Consumption, Production, Welfare B: Consumer Behaviour

1. Consumption, Production, Welfare B:Consumer Behaviour Univ. Prof. dr. Maarten Janssen University of Vienna Winter semester 2013

2. Consumer behaviour: Overview • Oftenit is important to know how consumers react: • Does raising taxes on cigarettes, alcohol increase government revenues, and if so by how much? • Is it effective to reduce gasoline consumption to raise gasoline tax and refund consumers for the higher prices? • If we want to assist young families with newborn babies, it is more effective to give them a lump sum amount or to provide them with a week of nursing care • Is it appropriate to interpret area under demand curve as a measure of consumer welfare? • Most of these questions require to go beyond the demand curve and inquire into consumer behaviour more deeply

3. Consumer behaviour: theory • Constraint optimization • Constraints: usually budget, but other constraints also possible (in policy examples may be important) • Optimization: what does consumer want? Notion of preference (well-being; Bentham) is important • Preference relationship > • x>y : x is strictly preferred to y • x≥y : x is weakly preferred to y • x~y : consumers is indifferent between x and y

4. Axioms on preference relation • Completeness: for all possible x,y x≥y or y≥x • Transitivity: for all possible x,y,z if x≥y andy≥z, then x≥z • Are these axioms realistic? What would constitute violations? • Why are these axioms made?: • Without them, a notion of consumer well-being is difficult and welfare questions hard to address • Formally, if a preferencerelationdoes not satisfytheseaxioms, theycannotbedescribedby a utilityfunction • Transitivity is strongly connected torationality (violationandthemoney pump argument)

5. What is a utility function? • Way to describe a preference relation using the mathematically convenient way of functions (so we can use the corresponding mathematical operations). • Utility function u(.) describes preference relation ≥ if u(x) ≥ u(y) if, andonlyif, x≥y • Any monotomic transformation of u(.) describes the same preference relation • Can any rational preference relation be described by a utility function? • No, lexicographic preferences (essentially two-dimensional) • Utility function is often graphically represented by a set of indifference curves

6. Other frequently used assumptions regarding preferences • Local non-satiation: for any choice option, there is an alternative choice that if preferred • Monotonicity: If x» y, then x>y • Convexity: Ifx≥yandz≥y, thenαx+(1-α)y ≥z for 0 <α < 1. • As said some notion of preferences is needed to be able to evaluate policy questions

7. Consumer Theory without preferences • Revealed preference: We can look at choices made of individuals and ask whether they satisfy some natural consistency requirements • General: if in two choice situations, x and y were both included, and in one choice situation the agent chose x, then he cannot uniquely choose y in the other situation • Under a budget constraint: if at prices p and wealth level w, individual chose x(p,w) and if at prices p’ and wealth level w’ individual chose x(p’,w’), then px(p’,w’) ≤ w implies p’x(p,w) ≤ w’ • Graphical illustration budget constraint two goods

8. Implications for demand theory • Does RP imply that demand curves are downward sloping? • Graphical illustration • Only if price changes are compensated by wealth changes • Slutsky compensation: you compensate agent so that she can just afford old consumption bundle, i.e., p’x(p,w) = w’ • RP in this case implies (p’ – p)[x(p’,w’) - x(p,w)] ≤ 0

9. Recent study by Wieland Müller et al. (AER 2013, forthcoming) • Internet experiments with large sample of Dutch population, of which researchers know many features (age, education, wealth, etc.) • They perform RP tests in choice situations • Who is more rational (is more consistent with RP)? • Younger, more educated people • Doing well in RP tests correlates well with wealth of individuals (if corrected for age, education and other features)

10. Implication Equivalence • RP has empirical implications (that can be violated) • Utility maximization under a budget constraint has empirical implications • These empirical implications are almost identical

11. Maximization implication • Budget set has a slope of • Utility function has indifference curve given by implying (if only and change) • In optimum ratio of marginal utilities has to be equal to price ratio • Helps to derive demand functions

12. Application: gasoline tax proposal under president Carter • Carter proposed to increase gasoline tax to reduce use of gasoline in USA • Critique: the poor can then not afford to have a car (as they cannot afford to pay gigher gasoline price) • Carter reacted by saying that the poor will be income compensated for the tax increase • Critique’s then said that the whole proposal is then ridiculous as it is ineffective: if people can afford the same amount as before, they will. • Who is right?

13. Econ Questions and Analysis • Will the consumption of gasoline decrease after an gasoline price tax? • If consumers are compensated will they consume less gasoline? • - How are they compensated? • If they are Slutsky compensated, will they consume less? • How to reconclide answers to 1 and 3? • If they are Slutsky compensated, will government run a deficit over this policy? Other goods Original budget line Gasoline consumption