: TV
P
·B: Preference maximizing
market basket
B
U
·Expenditure
A
·OU: Private
R
U3
·OZ: Police
U1
Police
O
S
Q
V
Z
Expenditures ($)
Private
Before Grant
Expenditures ($)
·  Budget line: PQ
Matching Grant
·  A: Preference maximizing
T
market basket
After Grant
P
·C: Preference maximizing
market basket
Expenditures
·OW: Private
W
R
·OX: Police
C
U2
U1
O
S
Q
R
X
Police ($)
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Microeconomics ­ECO402
VU
Private
Expenditures ($)
Matching Grant
T
Non-matching Grant
·Point B
P
·OU: Private expenditure
·OZ: Police expenditure
B
U
Matching Grant
W
A
·Point C
U3
C
U2
·OW: Private expenditure
U1  ·OX: Police expenditure
R
O
Q
X
Police ($)
Corner Solution
­  A corner solution exists if a consumer buys in extremes, and buys all of one
category of good and none of another.
·  This exists where the indifference curves are tangent to the horizontal
and vertical axis.
MRS is not equal to PA/PB
·
Frozen
Yogurt
(cups
monthly) A
A corner solution
exists at point B.
U1
U2
U3
B
Ice Cream (cup/month)
A Corner Solution
­  At point B, the MRS of ice cream for frozen yogurt is greater than the slope of the
budget line.
­  This suggests that if the consumer could give up more frozen yogurt for ice cream
he would do so.
­  However, there is no more frozen yogurt to give up!
­  When a corner solution arises, the consumer's MRS does not necessarily equal the
price ratio.
In this instance it can be said that:
MRS PIceCream / PFrozen Yogurt
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Microeconomics ­ECO402
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If the MRS is, in fact, significantly greater than the price ratio, then a small
­
decrease in the price of frozen yogurt will not alter the consumer's market
basket.
A college Trust Fund
­
­  Suppose Jane Doe's parents set up a trust fund for her college education.
­  Originally, the money must be used for education.
­  If part of the money could be used for the purchase of other goods, her
consumption preferences change.
A College Trust Fund
Other
Consumption
($)
A: Consumption before the trust fund
The trust fund shifts the budget line
B: Requirement that the trust fund
C
must be spent on education
U
P
C: If the trust could be spent on
B
other goods
U
A
U
Q
Education ($)
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Table of Contents:
  1. ECONOMICS:Themes of Microeconomics, Theories and Models
  2. Economics: Another Perspective, Factors of Production
  3. REAL VERSUS NOMINAL PRICES:SUPPLY AND DEMAND, The Demand Curve
  4. Changes in Market Equilibrium:Market for College Education
  5. Elasticities of supply and demand:The Demand for Gasoline
  6. Consumer Behavior:Consumer Preferences, Indifference curves
  7. CONSUMER PREFERENCES:Budget Constraints, Consumer Choice
  8. Note it is repeated:Consumer Preferences, Revealed Preferences
  9. MARGINAL UTILITY AND CONSUMER CHOICE:COST-OF-LIVING INDEXES
  10. Review of Consumer Equilibrium:INDIVIDUAL DEMAND, An Inferior Good
  11. Income & Substitution Effects:Determining the Market Demand Curve
  12. The Aggregate Demand For Wheat:NETWORK EXTERNALITIES
  13. Describing Risk:Unequal Probability Outcomes
  14. PREFERENCES TOWARD RISK:Risk Premium, Indifference Curve
  15. PREFERENCES TOWARD RISK:Reducing Risk, The Demand for Risky Assets
  16. The Technology of Production:Production Function for Food
  17. Production with Two Variable Inputs:Returns to Scale
  18. Measuring Cost: Which Costs Matter?:Cost in the Short Run
  19. A Firm’s Short-Run Costs ($):The Effect of Effluent Fees on Firms’ Input Choices
  20. Cost in the Long Run:Long-Run Cost with Economies & Diseconomies of Scale
  21. Production with Two Outputs--Economies of Scope:Cubic Cost Function
  22. Perfectly Competitive Markets:Choosing Output in Short Run
  23. A Competitive Firm Incurring Losses:Industry Supply in Short Run
  24. Elasticity of Market Supply:Producer Surplus for a Market
  25. Elasticity of Market Supply:Long-Run Competitive Equilibrium
  26. Elasticity of Market Supply:The Industry’s Long-Run Supply Curve
  27. Elasticity of Market Supply:Welfare loss if price is held below market-clearing level
  28. Price Supports:Supply Restrictions, Import Quotas and Tariffs
  29. The Sugar Quota:The Impact of a Tax or Subsidy, Subsidy
  30. Perfect Competition:Total, Marginal, and Average Revenue
  31. Perfect Competition:Effect of Excise Tax on Monopolist
  32. Monopoly:Elasticity of Demand and Price Markup, Sources of Monopoly Power
  33. The Social Costs of Monopoly Power:Price Regulation, Monopsony
  34. Monopsony Power:Pricing With Market Power, Capturing Consumer Surplus
  35. Monopsony Power:THE ECONOMICS OF COUPONS AND REBATES
  36. Airline Fares:Elasticities of Demand for Air Travel, The Two-Part Tariff
  37. Bundling:Consumption Decisions When Products are Bundled
  38. Bundling:Mixed Versus Pure Bundling, Effects of Advertising
  39. MONOPOLISTIC COMPETITION:Monopolistic Competition in the Market for Colas and Coffee
  40. OLIGOPOLY:Duopoly Example, Price Competition
  41. Competition Versus Collusion:The Prisoners’ Dilemma, Implications of the Prisoners
  42. COMPETITIVE FACTOR MARKETS:Marginal Revenue Product
  43. Competitive Factor Markets:The Demand for Jet Fuel
  44. Equilibrium in a Competitive Factor Market:Labor Market Equilibrium
  45. Factor Markets with Monopoly Power:Monopoly Power of Sellers of Labor