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Principles of Economics

Principles of Economics. Session 3. Topics To Be Discussed. Consumer Preferences Budget Constraints Consumer Choice Marginal Utility Substitution and Income Effect. Topics to be Discussed. Market Demand Consumer Surplus Recognizing Lock-In. Steps of Studying Consumer Behavior.

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Principles of Economics

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  1. Principles of Economics Session 3

  2. Topics To Be Discussed • Consumer Preferences • Budget Constraints • Consumer Choice • Marginal Utility • Substitution and Income Effect

  3. Topics to be Discussed • Market Demand • Consumer Surplus • Recognizing Lock-In

  4. Steps of Studying Consumer Behavior • Study consumer preferences • How and why do people prefer one good to another? • Study budget constraint • How are consumers constrained by their limited incomes? • Combine consumer preferences and budget constraints to determine consumer choices • What combination of goods will consumers buy to maximize their satisfaction?

  5. Market Basket • A market basket is a collection of one or more commodities. • One market basket may be preferred over another market basket containing a different combination of goods.

  6. Three Basic Assumptions • Preferences are complete. • Preferences are transitive. • Consumers always prefer more of any good to less.

  7. Consumer Preferences

  8. Indifference Curves Indifference curves represent all combinations of market baskets that provide the same level of satisfaction to a person.

  9. B H E A D Indifference Curve G Consumer Preferences • Combination B,A, & D yields the same satisfaction • E is preferred to U1 • U1is preferred to H & G Clothing (units per week) 50 40 30 20 10 Food (units per week) 10 20 30 40

  10. B H E A D G Consumer Preferences Clothing (units per week) The consumer prefers A to all combinations in the blue box, while all those in the pink box are preferred to A. 50 40 30 20 10 Food (units per week) 10 20 30 40

  11. Indifference Map An indifference map is a set of indifference curves that describes a person’s preferences for all combinations of two commodities.

  12. D B A U3 U2 U1 Indifference Map Clothing (units per week) • Market basket A is preferred to B. • Market basket B is preferred to D. Food (units per week)

  13. U1 A B D Indifference Curves Can’t Cross Clothing (units per week) The consumer should be indifferent between A, B and D. However, B contains more of both goods than D. U2 Food (units per week)

  14. A B 1 -4 D 1 E -2 G 1 -1 1 Substitution Clothing (units per week) 16 The amount of clothing given up for a unit of food decreases from 6 to 1 14 -6 12 10 8 6 4 2 Food (units per week) 1 2 3 4 5

  15. Marginal Rate of Substitution • The marginal rate of substitution (MRS) quantifies the amount of one good a consumer will give up to obtain more of another good. • It is measured by the slope of the indifference curve.

  16. Diminishing MRS A Clothing (units per week) 16 14 MRS = 6 -6 12 10 B 1 8 -4 D MRS = 2 6 1 E -2 G 4 1 -1 1 2 Food (units per week) 1 2 3 4 5

  17. Perfect Substitutes and Perfect Complements • Two goods are perfect substitutes when the marginal rate of substitution of one good for the other is constant. • Two goods are perfect complements when the indifference curves for the goods are shaped as right angles.

  18. Perfect Substitutes Apple Juice (glasses) 4 3 2 1 Orange Juice (glasses) 0 1 2 3 4

  19. Perfect Complements Left Shoes 4 3 2 1 0 1 2 3 4 Right Shoes

  20. Application of Consumer Preferences • Automobile executives must regularly decide when to introduce new models and how much money to invest in restyling. • An analysis of consumer preferences would help to determine when and if car companies should change the styling of their cars.

  21. Consumer Preferences Styling Consumers are willing to give up considerable styling for additional performance MRS＞1 Performance

  22. Consumer Preferences Styling Consumers are willing to give up considerable performance for additional styling MRS＜1 Performance

  23. Utility Utilityrefers to numerical score representing the satisfaction that a consumer gets from a given market basket.

  24. Utility Function U=f(X1 , X2 , X3 , …Xn) Assume the utility function for food (F) and clothing (C)U=f(F, C) = F + 2C • The consumer is indifferent to A & B • The consumer prefers A & B to C

  25. C U3 = 100 (Preferred to U2) A B U2 = 50 (Preferred to U1) U1 = 25 Utility Functions & Indifference Curves Clothing (units per week) Assume: U = FC C 25 = 2.5×10 A 25 = 5 ×5 B 25 = 10 ×2.5 15 10 5 Food (units per week) 0 5 10 15

  26. Ordinal vs. 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.

  27. Budget Constraints Budget constraints limit an individual’s ability to consume in light of the prices they must pay for various goods and services.

  28. Budget Line The budget lineindicates all combinations of two commodities for which total money spent equals total income.

  29. Budget Line • Let F = amount of food purchasedC = amount of clothing purchased Pf=Price of foodPc =price of clothing M = money income • Then

  30. Budget Line

  31. A Budget Line F + 2C = $80 B D E G Budget Line Clothing (units per week) Pc= $2 Pf = $1 M = $80 (M/PC) = 40 30 20 10 Food (units per week) 0 20 40 60 80 = (M/PF)

  32. 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.

  33. Budget Line • 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.

  34. Budget Line • The vertical intercept (M/PC), illustrates the maximum amount of C that can be purchased with income M. • The horizontal intercept (M/PF), illustrates the maximum amount of F that can be purchased with income M.

  35. A increase in income shifts the budget line outward A decrease in income shifts the budget line inward L3 L2 L1 (M= $40) (M = $160) (M = $80) Effect of Income Change Clothing (units per week) 80 60 40 20 Food (units per week) 0 40 80 120 160

  36. An increase in the price of food to $2.00 changes the slope of the budget line and rotates it inward. A decrease in the price of food to $.50 changes the slope of the budget line and rotates it outward. L3 L1 L2 (PF = 1) (PF = 1/2) (PF = 2) Effect of Price Change Clothing (units per week) 40 Food (units per week) 40 80 120 160

  37. Consumer Choice Consumers choose a combination of goods that will maximize the satisfaction they can achieve, given the limited budget available to them.

  38. Conditions to Maximize Utility • The choice must be located on the budget line. • The choice must give the consumer the most preferred combination of goods and services.

  39. Consumer Choice • The MRS of an indifference curve is: • The slope of the budget line is: • Therefore, satisfaction is maximized where:

  40. Satisfaction Maximization Satisfaction is maximizedwhen marginal rate of substitution (of F and C) is equal to the ratio of the prices (of F and C).

  41. Pc= $2 Pf = $1 M = $80 B Budget Line -10C U1 +10F Consumer Choice Clothing (units per week) Point B does not maximize satisfaction because the MRS (-10/10) = 1 is greater than the price ratio (1/2). 40 30 20 0 20 40 80 Food (units per week)

  42. Pc= $2 Pf = $1 M = $80 D U3 Budget Line Consumer Choice Clothing (units per week) 40 Market basket D cannot be attained given the current budget constraint. 30 20 0 20 40 80 Food (units per week)

  43. Pc= $2 Pf = $1 M = $80 A U2 Budget Line Consumer Choice Clothing (units per week) At market basket A the budget line and the indifference curve are tangent and no higher level of satisfaction can be attained. 40 30 At A: MRS =Pf /Pc = .5 20 0 20 40 80 Food (units per week)

  44. D  A B  U3 U2 U1 Consumer Choice Clothing (units per week) Pc= $2 Pf = $1 M = $80 40 D is not available. A offers less satisfaction than B. B is the optimum choice. 30 20 Budget Line 0 20 40 80 Food (units per week)

  45. Marginal Utility andConsumer Choice Marginal utility measures the additional satisfaction obtained from consuming one additional unit of a good.

  46. Diminishing Marginal Utility • The marginal utility derived from increasing from 0 to 1 units of food might be 9 • Increasing from 1 to 2 might be 7 • Increasing from 2 to 3 might be 5

  47. Principle of Diminishing MU The principle of diminishing marginal utility states that as more and more of a good is consumed, consuming additional amounts will yield smaller and smaller additions to utility.

  48. Marginal Utility andIndifference Curve If consumption moves along an indifference curve, the additional utility derived from an increase in the consumption one good, food (F), must balance the loss of utility from the decrease in the consumption in the other good, clothing (C).

  49. Marginal Utility andConsumer Choice

  50. Equation for Utility Maximization

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