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Consumer Theory

Consumer Theory. Consumers choose the best bundles of goods they can afford. Can afford – Budget constraints . “Best” – according to preferences . Why is it useful? Predict behavior changes. Policy analysis. Consumption Choice Sets.

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Consumer Theory

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  1. Consumer Theory • Consumers choose the best bundles of goods they can afford. • Can afford – Budget constraints. • “Best” – according to preferences. • Why is it useful? • Predict behavior changes. • Policy analysis.

  2. Consumption Choice Sets • A consumption choice set is the collection of all consumption choices available to the consumer. • What constrains consumption choice? • Budgetary, time and other resource limitations.

  3. Fruity Example • You are going to the grocery. You buy 2 apples, 3 oranges, and 4 pears. Apples and Oranges cost £1 each and a pear is £2. How much do you spend? • If you have £10 to spend, what can you buy? • Prices of apples, oranges, and pears are represented by pa, po, pp and income is m. What can one buy?

  4. Budget Constraints • A consumption bundle containing x1 units of commodity 1, x2 units of commodity 2 and so on up to xn units of commodity n is denoted by the vector (x1, x2, … , xn). • Commodity prices are p1, p2, … , pn. • When is a consumption bundle (x1, … , xn) affordable at given prices p1, …, pn? • We usually deal with 2 commodities.

  5. Budget Constraints • The consumer’s budget set is the set of all affordable bundles;x1³ 0, … , xn³ 0 and p1x1 + … + pnxn£m • The budget constraint is the upper boundary of the budget set. • Draw budget set for general two goods. • What is affordable, just affordable, not affordable?

  6. Budget Constraints • For n = 2 and x1 on the horizontal axis, the constraint’s slope is -p1/p2. What does it mean? • Increasing x1 by 1 must reduce x2 by p1/p2 • This is the opportunity cost. • The budget constraint and budget set depend upon prices and income. What happens as prices or income change? • Does inflation hurt us?

  7. Ad Valorem Sales Taxes • An ad valorem sales tax levied at a rate of 5% increases all prices by 5%, from p to (1+0.05)p = 1.05p. • An ad valorem sales tax levied at a rate of t increases all prices by tp from p to (1+t)p. • A uniform sales tax is applied uniformly to all commodities. • Write the new budget constraint. • Can the government replace this with an income tax? (Sort of like old betting tax) • Subsidies are opposite of a tax (1-s)p.

  8. The Food Stamp Program • Food stamps are coupons that can be legally exchanged only for food. • How does a commodity-specific gift such as a food stamp alter a family’s budget constraint?

  9. The Food Stamp Program • Suppose m = £100, pF = £1 and the price of “other goods” is pG = £1. • The budget constraint is then F + G =100. • What is budget set after 40 food stamps are issued? • What if food stamps can be traded on the black market for £.50?

  10. Budget with Rationing • What does the budget look like if we ration good 1? • What happens if we tax all goods purchased above the ration at rate t?

  11. Fun Budget Constraints • Quantity Discounts: Suppose p2 is constant at £1 but that p1=£2 for 0 £ x1£ 20 and p1=£1 for x1>20. • Try drawing a 3-d budget constraint. (p1=p2=p3=1, m=3) • Coke machine doesn’t give change. Candy machine does. Must buy Candy with Coke, but Coke with Candy. • Negative Prices: one hour of work gives £3, can of Beer is £1. Have £5 already.

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