1 / 36

Economic Models for Individual Choice Behavior

Explore microeconomic decision-making processes, rationality, utility theory, and marginal utility in modeling human behavior for buying goods. Understand how scarcity and budget constraints impact maximizing utility.

mariokim
Download Presentation

Economic Models for Individual Choice Behavior

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript


  1. Chapter 2: Modeling Individual Choice • Purposes of Chapter • Venture into microeconomics. • Examining the economic decision process of consumers, a key component of the economic decision process of firms, and several complexities in modeling human behavior.

  2. Another Economic Fundamental: Rationality • Rationality – the behavior of economic units (i.e. individuals, firms, government) reflects the pursuit of an underlying goal.

  3. The “Underlying Goals” in Rational Economic Behavior • Based upon values, what the economic unit (consumer, firm, government) holds to be important. • Varies across different units. • Typically includes one or more constraints, reflecting scarcity. • Generally phrased in terms of “maximizing” or “minimizing,” possibly subject to (constraint).

  4. Individual Choice in Buying Goods:Theory • Individuals want to be as happy as possible. • Individuals gain happiness from the consumption of goods. • The more consumption the better, at least to a satiation point. • The happiness we gain becomes less and less as we consume more and more of any good.

  5. Individual Choice in Buying Goods:Model • Utility – happiness that individuals feel (measured in “utils”). • Utility – caused by levels of the various goods that we consume. • Utility Function – A explicit relationship which specifies the level of utility based upon the amounts of all the goods that we consume.

  6. Marginal Utility • Marginal Utility (MU)-- the change in utility (U) resulting from a change in the quantity of an individual good (Q) consumed. • In mathematical terms, MU = ΔU/ΔQ.

  7. Positive and Diminishing Marginal Utility • The more consumption the better, i.e. Q  U, Positive Marginal Utility • The happiness we gain becomes less and less as we consume more and more of any good i.e. Q  MU,  Diminishing Marginal Utility

  8. Utility and Marginal Utility: An Example • Suppose I get utility from consuming coffee (and other goods). • Suppose my utility from coffee, holding consumption of all other goods constant, looks as follows.

  9. My Utility From Coffee (All Other Goods Constant) Coffee (Cups)Utility (Utils) 0 0 1 100 2 185 3 245 4 295 5 325 6 340 7 340 8 320

  10. My Marginal Utility From Coffee (All Else Constant) Coffee (Cups)UtilityMarginal Utility 0 0 -- 1 100 100 2 185 85 3 245 60 4 295 50 5 325 30 6 340 15 7 340 0 8 320 -20

  11. Ceteris Paribus • Ceteris Paribus – Latin term, meaning “all else constant,” or in the context of theories and models, “all other causes constant”. • Fundamental concept in theories and models: most behavior has multiple causes. • One can only look sensibly at responses to changes in one cause at a time, therefore one needs to hold others constant.

  12. Utility and Marginal Utility: Multiple Goods • My utility is determined by consumption of a number of goods (call it n goods). • Notation: Q1 = quantity consumed of good 1, Q2 = quantity consumed of good 2, etc. MU1 = marginal utility of good 1, MU2 = marginal utility of good 2, etc.

  13. Condition for Maximizing Utility, No Scarcity of Goods • I can have as much as I want of any good for free. • Then to maximize utility, I should choose to consume quantities of each good until each of their marginal utilities equals zero. • In mathematical notation: I choose quantities of goods so that MU1 = MU2 = MU3 = … = MUn = 0.

  14. Maximizing Utility With Scarcity and Finite Budget • Scarcity  every good as a price. • Notation: P1 = price of good 1, P2 = price of good 2, etc. • A related issue: finite budget: I have so much I can spend. • Also called Budget Constraint.

  15. Maximizing Utility: Scarcity and Finite Budget • Then to maximize utility subject to being within my budget constraint, I should choose to consume quantities of each good according to two conditions. (1) I spend my entire budget. (2) The “marginal benefit-cost ratio” is equal across all goods, i.e. MU1/P1 = MU2/P2 = … = MUn/Pn.

  16. An Example • Suppose my world has two goods, steak dinners (S) and bottled water (W), and I get similar utility from consumption of each one. • The price of a steak dinner (PS) equals $25, while the price of bottled water (PW) equals $1.

  17. Maximizing Utility Subject to Budget Constraint • I should seek to consume quantities of steak dinners and water so that I spend my entire budget and MUS/PS = MUW/PW, or equivalently MUS/$25 = MUW/$1.

  18. The Solution • Thus, I should choose my consumption of steak dinners and water where the marginal utility of steak dinners is 25 times the marginal utility of water. • Diminishing marginal utility for both steak dinners and water  I should consume a small amount of steak dinners and a lot of water.

  19. Behavior of the Firm: The Production Function • The Production Function – A relationship for the individual firm that specifies how inputs (natural resources, labor, and capital) are combined to produce output. • Capital – physical capital (machines) and human capital (skills, innate and acquired).

  20. Marginal Product of Labor • Marginal Product of Labor (MPN)-- the change in output (Q) resulting from a change in the amount of labor employed (N), ceteris paribus on the other inputs. • In mathematical terms, MPN = ΔQ/ΔN.

  21. The Law of Diminishing Returns • The Law of Diminishing Returns – as a firm uses more and more of a given input such as labor, ceteris paribus on the other inputs, there will come a time when the marginal product of labor will decrease (i.e. Diminishing Marginal Product of Labor).

  22. Production and Marginal Product: An Example • Suppose King David’s (a Marshall Street eatery) employs labor and other inputs (e.g. food, electricity, cooking machines) to produce lunches. • Suppose their production function with labor, ceteris paribus on the other inputs, looks as follows.

  23. King David’s Production Function Labor Input (People)Output (Lunches) 0 0 1 10 2 25 3 50 4 70 5 86 6 95 7 101 8 104 9 93

  24. King David’s Marginal Product of Labor Labor Input (N)Output (Q)MPN 0 0 -- 1 10 10 2 25 15 3 50 25 4 70 20 5 86 16 6 95 9 7 101 6 8 104 3 9 93 -11

  25. So How Much Should King David’s Produce and Employ? • Assumption: King David’s seeks to maximize profits. • Therefore, not enough information for them to make this decision. • Need additional information on: -- cost per unit of each input -- price of their output -- market structure, or degree of competitiveness with other lunch eateries

  26. The “Relevant Region” of Production and Employment • Increased usage of inputs, ceteris paribus, imply more output, i.e. N  Q, Positive Marginal Product of Labor. • The Law of Diminishing Returns has set in, i.e. N  MPN, Diminishing Marginal Product of Labor.

  27. Additional Complexities in the Economic Decision Process • Realistically, life places complexities that influence the rational economic decisions of both consumers and firms. • Here, we just introduce two of them and motivate how they can be influential.

  28. Complexity #1 – The Present Versus The Future • Consumers: Should I buy and/or work now or later (existence of interest on savings, investment in human capital)? • Firms: Should I expand my physical capital by buying this machine (trading current costs versus future benefits)?

  29. Intertemporal Decisions • Intertemporal Decisions – rational economic plans for consumers and firms in assessing the future along with the present. • Mechanisms for weighing the present versus the future. • The Discount Rate • Present Value

  30. The Discount Rate • The Discount Rate – the rate, in percentage terms, that we are willing to trade off money received one year from now versus money received today. • Equivalent amounts received today and in the future are worth more today – need to discount future amounts.

  31. The Discount Rate: An Example • Suppose you have a choice between $300 today and a higher amount next year. Suppose as well that you decide that you’re indifferent between $300 today and $360 next year. • Your discount rate = [($360  $300)/($300)]x100% = 20%

  32. Characteristics of the Discount Rate • Consumers– depends upon different individual’s utility or preferences. • High Discount Rate: devalues the future sharply, “wants it now”. • Low Discount Rate: more willing to forego the present for the future. • Firms – the market interest rate is their ultimate discount rate.

  33. Present Value • Present Value– an explicit formula for converting the value of dollars received in future years to their current value equivalents. • Hugely important in many aspects of financial world (interest rates).

  34. Complexity #2 – Risk and Uncertainty • Key Issue: future is unknown, affects economic decisions. • Risk – unknown events to which we can attach a probability. • Uncertainty – absolutely un-thought of events which may end up occurring. • Uncertain events which in fact occur will convert into risky events.

  35. Incorporating Riskin Economic Decisions • We develop expectations of unknown events – our best guess of what we think will happen, then we act upon those (right or wrong). • We practice risk aversion – of different events with the same expected return, we prefer less risk.

  36. Conclusions – Economic Decisions • Intertemporal issues and risk/uncertainty place complexities on the rational decisions of consumers, firms, and even government • We won’t use them explicitly here, the basics still tell us a lot. • We covered the decision rule for consumers, for firms we got the process started.

More Related